ACCT 506 - Financial And Integrated Audits

Frederick Choo

Financial and Integrated Audits

1

Table of Contents 1 Financial and Integrated Audits

3

2 The Auditor's Professional Environment

23

3 The Auditor's Ethical Environment

47

4 The Auditor's Legal Environment

75

5 Audit Plan - Preplan and Documentation

103

6 Audit Plan - Objectives

137

7 Audit Plan - Evidence

165

8 Audit Plan - Internal Control

191

9 Audit Plan - Materiality and Risk

229

10 Audit Plan - Program and Technology

255

11 Audit Sampling for Tests of Controls

283

12 Audit Sampling for Tests of Balances

304

13 Revenue Cycle - TOC and TOB

324

14 Expenditure Cycle - TOC and TOB

362

15 Inventory Cycle - TOC and TOB

396

16 Payroll Cycle - TOC and TOB

430

17 Capital Cycle - TOC and TOB

452

18 General Cash and Investments - TOC and TOB

476

19 Completing the Audit

504

20 Audit Report

540

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21 Other Audit Engagements

588

Appendix A

630

Appendix B

631

Appendixes C D E

632

Appendix F

633

Financial and Integrated Audits - Frederick Choo

Chapter 1 Financial and Integrated Audits Chapter Learning Outcomes (LOs) Checklist

After reading this chapter, you should be able to: 

LO1-1 Understanding the reason for auditing.

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LO1-2 Distinguish among auditing, attestation, and assurance services.

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LO1-3 Differentiate between financial audit and integrated audit.

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LO1-4

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LO1-5 Explain the different categories of audit and types of auditor.

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LO1-6 Explain the organizational structure, category, and hierarchy of CPA firms.

Differentiate between assurance and consulting services.

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1 Financial and Integrated Audits

Chapter 1 Financial and Integrated Audits Definition of Auditing

Auditing may be defined as: "A systematic process of objectively obtaining and evaluating evidence regarding assertions about economic actions and events to ascertain the degree of correspondence between those assertions and established criteria and communicating the results to interested users." Source: Committee on Basic Auditing Concepts, Statement of Basic Auditing Concepts AAA, 1973, p.2.

Several key phrases of this definition merit special comment in Table 1-1. TABLE 1-1 Definition of Auditing

Key Phrase

    

A systematic process Objectively evaluating and examining of evidence

Comments Auditing is a logically structured and planned inquiry process. Auditing involves independently obtaining and gathering evidence, such as confirmations of balances, and objectively evaluating the sufficiency and appropriateness of this evidence.

These are assertions made explicitly and/or implicitly by the auditee with regard to the accounting Assertions about economic actions information presented to the auditor, for example, the auditee has valued inventories at the lower and events of cost or market value. Based on the evidence gathered, the auditor forms an opinion as to the closeness with which the Degree of correspondence between auditee's assertions comply with established standards and polices, for example, generally accepted assertions and established criteria accounting principles (GAAP) and other statutory rules and regulations. The auditor communicates the degree of correspondence between the auditee's assertions and Communicating results to established criteria in the form of an audit report to interested parties that include stockholders, interested users lenders and creditors.

The Demand for Auditing

The definition of auditing can further be discussed in terms of a principal-agent framework that explains the demand for auditing. See Figure 1-1 below for the relationships. First, stockholders (referred to as principals) of a corporation appoint a board of directors who in turn hires a professional management team (referred to as agents) to run the corporation. Second, both the stockholders and management seek to maximize their self-interest. Their goals/activities are not necessarily congruent. Third, the stockholders appoint an outside independent party (an external auditor) to monitor and report the goals/activities of the management. The auditor provides a form of attestation service, an auditing service, to the stockholders. Fourth, the external auditor gathers and evaluates evidence concerning the explicit and implicit assertio ns made by the management (auditee’s assertions) in the financial statements and reports to the stockholders about the fairness of the financial statements presentation in the form of an audit opinion report. If the management’s financial statements are presented fairly, the auditor issues an unqualified opinion report. On the other hand, if the management’s financial statements are not presented fairly, the auditor issues a qualified opinion report. See Table 1-2 for a brief description of the various types of audit opinion report. A qualified audit opinion usually means that the management’s financial statements contain material misstatements. Misstatements may be in the form of errors, unintentional mistakes, or frauds, intentional misrepresentations. Two common types of intentional misrepresentations are misappropriation of assets, also known as employee fraud, and fraudulent financial reporting, also kno wn as management fraud. Table 1-2 Types of Audit Opinion Report

Types of Audit Opinion Report Unqualified Opinion, Standard Report Unqualified Opinion, Explanatory paragraph Added Qualified Opinion

Brief Description This report isrespects, issued when the auditor judges results that theofclient’s financial present, inwith all material the financial position, operations, andstatements cash flowsfairly in conformity GAAP. This report is issued when the auditor judges that it is necessary to add a paragraph to explain certain accounting related matters in a standard unqualified opinion report. This report is issued when the auditor judges that the client’s financial statements fairly present, in


Types of Audit Opinion Report

Brief Description all material respects, the financial position, results of operations, and cash flows in conformity with GAAP “except for” the material effect of certain accounting related matters to which the qualification relates. This report is issued when t he auditor judges that the cli ent’s financial statements, taken as a whole, do not fairly present the financial position, results of operations, and cash flows in conformity with GAAP. This report is issued when the auditor does not express an opinion on the client’s financial statements.

Adverse Opinion

Disclaimer of Opinion

Figure 1-1 The Demand for Auditing in a Principal-Agent Framework

XYZ Company Stockholders

Board of Directors

XYZ Co. Management (Accountant)

Independent Auditor (External)

Audit Report (Opinion)

Unqualified

Qualified Attestation Service (Audit)

Financial Statements containing Management’s

Misstatement

Implicit/Explicit Assertions

Error

Fraud

Unintentional Intentional mistake misrepresentation

Misappropriation of assets (Employee fraud)

Fraudulent financial reporting (Management fraud)

The Demand of Other Users

The principal-agent framework above focuses on the stockholders as a primary party demanding audited financial statements. Besides the stockholders, there are a diversity of other users (other 3 rd parties) of the audited financial statements. Table 1-3 describes other users of the audited financial statements. Table 1-3 Other Users of Audited Financial Statements

User Bondholders Court System Economists

Use of Audited Financial Statements Assess the ability of a company to repay indebtedness. Assess the financial position of a company in litigation. Assess the effects of economic policies and the implications for public policy decisions.

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User

Use of Audited Financial Statements

Financial Institutions Labor Unions Management Potential investors Regulatory Agencies Taxing Authorities

Determine whether to make a loan to a company. Assess the profitability of a company and the potential for future wages or profit sharing contracts. Review performance and make decisions affecting future directions of a company. Determine whether to invest in a company. Determine whether regulatory action is necessary to protect the public. Determine taxable income and tax due.

Type of Services

CPA firms provide five broad types of services as shown in Table 1-4. Table 1-4 Five Broad Types of Services

Type of Service



Attestation services



Tax services



Management advisory (consulting) services



Accounting services



Assurance services

Nature of Service Attestation services are any professional services in which a CPA firm issues a written report that expresses an opinion or conclusion about the reliability of a written assertion that is the responsibility of another party. Attestation services include financial audit of private (non-publicly traded) companies and integrated audit of public (publicly traded) companies; report on a client's internal control structure; review of private companies' financial statements; examination of prospective financial statements, and application of agreedThe AICPA’s Auditing upon procedures on specific elements, accounts, or items of a financial statement. Standard Board issues Statements on Auditing Standards (AUs), which provide guidance for CPAs who perform financial audit for private companies. On thether o hand, the SEC’s Public Company Accounting Oversight Board (PCAOB) issuesAuditing Standards (ASs), which provide guidance for CPAs who perform integrated audit for public companies. Table 1-5 describes four broad types of attestation services. See Appendix A for a list of the AUs and see Appendix B for a list of the ASs. Tax services include preparation of tax returns, assistant in tax planning, and engagement in tax litigation. The AICPA's Federal Taxation Executive Committee issues Statements on Responsibilities in Tax Practice (SRTPs), which provide guidance for CPAs who perform tax services. Management consulting services include design of accounting information systems, and engagement in marketing study, and executive recruiting. The AICPA's Management Advisory Service Executive Committee issues Statements on Standards for Management Advisory Services (SSMASs), which provide guidance for CPAs who perform management advisory services. Accounting services include preparation of financial statements and compilation of financial statements. The AICPA's Accounting and Review Services Committee issues Statements on Standards for Accounting and Review Services (ARs), which provide guidance for CPAs who perform accounting services. See Appendix D for a list of the ARs. Assurance services are independent professional services that improve the quality of information, or its context, for decision-makers. By this broad definition, assurance services include attestation services in that they improve the quality of information for decision-makers by issuing a written report about the reliability of certain written assertions ofanother party. Assurance services also encompass compilation services in that they improve the quality of information for decision-makers by presenting (compiling) them as financial statements in accordance with GAAP. However, assurance services do not include consulting services although they often deliver a similar body of knowledge and skills. A key difference between assurance and consulting services is the objective of the engagement. Assurance services are designed to optimize the client’s decision making whereas consulting services are designed to improve the client’s outcomes or conditions. The AICPA's Auditing Standards Board issues Statements on Standards for Attestation Engagements (ATs), which provide guidance for CPAs who perform accounting services. Table 1-6 describes six common types of assurance services. See Appendix C for a list of the ATs.

CPA firms provide four broad types of attestation services that are described in Table 1-5. Table 1-5 Four Broad Types of Attestation services

Four Broad Types of Attestation services



Financial Audit (private company)

Integrated Audit (public company)

nce about a client’s financial statements. The AICPA ’s This type of service involves obtaining and evaluating evide GAAP and Auditing Standard Board’s Auditing Standard AU 700 require that auditors of private companies in the United States to provide an opinion on the company’s financial statements. Based on this financial audit, the auditor issues a “positive” (means certain or confident) expression of opinion on whether the financial statements are presented fairly in conformity with the GAAP and Auditing Standards. Figure 1-3 presents an overview of the financial audit.

This type of service involves obtaining and evaluating evidenceabout a client’s internal control over financial reporting (ICFR) and its financial statements. The Sarbanes-Oxley Act Section 404(b) and PCAOB ’s Auditing Standard AS 5 require that auditors of public companies in the United States to provide an opinion on the effectiveness


Four Broad Types of Attestation services



Examination



Review



Agreed-upon procedures

of the company’s ICFR and an opinion on the company’s financial statements. Based on this integrated audit, the auditor issues an opinion on the effectiveness of the client’s ICFR and an opinion on the fair presentation of the financial statement in accordance with the standards of the PCAOB. Figure 1-4 presents an overview of the integrated audit. This type of service involves obtaining and evaluating evidence about a variety of situations which contain assertions made by another party. The auditor performing this type of service normally follows the AICPA’s Statements on Standards for Attestation Engagements (ATs). Based on the examination, the auditor issues “apositive” expression of opinion on whether the other party’s assertion conforms to certain applicable criteria. Examples of examination services include (1) prospective (rather than historical) financial statements, (2) management’s assertions about the effectiveness of a client’s internal control structure, and (3) a client’s compliance with specified laws and regulations. This type of service involves inquiries of an audit client’s management and comparative analyses of financial information. The scope of this service is significantly less than that of an audit or examination in that it usually does not involve obtaining and evaluating evidence. The auditor performing this type of service normally follows the AICPA’s Statements on Standards for Accounting and Review Services (ARs). Based on the review, the auditor issues a “negative” (means uncertain or unconfident) expression of opinion on whether the financial statements are presented fairly in conformity with established criteria such as GAAP. Thus, instead of stating a “positive” opinion that “the financial statements are presented fairly in conformity with GAAP”, a “negative” opinion is usually stated as that “ we are not aware of any material modifications that should be made to the statements in order for them to be in conformity with GAAP.” Examples of review services include (1) review of interim financial statements of public companies and (2) review of annual financial statement of non-public companies. This type of service involves the auditor, the client, and the intended users to agree on certain procedures to be performed on specified financial statement/non-financial statement matters. The auditor performing this type of service normally follows the AICPA’sStatements on Standards for Attestation Engagements (ATs) for financial matters (e.g., gross sales account for a lease agreement) and non-financial statement matters (e.g., compliance with federal issues a “summary of findings” report, affirmative action laws). Based on the agreed-upon procedures, the auditor which does not include an opinion.

Figure 1-3 An Overview of the Financial Audit (Private Company)

Management

Financial Audit

Implements internal controls

Conducts transactions

Attests to management’s internal controls

Accumulates transactions into account balances

Prepares financial statements

Issues financial statements

Attests to management’s financial statements

Issues audit report: 1. An opinion on the fair presentation of the financial statements

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Figure 1-4 An Overview of the Integrated Audit (Public Company)

Management

Integrated Audit

Attests to management’s report on ICFR

Reports on ICFR

Management Report on ICFR contains an explicit statement on whether management’s assessment of ICFR is effective as of the end of the period reported on

Issues audit report: 1. An opinion on the effectiveness of the company’s ICFR

Attests management’s financial statements

Prepares financial statements

Issues audit report: 2. An opinion on the fair presentation of the financial statements

Issues financial statements

ICFR = Internal Control Over Financial Reporting

CPA firms offer a wide variety of “other” assurance services. The six common “other” assurance service are shown in Table 1- 6. Chapter 21, Other Audit Engagements , provides more discussion on some “other” assurance services and attestation services of the assurance services. Table 1-6 Six Common “Other” Assurance Services

Type



Risk Assessment



Business Performance Measurement

  

Information Systems Reliability Electronic Commerce

Healthcare Performance

Function This assurance service identifies a client’s profile of business risks and assesses whether the client has appropriate systems in place to effectively manage those risks. This assurance service evaluates whether a client’s performance measurement system contains relevant and reliable measures for assessing the degree to which the client’s goals and objectives are achieved or how its performance compares to its competitors. This assurance service assesses whether a client’s internal information systems (financial and non-financial) provide reliable information for operating and financial decisions. This service assesses whether systems and tools used in electronic commerce provide data integrity, security, privacy, and reliability.See Figure 21-15 inChapter 21 for an example of a WebTrust report. This assurance service assesses and reports on the quality of care delivered by health care


Type

Function

Measurement



systems, and to provide comparative analyses on costs and delivery systems. This assurance service provides assistance to elderly people and their family members by offering financial advice and measuring how effectively health care providers meet the needs of the elderly and their families.

Elder Care

A diagrammatic representation of the relationship among the professional services is shown in Figure 1-2. Figure 1-2 Relationships among Professional Services

Assurance Services

Nonassurance Services

Attestation services Examination

Review

Financial Audit

Integrated Audit

Certain Management Consulting Services E.g., Fraud Investigation

Management Consulting Services

Tax Services

Agreed-Upon Procedures Accounting Services Compilation Risk Assessment

Web/SysTrust

XBRL

ElderCare Plus

Health Care

Performance Measurement

Source: Adapted from the Elliott Committee Report (AICPA, 1997)

The five broad types of services shown in Table 1-4 above fall into four categories of audit (see Table 1-7) and they are usually conducted by several types of auditor (see Table 1-8). Table 1- 7 Four Categories of Audit

Category of Audit



Financial audit



Integrated audit



Compliance audit



Operational audit

Nature of Work This type of service involves obtaining and evaluating evide nce about a client’s financial statements. The AICPA’s GAAP and Auditing Standard Board’sAuditing Standard AU 700 require that auditors of private companies in the United States to provide an opinion on the company’s financial statements. Based on this financial audit, the auditorissues a “positive” (means certain or confident) expression of opinion on whether the financial statements are presented fairly in conformity with the GAAP and Auditing Standards. See Figure 1-3 for an overview of the financial audit. about a client’s internal control over This type of service involves obtaining and evaluating evidence financial reporting (ICFR) and its financial statements. The Sarbanes-Oxley Act Section 404(b) and PCAOB’s Auditing Standard AS 5 require that auditors of public companies in the United States to provide an opinion on the effectiveness of thecompany’s ICFR and an opinion on the company’s financial statements. Based on this integrated audit, the auditor issues an opinion on the effectiveness of the client’s ICFR and an opinion on the fair presentation of the financial statement in accordance with the standards of the PCAOB. See Figure 1-4 for an overview of the integrated audit. A compliance audit involves reviewing internal controls, operational procedures, and regulations. This type of audit attests whether internal procedures of management and external regulations of regulatory authorities are complied with. The outcome of a compliance audit is a report prepared by (or recommendation made by) the auditor to the management or the relevant authorities. An operational audit involves analyzing organization structure, internal functions, workflow, and managerial performance. This type of audit determines (or measures) the efficiency and effectiveness of an organization. The outcome of an operational audit is a report prepared by (or recommendation made by) the auditor to the management or the relevant authorities.

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Table 1-8 Types of Auditor

Category of audit Financial Audit Integrated Audit Compliance Audit Operational Audit

Type of auditor

Affiliation

CPA

AICPA, CPA Associations

IRA, Internal Auditor, DCA Federal and State Auditor

IRS, IIA, DCA Agency US Government Accountability Office (GAO), State Auditors

IRA

= Internal Revenue Agent

IIA DCA CFE CIA CISA CFP CFF

= Defense Institute Contract of Internal Auditors = Auditor = Certified Fraud Examiner = Certified Internal Auditor = Certified Information Systems Auditor = Certified Financial Planner = Certified in Financial Forensics

Title CPA, CFE, CFP, CISA, CFF, etc. CIA

The function of the various types of auditor is shown in Table 1-9. Table 1-9 Function of Various Types of Auditor

Type of Auditor







CPA

IRA, Internal Auditor, DCAA

Federal and State Auditor

Function An independent or external auditor (CPA) performs financial audit and integrated audit. The independent auditor is either an individual practitioner or a member of a public accounting firm. For private companies, the CPA’s work focuses on the fair presentation of financial statements and accounting records. The CPA i s responsible for reporting (in the form of an audit opinion) to the stockholders. For public companies, the CPA performs an integrated audit which focuses on the effectiveness of internal control over financial reporting (ICFR). The CPA is responsible for reporting on the fair presentation of the company’s financial statements as well asthe effectiveness of the company’s ICFR. Internal Revenue Agent (IRA) An internal revenue agent's work focuses on the compliance with and enforcement of federal tax law. The IRA also audits the income tax returns of individuals and corporations. The IRA reports to the Commissioner of Internal Revenue. Internal Auditor (CIA) An internal auditor's work focuses on compliance with operational procedures and regulations. The CIA’s work may supplement the work of an independent auditor in a financial audit. The CIA reports to the management of an entity. Defense Contract Audit Agent (DCAA) A defense contract audit agent's work focuses on the compliance and fulfillment of defense contracts. The DCAA reports to the Department of Defense. The U.S. Government Accountability Office (GAO) auditor (federal auditors) and the state Auditor General Office auditor (state auditors) perform operational audits. A federal or state auditor's work focuses on the effectiveness and efficiency of federal or state departments and agencies. The federal auditor of GAO, headed by the comptroller general, reports to Congress while the state auditor reports to the respective state governments.

Table 1-10 provides brief comments on the six organizational structures of CPA firms. Table 1-10 Organizational Structure of CPA Firms

Organizational Structure



Proprietorship



General Partnership



General Corporation



Professional Corporation (PC)

Brief Comments Traditionally, all one-owner CPA firms were organized as proprietorships, but in recent years, most of them have changed to organizational structures with limited liability because of increased litigation risks. This organizational structure is the same as a proprietorship, except that is applies to multiple owners. This organizational structure has also become less popular as other organizational structures that offer some legal liability protection became authorized under state laws. The advantage of a corporation is that stockholders are liable only to the extent of their investment in the corporation. Most CPA firms do not organize as general corporations because they are prohibited by law from doing so in most states. A professional corporation provides professional services and is owned by one or more stockholders. PC laws and the resulting liability protection vary significantly from state to state. PC laws in some states offer personal liability protection similar to that of general corporations, whereas the protection in other states is minimal. This variation makes it difficult for a CPA firm with clients in different states to operate as a PC.


Organizational Structure

 

Limited Liability Company (LLC)

Limited Liability Partnership (LLP)

Brief Comments A limited liability company combines the most favorable attributes of a general corporation and a general partnership. An LLC is typically structured and taxed like a general partnership, but its owners have limited personal liability similar to that of a general corporation. Currently, nearly all of the states have LLC laws, and most also allow accounting firms to operate as LLCs. A limited liability partnership is owned by one or more partners. It is structured and taxed like a general partnership, but the personal liability protection of an LLP is less than that of a general corporation or an LLC. Partners of an LLP are personally liable for the partnership’s debts and obligations, their own acts, and acts of others under their supervision. Partners are not personally liable for liabilities arising from negligent acts of other partners and employees not under their supervision. It is not surprising that all the Big Four CPA firms and many smaller CPA firms now operate as LLPs.

Table 1-11 describes the organizational category of CPA firms. Table 1-11 Organizational Categories o f CPA Firms

Category



Local CPA Firms



Regional CPA Firms



National CPA Firms



The “Big 4” International CPA Firms



Other Category

Brief Comments Local CPA firms typically have one or two offices, include only one CPA or a few CPAs as partners, and serve clients in a single city or area. These firms usually provide income tax, management consulting, and accounting services. Auditing service is usually only a small part of the practice and tends to involve small business concerns that find a need for audited financial statements to support applications for bank loans. Many local CPA firms have become regional CPA firms by opening additional offices in neighboring cities or states and increasing the number of professional staff. Merger with other local firms is often a route to regional status. This growth is often accompanied by an increase in the amount of auditing as compared to other services. CPA firms with offices in most major cities in the United Stated are called national CPA firms. They are also referred to as “second tier” CPA firms (the first tier is the “Big 4”). The national CPA firms may operate internationally as well, either with their own offices or through affiliations with firms in other countries. Since the beginning of 1990s, mergers of the then “Big 8” international CPA firms and the di ssolution of the then Arthur Andersen LLP have reduced them to the “Big 4” international CPA firms. Since only a very large international CPA firms has sufficientstaff and resources to audit a large corporation, these “Big 4” CPA firms audit nearly all of the largest American corporations (the “Fortune 500” corporations). Although these firms offer a wide range of professional services, auditing services typically represent the largest share of their profession services. Annual revenue of an international CPA firms is in the billions of dollars. In alphabetical order, the “Big 4” CPA firms are Deloitte & Touche LLP, Ernst & Young LLP, KPMG LLP, and Pricewaterhouse-Coopers LLP. Since the late 1990s, a number of publicly traded companies such as American Express, CBIZ, Inc., and H&R Block began acquiring CPA firms. These companies are often referred to as “consolidators” because they acquire CPA firms in various cities and consolidate them into their overall corporations. They usually only acquire the non-attestation services division of the CPA firms and absorb the non-attestation services partners and other personnel of the acquired CPA firms as employees of the overall corporations. Then they “outsource” back these non-attestation services partners and other personnel to the remaining attestation/auditing services partners of the acquired CPA firms to provide attestation/auditing services for the overall corporations.

Table 1-12 describes the organizational hierarchy of CPA firms. Table 1-12 Organizational Hierarchy of CPA Firms

Level

 

Staff Accountant or Associate Senior or in-charge Accountant



Manager



Partner

Average Experience

Typical Responsibilities

0-2 years

Performs most of the detailed audit-field-work.

2-5 years

Coordinates and is responsible for the detailed audit-field-work, including supervising and reviewing staff work. Helps the senior or in-charge auditorplan and manage the audit, reviews the incharge’s work, and manages relations with the client. A manager may be responsible for more than one engagement at the same time. Reviews the overall audit work and is involved in significant audit decisions. A partner is an owner of the firm and therefore has the ultimate responsibility for

5-10 years

10+ years

conducting the audit and serving the client.

Figure 1-5 shows organization of a typical CPA firm.

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Figure 1-5 Organization of a Typical CPA Firm

Executive Committee Managing Partner

Practice Offices Partners-in-Charge

Tax Services

Auditing, Attestation, and Assurance Services

Partner

Manger

Advisory and Accounting Services

Partner

Manager

Senior or in-charge accountant

Staff accountant or associate






A Brief History of Auditing

The last Table 1-13 in this Chapter presents a brief history of auditing. Table 1-13 A Brief History of Auditing

Time



In the 60s and 70s

A Brief History of Auditing In the 60s and 70s, the detection of fraud began to assume an important role in auditing. Auditing standards used the term “irregularities” to describe fraudulent financial reporting and misappropriation of assets. Auditors began to take on a greater responsibility for the detection of fraud because (a) there was an increase in congressional pressure to account for fraud in large corporations, (b) there were a number of successful lawsuits claiming that fraudulent financial reporting had gone undetected by the independent auditors, and (c) there was a perception by the public that the auditors should be expected to detect material fraud. Consequently, the major accounting organizations (including the AICPA) sponsored National the Commission on Fraudulent Financial Reporting (the Treadway Commission or COSO) to study the causes of fraudulent reporting and make recommendations to reduce its incidence. The commission’s final report, which was issued in 1987, made a number of recommendations for auditors, public companies, regulators, and educators. Many of the recommendations for auditors were enacted by the AICPA in a set of Statements on Auditing Standards (AUs) known as the “expectation gap” standards. In addition, the commission’s recommendations about internal control led to the development of an internal control framework, titled Internal Control-Integrated Framework, which was to be used to evaluate the internal control of an organization. Overall, the development of these internal control concepts and criteria had increased the demand for auditors to attest to the effectiveness of an


Time



In the 80s and 90s



In the 2000s

A Brief History of Auditing organization’s internal control. In the 80s and 90s, the billions of dollars in federal funds that were required to “bail out” the Saving and Loan industry caused a movement toward increased regulation of federally insured financial institutions. Congress and regulatory agencies believed that the key to preventing such problems was to enact effective laws and regulations and to require auditors to report on compliance with provisions of these laws and regulations. In 1996, in response to a continuing expectation gap between user demands and auditor performance, the AICPA issued standards that require the auditors to explicitly assess the risk of material misstatement in all financial statement audits. Later, these standards were replaced with even more stringent standards that require the auditors to design specific audit procedures that can detect fraudulent financial reporting. Meanwhile, the vast improvement in information technology has resulted in the need for auditors to develop innovative computer assisted auditing techniques (CAATs) in auditing. Consequently, a special group of

auditors, as the Certified Information Systems Auditor (CISA), was formed to specialize in auditing computer known information systems. In 2001, Enron Corporation filed for bankruptcy after acknowledging that fraudulent accounting had been used to significantly inflate its earnings. Shortly thereafter, it was revealed that WorldCom had also used fraudulent accounting to significantly overstate its reported income. At the same time, there were a record number of public companies restating their prior-period financial statements. Consequently, investors began to question the reliability of financial statements and the credibility of the auditing profession. These events drew quick responses from a number of congressional committees, the SEC, and the U.S. Justice Department. In 2002, Congress passed the Sarbanes-Oxley Act of 2002, which imposed reforms such as the increased penalties for corporate fraud; the restriction on management consulting services that the auditors can perform, and the creation of the Public Company Accounting Oversight Board (PCAOB) to oversee the auditing profession. The PCAOB has broad power to issue and enforce auditing standards, and to register CPA firms that audit public companies. Thus, the establishment of the PCAOB has significantly reduced the auditing profession’s power in self-regulation. Consequently, auditors who perform financial audit for private companies follow the AICPA’s Statements on Auditing Standards (AUs) whereas auditors who perform integrated audit for public companies follow the PCAOB’s Auditing Standards (ASs). In 2010, the Dodd-Frank Act of 2010 amended Section 404 of the Sarbanes-Oxley Act by exempting certain smaller companies from the requirement for an integrated audit of their internal control over financial reporting (ICFR). However, management of these smaller companies must still provide their annual assessment of the effectiveness of internal controls.

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Multiple-Choice Questions 1-1

The primary objective of an independent audit is a. to gather and evaluate evidence. b. to investigate errors and irregularities. c. to form an opinion about the fairness of a client's financial statements. d. to match a client's assertions on financial items with established criteria.

1-2

An audit that determines thestrength of a client's internalcontrols or its conformity withtax law is not classified asa(n) a. internal audit. b. tax audit. c. financial audit. d. compliance audit.

1-3

The independent auditor is ultimately responsible to a. the client's management. b. the client's management and stockholders. c. the client's board of directors. d. the client's stockholders and board of directors.

1-4

Attestation services performed by a CPA include a. audit, review and tax services. b. audit, review and compilation services. c. audit, review and management consulting services. d. audit, review and examination services.

1-5

Operational auditing is primarily concerned with a. future improvement to accomplish the goals of management. b. the accuracy of data reflected in management’s financial records. c. verification that a company’s financial statements are fairly presented. d. past protection provided by existing internal control.

1-6

“Other assurance services” are similar to, yet differ somewhat from, attestation services. When performing “other assurance services,”

the CPA a. is not required to issue a written report, and the assurance is about the reliability and relevance of information. b. is required to issue a written report, and the assurance is about the reliability and relevance of information. c. is not required to issue a written report, and the assurance is about the completeness and sufficiency of information. d. is required to issue a written report, and the assurance is about the completeness and sufficiency of information. 1-7

Which of the following audits can be regarded as solely “compliance” audits? a. An independent CPA firm’s audit of the local school district. b. An internal auditor’s review of his employer’s payroll authorization procedures. c. GAO auditor’s evaluation of the computer operations of governmental units. d. Internal Revenue Service Agents’ examinations of t he returns of taxpayers.

1-8

A CPA certificate is evidence of a. recognition of independence. b. culmination of the educational process. c. basic competence at the time the certificate is granted. d. membership in the AICPA.

1-9

The use of the title CPA is regulated by a. the federal government through the licensing department of the Commerce Department. b. state law through the licensing department of each state. c. the AICPA through the licensing departments of the tax and auditing committees. d. the Securities and Exchanges Commission (SEC).


1-10

An examination of part of an organization’s procedures and methods for the purpose of evaluating efficiency and effectiveness is what type of audit?

a. Production audit. b. Financial statement audit. c. Compliance audit. d. Operational audit. 1-11

CPA firms have as their primary responsibility theperformance of the audit function on published financial statements of a. all corporations. b. all corporations listed on the New York Stock Exchange. c. all publicly-traded companies. d. all federally-charted corporations.

1-12

In response to the growing demand for assurance ofbusiness transacted electronically overthe Internet, the AICPA created a. Information System Reliability assurance services. b. CPA WebTrust assurance services. c. AICPA WebPartner assurance services. d. Internet Reliability assurance services.

1-13

The independent auditor is primarily accountable to a. the management of an audit client because the auditor is hired and paid by the management. b. the audit committee of an audit client because that committee is responsible for coordinating and reviewing the audit. c. stockholders, creditors, and the investing public. d. the SEC because it determines the responsibility of the auditor.

1-14

Assurance services involves all of the following except a. improving the quality of information for decision making. b. improving the quality of the context for decision making. c. improving the relevance of information. d. improving the outcome of an information system.

1-15

The work of an internal auditor is best described as a. an audit of a company’s compliance with management’s policies and procedures. b. an evaluation of a company’s susceptibility to fraud. c. an audit of company’s computer systems. d. an audit of a company’s efficiency and effectiveness.

1-16

Which of the following best describes why an independent auditor reports on financial statements? a. Independent auditors are likely to detect fraud. b. Competing interests may exist between management and the users of the financial statements. c. Independent auditors are likely to correct misstated account balances. d. Ineffective internal controls are likely to be discovered by the independent auditors.

1-17

Who is primarily responsible for the assertions in financial statements? a. Audit partner in charge of the audit engagement. b. Senior auditor in charge of audit field work. c. Staff auditor in charge of audit work papers. d. Audit client’s management.

1-18

In performing an attestation engagement, a CPA typically a. supplies litigation support services. b. assesses control risk at a low level. c. expresses a conclusion in the form of a written communication about an assertion. d. provides management consulting advice.

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1-19

Which of the following professional services would be considered an attest engagement? a. A consulting service engagement to provide computer advice to a client. b. An engagement to report on compliance with statutory requirements. c. An income tax engagement to prepare federal and state tax returns. d. The compilation of financial statements from a client’s accounting records.

1-20

The main objective of assurance services is to a. provide more reliable information for decision makers. b. provide confidential information for decision makers. c. improve the quality of information for decision makers. d. improve the quantity of information for decision makers.

1-21

“Other assurance services”performed by a CPA include

a. ElderCare Plus, Web Trust, and review. b. Risk Assessment, business performance measurement, and certain management consulting. c. Examination, electronic commerce, and compilation. d. Audit, review, and agreed-upon procedures. 1-22

The Sarbanes-Oxley Act of 2002 and PCAOB Standard No.5 require an integrated audit for publicly traded companies in States. This integrated audit is usually performed by which of the following types of auditor? a. Internal auditor (CIA) of a public company. b. Internal revenue agent (IRA) or defense contract audit agent (DCAA). c. Federal, state, or local government auditor. d. Certified public accountant (CPA).

1-23

In 2002, Congress passed the Sarbanes-Oxley Act of 2002 that did not impose which of the following reforms? a. The creation of the Government Accountability Office (GAO). b. The increased penalties for corporate fraud. c. The restriction on management consulting services. d. The creation of the Public Company Accounting Oversight Board (PCAOB).

1-24

Which of the following statements accurately describes U.S. CPA firms that are not sole proprietorships? a. The firm will be subject to an annual peer review. b. The most common organizational structure is the limited liability partnership structure. c. Most derive the majority of their revenues from tax services. d. The number of other professionals within a firm generally equals the number of partners in the firm.

1-25

Which of the following isthe total number of opinion in a financial auditand an integrated audit?

Number of opinion

I. II. III. IV.

Financial Audit None One Two Three

Integrated Audit Two Three Two Three

a. I b. II c. III d. IV

Key to Multiple-Choice Questions

1-1c. 1-2 c. 1-3 d. 1-4 d. 1-5 a. 1-6 a. 1-7 d. 1-8 c. 1-9 b. 1-10 d. 1-11 c. 1-12 b. 1-13 c. 1-14 d. 1-15 a. 1-16 b. 1-17 d. 1-18 c. 1-19 b. 1-20 c. 1-21 b. 1-22 d. 1-23 a. 1-24 b. 1-25 b.

the United


Simulation Question 1-1 Simulation Question 1-1 is an adaptation with permission from a case by Walker, P. L., W.G. Shenkir, and C.S. Hunn in Issues the in Accounting Education , a publication of the American Accounting Association in Sarasota, Florida. This simulation question is based upon a true set of facts. The information contained in the simulation question was obtained from publicly available sources.



Introduction

Prudential Insurance Company of America(hereafter, PI), whose symbol is the Rock of Gibraltar, assures its customers that “for financial security and peace of mind” they could depend on the Rock. For years its advertisements built its “Rock-Solid” image. PI was created around its people, who were committed to a set of core values lauded by management: client focus, winning, trust, and respect for each other. The company was dedicated to “selling the right product, to the right client, in the right way.” Yet for Prudential customers, se lling the right product in the right way proved to result in something less than “peace of mind.”



The Nicholsons’ Story



What Went Wrong?

Keith and Carol Nicholson trusted their financial security to the PI when they purchased a rather sizable life insurance policy from their PI agent. At one point, the policy’s cash value was $103,000. Since Keith suffered from leukemia, this policy was comfort for the unstable times that lay ahead of them. Carol needed to know that this money was going to be there. Carol had been known to say that she trusted her PI agent as she trusted her pastor. He was going to play a vital role in smoothing a eith very uncertain future. Therefore, when her agent suggested that she and her husband take out a new life insurance policy on K “at no additional cost,” the couple agreed, no questions asked. They just signed the forms, believing that they had bought even more certainty to the unpredictable future. Eventually, Keith succumbed to leukemia. Much to Carol’s surprise, the six figure nest egg that she thought would be awaiting her was now a mere $22,000. Carol’s agent had not been honest when he had Carol and her husband changed his life insurance policy. The Nicholsons’ agent had taken advantage of the couple’s trust by having them borrow against their old policy to purchase a new and more expensive policy.1 Without even realizing it, Carol and Keith had signed a blank withdrawal form that allowed their agent to raid the cash value of the old policy to begin to pay for the new policy. Carol’s reaction was a tearful plea of “How could they?” You should access Data File 1-1 in iLearn for PI is a massive entity whose asset base is equivalent to the economy of Sweden. Table 1, which presents the top ten life/health insurers ranked by assets, and Table 2, which presents them ranked by premium income. PI’s primary businesses were life insurance, health care, investments, and property and casualty insurance. Of all the different types of insurance

being offered by PI and its competitors, life insurance was the most lucrative for both the company and its agents. From 1983 through to 1987, PI You should access Data File saw record-breaking increases in its sales of life insurance policies, even though the industry saw a decline in sales. 1-1 in iLearn for T able 3, which presents PI’s total life insurance sales-1987, 1982 and Table 4, which presents industry life insurance purchases in the United States. Carol and Keith Nicholson were not the only victims of PI’s churning scam. Before the end of 1995, over10.7 million life insurance f the policyholders had allegedly fallen prey to the scam and a class action lawsuit was soon filed. Additionally, investigations o nations’ largest life insurer spanned the country, from New Jersey to Florida to Arizona, in an ffort e to answer the question, “How could they?”

In 1996,sales as part of the Florida Department of Insurance’s ofprocess PI, a former PIcustomers Vice -President of insurance. Regional Marketing testified regarding practices. In part of his testimony, the witnessinvestigation discussed the of how buy life WITNESS: They said that their agent sits there, and he says sign there, sign here, sign here, sign here, and I have to trust in the agent. I sign; he turns it over and says sign here, sign here, and sign here. I sign. Most people, even after they signed them, didn’t take them home and read them. That is what it’s like applying for life insur ance. The Nicholsons were among the many insurance customers who just signed forms as instructed by their agent. According to this e-PI employee, the most prevalent financing scam at PI was selling a new policy as “free life insurance” by essentially using theaccumulated cash value of an older policy t o pay the new, i ncreased premiums. In many cases, the old “whole life” or “universal policy” was re placed with a “term” policy. The former policies build up cash value, whereas “term” policies do not. In some cases, insured persons would increase their total life insurance coverage because they had more overall coverage from the term policy. In his two days of testimony, the confidential witness commented as follows: WITNESS: I would say financing was minuscule in ’82, ’83, ’84 and – then started growing rapidly in ’85, ’86,’87,’88, and then started to level off probably in ’90,’91.’92, and then may have gone down a little bit in ’93, ’94. PI contended that such practices were never condoned. Under oath, the ex-employee stated otherwise: WITNESS: That has always been Prudential’s public statement, financing and replacement is bad; not generally in the best inte rests of the policy holder … At the peak, it was used in at least 30 percent of the cases and probably higher. According to a Coopers & Lybrand’s (now PricewaterhouseCooper LLP) assessment of PI’s controls: Training of field management with respect to supervising sales practices and identifying and dealing with compliance-related issues has been inconsistent at best. Assuch, managers are not always sure as to what constitutes “good” vs. “bad” sales practices, are reactive toward compliance issues, and are not held accountable for their own actions or those of their representatives. PI, like many life insurers during this period (1982-1993), offered a very complex product. Without adequate instruction, many agents felt as if they had been misled about what they were selling. Even so, it should be noted that many PI employees were fully aware of the consequences of their actions. The deposed former employee noted that there existed an informal system of training on refinancing policies. The witness told how this manipulative practice was able to spread: WITNESS: What happens is because there is no formal training of this kind of thing; it passes by word of mouth or by transfer of people. So it doesn’t surprise me that you will find it pop up here or pop up there. Then after these people got to be very successful, they would go to conferences and say, illustration sold nicely, too.“this is how we do it.” An then it spread countrywide, and my belief is it really got heavy in ’84 and ’85 because

1

Such a tactic is referred to as a “churning,” “financing,” or “refinancing.”

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employee remarked that many agents set up booths at the Regional Business Conference in an effort to “illustrate” the art of The exselling financed insurance. The employee also claimed that, in support of these practices, many agents developed and used their own sales materials, as revealed by testimony on these self-developed materials: QUESTION: Typically, would he [management] say anything about it? Would he care? WITNESS: I don’t know. I’m not sure. But keep in mind that the managers are paid overrides. If there is a piece that appears to be working, they’re not going to stop using it, because it affects their pocketbook. The former PI worker also discussed the monetary consequences of churning: QUESTION: So … this document [a memo] would indicate that the company knew way back in ’76 that financed insurance was regularly producing unacceptable results? WITNESS: Correct. And the next question is why it was producing unacceptable results. Did you [Prudential] look into it? Did you rudential didn’t care [Prudential] ascertain what occurred in the sale that produced unacceptable results? The answer is nothing. The reason that P was they were sales driven. Everything was measured off new sales … There was a benefit to the agents, to management, to individu als working for the company, because their bonuses grew dramatically … If you look at the pay scale of management in 1976, a seniorvice president in 1976 probably made $$100,000 a year, a lot of money. A senior vice president in the company today probably in the same position might make a million dollars a year. Now inflation has been eating away a lot since 1976, but I don’t think it ate ten times … so there was a financial incentive for he employees, all employees, not just senior people. The incentive for the salesperson was simply commissions. Characteristically, a large percentage of the premium paid by the consumer in the first year went directly to the agent. That commission shrunk in later years. The ex-employee further elaborated upon this subject in the second day of his testimony: WITNESS: Another file you would want to look at is Phoenix West. That was an investigationnedolast year [1995] … As a result of that investigation, there were recommendations with regard to the discipline of many, many people; but if you look at that whole investigation, you will see the attitude of the company toward people who were engaged in wrongful financial insurance transactions over a long period of time, with the knowledge of many people … They merely state that we did it because we made money and we didn’t care … And Phoenix W est is just a microcosm of what was really going on in the country. John Vetter, an insurance representative in the beleaguered Phoenix West Agency, admitted to some questionable sales. In an investigation of the Phoenix West Agency, the Florida Department of Insurance documented that: He [John Vetter] said your judgment gets clouded out in the field when you are pressured to sell, sell, sell. In response to questions on how he could explain a case where he had rewritten a policy instead of reinstating it when the rewrite resulted in a higher premium for the insured, he responded that it was “pure greed.” With everyone in PI benefiting financially from refinanced life insurance policies, there seemed to be no need to stop, regardless of management’s “official” stance on the issue: WITNESS: You will probably see that in Prudential all the documents that you see or the bulk of the documents you see will be very good on their face, they’ll say “you shall not do this.” The problem was that there was nothing behind “you shall not do this.” There was no mechanism to punish. In fact, I don’t believe you’ll find a single termination of an agent or member of management for financing insurance outside of Cedar Rapids and a couple of other districts in the 80s. The ex-employee felt not only that management condoned churning, but also that management explicitly allowed it. Many PI customers complained about their new life insurance policies before this scandal fully surfaced in 1994, and, according to this ex-employee, PI addressed such complaints in the following manner: WITNESS: … whenever they [the customer] had a complaint, the first thing they had to do if they had an oral complaint, they hadto put it in writing. That knocked down a number of the complaints right away because most of our customers, because most of their educational level and because of their financial circumstances, hesitated to put things in writing. The second thing we did is we would get the complaint and then would ask the agent what the agent did. If the agent said he did it right, we would deny the complaint and we would hold to that denial through three or four subsequent complaints. And basically we didn’t actually do an investigation except to get the statementof the person who was complained about, and that was the position in Prudential probably until late 1994. Some PI executives did seek changes, given the growing number of customer complaints (although it was later alleged that not all complaints were logged into the company’s database). One such measure was having the customer sign a release verifying that he or she fully understood the terms and conditions of his or her new policy. Testimony recounts the reaction to such a measure: WITNESS: The next one is a memo [dated August 29, 1995 ] from Bill Hunt [Head of Ordinary Agencies]: “I do not believe we should have the applicant sign off on anything. Not only does this imply a lack of trust toward agents, it also has the potential to build skepticism from the prospective insured regarding what they are being sold.” Basically what he is saying is he is not going to ask him to sign anything because it could disrupt the sale. The selling of life insurance has become a complex process. Clearly, customers frequently do not understand the product they are buying, but instead appear to place a high level of trust in their agent. That trust places additional burdens and responsibilities on agents and PI itself. It also appears evident that sales practices such as churning and refinancing were not only widespread but may have been occurring for an extended period of time. The witness implied that financial incentives may have encouraged this activity and that management’s att itude toward controls and problems was questionable.



A New CEO

As early as 1982, the company’s internal auditors reported to the Board of Directors fraudulent practices on the part of sales agents. In addition, internal audits of individual divisions and regional offices in the early 1990s detailed a failure by management to enforce consumerprotection laws and regulations. In a June 1994 report commissioned by PI in the wake of regulatory inquiries about insurance sales practices, Coopers & Lybrand stated that PI officials failed to act adequately upon such warnings. The Board admitted that it had been made aware of “major irregularities,” but they continually asserted that they trusted management’s claims that the problems were being prop erly monitored. In November 1994, PI’s Board of Directors turned to Arthur Ryan (the president of Chase Manhattan Corp.) This was the first time in over 120 years that PI had looked outside the company to fill the position of CEO. Lacking any formal background in the field of insurance, his reputation was built upon his ability to streamline operations and introduce new technology. He is renowned to rolling up his sleeves at his own computer. He enjoys working one-on-one and is perfectly comfortable at center stage of the company auditorium. Simply put, Ryan is direct, open, focused, and engaged.



The New CEO’s Reaction and Changes


Ryan had made a conscious choice to change PI’s business approach. Under Ryan’s command, PI would no longer be a “series of independent silos, freewheeling subsidiaries working at cross-purpose with fragmented game plans.” The buzzword at Ryan’s PI would be about facilitating teamwork and cooperation. To break from the past, Ryan began recreating PI’s management team. Much of t he old guard was released. Ryan hired twelve ofthe 14 executives who reported directly to the CEO. Of the top 150 executives, two-thirds were new, and half of these replacements were newcomers to PI. Ryan also decided on cutbacks like those that had won him much praise at Chase Manhattan. Within two years of Ryan’s arrival,a workforce of 100,000 had been reduced to 83,000. Ryan also eliminated about $790 million in overhead by shutting down five regional headquarters (that had once been proud outposts for the company’s management). He also sold the home-mortgage operation, thereby reducing the company’s exposure in the homeowner’s insurance side of the business. By the end of 1995, Ryan’s restructuring had ed result in seven major operating groups: individual insurance, money management, securities, healthcare, private asset management, international insurance, and a diversified group. Although Ryan’s actions would appear to be a step in the right direction, not all of his streamlining was met with open arms. The company’s insurance sales force, which numbered 20,000 when Ryan came to PI, swa cut in half within four years. The company fired or counseled out agents who could barely sell enough insurance to cover the costs of their employee benefits. During the first months of 1997, more than 1,600 junior and senior insurance-sale managers were still going through “very severe reviews.” As a result, about 100 of these employees left PI. Ryan’s labor troubles did not end with complaints from the sales force over tighter controls. In an effort to mitigate some of the damage to PI’s bottom line resulting from the churning scandal, PI attempted to increase agent production quotas. The proposed labor contract would have increased quotas by 25 percent, but the union representing PI’s insurance agents rejected the deal. In 1998, PI officials estimated that the class-action suit could cost PI as much as $2 billion. Many questions still remain for Ryan, but for the customers of PI, the most significant question remaining is, “Has enough been done to ensure that they will no be the next Carol Nicholson?”

Required 1. a. Research the risk framework suggested by the Special Committee on Assurance Services (also known as Elliott Committee) at the AICPA’s website: http://www.aicpa.org b. Assume you were engaged by PI toprovide “Risk Assessment” assurance services. Identify and discuss the following risks associated with PI for the period from the 1980s and the early 1990s: i. Marketing and sales risks ii. Corporate culture risks iii. Strategic risks A document that may help you in answering 1.b. is the AICPA’s statement of Position 98-6,Reporting on Management’s Assessment Pursuant to the Life Insurance Ethical Market Conduct Progra m of the Insurance Marketplace Standards Association. 2. Assume you were engaged by PI to provide “Risk Assessment” assurance services. Suggest controls that should be established to manage the risks identified in 1.b.

Note: These controls are not the traditional internal controls. Rather, they are controls that are needed to help PI manage its risk and ultimately achieve its objectives. e of Sponsoring Organization’s (COSO) report, A document that may help you in answering SQ1-1 is the Committe Internal Control-Integrated Fr amework (also known as the Treadway Commission Report).

Simulation Question 1-2 Simulation Question 1-2 is an adaptation with permission from a case by Phillips, F. and D. Kalesnikoff inIssues the in Accounting Education , a publication of the American Accounting Association in Sarasota, Florida. This simulation question is based upon a true set of facts. The information contained in the simulation question was obtained from publicly available sources.



Introduction

Professor Irene Ballinger is founder and chief executive officer of Q-Dots Incorporated (hereafter, QDI) – a small, private company that operates adjacent to Cornell University in Ithaca, NY. QDI has pioneered ways to mass produce and manipulate nanoscopic fragments of silicon, which are called “quantum dots.” In addition to being extremely small, consisting of only a few hundred atoms, quantum dots have the unique capability of being “tuned” to light-up in any color by simply changing their size. Dr. Ballinger first reported the properties of quantum dots or q-dots, as she calls them, at an academic conference in June 1999. A discussant at the conference commented that the discovery might be useful in a broad array of applications, ranging from microscopic lighting to television display. Intrigued by these possibilities, Ballinger set out to determine whether the theory could be applied in practice. After nearly two years of further research, she discovered that Q-dots could be used in multiphoton microscopy. Simply put, with q-dots, Ballinger could make tiny blood vessels beneath a mouse’ skin appear so bright and vivid in high-resolution images that she could see the vessel walls ripple with each hearbeat-100 times a second. Ballinger referred to this application as a Q-light – a finding that published in a leading academic journal in May 2001.

Within a few months, Ballinger began receiving enquiries from scientists around the world about the availability of Q-lights for use in their laboratories. In late 2001, Ballinger decided to create QDI (a private company), employing a team of nanotechnology engineers to fully develop the Q-lights and make the marketable to a broader base of customers. In addition, Ballinger hired a management team to “take care fo the business side of things.” The management team purchased a 25 percent interest in QDI when it was incorporated at the beginning of January 2002.

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The first line of Q-lights was completed and available for commercial distribution in March 2002. Q-lights were an immediate success, and have become one of QDI’s primary sources of revenue. The other major source of revenue for I QD is the manufacture and distribution of “raw” Q-dots that other researchers are using to develop their own new product applications. Things had been going well for Ballinger and QDI until August 14, 2004, when Ballinger received a letter from attorneys at the University of California, Berkeley claiming that Ballinger’s Q-lights “discover” took place several months later than a similar discovery by a team of researchers from Berkeley. Patent applications had been filed by both Ballinger’s management team and the Berkeley team around the same time, and it is not clear which researchers, if any, will be granted the patent for multiphoton microscopy. The Berkeley attorneys threaten legal action if QDI does not immediately stop production and sale of Q-lights. These threats have shaken Ballenger, who now wants out of the commercial side of her scientific work. She has said, “The last thing I want is to have my research lab shut down.” She has advised her management team to ship Q-lights only to existing customers and to store any excess dots Q- production at a colleague’s research lab in Pittsburgh. Fortunately for Ballinger, the QDI management team does not view the legal action as a credible threat, and has agreed to purchase Ballinger’s shares under the terms set out in Table 1. You should access Data File 1-2 in iLearn for Table 1, which presents details of the purchase-and-sale agreement.



Request for “Business Performance Measurement” Assurance Services

Your CPA firm has been providing tax services to QDI since it was incorporated as a private company on January 1, 2002. In 2004, QDI also engaged your firm to provide “business performance measurement” assurance services. Specifically, Ballinger would ke your li firm to look at the numbers that will be used to determine the purchase-and-sale price and to analyze the purchase-and-sale agreement to make absolutely certain that she is rewarded fairly for what she contributed to QDI.

Required Tom Cohen, the assurance services partner in your CPA firm’s office has asked you to review the proposed terms of the agreement (see Table 1) and the notes he made during his meeting with Ballinger (see Table 2). You should access Data File 1-2 in iLearn for Table 1, which presents details of the purchase-andsale agreement, and Table 2, which presents Tom Cohen’s notes on information gathered from Dr. Ballinger.After reviewing these two documents, Tom Cohen also would like you to write him a report that identifies and analyses significant engagement issues pertaining to this “business performance measurement” assurance services. Your report should consist of three

parts that fully address the questions provided in each part as follows: Part 1: Regarding the proposed buy-out agreement. a. What are the strong and weak points of the proposed buy-out agreement? b. What is it that has to be measured for the buy-out to occur? c. What skills are required in performing this measurement? d. What level of assurance can be reached? e. Will this level of assurance meet the needs of Dr. Ballinger? f. Will this level of assurance meet the needs of QDI’s management? g. What are the 3.0 and 1.5 multipliers intended to represent? h. What are the implications of the non-compete clause? i. What suggestions/advice should Tom Cohen make with regards to the proposed agreement? Part 2: Regarding litigation a. Who is bearing the risk of the litigation? b. What are the ramifications if Berkeley’s threat of litigation becomes a reality? c. What would be the implications of losing a law suit to Berkeley? Part 3: Regarding financial reporting a. What are your general thoughts on management’s accounting decisions? b. Is management’s write-off of Q-lights and Q-screen product development costs consistent with their earlier communicated thoughts on the litigation? c. Is the payment to lobbyists unethical or just smart business? d. Does the payment to lobbyists constitute an asset or expense? e. If the payment to lobbyists is an expense, is it an operating or non-operating expense? f. How does the FBI contract fit with principles governing revenue recognition? What about conservatism? What makes sense given the situation? g. Is management’s decision to expense the Q-prints development and production costs consistent with fundamental accounting concepts and principles? Note: Your report must not be a list of answers to the above questions. It must be written in a report format with Parts 1, 2 and 3 as three sub-headings.


Simulation Question 1-3 Simulation Question 1-3 is an adaptation with permission from a case by R. N. Schmidt and F. Phillips inIssues the in Accounting Education , a publication of the American Accounting Association in Sarasota, Florida. This simulation question is based upon a true set of facts. The information contained in the simulation question was obtained from publicly available sources.



Introduction

Assume that you are an audit manager at KST LLP, a mid-sized public accounting firm located in northern Colorado. Recently, you attended a local Oktoberfest celebration and had the opportunity to be seated at a table with Sammy Blitz —the CEO of a local private manufacturing firm. Always looking for the opportunity to extend your network of contacts and potential clientele, you engage in an insightful conversation with Sammy and learn a great deal about him and his business, both of which have interesting backgrounds.

Background  Company Blitz Bow Corporation (BBC) is a manufacturer of archery equipment with a predominant focus on manufacturing high-quality bows for competitive archers and bow hunting enthusiasts. BBC was incorporated in 1977 when former repeat summer Olympic competitor Samuel (Sammy) Blitz, with the financial support of his sister, Lauren Blitz, began to manufacture bows for archery competitors. Since 1983, BBC has exclusively sold its bows through its single retail store located immediately beside its manufacturing facility. The proximity of the manufacturing facility and retail store has allowed Sammy to maintain strict quality control over BBC products while also permitting patrons the opportunity to tour the manufacturing facilities. Despite the demands of owning and managing a family business, Sammy took time and great pride in watching his son, Brandon, share in his passion for the sport of archery. After enjoying success as a junior amateur, Brandon later pursued a mechanical engineering degree. Now, Brandon is the VP of Operations at BBC, and for nearly a decade Sammy and Brandon have worked closely together at BBC leading a team on product innovations. Although relatively small compared to its competitors in terms of gross sales, BBC has established itself as a North American leader in product innovation and as such has reaped the benefits of the strong consumer brand loyalty that typically plagues the sports market. Specifically, BBC has changed its product line from initially focusing on traditional recurve bows, which are the only bows permitted at the Olympic Games, to compound bows. Innovation in the archery industry, market preferences, and resurgence in bow hunting have established compound bows as the fastest growing market niche in the bow manufacturing industry. Consumers in the compound bow market demand specific features to maximize their probability of success in the field. In particular, the bow's ability to propel arrows with high levels of kinetic energy is critical to bow hunting enthusiasts (widel y referred to as “knock down power”), in addition to flat arrow trajectory, accuracy, and quiet operation. In regard to the first two features, bow manufacturers have focused on modifying the design of the bow to mechanically maximize arrow speed, which is a key driver for kinetic energy and flat trajectory. As such, bow manufacturers use their estimates of arrow speed in their advertising campaigns to differentiate their bows from competitors. Moreover, consumer research conducted by the archery industry has documented that this single measure of foot-per-second arrow speed is an important determinant in the consumer's choice to purchase a particular bow, despite the fact that bows that offer blazing arrow speeds often do so at the cost of reduced accuracy and increased noise of operation. Given that every incremental foot per second is important, consumers demand that manufacturers furnish a highly accurate estimate of arrow speed for every bow model.



The Meeting

your office plans, window, youphone are reminded thick layer of snow that December hashave arrived. As your mindthat slips to asked your upcoming Looking weekend out snowboarding your rings. Itbyisthe your receptionist announcing that you a drop-in client has specifically to meet with you. Glancing at the clock, you realize that it is already 4:00 p.m. on Friday, but are always happy to meet with potential new clients. You open the boardroom door and are surprised to see a familiar face —Sammy Blitz. After a brief catch up over coffee, the conversation turns to business. Sammy: “Thank you for seeing me on such short notice. I was happy to have the opportunity to meet you several months ago, and I noted your interest then in our business at BBC.” You: “It was my pleasure. How can I be of service?” Sammy: “With the new line-up of bows set to be unveiled next month, I was recently informed about the advertising campaigns of my competitors. I'm tired of seeing my competitors make up stories about how great their bows are. This really has gotten out of control. Given the structural complexities in compound bows, manufacturers have seen the opportunity to make ridiculous statements with limited to no support for their claims.” You: “What are some examples?” Sammy: “Our closest competitor, Wicked Axis Archery, came out with a new line of bows this year whicht claims i are ‘quiet as a mouse.’ In truth, Wicked bows vibrate violently when you release the arrow, to the extent that the sound would wake the dead! Another competitor, ProCam , is misleading consumers in i ts claims that its cam designs deliver superior ‘let-off' for the archer at full draw. Perhaps what is bothering me the most is the marketing campaign of the newest entrant to the bow manufacturing market, Bow Fever. This company is advertising that its bows are able to deliver arrow speeds of 365 feet per second, when in truth these speeds are being determined in conditions that take advantage of the more flexible IBO standards rather than the more stringent ATA standards. As we had discussed in October, arrow speed is arguably the most critical element that manufacturers focus on, given its importance to consumers. It is no secret that we take great pride at BBC to make our bows capable of sending arrows at the fastest speeds in the industry. We view Bow Fever's claims as a serious threat to our future profitability.” You: “Sounds like you either need a lawyer or a new engineer. How can I help you today?” Sammy: “I just got back from a bow manufacturer association conference last week. Consumers are seriously complaining about the arrow speed claims of the bow manufacturers. I'm concerned because customers who have been loyal to BBC for years have begun to question whether they can trust our arrow speeds. They suspect that all manufacturers are overstating their arrow speed ratings. Heck, it documented in virtually archery forum. and TakeI want a look, example, archerytalk.com. all being with theissame broad brush. I shareevery in theonline customers' concerns, to for make sure ouratcustomers can trustWe're that our bows painted deliver what we say they deliver—an honest to goodness 360-feet-per-second arrow speed. We have carefully constructed our quality control processes to ensure that every bow is manufactured to the specified ratings. I want to cut to the point. My son, Brandon, recalls from one of his elective university courses that there is some sort of service that public accountants can provide that increases the credibility of numbers. Basically, what I want is for you to back up my claim that our bow shoots arrows at 360 feet per second. Actually, now

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that I think of it, maybe we should be more aggressive and assert that our bows shoot arrows faster than any of our competitors. What do you think? Is there some ort s of service you folks can do?” You: “Let me look into this for you, Sammy. May I ask why you are interested in our firm?” Sammy: “Well, you folks are accountants. Accountants know how to deal with numbers, and this arrow speed number in feet per second is an important number to me and my customers. I figured you would know how to help me out. Also, I'm confident that your firm has the necessary expertise. In fact, I know several of your colleagues from the local archery club. I believe Erich is a partner, and Sarah and John have recently started with your firm, maybe a year or two ago. Unfortunately, Erich must have left early for the weekend, because he wasn't available earlier. Let him know that I hope he is bett er at accounting than shooting!” You: “I'll be sure to pass on the joke.” You promised to check into the situation and get back to Sammy on Monday. After Sammy left the office, you slouched back in your chair. You believed that you would be considered for promotion to senior manager if you could secure BBC as a client to the — firm a client that Erich, the office audit partner, would be eager to have. You accessed your online auditing and attestation standards, and also did some quick research on compound bow dynamics and industry guidelines on bow speed ratings. You should access Data File 1-3 in iLearn for Exhibit 1, which presents a picture of a compound bow; Exhibit 2, which presents notes on the dynamics of a compound bow, and Exhibit 3, which presents notes on ATA and IBO criteria for Bow Speed Rating. You then started writing a memo to Erich striving to explain what specific

types of engagements the firm could provide BBC to meet its needs. Furthermore, you tried with your current limited knowledge of BBC's business to outline anticipated complexities involved with the proposed engagement.

Required Write a memo to Erich, the office audit partner, with regard to the following: 1. Explains what types of engagement your CPA firm should provide to BBC. Should it be auditing, attestation, assurance, or other types of service? 2. What specific auditing, attestation, assurance, or other standards should you consider as a guide for this engagement? 3. Based on Exhibits 1, 2, and 3, and your current limited knowledge of BBC’s compound bow, explainhow would you test Sammy’s assertion that his compound bow shoots at 360 feet per second? Note: A document that may help you in answering SQ1-3 is PCAOB AT Section 101, Attest Engagement .


Chapter 2 The Auditor’s Professional Environment Chapter Learning Outcomes (LOs) Checklist


LO2-1 Understand the AICPA’s influence on the auditor’s professional environment .



LO2-2 Describe four fundamental principles underlying an audit (AICPA).



LO2-3 Describe the AICPA’s six elements of quality control.



LO2-4 Understand the Securities and Exchange Commission’s (SEC’s) influence on the auditor’s professional environment.



LO2-5 Summarize the duties of the Public Company Accounting Oversight Board (PCAOB).



LO2-6 Understand multiple sets of standards for the audit of public, private, and foreign companies



LO2-7 Explain the influence of the Corporate and Criminal Fraud Accountability Act of 2002.



LO2-8 Discuss the influence of the International Federation of Accountants (IFAC) and the International Standards on Auditing (ISAs).



LO2-9 Identify some key changes required by the SEC that affect the audit committee.

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Chapter 2 The Auditor’s Professional Environment The American Institute of Certified Public Accountants (AICPA) and Securities Exchange Commission (SEC) are the two major forces that influence the auditor’s professional environment. The AICPA’s influence is depicted in Figure 2-1. Figure 2-1 AICPA’s Influence on the Auditor’s Professional Environment

AICPA Influences CPA firms and individual CPAs through

Auditing Standard Board (ASB) Previously promulgated

10 Generally Accepted Auditing Standards (GAAS)

CPA Firms Division Professional Ethics Peer Review Board Executive Committee (PEEC) Directs

Peer Review Program

Quality Control Standards Committee

Enforces

Code of Professional Conduct (CPC)

Establishes

6 Elements of Quality Control

Audit Practice and Quality Centers (CAQ) Improves

Audit Practice Quality

Currently replaced by

4 Fundamental Principles Detailed guideline in

More than 100 Statements on Auditing Standards, labeled as AUs # in Topical Order

Organized into 6 topical contents

AU 200 General Principles and Responsibilities AU 300-499 Risk Assessment andResponse to AssessedRisks AU 500 Audit Evidence AU 600 Using the Work of Others AU 700 Audit Conclusions and Reporting AU 800-999 Special Considerations

the Auditor’s Professional Environment AICPA’s Influence on

The AICPA is a national professional organization. Its membership is voluntary; however, a majority of CPAs are members of AICPA. The AICPA’s influence on the auditor’s professional environment is briefly discussed in Table 2-1.


Table 2-1AICPA’s Influence on the Auditor’s Professional Environment

Division/Committee



Auditing Standards Division (ASB)



CPA Firms Division



Professional Ethics Executive Committee (PEEC)





Quality Control Standards Committee

Audit Practice and Quality

Center (CAQ)

Influence An important arm of the Auditing Standards Division is the Auditing Standards Board (ASB), which promulgates the 10 generally accepted auditing standards (GAAS) that guide the quality of audit services. Compliance with the 10 GAAS is mandatory for members of AICPA who perform auditing and other related professional services. See Table 2-2 for details. Detailed guideline to the 10 GAAS are provided by more than 100 Statements of Auditing Standards (AUs) issued by the ASB. The AUs are labeled by their AU numbers #, which are based on the topical content with which they are issued. For example, the Statement on Auditing Standards, Consideration of Fraud in a Financial Statement Audit , is labeled as AU 240. As part of improving clarity and converging with international auditing standards, the ASB replaced the previously promulgated 10 GAAS with a more comprehensive and coherent description of the “Principles Underlying an Audit in Accordance with Generally Accepted Auditing Standards .” These fundamental principles are grouped into four categories: (1) the purpose and premise of an audit, (2) personal responsibilities of the auditor, (3) auditor actions in performing the audit, and (4) reporting. They are referred to as the Four Fundamental Principles underlying an audit. See Table 2-3 for details. In addition, as part of improving clarity and converging with international auditing standards, the more than 100 AUs are reorganized into six groups in a new AU codification scheme: (1) AU 200 General Principles and Responsibilities, (2) AU 300-499 Risk Assessment and Response to Assessed Risks, (3) AU 500 Audit Evidence, (4) AU 600 Using the Work of Others, (5) AU 700 Audit Conclusions and Reporting, and (6) AU 800-999 Special Considerations. For example, the Statement on Auditing Standards, Consideration of Fraud in a Financial Statement Audit , is grouped under General Principles and Responsibilities as AU 240 (previously AU 316). See Appendix A for details. With the passage of the Sarbanes-Oxley Act of 2002, the auditing standards to be used in the audits of public companies (integrated audits) are to be established and promulgated by the Public Company Accounting Oversight Board (PCAOB). Consequently, the AICPA reconstituted the ASB as a body with the authority to establish the auditing standard to be used in the audits of private companies (financial audits). This means that a CPA practicing in the United States normally performs an integrated audit of a public company in accordance with the auditing standards (ASs) established by the PCAOB, and normally performs a financial audit of a private company in accordance with the auditing standards (AUs) established by the ASB. In addition, the PCAOB adopted and retained the ASB’s previously promulgated 10 GAAS as part of its interim auditing standards; thus, auditors performing an integrated audit for a public company must continue to follow the 10 GAAS until they have been superseded by a PCAOB standard. In the CPA Firms Division, membership is granted to CPA firms, not to individual CPAs. This division consists of two sections: theSection Securities and Exchange Practice Section (SECPS) the Private Companies Practice (PCPS). CPA firmsCommission voluntarily join either, or both, sectionsand based on the type of clients that they serve. Each section promotes a high quality of services offered by the CPA firms. For example, the SECPS requires audit partners on SEC audit clients to be rotated at least every seven years, mandatory peer (or quality) review (every three years) and mandatory continuing education for firm personnel (120 hours every three years). The executive committees of the two sections have the power to sanction member firms for poor quality services. These sanctions may include additional education requirements, special peer reviews, fines, and suspension or expulsion from the CPA Firms Division. The Professional Ethics Executive Committee (PEEC) enforces the Code of Professional Conduct (CPC) and interprets Rules of Conduct (more discussion in Chapter 3). The CPC is essential because a distinguishing mark of a profession is its acceptance of responsibility to the public. The Quality Control Standards Committee monitors a peer (or quality) review program among the CPA firms. Every three years, members of the CPA Firms Division must subject their practice to a Peer (or Quality) Review Program. A peer (or quality) review involves a study of the adequacy of the reviewed firm's established quality control policies and procedures (see Table 2-5), and tests the extent of the reviewed firm's compliance with these policies. Typically, these tests consist of areview of selected working paper filesand audit reports. A peer (or quality) review may be performed by another CPA firm (a firm review), by a state CPA society or association, the Quality Review Executive Committee (a committee-appointed review team), or by a regional association of CPA firms (an association review). The reviewer issues a report stating their conclusions and recommendations. The AICPA has established audit practice and quality centers as resource centers to improve audit practice quality. In addition to these resource centers for CPA firms, the AICPA has established audit quality centers for governmental audits and employee benefit plan audits.

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TABLE 2-2 10 Generally Accepted Auditing Standards (PCAOB)

10 Generally Accepted Auditing Standards General Standards

1. 2. 3.

The audit must be performed by a person or persons having adequate technical training and proficiency as an auditor. In all matters relating to the assignment, an independent mental attitude is to be maintained by the auditor or auditors. Due professional care is to be exercised in the performance of the audit and the preparation of the report.

Standards of Field Work

1. 2.

3.

The auditor must adequately plan the work and must properly supervise any assistants. The auditor must obtain a sufficient understanding of the entity and its environment, including its internal control, to assess the risk of material misstatement of the financial statements whether due to error or fraud, and to design the nature, timing, and extent of further audit procedures. The auditor must obtain sufficient appropriate audit evidence by performing audit procedures to afford a reasonable basis for an opinion regarding the financial statements under audit.

Standards of Reporting

1. 2. 3. 4.

The report shall state whether the financial statements are presented in accordance with generally accepted accounting principles. The report shall identify those circumstances in which such principles have not been consistently observed in the current period in relation to the preceding period. Information disclosures in the financial statements are to be regarded as reasonably adequate unless otherwise stated in the report. The report shall either contain an expression of opinion regarding financial statements, taken as a whole, or an assertion to the effect that an opinion cannot be expressed. When an overall opinion cannot beexpressed, the reasons thereof should be stated. In all cases where an auditor's name is associated with financial statements, the report should contain a clear-cut indication of the character of the auditor's work, if any, and the degree of responsibility the auditor is taking.

Table 2-3 Four Fundamental Principles Underlying an Audit (AICPA)

Four Fundamental Principles Purpose of an Audit and Premise upon which an Audit is Conducted

1. The purpose of an audit is to provide financial statement users with an opinion by the auditor on whether the financial statements are presented fairly, in all material respects, in accordance with the applicable financial reporting framework. An auditor’s opinion enhances the degree of confidence that intended users can place in the financial statements. 2. An audit in accordance with generally accepted auditing standards is conducted on the premise that management and, where appropriate, those charged with governance, have responsibility a. for the preparation and fair presentation for the financial statements in accordance with the applicable financial reporting framework; this includes the design, implementation, and maintenance of internal control relevant to the preparation and fair presentation of financial statements that are free from material misstatement, whether due to fraud or error; and b. to provide the auditor i. all information, suchwith as records, documentation, and other matters that are relevant to the preparation and fair presentation of the financial statements; ii. any additional information that the auditor may request from management and, where appropriate, those charged with governance; and iii. unrestricted access to those within the entity from whom the auditor determines it necessary to obtain audit evidence. Responsibilities

3. Auditors are responsible for having appropriate competence and capabilities to perform the audit; complying with relevant ethical requirements; and maintaining professional skepticism and exercising professional judgment, throughout the planning and performance of the audit. Performance

4. To express an opinion, the auditor obtains reasonable assurance about whether the financial statements as a whole are free from material misstatement, whether due to fraud or error. 5. To obtain reasonable assurance, which is a high, but not absolute, level of assurance, the auditor a. plans the work and properly supervises any assistants. b. determines and applies appropriate materiality level or levels throughout the audit. c. identifies and assesses risks of material misstatement, whether due to due to fraud or error, based on an understanding of the entity and the environment, including the entity’s internal control. d. obtains sufficient appropriate audit evidence about whether material misstatements exist, through designing and implementing appropriate responses to the assessed risks. 6. The auditor is unable to obtain absolute assurance that the financial statements are free from material misstatement because of inherent limitations, which arise from a. the nature of financial reporting; b. the nature of audit procedures; and c. the need for the audit to be conducted within a reasonable period of time and so as to achieve a balance between benefit and cost. Reporting

7. Based on an evaluation of the audit evidence obtained, the auditor expresses, in the form of a written report, an opinion in accordance with the auditor’s findings,in or accordance states that an opinion cannot befinancial expressed. The opinion states whether the financial statements are pr esented fairly, in all material respects, with the applicable reporting framework.


11 Attestation Standards (AICPA and PCAOB)

Other attestation services such as agreed-upon procedures services get little or no specific guideline from the 10 GAAS because those standards relate primarily to historical financial statements prepared in accordance with GAAP for the auditing service. This problem has been addressed by the Auditing Standards Board through the issuance of 11 Attestation Standards that parallel the previously 10 GAAS. Following the same framework used for auditing standards, detailed interpretations of the 11 Attestation Standards are provided in more than 10 Statements on Standards for Attestation Engagements (ATs). For example, AT 501 An Examination of an Entity’s Internal Control Over Financial Reporting That Is Integrated With an Audit of Its Financial statements . Table 2-4 describes the 11 Attestation Standards. See Appendix C for a list of the ATs. In addition, the AICPA’s Accounting and Review Services Committee Auditing issued a number of Statements on Standards for Accounting and Review Services (ARs) that provide guideline for other attestation services such as review services. For example, AR 50 Standards for Accounting a nd Review Services. See Appendix D for a list of ARs. The PCAOB adopted and retained both the ATs and ARs as part of its interim auditing standards. Table 2-4 11 Attestation Standards (AICPA and PCAOB)

11 Attestation Standards General Standards 1. The engagement shall be performed by a practitioner having adequate technical training and proficiency in the attest function. 2. The engagement shall be performed by a practitioner having adequate knowledge in the subject matter. 3. The practitioner shall perform an engagement only if he or she has reason to believe that the subject matter is capable of evaluation against criteria that are suitable and available to users. 4. In all matters relating to the engagement, independence in mental attitude shall be maintained by the practitioner. 5. Due professional care shall be exercised in the planning and performance of the engagement. Standards of Field Work 1. The work shall be adequately planned and assistants, if any, shall be properly supervised. 2. Sufficient evidence shall be obtained to provide a reasonable basis for the conclusion that is expressed in the report. Standards of Reporting 1. The report shall identify the subject matter or assertion being reported on and state the character of the engagement. 2. The report shall state the practitioner’s conclusion about the subject matter or the assertion in relation to the criteria against which the subject matter was evaluated. 3. The report shall state all of the practitioner’s significant reservations about the engagement, the subject matter, and, if applicable, the assertion related thereto. 4. The report shall state the use of the report is restricted to specified parties, in certain circumstances.

Peer Review Program CPA firms must be enrolled in the AICPA’s Peer Review Program for members in the firm to be eligible for membership in the AICPA. A peer review is the review, by a CPA firm, of another CPA firm’s compliance with its quality control system. The purpose of a peer review is to determine and report whether the CPA firm being reviewed has developed adequate quality control policies and procedures and follows them in practice. The AICPA Peer Review Program is administered by the state CPA societies under the overall direction of the AICPA peer review board. Reviews are conducted every three years by a CPA firm selected by the firm being reviewed. CPA firms in the Securities and Exchange Commission Practice Section (the SECPS part) who are reviewed (inspected) by the PCAOB must be reviewed by the AICPA National Peer Review Committee to evaluate the non-SECPS part; i.e., the Private Companies Practice Section (PCPS) part of the firm’s accountin g and auditing practice which is not reviewed (inspected) by the PCAOB. After the review is completed, the reviewer CPA firms issue a report stating their conclusions and recommendations. Results of the peer review are included in a public file by the AICPA. Code of Professional Conduct

The AICPA Code of Professional Conduct defines both ideal principles and a set of specific, mandatory rules describing minimum levels of conduct a CPA must maintain. The Professional Ethics Executive Committee (PEEC) enforces the Code of Professional Conduct (CPC) and interprets Rules of Conduct (more discussion in Chapter 3). In addition, because the CPC has been adopted by most State Boards of Accountancy, which have authority to grant

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or revoke professional CPA licenses, violations of the CPC can result in suspension or revocation of a CPA’s right to practice. Five Elements of Quality Control (PCAOB)

The Quality Control Standards Committee previously established five elements of quality control that CPA firms should consider in setting up their policies and procedures in order to conform to professional standards. The five elements of quality control are shown in Table 2-5 with a brief description of the requirements for each element. The PCAOB adopted and retained the five elements of quality control as part of its interim auditing standards. Table 2-5 Five Elements of Quality Control (PCAOB)

Element

 



Independence, integrity, and Objectivity Personnel management

Acceptance and continuation of clients and engagement



Engagement performance



Monitoring

Brief Description of Requirements All personnel on engagements should maintain independence in fact and in appearance, perform all professional responsibilities with integrity, and maintain objectivity in performing their professional responsibilities. Policies and procedures should be established to provide the CPA firm with reasonable assurance that (1) all new personnel should be qualified to perform their work competently, (2) work is assigned to personnel who have adequate technical training and proficiency, (3) all personnel should participate in continuing professional education and professional development activities that enable them to fulfill their assigned responsibilities, and (4) personnel selected for advancement have the qualifications necessary for the fulfillment of their assigned responsibilities. Policies and procedures should be established for deciding whether to accept or continue a client relationship. These policies and procedures should minimize the risk of associating with a client whose management lacks integrity. They include inquiring of the prospective client’s banker, legal counsel, investment banker, underwriter, or other persons who do business with company for information about the company and its management. Also, the CPA firm should only undertake engagements that can be completed with professional competence. Policies and procedures should exist to ensure that the work performed by engagement personnel meets applicable professional standards, regulatory requirements, and the CPA firm’s standards of quality. firm’s standards They include establishing procedures for (1) planning engagements, (2) maintaininge th of quality, and (3) reviewing engagement working papers and reports. Policies and procedures should exist to ensure that the other four quality control elements are being effectively applied.

Six Elements of Quality Control (AICPA)

The Quality Control Standards Committee of the AICPA replaced the previously established five elements of quality control with six elements of quality control in Statement on Quality Control Standards (SQCS No.8), A Firm’s System of Quality Control. Table 2-6 provides a brief description of the requirements for each element. A CPA firm’s system of quality control should be designed to provide the firm with reasonable assurance that the firm and its personnel comply with professional, legal, and regulatory requirements and that the partners issue appropriate reports. The nature and extent of a CPA firm’s quality control policies and procedures depend on a number of factors, such as the firm’s size, the degree of operating autonomy allowed, its personnel policies, the nature of its practice and organization, and appropriate cost-benefit considerations. For example, a sole practitioner with small professional staff members may use a simple checklist and conduct periodic informal discussions to monitor his or her firm’s compliance with professional standards. On the other hand, a large international CPA firm may develop in-house procedures and assign full- or part-time staff to oversee and ensure compliance with the firm’s quality control system. While not required, communication of the firm’s quality control system normally should be in writing, with the extent of documentation varying with the size of the firm. A firm’s quality control policies and the Code of Professional Conduct should be covered in the firm’s training programs. As mentioned earlier, the PCAOB adopted and retained the five elements of quality control as part of its interim auditing standards. Thus, a CPA firm performing an integrated audit for a public company must continue to follow the five elements of quality control until they have been superseded by a PCAOB element. Table 2-6 Six Elements of Quality Control (AICPA)

Element



Leadership responsibilities for quality within the firm

Brief Description of Requirements The firm should promote a culture that quality is essential in performing engagements and should establish policies and procedures that support that culture. For example, the firm’s training programs


Element

Brief Description of Requirements

(“tone at the top”)

 

emphasize the importance of quality work, and this is reinforced in performance evaluation and compensation decisions. All personnel on engagements should maintain independence in fact and in appearance, perform all Relevant ethical professional responsibilities with integrity, and maintain objectivity in performing their professional requirements responsibilities. For example, each partner and employee must answer an “independence questionnaire” annually, dealing with such things as stock ownership and membership on boards of directors. Policies and procedures should be established for deciding whether to accept or continue a client Acceptance and continuation relationship. These policies and procedures should minimize the risk of associating with a client whose of clients and engagement management lacks integrity. The firm should only undertake engagements that can be completed with professional competence. For example, a client evaluation form, dealing with such matters as predecessor auditor comments and evaluation of management, must be prepared for every new client



Human resources



Engagement performance



Monitoring

before acceptance. Policies and procedures should be established to provide the firm with reasonable assurance that (1) all new personnel should be qualified to perform their work competently, (2) work is assigned to personnel who have adequate technical training and proficiency, (3) all personnel should participate in continuing professional education and professional development activities that enable them to fulfill their assigned responsibilities, and (4) personnel selected for advancement have the qualifications necessary for the fulfillment of their assigned responsibilities. For example, each professional must be evaluated on every engagement using the firm’s individual engagement evaluation report. Policies and procedures should exist to ensure that the work performed by engagement personnel meets applicable professional standards, regulatory requirements, and the firm’s standards of quality. For example, the firm’s director of accounting and auditing is available for consultation and must approve all engagements before their completion. Policies and procedures should exist to ensure that the other quality control elements are being effectively applied. For example, the quality control partner must test the quality control procedures at least annually to ensure the firm is in compliance.

Audit Practice and Quality Centers (CAQ)

The AICPA has established audit practice and quality centers as resource centers to improve audit practice quality. The Center for Audit Quality (CAQ) is an autonomous public policy organization affiliated with the AICPA serving investors, public company auditors, and the capital markets. The Center’s mission is to foster confidence in the audit process and to make integrated audits even more reliable and relevant for investors. In addition to these resource centers for CPA firms, the AICPA has established audit quality centers for governmental audits and employee benefit plan audits. SEC’s Influence on Auditor’s Professional Environment

The Securities and Exchange Commission (SEC) is a federal government agency that regulates the trading of securities. It influences the auditor’s professional environment in: 1. Enforcement of the Securities Act of 1933 and the Securities Exchange Act of 1934 and publication of important regulations such as Regulation S-X. 2. Establishment of the Public Company Accounting Oversight Board (PCAOB) under the Sarbanes-Oxley Act of 2002. 3. Monitoring of corporate frauds under the Corporate Criminal Fraud Accountability Act of 2002. The SEC’s influence on the auditor’s professional environment is shown in Figure 2-2.

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Figure 2-2 SEC’s Influence on Auditor’s Professional Environment

Securities and Exchange Commission (SEC) Influences CPA firms and individual CPAs through

Securities Act 1933 Securities Exchange Act 1934

Require filing of

Forms S-1 to S-16 Form 8K Form 10K Form 10Q

Publication of

Sarbanes-Oxley Act 2002

Corporate and Criminal Accountability Act 2002

Establishment of

Monitoring of Corporate Fraud

Regulation S-X Public Company Accounting Oversight Board (PCAOB) Regulation S-K Accounting Series Releases Accounting & Auditing Enforcement Releases

Register CPA firms Establish Standards Inspect CPA firms Take Disciplinary Actions Enforce Compliance

The Securities Act 1933 and Securities Exchange Act 1934

The Securities Act of 1933 and Securities Exchange Act 1934 of the SEC impose a variety of reports to be filed by its members. Auditors whose clients are members of the SEC must perform certain duties associated with these reports and must make sure their clients have filed the appropriate reports. The SEC also exerts strong influence over the Financial Accounting Standards Board (FASB) in the development of generally accepted accounting principles (GAAP). Furthermore, the SEC publishes publications such as Accounting and Auditing Enforcement Releases, which announce accounting and auditing matters related to the SEC's enforcement activities. Sanctions against independent auditors include restrictions for specified periods against mergers with other firms and prohibits for specified periods against undertaking new engagements. Table 2-7 provides brief comments on the SEC’s filing requirements and publications. Table 2-7SEC’s Reporting Requirements and Publications

Filing Requirements Of the Securities Acts



Forms S-1 to S-16



Form 8-K

Brief comments A registration statement that consists of a prospectus and Forms S-1 to S-16 is to be filed whenever a company plans to issue new securities. The auditor's responsibilities include auditing the accompanying financial statements, performing a subsequent events review and issuing a comfort letter to the underwriters. Form 8-K to be filed when one of the following significant corporate occurred: (1) changes in auditor; (2) changes in control; (3) changes in code of ethics; (4) resignation of directors; (5) acquisition or disposition of a significant amount of assets, and (6) bankruptcy or receivership. The auditor's responsibilities include issuing a letter of agreement concerning a change of auditor. Effective August 2004, the SEC adds eight new disclosure items which will trigger an 8-K filing: (1) entry into a material agreement that isnot in the ordinary course of business; (2) termination of such amaterial non-ordinary course agreement; (3) creation of a material direct financial obligation or a material obligation under an off-balance sheet arrangement; (4) triggering events that accelerate or decrease a material direct financial obligation or a material obligation under an off-balance sheet arrangement; (5) material costs associated with exit or disposal activities; (6) material impairments; (7) notice of the listing or failure to satisfy a continued listing rule or standard; and (8) non-reliance on or restatements of previously issued financial statements or a related audit report or completed interim review. In addition, disclosures as to the sale of unregistered securities, modifications of shareholder's rights,


Filing Requirements Of the Securities Acts



Form 10-K



Form 10-Q

Brief comments departure or the election of directors or principal officers and amendments to the corporate charter or by-laws were transferred from other periodic filings (forms) to trigger an 8-K filing. Finally, in view of the complexity of some of the issues and computations involved in the new requirements, the SEC's requirement to file an 8K within two days was changed to four days. Form 10-K to be filed annually thatconsists of detailed financial information.The auditor's responsibilities include auditing the accompanying financial statements. Form 10-Q to be filed quarterly. The auditor's responsibilities include issuing a letter tobe filed with the interim financial statements. The letter states whether, inthe auditor's opinion, any changein accounting principle or practice is preferable in the circumstances.

Publications of Enforced Activities



Regulation S-X



Regulation S-K

 

Financial Reporting Releases Staff Accounting Bulletins

Regulation S-X is the principle accounting regulation of the SEC and it covers the requirements for auditor's independence, audit reports, and financial statements to be filed with the SEC. Regulation S-K is the uniform disclosure regulation and it covers the disclosure requirements for nonfinancial statements or tax information. Financial Reporting Releases announce the SEC's current positions on accounting and auditing rules and regulations. Staff Accounting Bulletins, which are unofficial interpretations of Regulation S-X and GAAP and they provide guideline for handling events and transactions with similar accounting implications.

Sarbanes-Oxley Act 2002

In 2002, the SEC established the Public Company Accounting Oversight Board (PCAOB) under the Sarbanes-Oxley Act of 2002. Many duties of the PCAOB influence the auditor’s professional environment. See Appendix B for the POAOB’s Rules and Standards relating to the various duties. Table 2-8 provides brief comments on the duties of the PCAOB. Table 2-8 Duties of the PCAOB

Duties



Register CPA firms



Establish, or adopt, by rule, auditing, quality control, ethics, independence, and other standards relating to the preparations of audit reports for issuers



Brief Description of Requirements In order to audit a public company, a CPA firm must register with the PCAOB. Foreign CPA firms who audit

Conduct inspections (reviews) of CPA firms

a U.S. company or perform some audit work in a foreign subsidiary of a U.S. company must also register with the PCAOB. The PCAOB is required to cooperate with designated standard-setting bodies, such as the AICPA, in setting standards, and it has the legal authority to adopt, amend, modify, repeal, and reject any standards suggested by s established by the AICPA’s those bodies. The PCAOB adopted and retained the 10 GAAS and the AU Auditing Standards Board (ASB) as its interim auditing standards. In addition, the PCAOB has issued a number of its own auditing standards; refer to as Auditing Standards (ASs). For example, effective May 2004, the PCAOB’s Auditing Standard No.1 (AS 1), References in Auditors' Reports to the Standards of the Public Company Accounting Oversight Board, requires that auditors' reports on integrated audits of public companies include a reference that the engagement was performed in accordance with the standards of the PCAOB. This replaces the previous reference that the engagement was performed in accordance with the standards of the AICPA. See Appendix B for thePOAOB’s Rules and Standards The PCAOB also requires (1) CPA firms to prepare and maintain audit working papers and other information related to any audit report for a period of not less than seven years, (2) A second partner review and approval of audit reports, (3) CPA firms must adopt quality control standards, (4) The partner-in-charge and the reviewing partner of an audit must rotate off the audit every five years, and (5) The auditor must report to the audit committee. The PCAOB is required to conduct annual quality inspections (reviews) of CPA firms that audit more than 100 clients; all others must be inspected (reviewed) every three years. Moreover, the PCOAB planned to inspect 5% of the Big 4’s audit engagements, 15% of the next four largest (“second-tier”) audit firms’ audit engagements, and 50% of the audit engagements of CPA firms with fewer than 100 audit clients. It should be noted that the PCAOB does not make public certain results of its inspections. The SarbanesOxley Act of 2002 requires that the results of inspections be forwarded to the SEC, the appropriate state-level licensing board, and, in a limited form, to the public. Specifically, the PCAOB is prohibited from releasing to the public: (1) “Criticisms of, or potential defects in, a (CPA) firm’s quality control systems.” Problems relating to a CPA firm’s quality control systems will be made public only if, in the opinion of the PCOAB, the CPA firm fails to correct the deficiencies within 12 months and the CPA firm’s likely appeal to from the public portion of the inspection report “any other the SEC is denied. The PCOAB will also emove r discussion of the firm’s quality control systems” because “discussing aspects of a firm’s quality controls, in a context where criticisms and potential defects cannot be discussed, may create a distorted and misleading

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Duties

Brief Description of Requirements impression.” (2) “Specific information concerning issuers’ (audit clients’) financial statements.” When the PCOAB identifies “possible departures from GAAP,” materiality will determine whether the client needs to restate its financials. If the departure is not material, the PCOAB will advise the CPA firm to discuss – the only agency the matter with the audit client. If the departure is material, the PCOAB will notify the SEC authorized to direct a restatement. Since restated financial statements are a matter of public record, the public (investors) could face with a situation where a company (audit client) issues restated financial statements, which have srcinally given an unqualified (clean) opinion by its auditor (CPA firm). (3) “Violations of law, rules, or professional standards triggering investigations, disciplinary action, or referral to other regulators or law enforcement authorities.” Sometime the PCOAB’s inspection process will uncover information that results in an investigation,



Conduct investigations and disciplinary proceedings, and impose appropriate sanctions



Enforce compliance with the Sarbanes-Oxley Act 2002, the rules of the Board, professional standards, and the securities laws relating to the preparation and issuance of audit reports.

disciplinary or referral to regulatory/enforcement authorities. Sarbanes-Oxley of 2002 requires that action, such proceedings be other kept confidential unless all parties agreeThe to public disclosureAct or until the investigatory/disciplinary process has run its course and the SEC has ruled on any appeal. The PCAOB must notify the SEC of pending investigation involving potential violations of the securities laws, and coordinate its investigation with the SEC Division of Enforcement. All documents and information prepared or received by the PCAOB as evidence in connection with a disciplinary action are confidential and privileged. The PCAOB may sanction a CPA firm if it fails to adopt quality control standards including temporary suspension or permanent revocation to practice in respect of audits of public companies. The PCAOB is to enforce compliance with the SEC rules such as the independent rule issued in November 2001. Chapter 3 discusses further this rule. The PCAOB is to enforce compliance with the auditing standards including the audit report on internal controls. The audit report (or a separatereport) is to be expanded to address internal controls of the company by attesting and reporting on management’s control assessments, including whether such internal controls (1) include the maintenance of records that in reasonable details accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of the financial statements in accordance with GAAP, and that receipts and expenditures are being made only in accordance to authorizations of management and directors of the company.

As described in Table 2-1, AICPA members (CPAs) who perform auditing and other related professional services are required to comply with the Four Fundamental Principles and the Statements on Auditing Standards (AUs) promulgated by the AICPA’s Auditing Standard Board (ASB). However, as described in Table 2-7, as a result of the passage of the Sarbanes-Oxley Act of 2002, the auditing standards to be used in the audits of public companies (integrated audits) are to be established by the Public Company Accounting Oversight Board (PCAOB). Consequently, the AICPA reconstituted its ASB as a body with the authority to establish the auditing standards to be used in the audits of private companies (financial audit). This means that a CPA practicing in the United States normally performs an integrated audit of a public company in accordance with the auditing standards (ASs) established by the PCAOB, and normally performs a financial audit of a private company in accordance with the auditing standards (AUs) established by the ASB. In addition, a CPA practicing in the United States normally performs an integrated audit of a foreign public company in accordance with the International Standards on Auditing (ISAs) promulgated by the International Auditing and Assurance Standards Board (IAASB) of the International Federation of Accountants (IFAC) and the ASs established by the PCAOB. Likewise, a CPA practicing in the United States normally performs a financial audit of a foreign company in accordance with the ISAs promulgated by the IAASB and the AUs established by the ASB. Figure 2-3 shows the multiple sets of standards for the audit of public, private, and foreign companies.


Figure 2-3 Multiple Sets of Standards fo r the Audit of Public, Private, a nd Foreign Companies

Multiple Sets of Standards

U.S. Public Companies

U.S. Private Companies

Foreign

Public Companies

Follow ASs

Follow AUs and ISAs

Issued by PCAOB

Issued by ASB

Conduct Integrated Audit

Private Companies

Follow ISAs and ASs Follow ISAs and AUs

Issued by IAASB

Conduct Financial Audit

Conduct Integrated Audit for Foreign Public Companies

Conduct Financial Audit for Foreign Private Companies

ASs = Auditing Standards AUs = Statements of Auditing Standards ISAs = International Standards on Auditing

Terms Used in Auditing Standards and Levels of Auditor’s Responsibility

Both the PCAOB and the ASB have issued auditing standards that define the use of certain terms in auditing standards and the levels of auditor’s responsibility. The PCAOB issued PCAOB Rule 3101 Certain Terms Used in Auditing and Related Professional Practice Standards that is very similar to AU 200 Defining Professional Requirements in Statements on Auditing Standards issued by the ASB. For examples, if a standard issued by both the PCAOB and the ASB states that an auditor “must” perform a particular procedure, there are no exceptions –the procedure must be performed on an audit. On the other hand, if a standar d states that a procedure “should” be performed, they may be circumstances in which alternate procedures may be performed instead. Table 2-9 summarizes the terms used and the levels of responsibility in both standards. Table 2-9Terms Used in Auditing Standards and Levels of Auditor’s Responsibility

Terms Used in Auditing Standards

     

“must”

Levels of Auditor’s Responsibility

Meaning

Unconditional responsibility

Auditors must fulfill the requirements in all cases.

Presumptively mandatory

Auditors must comply with the requirements unless the auditors

responsibility

demonstrate and document that alternative actions were sufficient to achieve the objectives of the standards. Auditor should consider the requirements. Whether the auditors comply with the requirements will depend on the exercise of professional judgment in the circumstances.

“is required” “shall” [by PCAOB only] “should”

“may” “might”

Responsibility to consider

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Terms Used in Auditing Standards

 

Levels of Auditor’s Responsibility

Meaning

“could” “should consider” [by ASB only]

Corporate and Criminal Fraud Accountability Act 2002

In light of the ENRON scandal in 2001, the SEC steps up its monitoring of public companies under the Corporate and Criminal Fraud Accountability Act of 2002. This act has significant influence on the auditor’s professional environment concerning the detection of fraud. Table 2-10 summarizes some provisions of the act. Table 2-10 Provisions of the Corporate and Criminal Fraud Accountability Act 2002

Provisions of the Corporate and Criminal Fraud Accountability Act 2002

    

Auditors are required to maintain all audit working papers for seven years. It is a felony to knowingly destroy or create documents (including audit working papers) to impede, obstruct or influence any existing or contemplated federal investigation. The statute of limitations on securities fraud claims is extended to five years from the fraud, or two years after the fraud was discovered. Employees of CPA firms (and audit clients) are extended whistleblower protection that would prohibit the employer from taking certain actions against employees. Whistle blower employee s are also granted a remedy of special damages and attorney’s fee. Securities fraud by CPAs (and audit clients) is punishable up to ten years in prison.

Other Forces that Influence the Auditor’s Professional Environment

Besides the AICPA and SEC, there are other forces that influence the auditor’s professional environment. A brief description of these other forces and their influences is given in Table 2-11. Table 2-11Other Forces that Influence the Auditor’s Professional Environment

Other Forces







Their Influences

The Financial Accounting Standards Board is an independent private body that develops generally accepted accounting principles (GAAP). The board consists of seven members who are assisted by alarge research staff and an advisory council.It issues Statements of Financial Accounting Standards (SFASs) that are officially recognized by the AICPA. See http://www.fasb.org/ for more information. The governmental accounting standards board sets accounting and auditing standards for Governmental Accounting Standards Board the government sector. The board consists of fivemembers who have the authority to (GASB) promulgate accounting and auditing standards for the state and local governmental agencies, such as the Statement of Governmental Accounting Standards (SGASs). See http://www.gao.gov/ for more information. The International Federation of Accountants (IFAC) is a worldwide organization of International Federation of Accountants national accounting bodies (e.g. AICPA) that fosters a coordinated worldwide accounting (IFAC) profession with harmonized standards. One of its committees, the International Auditing and Assurance Standards Board (IAASB) issues international standards on auditing and reporting practices that is intended to improve uniformity of auditing services throughout the world. The pronouncements of the IAASB do not override its members' respective national auditing standards. However, members from countries thatdo not have such standards are encouraged to adopt IAASB standards while members from countries that already have such standards are encouraged to compare them to IAASB standards and seek to eliminate any material inconsistencies. As mentioned earlier, members of AICPA who perform auditing and other related professional services have been required to comply with the four fundamental principle s promulgated by the AICPA’s Auditing Standard established by AICPA and the AU Board (ASB). However, as a result of the passage of the Sarbanes-Oxley Act of 2002, the auditing standards to be used in the audits of public companies (integrated audits) are to be established and promulgated by the PCAOB. Consequently, the AICPA reconstituted its ASB as a body with the authority to establish the auditing standards to be used in the audits of private companies (financial audit). This means that a CPA practicing in the United States normally performs an integrated audit of a public company in accordance Financial Accounting Standards Board (FASB)


Other Forces

Their Influences with the auditing standards (ASs) established by the PCAOB, and normally performs a financial audit of a private company in accordance with the auditing standards (AUs) established by the ASB. In addition, a CPA practicing in the United States normally performs an integrated audit of a foreign public company in accordance with the International Standards on Auditing (ISAs) promulgated by the International Auditing and Assurance Standards Board (IAASB) of the International Federation of Accountants (IFAC) and the ASs established by the PCAOB. Likewise, a CPA practicing in the United States normally performs a financial audit of a foreign company in accordance with the ISAs promulgated by the IAASB and the AUs established by the ASB. See Figure 2-3 for the multiple sets of standards for the audit of public, private, and foreign companies. See http://www.ifac.org/ for more information.



State Society (or Association) of CPAs



State Board of Accountancy



Audit Committee

Each statemany has aCPAs Stateare Society (or Association) CPAs. (or Its Association) membership of is CPAs voluntary, however, both members of a StateofSociety and the AICPA. Each State Society (or Association) has its own codes of professional ethics that closely parallel the AICPA's Code of Professional Conduct. See http://www.calcpa.org/ for more information. Each state has a State Board of Accountancy. A State Board of Accountancy usually consists of five to seven CPAs and at least one public member, who are generally appointed by the governor of each state. The State Board of Accountancy works independently of the AICPA and theState Society (or Association) ofCPAs. It issues, renews, suspends or revokes a CPA's licenses to practice. See http://www.dca.ca.gov/ for more information. An audit committee is a subcommittee of the board of directors that is composed of independent, outside directors. The committee monitors audit activities and serves as a surrogate for the interests of stockholders. In 1999, the SEC adopted a report from the New York Stock Exchange and the National Association of Securities Dealers that addresses the effectiveness of the audit committee. Table 2-12 describes some key changes affecting the audit committee. See http://www.pcaobus.org/ for more information.

Table 2-12 Key Changes Affecting the Audit Co mmittee

Requirements

Brief Descriptions

The outside independent directors must have no material relationship with the company. Former The audit committee should be partners or employees of the external auditors who worke d on the company’s audit engagement are composed of outside independent not deemed independent. Restrict payment to the outside independent directors for audit committee directors. service to $60,000 or less. Each independent director is generally limited to three public company audit committees. “Financially literate” means that all audit committee members are able to read and understand  All members should be financial statements at the time of their appointment to the audit committee. financially literate, and at least one “Financial expertise” takes into account the following: (1) prior experience as a public accountant or member should have accounting or auditor, CFO, controller, chief accounting officer, or similar position; (2) an understanding of GAAP related financial management and financial statements; (3) experience in the preparation or auditing of financial statements of a expertise. similar company; (4) experience with internal accounting controls; (5) an understanding of accounting for estimates, accruals, and reserves, and (6) an understanding of audit committee functions. Section 301 of the Sarbanes-Oxley Act, audit committees are now directly responsible for the  The audit committee should be Under appointment, compensation, and oversight of the external auditor. Moreover, Section 202 of the responsible for the selection, Sarbanes-Oxley Act amends section 10A of the Securities Exchange Act of 1934 to require that the evaluation, and replacement of the audit committee must also pre-approve all audit and non-audit services provided by the external external auditor. auditor. The audit committee must endure compliance with Section 303 of the Sarbanes-Oxley Act, which  The audit committee should be makes it unlawful for any officer or director of a company to fraudulently influence, coerce, responsible for assessing the manipulate, or mislead any external auditor engaged in the performance of an audit. independence of the external auditor. Section 206 of the Sarbanes-Oxley Act makes it unlawful for a registered CPA firm to perform the audit of a company if the CEO, CFO, chief accounting office, or controller (or equivalent) was employed by the accounting firm and participated in the audit of the company during the one-year period preceding the date of the audit engagement. audit committee should review with the external auditor any audit problems or difficulties and  The external auditor should The management’s response including: (1) Accounting adjustments noted or proposed but passed (as discuss with the audit committee the immaterial or otherwise). (2) National office consultations. (3) Review with the external auditor of auditor’s judgments about the quality,



the degree of aggressiveness or the responsibilities, budget, and staffing of the internal audit function. conservatism, and the underlying estimates of the company’s accounting principles.

35

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Requirements

Brief Descriptions

The audit committee must be informed of any significant matters identified during the quarterly The external auditor should review of the financial statements by the external auditor. review the company’s quarterly The audit committee is also required to include in the proxy statement its “Report to Shareholders,” financial statements before they are which indicates the audit committee has reviewed and discussed the audited year-end financial filed (10-Q filing) with the SEC. statements (10-K filing)including management’s discussion and analysis (MD&A) with management and the external auditor. The audit committee to review the effect of regulatory and accounting initiatives, as well as off The audit committee to review balance-sheet structures, on the financial statements. specific accounting issues. The audit committee or a comparable body of the board of directors to review and approve all related-party transactions. The audit committee to ensure that a “going concern” qualification issued by the external auditor is





The audit committee establish procedures whistleblower communication.

to for

disclosed by the company through the issuance of a press release. Section 310 of the Sarbanes-Oxley Act requires the audit committee to establish procedures for the receipt, retention, and treatment of complaints received by the company regarding accounting, internal controls, or auditing matters. This must include the ability of the employees to submit, on a confidential and anonymous basis, concerns regarding questionable accounting or auditing matters.



An individual's license to practice as a CPA may be revoked by a. the State Boards of Accountancy. b. the SEC. c. the State Society of CPAs. d. the AICPA.

2-2

Generally accepted auditing standards may not be followed by a. every independent audit service. b. every CPA who is a member of the AICPA. c. every independent audit service on clients who are members of the SEC. d. every compilation service.

2-3

The standards of field work of the Generally Accepted Auditing Standards emphasize a. adequate training. b. adequate planning. c. informative disclosure. d. independence.

2-4

Which of the following characteristics is not in the general standards of the Generally Accepted Auditing Standards? a. Due professional care and independence. b. Adequate training and due professional care. c. Sufficient appropriate evidence and understanding internal controls. d. Independence.

2-5

Which of the following is an element of a CPA firm’s quality control that should be considered in establishing its quality control policies and procedures?

a. Independence, integrity, and objectivity. b. Considering risk and materiality. c. Complying with laws and regulations. d. Using statistical sampling techniques. 2-6

In a situation where no specific guideline orstandard exists, an auditor should look to which of the following authorities for guideline: a. Statements on Auditing Standards (AUs). b. Statements on Standards for Accounting and Review Services (ARs). c. Statements on Standards for Attestation Engagements. d. The AICPA code of professional conduct (CPC).

2-7

The SEC requirements of greatest interest to CPAs are set forth in the SEC’s

a. Forms 8-K, 10K, and 10Q. b. Director’s newsletter. c. S-1 through S-16 forms. d. Regulation S-X and Accounting Series Releases. 2-8

Generally Accepted Auditing Standards (GAAS) and Statements on Auditing Standards (AUs) should be looked upon by practitioners as a. ideals to work towards, but which are not achievable. b. maximum standards which denote excellent work. c. minimum standards of performance, which must be achieved in each audit engagement. d. benchmarks to be used on all audits, reviews, and compilations.

2-9

The AICPA’s division for CPA firms has two sections: the SEC Practice Section and the Private Companies Practice Section. Which one of the following is not a requirement for belonging to the Private Companies Section?

a. Adherence to quality control standards. b. Mandatory peer review program. c. Partner rotation after a period of seven consecutive years. d. Continuing education.

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2-10

A basic objective of a CPA firm is to provide professional servicesto conform to professional standards.Reasonable assurance of achieving this basic objective is provided through a. a system of quality control. b. continuing professional education. c. compliance with generally accepted reporting standards. d. a system of peer review.

2-11

Which of the following best describes the purpose of attestation standards and GAAS? a. Measures of quality for attestation and audit services. b. Methods to discharge professional responsibilities in attestation and audit services. c. Rules that represent the public’s expectations on attestation and audit services. d. Objectives used to select evidence for attestation and audit services.

2-12

An audit committee should do all of the following except a. Recommend the retention or dismissal of the external auditor. b. Determine whether material financial fraud ought to be reported in a company’s financial statements. c. Consult with the external auditor prior to the audit engagement to convey any special concerns the committee has and to request any special investigations. d. Review the audit fees for reasonableness and investigate the reasons why audit fees may be higher than proposed.

2-13

Which of the following is not a duty of the Public Company Accounting OversightBoard? a. Conduct inspection of CPA firms. b. Freeze the payment of audit fee to CPA firms during an investigation of possible violations of securities laws. c. Establish auditing standards and quality control. d. Enforce compliance with the Sarbanes-Oxley Act of 2002.

2-14

Which of the following isnot a provision in the Corporate and Criminal Fraud Accountability Actof 2002? a. It is a felony for auditors to destroy audit working papers. b. Auditors must maintain audit working papers for seven years. c. The status of limitation extended to two years after the fraud was discovered by the auditors. d. Whistleblower auditors are not granted special damages and attorney’sfees.

2-15

Which of the following is the authoritative body designated to promulgate attestation standards? a. Auditing Standard Board. b. Government Accounting Standard Board. c. Financial Accounting Standard Board. d. Government Accountability Office.

2-16

Which of the following is a conceptual difference between the attestation standards and generally accepted auditing standards? a. The attestation standards provide a framework for the attest function beyond historical financial statements. b. The requirement that the practitioner by independent in mental attitude is omitted from the attestation standards. c. The attestation standards do not permit an attest engagement to be part of a business acquisition standards. d. None of the standards of field work in generally accepted auditing standards are included in the attestation standards.

2-17

Which of the following is not an attestation standard? a. Sufficient evidence shall be obtained to provide a reasonable basis for the conclusion that is expressed in the report. b. The report shall identify the assertion being reported on and state the character of the engagement. c. The work shall be adequately planned and assistants, if any, shall be properly supervised. d. A sufficient understanding of internal control shall be obtained to plan the engagement.

2-18

The third general standard statesthat due professional careis to be exercised inthe planning andperformance ofthe audit and the preparation of the report. This standard requires a. thorough review of the existing safeguards over access and records. b. limited review of the indications of employee fraud and illegal acts. c. review of the adequacy of the with technical and proficiency of firm personnel. d. objective supervision of assistants by the auditor finaltraining responsibility for the audit.


2-19

Which of the following is an element of a CPA firm’s quality control system that should be considered in establishing its quality control policies and procedures?

a. Complying with laws and regulations. b. Using statistical sampling techniques. c. Managing personnel. d. Considering audit risk and materiality. 2-20

The primary purpose ofestablishing qualitycontrol policiesand procedures fordeciding whetherto accept a new client is to a. enable the CPA firm to attest to the reliability of the client. b. satisfy the CPA firm’s duty to the public concerning the acceptance of new clients. c. minimize the likelihood of association with client whose management lacks integrity. d. anticipate before performing any field work whether an unqualified opinion can be expressed.

2-21

A CPA firm’s quality control procedures pertaining to the acceptance of a prospective audit client would most likely include

a. inquiry of management as to whether disagreement between the predecessor auditor and the prospective client were resolved satisfactorily. b. consideration of whether sufficient appropriate evidential matter may be obtained to afford a reasonable basis for an opinion. c. inquiry of third parties, such as the prospective client’s bankers and attorneys, about information regarding the prospective client and its management. d. consideration of whether internal control is sufficiently effective to permit a reduction in the extent of required substantive tests. 2-22

Which of the following are elements of a CPA firm’s quality control that should be considered in establishing its quality control policies and procedures?

a. b. c. d. 2-23

Monitoring Yes Yes Yes No

Engagement Performance No Yes Yes Yes

The nature and extent of a CPA firm’s quality control policies and procedures depend on

a. b. c. d. 2-24

Human resources Yes Yes No Yes

The CPA Firm’s Size Yes Yes Yes No

The Nat

ure of the CPA Firm’s Practice Yes Yes No Yes

Cost-Benefit Consideration Yes No Yes Yes

A CPA firm should establish procedures for conducting andsupervising work at all organizational levelsto provide reasonable assurance that the work performed meets the firm’s standards of quality. To achieve this goal, the firm most likely would establish procedures for a. evaluating prospective and continuing client relationships. b. reviewing engagement working papers and reports. c. requiring personnel to adhere to the applicable independence rules. d. maintaining personnel files containing document related to the evaluation of personnel.

2-25

Which of the following statementsbest explains why the CPA profession hasfound it essential to promulgate ethical standards and to establish means for ensuring their observance? a. A distinguishing mark of a profession is its acceptance of responsibility to the public. b. A requirement for a profession is to establish ethical standards that stress primarily a responsibility to clients and colleagues. c. Ethical standards that emphasize excellence in performance over material rewards establish a reputation for competence and character. d. Vigorous enforcement of an established code of ethics is the best way to prevent unscrupulous acts.

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2-26

Which of the following is not required by the SEC regarding an outside independent member of an audit committee? a. The member must be paid $60,000 or less for the audit committee service. b. The member must have no material relationship with the company. c. The member must be financially literate. d. The member must be former outside auditor of the company.

2-27

Which of the following is not a correct statement regarding the composition of the members of an audit committee? a. All audit committee members should be financially literate within a reasonable period of time after their appointment. b. At least one member should have accounting or related financial management expertise. c. All audit committee members should not be affiliated persons of the company or a subsidiary. d. The audit committee should be composed of outside directors.

2-28

Which provision of the Sarbanes-Oxley Act of 2002 does not apply to the audit committees? a. Under Section 301 of the Sarbanes-Oxley Act, audit committees are now directly responsible for the appointment, compensation, and oversight of the external auditor. b. Under Section 202 of the Sarbanes-Oxley Act, audit committees are now to pre-approve all audit and non-audit services provided by the external auditor. c. Under Section 310 of the Sarbanes-Oxley Act,audit committees are now to establish procedures for the receipt, retention, and treatment of complaints received by the company regarding accounting, internal controls, or auditing matters, including whistleblower communication. d. Under Section 204 of the Sarbanes-Oxley Act, audit committees are now to receive reports on the results of all tests of control and tests of balances conducted by the external auditor.

2-29

The Sarbanes-Oxley Act of 2002 expands an audit committee’s responsibilities concerning specific accounting issues. Which of the following specific accounting issues is not part of the expanded responsibility? a. The audit committee is responsible to review the effect of off-balance-sheet structures on the financial statements. b. The audit committee is responsible to review the effect of subsequent events on the financial statements. c. The audit committee is responsible to review and approve all related-party transactions. d. The audit committee is responsible to disclose “agoing concern” qualification issued by the external auditor through the issuance of a press release.

2-30

Which of the following is not a characteristic of the Public Company Accounting Oversight Board (PCAOB)? a. PCAOB is responsible to oversee the audits of public companies that are subject to the securities laws. b. PCAOB is non-governmental, not-for-profit corporate entity that will be funded by fees imposed on all public companies, and fees from CPA firms that must register with the PCAOB in order to audit public companies. c. PCAOB may not regularly inspect a registered CPA firm’s operation and it may not sanction the CPA firm if it fails to adopt quality control standards. d. PCAOB consists of five board members, two of which must be or must have been CPAs, and the Chair may be held by one of the two CPAs, but must not have practiced accounting during the five years preceding his or her appointment.

2-31

Which of the following is not a duty of the Public Company Accounting OversightBoard? a. b. c. d.

2-32

Register foreign CPA firms who audit a foreign subsidiary of a U.S. company. Enforce compliance with he t Sarbanes-Oxley Act of2002. Notify the SECof pending investigation involving potential violations of the securities laws. Require the partner-in-charge of an audit to rotate off the audit everyseven years.

Which of the following is a correct statement concerningthe auditing standards of the Public Company Accounting Oversight Board (PCAOB)? a. The PCAOB’s auditing standards replace the AICPA’s Generally Accepted Auditing Standards (GAAS). b. The PCAOB’s auditing standards supplement the AICPA’s Generally Accepted Auditing Standards (GAAS). c. The PCAOB’s auditing standards and the AICPA’s Generally Accepted Auditing Standards (GAAS) are one and the same. d. The PCAOB’s auditing standards change the audit procedures performed by an auditor.


2-33

Effective August2004, the SEC adds eight new disclosure itemswhich will trigger an 8-K filing. Which of the followingis not one of the new requirements? a. Entry into a material agreement that is in the ordinary course of business. b. Creation of a material direct financial obligation under an off-balance sheet arrangement. c. Material costs associated with exit or disposal activities. d. Material impairments.

2-34

Regarding thequality inspection ofCPA firms, the PCOAB is not prohibited fromreleasing tothe public the following information in its inspection reports: a. Specific information concerning an audit client’s financial statements. b. Criticisms of, or potential defects in, an audit firm’s quality control systems. c. Violations of law, rules, or professional standards triggering investigations, disciplinary action, or referral to other regulators or law enforcement authorities. d. Failure of an audit firm to perform and document sufficient audit procedures related to the existence and valuation of reported inventories.

2-35

Which of the following istrue as a result of the passage ofthe Sarbanes-Oxley Act of 2002? a. The AICPA reconstituted the ASB (Auditing Standard Board) as a body with the authority to establish the GAAS (generally accepted auditing standards) to be used in the audits of public companies in the United States of America. b. A CPA practicing in the United States of America normally audits the financial statements of a public company in accordance with the GAAS established by the ASB (Auditing Standard Board). c. A CPA practicing in the United States of America normally audits the financial statements of a public company in accordance with the ISAs (International Standards on Auditing) promulgated by the IAASB (International Auditing and Assurance Standards Board) of the IFAC (International Federation of Accountants). d. A CPA practicing in the United States of America normally audits the financial statements of a non-public company in accordance with the GAAS established by the ASB and the International Standards on Auditing (ISAs) promulgated by the International Auditing and Assurance Standards Board (IAASB) of the International Federation of Accountants (IFAC).

2-36

A duty of the PCOAB is to ensure that: a. The partner-in-charge and the reviewing partner of an audit must rotate off the audit every five years b. The partner-in-charge and the reviewing partner of an audit must rotate off the audit every seven years c. CPA firms to maintain audit working papers related to an audit report for more than seven years. d. CPA firms to maintain audit working papers related to an audit report for two years on-site and five years off-site.

2-37

The ASB (Auditing Standard Board) issued AU 230 Audit Documentation, which states “Audit documentation should include abstracts or copies of significant contracts or agreements that were examined to evaluate the accounting for significant transactions.” With regard to this particular audit procedure: a. Auditors must fulfill the procedure in all cases. b. Auditors must comply with the procedure unless the auditors demonstrate and document that alternative actions were sufficient to achieve the objectives of the standards. c. Auditor should consider the procedure. Whether the auditors comply with the procedure will depend on the exercise of professional judgment in the circumstances. d. Auditors should consider the procedure and must comply with the procedure after the consideration.

2-38

With the passage of the Sarbanes-Oxley Act of 2002, the auditing standardsto be used in the audits of public companies(integrated audits) are to be established and promulgated by the a. Auditing Standard Board (ASB). b. Public Company Accounting Oversight Board (PCAOB). c. International Auditing and assurance Standards Board (IAASB). d. State Board of Accountancy.

2-39

With the passage of the Sarbanes-Oxley Act of 2002, auditors performingan integrated auditfor a public companymust a. continue to follow the four fundamental principles of the AICPA until they have been superseded by a PCAOB principle. b. continue to follow the six elements of quality control of the AICPA until they have been superseded by a PCAOB element. c. continue to follow the 10 GAAS until they have been superseded by a PCAOB standard. d. continue to follow the International Standards on Auditing (ISAs) until they have been superseded by a PCAOB standard.

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2-40

Which of the following isnot a correct statement of the four fundamental principles underlying anaudit? a. An auditor’s opinion enhances the degree of confidence that intended users canplace in the financial statements. b. To express an opinion, the auditor obtains reasonable assurance about whether the financial statements as a whole are free from material misstatement, whether due to fraud or error. c. The auditor is unable to obtain absolute assurance that the financial statements are free from all misstatements because of inherent limitations. d. Based on an evaluation of the audit evidence obtained, the auditor expresses, in the form of a written report, an opinion in accordance with the auditor’s findings, or states that an opinion cannot be expressed.

2-41

With regard to the six elements of quality control, the element of “Engagement performance” requires that

a. policies and procedures should be established to provide the firm with reasonable assurance that work is assigned to personnel who have adequate technical training and proficiency. b. policies and procedures should be established for deciding whether to accept or continue a client relationship. c. policies and procedures should exist to ensure that the other quality control elements are being effectively applied. d. policies and procedures should exist to ensure that the work performed by engagement personnel meets applicable professional standards, regulatory requirements, and the firm’s standards of quality. 2-42

Which of the following is not a characteristic of the AICPA’s Peer Review Program?

a. CPA firms in the Securities and Exchange Commission Practice Section (the SECPS part) who are reviewed (inspected) by the PCAOB must also have their non-SECPS parts reviewed by the PCAOB. b. After the review is completed, the reviewer CPA firms issue a report stating their conclusions and recommendations. c. The AICPA Peer Review Program is administered by the state CPA societies under the overall direction of the AICPA peer review board. d. Reviews are conducted every three years by a CPA firm selected by the firm being reviewed. 2-43

A CPA practicing inthe United States of America normally performs an integrated auditof a foreign publiccompany in accordance with a. the auditing standards (AUs) established by the Auditing Standard Board (ASB). b. the auditing standards (ASs) established by the Public Company Accounting Oversight Board (PCAOB). c. the auditing standards (ISAs) established by the International Auditing and Assurance Standards Board (IAASB). d. the auditing standards (ISAs) established by the IAASB and the auditing standards (ASs) established by the PCAOB.


2-1 a. 2-2 d. 2-3 b. 2-4 c. 2-5 a. 2-6 c. 2-7 d. 2-8 c. 2-9 c. 2-10 a. 2-11 a. 2-12 b. 2-13 b. 2-14 d. 2-15 a. 2-16 a. 2-17 d. 2-18 d. 2-19 c. 2-20 c. 2-21 c. 2-22 b. 2-23 a. 2-24 b. 2-25 a. 2-26 d. 2-27 a. 2-28 d. 2-29 b. 2-30 c. 2-31 d. 2-32 c. 2-33 a. 2-34 d. 2-35 d. 2-36 a. 2-37 b. 2-38 b. 2-39 c. 2-40 c. 2-41 d. 2-42 a. 2-43 d.


Simulation Question 2-1 Simulation Question 2-1 is an adaptation with permission from a case by Knapp M.C.Contemporary in Auditing: Real Issues & Cases , a publication of the South-Western, a division of Thomson Learning in Ohio. This simulation question is based upon a true set of facts; however, the names and places have been changed. Anna Chan graduated from San FranciscoState University in the spring of 2003 with a bachelor’s degree in accounting. During her study at the College of Business, Chan earned a 3.9 grade point average and participated in many extracurricular activities, including the Beta “Meet the Alpha Psi Chapter and Accounting Students Organization. During the fall semester of 2002, Chan participated in thecampus onFirms” night. Subsequently, she interviewed with several public accounting firms and large corporations and received six job offers. After level position on the auditing staff of a “Big Four” CPA firm. Chan was not sure whether considering those offers, she decided to accept an entryshe wanted to pursue a partnership position with her new employer. However, she believed that the training programs the CPA firm provided and the breadth of experience she would receive from a wide array of client assignments would get her career off to a good start. Chan spent the first two weeks on her new job at her firm’s regional audit staff training seminarin San Jose. On returning to her office in San Francisco in early June 2003, she was assigned to work on the audit of UCSF Hospital. Chan’s immediate supervisor on the UCSF Hospital’s engagement was Amy Wright, a third year senior. On her first day on the UCSF Hospital’s audit, Chan learned that she would audit the hospital’s cash accounts and assist with accounts receivable. Chan was excited about her first client assignment and plea sed that she would be working for Wright. Wright had a reputation as a demanding supervisor who pushed for her engagements to be completed under budget. She was also known for having an excellent rapport with her audit clients, and for being fair and straightforward with her subordinates. Like many newly hired staff auditors, Chan was apprehensive about her new job. She understood the purpose of independent audits and was familiar with the work performed by auditors but doubted that one auditing course, ACCT506, and a two-week staff-training seminar had adequately prepared herfor her new work role. After being assigned to work under Wright’s supervision, Chan was relieved. She sensed that although Wright was demanding, the senior supervisor would be patient and understanding with a new staff auditor. More importantly, Chan believed that she could learn a lot working under the direct supervision of Wright. Thus, Chan resolved that she would work hard to impress Wright and had hopes that the senior supervisor would mentor her through the first few years of her career at the CPA firm. During Chan’s second week of audit at UCSF Hospital, Wright casually asked her over lunch whether she had taken the CPA examin May. After a brief pause, Chan replied that she had not but planned to enroll in a CPA Review Course and study intensively for the exam during the next five months and then take the exam in November. Wright agreed that was a good strategy and offered to lend Chan a set of CPA review books – an offer Chan declined. The truth is that Chan has returned to her home state of Arizona during the first week of May and sat for the CPA exam. For fear of admitting failure, Chan decided not to tell her co-workers that she had taken the exam. Moreover, Chan realized that she and her co-workers might not pass all parts of the exam on their first attempt. She did not want to be labeled with herworkers coas not a “first timer” of the CPA exam for the rest of her career. Chan continued to work on the USCF Hospital audit throughout the summer. She completed the cash audit within budget. Moreover, she submitted very thorough documentations of her work in the working paper file. Wright was pleased with Chan’s work and frequently complimented and encouraged her. As the audit of the UCSF Hospital was near completion in early August, Chan received her grades on the CPA exam in the mail one Friday evening. To her surprise, she had passed all parts of the exam in her first attempt. She immediately called Wright to let her know of the impressive accomplishment. To Chan’s surprise, Wright seemed irritated, if not disturbed, by the good news. Chan then remembered having told Wright earlier on that she had not taken the exam in May. Chan immediately apologized and explained why she had chosen not to tell the truth. Following her explanation, Wright still seemed annoyed, so Chan decided to drop the subject and pursue it later in person. The following week, Wright spent Monday through Wednesday with another audit client, while Chan and the other staff assigned to the UCSF audit continued to wrap up the engagement. On Wednesday morning, Chan received a call from Robert Moore, the partner-in-charge of the UCSF Hospital audit. Moore asked Chan to meet with him late that afternoon in his office. She assumed that Moore simply wanted to congratulate her on passing the CPA exam. The usually upbeat Moore was somber when Chan stepped into his office that afternoon. After she was seated, Moore informed her that he had spoken with Amy Wright several times during the past few days and that he had consulted with the three other audit partners in the office regarding a situation involving Chan. Moore told Chan that Wright was very upset by the fact that she (Chan) had lied regarding the CPA exam. Wright had indicated that she would not be comfortable having a subordinate on future audit engagements whom she could not trust to be truthful. Wright had also suggested that Chan be dismissed from the CPA firm because of the lack of professional integrity she had demonstrated. After a brief silence, Moore told a stunned Chan that he and the other audit partners agreed with Wright. He informed Chan that she would be given 60 days to find another job. Moore also told Chan that he and the other partners would not disclose that she ad been h “counseled out” of the firm if contacted by employers interested in hiring her.

Required 1. 2. 3. 4. 5.

Which of the six elements of quality control identified by the AICPA’s Quality Control Standards Committee applies to Wright’s rationale in dealing with Chan’s white lies? Explain. How would you have dealt with the situation if you had been in Chan’s position?Explain. How would you have dealt with the situation if you had been in Wright’s position?Explain. How would you have dealt with the situation if you had been in Moore’s position?Explain. What lessons have you learned from this simulation question regarding the auditor’s professional environment discussed in Chapter 2?

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Simulation Question 2-2 Simulation Question 2-2 is an adaptation with permission from a case by Knapp M.C.Contemporary in Auditing: Real Issues & Cases , a publication of the South-Western, a division of Thomson Learning in Ohio. This simulation question is based upon a true set of facts; however, the names and places have been changed. After spending much of the prior three months working elbow-to-elbow with as many as six colleagues in a cramped and poorly ventilated conference room, Kevin Nguyen was look forward to moving on to his next assignment. Nguyen was an in-charge accountant on the audit staff of the San Francisco office of a large international CPA firm, the firm that had offered him a job two years earlier as he neared completion of his accounting degree at San Francisco State University. His current client, Discovery & Things, Inc., a public company and the second largest client of Nguyen’s office, owned a chain of retail stores in the western United States that stretched from Seattleto San Diego and as far east as Denver and Albuquerque. Although Discovery and Things’ stores operated under different names in different cities, each stocked the same general types of merchandise, including briefcases and other leather goods, luggage and travel accessories, and a wide range of gift items, such as costume jewelry, imported from Pacific Rim countries. The company also has a wholesale division that marketed similar merchandise to specialty retailers throughout the United States. The wholesale division accounted for approximately 60 percent of the company’s annual sales. , just one block from bustling Market Street, served as Discovery and Things’ A nondescript building in downtown San Francisco corporate headquarters. The company’s fiscal year -end fell on the final Saturday of January. With the end of March just a few days away, Nguyen and his fellow “Dizzies” – the nickname that his office assigned to members of the Discovery and Things audit engagement team – were quickly running out of time to complete the audit. Nguyen was well aware that the audit was behind schedule since he collected, coded, and input into an electronic spreadsheet the time worked each week by the individual Dizzies. He used the spreadsheet package to generate a weekly time and progress report that he submitted to Jessica Lee, the senior who supervised the field work on the Discovery and Things audit. In addition to Nguyen and Lee, another in-charge accountant, Melissa Wan, and four staff accountants had worked on the Discovery and Things audit since early January. Nguyen and Wan knew each other well. They had shared the same start date with their employer and the past two summers had attended the same weeklong staff and incharge training sessions at their firm’s national education headquarters. Wan’s primary responsibility on the current year’s audit was the receivables account but she also audited the PP&E (Property, plant, and equipment) and leases accounts. Besides his administrative responsibilities, which included serving as the engagement timekeeper and maintaining the correspondence file for the audit, Nguyen supervised and coordinated the audit procedures for inventory accounts payable, and a few smaller accounts. Nguyen was thankful that it was Friday afternoon. In recent weeks with the audit deadline looming, Jessica Lee had required the Discovery and Things crew to work until at least 8 p.m. each weekday except Friday, when she allowed them to leave “early” at 5 p.m. The engagement team had spent three consecutive Saturdays in the client’s headquarters and would be spending both Saturday and Sunday of the coming weekend hunched over their audit workpapers. Nguyen had just completed collecting and coding the hours worked during the current week by the other members of the engagement team. Now it was time for him to enter in the electronic spreadsheet his chargeable hours, which he dutifully recorded at the end of each work day in his little “black book.” Before entering his own time, Nguyen decided to walk across the hall and purchase a snack in the employees’ break room. In fa ct, he was stalling, trying to resolve a matter that was bothering him. Less than 30 minutes earlier, Melissa Wan had told him that during the current week, which included the previous weekend, she had spent 31 hours on the receivables account, 18 hours on the leases account, and three hours on PP&E. What troubled Nguyen was the fact that he knew Wan had worked several more hours during the current week on the Discovery and Things audit. This was not the first time Wan had underreported her hours worked. On several occasions, Nguyen had noticed her secretively slipping workpaper files into her briefcase before leaving for home. The next morning, those files included polished memos or completed schedules that had not existed the previous day. Nguyen was certain that Wan was not reporting the hours she spent working at home on her audit assignments. He was just as certain that each week she consciously chose to shave a few hours off the total number she had spent working at the client’s headquarters. Collectively, Nguyen estimated that Wan had failed to report at least 80hours she had worked on the audit. “Eating Time” was a t aboo subject among auditors. Although the subject was not openly discussed, Nguyen was convinced that ma ny audit partners and audit managers subtly encouraged subordinates to underreport their time. By bringing their jobs in near budget, those partners eaters among Nguyen’s peers seemed to be the and managers enhanced their apparent ability to manage engagements. The most avid timeindividuals who had been labeled as “fast-track” superstars in the office. After Wan had reported her time to Nguyen that afternoon, he had nonchalantly but pointedly remarked, “Melissa, who are yourying t to impress by eating so much of your time?” His comment had caused the normally mild-mannered Wan to snapback, “Hey, Dude, you are the timekeeper, not the boss. So just mind your own #$&! business.” Immediately, Nguyen regretted offending Wan, whom he consider ed his friend. But she stomped away before he could apologize. Nguyen knew who Wan was trying to impress. Jessica Lee would almost certainly be promoted to audit manager in the summer and then become the audit manager on the Discovery and Things engagement, meaning that there would be a vacancy in the all-important senior position on the engagement team. Both Wan and Nguyen also anticipated being promoted during the summer. The two new seniors would be the most likely candidates to take over the job of overseeing the field work on the Discovery and Things audit. The in-charge accountant who handled the administrative responsibilities on the engagement was typically the person who had been tabbed to take over the senior’s role.But Nguyen worried that the close friendship that had developed between Wan and Lee might affect his chances of landing the coveted assignment. Almost every day, Wan and Lee went to lunch together without extending even a token invitation to Nguyen or their other colleagues to join them. Baron Davis , the audit engagement partner would choose the new senior for the Discovery and Things engagement, but Jessica Lee would certainly have a major influence on his decision. There was little doubt in Nguyen’s mind that Wan routinely underreported the time she worked on the Discovery and Things audi t to enhance her standing with Lee and Davis. Not that Wan needed to spruce up her image. She had passed the CPA exam on her first attempt, had a charming personality that endeared her to her superiors and client executives, and, like both Lee and Davis, was a UC Berkeley graduate. Nguyen, on the other hand, had suffered through three attempts at the CPA exam before finally passing, was shy by nature, and graduated from San Francisco State University. What irritated Nguyen the most about his subtle rivalry with Wan was that the past two weekends he had spent several hours helping her research contentious technical issues for Discovery and Things’ complex lease contracts on its retail store sites. Earlier in the engagement,


the client’s allowance for bad debts. In each of those cases, Nguyen Wan had also asked him to help analyze some tricky journal entries involving had not charged any time t o the given accounts, both of which were Wan’s responsibility. Before entering his time for the week, Nguyen checked once more the total hours that he had charged to date to his major accounts. For both inventory and accounts payable, he was already over budget. By the end of the audit, Nguyen estimated that he would “bust” the assigned time budgets for those two accounts by 20 to 25 percent each. On the othernd, ha Wan, thanks to her superior “time management” skills, would likely exceed the time budget on her major accounts by only a few hours and might even come in under budget, which was almost unheard of, at least on the dozen or so audits to which Nguyen had been assigned. After finishing the bag of chips he had purchased in the snack room, Nguyen reached for the computer keyboard in front of him. In a few moments, he had entered his time for the week and printed the report that he would give to Jessica Lee the following morning. After briefly glancing at the report, he slipped it into the appropriate workpaper file, turned off the light in the empty conference room, and locked the door hour “weekend.” behind him as he resolved to enjoy his brief sixteen-

Required 1. 2. 3. 4. 5. 6.

Which of the six elements of quality control identified by the AICPA’s Quality Control Standards Committee applies to Wan’s rationale in underreporting the time she worked? Explain. If you had been in Wan’s position, would you underreport the time you worked? Explain. If you had been in Nguyen’s position, would you underreport the time you worked? Explain. Suggest several measures that Nguyen’s CPA firms can t ake to ensure that time budgets do not interfere with the successful completion of the Discovery and Things audit or become dysfunctional in other ways. Suggest several measures that Nguyen’s CPA firms can t ake to reduce the likelihood that personal rivalries among auditors of the same rank will become dysfunctional. What lessons have you learned from this simulation question regarding the auditor’s professional environment discussed in Cha pter 2?

Simulation Question 2-3 Simulation Question 2-3 is an adaptation with permission from a case by Knapp M.C.Contemporary in Auditing: Real Issues & Cases , a publication of the South-Western, a division of Thomson Learning in Ohio. This simulation question is based upon a true set of facts; however, the names and places have been changed. It was nearly 8:30 p.m. on a Friday evening in early August. Fred Choo, an audit manager for a large international accounting firm, had spent several minutes shuffling through the audit workpapers and correspondence stacked on his desk, trying to decide what work he should take home over the weekend. Finally, only one decision remained. Choo could not decide whether to take the inventory file with him. Compulsive by nature, Choo knew that if he took the inventory file home, he would have to complete his review of that file, which would increase his weekend workload from 6 hours to more than 12 hours. As he stewed over his decision, Choo stepped to the window of his office and idly watched the evening traffic on the downtown streets several stories below. Choo had suffered through a tough week. His largest audit client was negotiating to acquire a competitor’s company within its accounting records. industry. For the past two months, Choo had supervised the field work on an intensive acquisition audit of the petitor’s com The client’s chief executive officer (CEO) suspected that the competitor’s executives had embellished their firm’s financial data in anticipation of the proposed acquisition. Since the audit client was overextending itself financially to acquire the competitor company, the CEO wanted to be sure that the competitor company’s financial data were reliable. The CEO’s principal concern was the valuation of the competitor company’s The client’s CEO had requested that Choo be assigned to the acquisition audit inventory, which accounted for 45 percent of its total assets. because he respected Choo and quality of his work. Normally, an audit manager spends little time “on the trenches” supervising day-to-day audit procedures. Because of the nature ofthe this engagement, however, Choo had felt it necessary to spend 10 hours per day, six and seven days per week, poring over the accounting records of the targeted takeover company with his audit staff assistants. As Choo stared at the gridlocked streets below, he was relieved that the acquisition audit was almost complete. After he tied up a few loose ends in the inventory file, he would turn the workpapers over to the audit engagement partner for a final review. Choo’s tough week had been highlighted by several contentious meetings with client personnel, a missed birthday party for his young daughter, and an early breakfast Thursday morning with his office managing partner, Ken Trotman. During that breakfast, Trotman had notified Choo that he had been passed over for promotion to partner-for the second year in a row. The news had been difficult for Choo to accept. For more than 10 years, Choo had been a hardworking and dedicated employee of the large accounting international accounting firm. He had never turned down a difficult assignment, never complained about the long hours his work required, and made countless personal sacrifices, the most recent being the missed birthday party. After informing Choo of the bad news, Trotman encouraged him to stay with the firm. Trotman promised the following year he would vigorously campaign for Choo’s promotion and “call in all favors” owed to him by partners in other offices. Despite that promise, Choo realized that he had only a minimal chance of being promoted to partner. Seldom were twotime “losers” ticketed for promotion. Although he had been hoping for the vest, Choo had not expected a favorable report from the Partner Selection Committee. In recent weeks, he had gradually admitted to himself that he did not have the profile for which the committee was searching. Choo was not a rainmaker like his friend and fellow audit manager, Kim Park, whose name appeared on the roster of new partners to be formally announced the following week. Park was a member of several important civic organizations and had a network of well-connected friends at the local golf club. Those connections had served Park well, allowing him to steer several new clients to the firm in recent years. of to a rainmaker, a technician. If audit someone in theWhen office ahad accounting auditing issue issues, totheresolve, individual Instead went first Choo, not Choo to onewas of the office’s six partners. newa difficult client posed complexortechnical audit that engagement partner requested that Choo be assigned to the job. One reason Choo was a perfect choice for difficult engagements was that he micromanaged his jobs, insisting on being involved in every aspect of them. Choo’s management style often resulted in his “busting”time budgets for audits, although he seldom missed an important deadline. To avoid missing deadlines when a job was nearing completion, Choo and the staff assistants in his audit engagement team would work excessive overtime, including long weekend stints.

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Finally, Choo turned away from his window and slumped into his chair. As he sat there, he tried to drive away the bitterness that he was feeling. “If William Lee hadn’t left the firm, maybe I wouldn’t be in this predicament,” Choo thought to himself. Thre e years earlier, William Lee, an audit partner and Choo’s closest friend within the firm, had resigned to become the chief financial officer (CFO) of a large client. After Lee’s resignation, Choo had no one within the firm to sponsor him through the tedious and political partner selection process. Instead, Choo had been “lost in the shuffle” with the dozens of other hardworking, technically inclined audit manager within the firm who aspir ed to a partnership position. Near the end of breakfast Thursday morning, Trotman had mentioned to Choo the possibility that he could remain with the firm in a senior manager position, IN recent years, Choo’s CPA firm had relaxed its “up or out” promotion policy. But Choo was not sure he wanted to remain with the firm as a manager with no possibility of being promoted to partner. Granted, there were clearly advantages associated with becoming a permanent senior manager. For example, no equity interest in the firm meant not absorbing any portion of its future litigation losses. On the other hand, in Choo’s mind accepting an appointment as a permanent senior manager seemed equivalent to having “career failure” stenciled on his office door. Ten minutes till nine, time to leave. Choo left the inventory file lying on his desk s he closed his laptop and then stepped toward the door of his office. After flipping off the light switch, Choo paused momentarily. He then grudgingly turned and stepped back to his desk, picked up the inventory file, and tucked it under his arm.

Required 1. 2. 3. 4. 5. 6.

Which of the six elements of quality control identified by the AICPA’s Quality Control Standards Committee applies to Choo’s rationale in working excessive overtime to meet deadlines? Explain. If you had been in Choo’s position, would you work excessive overtime to meet deadlines? Explain. Which of the sixelements of quality control identified by the AICPA’s Quality Control Standards Committee applies to the “up or out” promotion policy in Choo’s CPA firm? Explain. If you had been in Choo’s position, would you remain with the CPA firm as a permanent senior audit manager? Explain. Suggest several measures that Choo’s CPA firms can take to reduce the likelihoodthat aspiring audit managers will not be “lost in the shuffle” through the tedious and political partner selection process. What lessons have you learned from this simulation question regarding the auditor’s professional environment discussed in Chapter 2?


Chapter 3 The Auditor’s Ethical Environment Chapter Learning Outcomes (LOs) Checklist


LO3-1 Apply the American Institute of Certified Public Accountants’ (AICPA’s) Rules of Conduct.



LO3-2 Understand the interpretations of Rule 101 Independence.

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LO3-3 Differentiate between the AICPA and the Public Company Accounting Oversight Board’s (PCAOB’s) rules on independence.



LO3-4 Identify some threats to and examples of auditor’s non -independence.



LO3-5 Describe the enforcement mechanisms for the AICPA’s Code of Professional Conduct (CPC) and the PCAOB’s Auditor Independence rules.

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Chapter 3 The Auditor’s Ethical Environment The AICPA Code of Professional Conduct (CPC), labeled as ETs, provides the principles and rules an auditor should follow in the practice of public accounting (see Appendix E for a list of ETs). The CPC consists of two sections: Principles of Professional Conduct and Rules of Conduct. Additional guidance for applying the Rules of Conduct is provided by the Interpretations of Rules of Conduct and Ethics Rulings. The guidance provided by the CPC starts at a conceptual level with the principle s and progressively moves to general rules and their interpretations and then to specific rulings on individual cases. Figure 3-1 shows the four parts of the CPC. Figure 3-1 Code of Professional Conduct

Not enforceable

Principles of Professional Conduct

Rules of Conduct

Specifically enforceable

Interpretations of Rules of Conduct

Not specifically enforceable, but departure must be justified

Ethics Rulings

Principles of Professional Conduct

The Principles of the Code of Professional Conduct express the profession's recognition of its responsibilities to the public, to clients, and to colleagues. They form the basis of ethical and professional conduct and guide members of the AICPA in the performance of their professional responsibilities. Moreover, they demand from its members an unswerving commitment to honorable behavior, even at the sacrifice of personal advantage. However, these principles are not enforceable. Rather, they provide a framework for the Rules of Conduct, which are enforceable. The six ethical principles and their requirements are shown in Table 3-1 below: Table 3-1 Principles of Professional Conduct

Principles



Responsibilities



The public interest



Integrity





Objectivity and independence

Due care

Requirements Members of the AICPA have responsibilities to all those whouse their professional services. They also have a continuing responsibility to cooperate with each other to improve the methods of accounting and reporting, to maintain the public confidence, and to carry out the profession's special responsibilities of self-governance. The accounting profession's public consists of clients, creditors, governments, employers, investors, and the business and financial community. These groups of people rely on the CPAs' objectivity and integrity to maintain the orderly functioning of commerce. This reliance imposes a public interest responsibility on CPAs. For the public to trust the accounting profession, members of the AICPA must act with integrity in making all decisions. Integrity requires CPAs to be honest and that service and public trust not to be subordinated to personal gain and advantage. Moreover, integrity can accommodate the inadvertent error and the honest difference of opinion. However, it cannot accommodate deceit or subordination of principle. The principle of objectivity requires a CPA to be impartial, intellectually honest, and free of conflict of interest. On the other hand, the principle of independent in fact and in appearance precludes relationships that may appear to impair a CPA's objectivity in rendering attestation services. For a CPA in public practice, the maintenance of objectivity and independence requires a continuing assessment of client relationships and public responsibility. The principle of due care requires CPAs to pursue excellence in providing professional services. In doing so, CPAs must discharge their professional responsibilities with competence and diligence. A CPA obtains competence through both education and experience.Competence also requires a CPAto continue to learn throughout his/her career. Diligence imposes the responsibility to render services promptly and carefully, to be thorough, and to observe applicable technical and ethical standards.


Principles



Scope and nature of services

Requirements In determining whether or not to perform specific services, members of the AICPA in public practice should consider whether such services are consistent with the principles of professional conduct for CPAs. There are no hard-and-fast rules to help membersin determining whether ornot to provide specific services in this regard; however, they must be satisfied that they are meeting the spirit of the principles of professional conduct for CPAs.

Rules of Conduct

The bylaws of the AICPA require its members to adhere to the Rules of the Code of Professional Conduct. These rules establish minimum standards of acceptable conduct in the performance of professional services. These Rules are specifically enforceable in that the bylaws of the AICPA provide its Professional Ethics Executive Committee (PEEC) the authority to discipline a CPA guilty of violating the Rules. In addition to the Principles and Rules of Conduct, the AICPA ’s PEEC promulgates the Interpretations of the Rules of Conduct and Ethics Rulings:

 Interpretations of the Rules of Conduct The Interpretations of the Rules of Conduct are promulgated by the PEEC to provide guidelines as to the scope and applicability of specific rules. They are not specifically enforceable but CPAs must justify departures from the Interpretations in disciplinary hearings.  Ethics Rulings The PEEC also promulgates Ethics Rulings, which are questions and answers to specific ethical situations. They indicate the applicability of the Rules of Conduct and Interpretations of the Rules of Conduct to a particular set of factual circumstances. Ethics Rulings are not specifically enforceable but CPAs must justify departures from the Ethics Rulings in disciplinary hearings. Specific Rules of Conduct Rule 101 - Independence A member in public pra ctice shall be independent in the performance of professi onal services as required by standa rds pr omulga ted by bodies designated by Council.

Independence is the most important rule of conduct for CPAs. Without independence, a CPA's opinion on the financial statements would be of little value. Owing to its importance, Rule 101 has been the subject of many Interpretations of the Rules of Conduct and Ethics Rulings. An important interpretation of Rule 101 relates to the phrase “a member in public practice” which simply means “a CPA” in practice. The interpretation of the Rules relates the phrase “a member in public practice” to “covered members” who are in a position to influence an attest engagement. Covered members include: 1. Individuals on the attest engagement team. 2. An individual in a position to influence the attest engagement, such as individuals who supervise or evaluate the engagement partner. 3. a partner or manager who provides non-attest services to the client. 4. A partner in the office of the partner responsible for the attest engagement. 5. The firm and its employee benefit plans. 6. An entity that can be controlled by any of the covered members listed above or by two or more of the covered individuals or entities operating together. SEC’s Auditor Independence Rules

The Sarbanes-Oxley Act of 2002 establishes the Public Company Accounting Oversight Board (PCAOB), whose responsibilities are to oversee the audits of public companies that are subject to the securities laws. These responsibilities include overseeing SEC’s Auditor Independence Rules under Section 103 of the Act; specifically, the PCAOB’s Auditor Independence Rule 3520. The PCAOB Rule 3520 is summarized as follows:

 Services Outside the Scope of Practice of Auditors The PCAOB uses the following general principles to evaluate the effect of non-audit services on auditor independence: 1. an auditor cannot function in the role of management; 2. an auditor cannot audit his or her own work, and 3. an auditor cannot serve as an advocate for the client. Based on these general principles, it is unlawful for a registered CPA firm to provide non-audit services to an a public company, including: 1. bookkeeping or other services related to the accounting records or financial statements of the audit client; 2. financial information systems

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design and implementation; 3. appraisal, valuation, and actuarial services; 4. internal audit outsourcing services; 5. management functions or human resources; 6. various investment services such as broker or dealer, investment adviser, or investment banking services; 7. legal services and expert services unrelated to the audit, and 8. any other services that the PCAOB determines, by regulation, to be impermissible such as certain tax services.

 Auditor Communicates to Audit Committee Before accepting a new or continuing audit engagement, the audit firm must communicate in writing to the audit committee all relationships between the audit firm and the client that may reasonably be thought to bear on the audit firm’s independence. 

Auditor Reports to Audit Committee

Theallauditing firm treatments must reportof to financial the audit committee 1. critical accounting and practices be used, and 2. alternative informationall: within GAAP that havepolicies been discussed withtomanagement, ramifications of the use of such alternative disclosures and treatments, and the treatment preferred by the accounting firm.

 Conflicts of Interest The CEO, Controller, CFO, Chief Accounting Officer or person in an equivalent position cannot have been employed by the company’s audit firm during the 1-year period preceding the audit. In other words, an auditing firm is not independent of a client that employs the auditing firm’s employees (auditors) within the one year period preceding the audit.  Partner Rotation A lead (coordinating) partner and a review (concurring) partner must rotate off of an engagement after five consecutive years.  Audit Committee Pre-approve Audit committee to pre-approve audit services and non-audit services, unless non-audit service fees are less than 5 percent of total audit fees. For example, certain non-audit services, such as tax services, may be provided if they are pre-approved by the audit committee, or their fees are less than 5 percent of total audit fees. The audit committee must disclose to investors in periodic reports its decision to pre-approve non-audit services.  Partner Compensation An auditing firm is not independent of an audit client if any audit partner is compensated for securing with the client billable work for services other than audit or attestation.  Expanded Disclosure Public companies disclose audit fees and fees for an explanation of audit-related, tax, and all other services.  Study of Mandatory Rotation of Registered Public Accountants The PCOAB is to conduct a study on the potential effects of requiring the mandatory rotation of audit firms. In addition, the SEC issued Regulation S-X Rule 2-10 to strengthen requirements of the PCAOB’s Auditor Independence Rule 3520 regarding auditor independence. The Regulation S-X Rule 2-01 describes four overarching independence principles indicating that a relationship between the accountant and the audit client should not: 1. Create a mutual or conflicting interest between the accountant and the audit client; 2. Place the accountant in the position of auditing his or her own work; 3. Result in the accountant acting as management or an employee of the audit client; or 4. Place the accountant in the position of being an advocate for the audit client. Rule 2-01 also prohibits specific relationships including financial relationships, employment relationships, business relationships, relationships whereby the audit firm provides non-audit services to the audit client, and relationships involving contingent fees. Finally, Rule 2-01 includes requirements regarding partner rotation and audit committee administration of the engagement. CPAs who audit non-public (private) companies must follow AICPA’s Independence Rule 101. On the other hand, CPAs who audit public companie s must follow PCAOB’s Auditor Independence Rule 3520. When there is a different requirement between the two set of rules; for example, a CPA applies both AICPA and PCAOB’s independence rules to a non-public audit client, PCAOB Independence Rules takes prec edent over the AICPA’s Independence Rules. One example of such different requirement is that AICPA’s Independence Rules requires an engagement partner to rotate off an engagement every seven years, whereas PCAOB Independence Rules require the partner to rotate off every five years. In this situation, PCAOB’s five years rotation requirement applies. It is difficult to interpret the independent rules because independence is primarily a state of mind. The AICPA Conceptual Framework for Independence Standards suggests that CPAs interpret the independent rules by evaluating whether a particular threat would lead to a reasonable person, aware of all the relevant fats, to conclude


that s/he is not independent. Table 3-2 describes some of these threats and examples of non-independence. Based on this “threat” framework, Table 3-3 provides interpretations and brief comments of AICPA’s Rule 101 Independence and the different requirements of the PCAOB’s Auditor Independence Rule 3520. Table 3-2 Threats and Examples of Non-independence

Threat

Examples

(1) Financial Interest– A potential benefit to an auditor from a (a) An auditor has a direct financial interest or a material indirect financial financial interest in, or some other financial relationship with, interest in the audit client. an audit client. (b) An auditor has a loan from the audit client. (c) An auditor is excessively relied on revenue from a single audit client. (d) An auditor has a material joint venture with the audit client. (2) Familiarity – An auditor has a close or longstanding (a) A spouse of the auditor holds a key position with the client, e.g., CEO. relationship with client personnel or with individuals who (b) An auditor has provided audit services to the same client for a prolonged performed non-audit services to the same client. period. (c) An auditor performs insufficient audit procedures because of his/her familiarity with the client. (d) An auditor for the CPA firm recently was a director or officer of the audit client. (3) Undue Influence – An audit client’s management coerces (a) Management’s threat to replace the auditor over a disagreement on the the auditor or exercises excessive influence over the auditor. application of an accounting principle. (b) Management’s pressure to reduce audit procedures for purpose of reducing audit fees. (c) An auditor receives a gift from the audit client that is significant. (4) Management Participation– An auditor taking on the role of (a) An auditor serves as an officer or director of the audit client. client management or perform client management functions. (b) An auditor establishes and maintains internal controls for the audit client. (c) An auditor hires, supervises, or terminates the audit client’s employees. (5) Adverse Interest– Actions between the auditor and the audit (a) Threatened or actual litigation between the auditor and the audit client. client that are in opposition. (6) Advocacy – Actions taken by the auditor to promote the (a) An auditor promotes the audit client’s securities as part of an initial audit client’s interest or position. public offering. (b) An auditor represents the audit client in U.S. tax court. (7) Self-audit – As a part of an audit engagement, an auditor (a) An auditor’s CPA firm has provided non-audit services relating to the uses evidence that results from non-audit services provided to audit client’s information system and the auditor is now considering results the audit client. obtained from that information system in the audit of the same client.

Table 3-3 Interpretations of Rule 101 Independence

Interpretation



Auditor and client relationship



Financial interests

Brief Comments Rule 101 prohibits a CPA from auditing a client while holding a position as director, officer, or employee of that client. However, a CPA may serve as an honorary director or a trustee of a not-forprofit organization while auditing the same not-for-profit organization (not-for-profit client). In such a case, independence is not impaired if the CPA's position is purely honorary (and identified as honorary in all letterheads and externally circulated materials), the CPA restricts involvement to the use of his/her name only (that is, only lends the prestige of his/her name to the not-for-profit organization), and the CPA must not vote or participate in the management functions of the not-forprofit organization. It should be noted that PCAOB Rules prohibit a public company from employing the CEO, Controller, CFO, Chief Accounting Officer or person in equivalent position from the company’s audit firm during the 1-year period preceding the audit. It should also be noted that PCAOB Rules require the lead and reviewing partner to rotate off an audit engagement after five consecutive engagements. In contrast, Rule 101 requires the partner to rotate off an audit engagement after seven consecutive engagements. Lastly, before accepting a new or continuing audit engagement, PCOAB Rule 3526 requires the audit firm to communicate in writing to the audit committee all relationships between the audit firm and the client that may reasonably be thought to bear on the audit firm’s independence. Rule 101 prohibits a CPA (includingimmediate family members of the CPA who are defined as spouse, spousal equivalent, and dependents) from having direct a financial interest (e.g., owning any stock) in the audit client. Note: Materiality of the direct financial interest is not relevant here. It also prohibits a CPA (includingclose family relatives of the CPA who are defined as parent, siblings, and non-dependent children) from owningmaterial indirect financial interest in the audit client. Examples of indirect financial interests are: a CPA has investments in a bank that loans money to an audit client, or a CPA owns stock in a mutual fund that, in turn, owns stock in the audit client, or a CPA's own stock in anaudit client. Independence is impaired in the foregoing examples

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Interpretation

Brief Comments only if either the CPA's investments in the bank or the mutual fund's holdings in the audit client are material in relation to the CPA's personal wealth, or the close family relative's financial interest in the audit client is material to his or her own personal wealth and the CPA has knowledge of the interest. As a rule of thumb, a financial interest is presumed to be material if it exceeds 5% of the CPA's personal net worth or the personal net worth of the CPA's close family relatives. See Table 3-4 for a summary of the effect of Rule 101 on family members, relatives, and friends. It should be noted that PCAOB Rules clearly define “immediate family members” and “close family relatives” as: (1) “immediate family members” – a person’s spouse, spousal equivalent (including more support), and (2) “close family cohabitant), and dependents (i.e., person who received half or members” – a person’s parents (including adoptive parents and step-parents), dependents (i.e., person who received half or more support), nondependent children (including step-children), and







Joint investor or investee Relationship with client

Auditing and accounting services for the same client

Auditing and management advisory services to the same client

brothers of these).and sisters (excluding grandchildren, grand-parents, parents-in-law, and the spouses of each Finally, a CPA is not permitted to have anyloan to or from audit clients; however, home mortgages and most secured loans from financial institution clients are permitted if made under normal lending procedures and negotiated prior to audit engagement. The phrase "financial institution client" is defined in the Interpretation as “an entity that, as part of its normal business operations, makes loans to the general public. ” The phrase “normal lending procedures” implies that the terms of the loans should be made without any favoritism to the CPAs. It should be noted that PCAOB Rules consider a CPA not independent of an audit client if any audit partner received compensation based on the partner securing with the client billable work for services other than audit or attestation. A CPA is not permitted to have any joint or closely held business investment, i.e., joint investor or investee relationship , with the client. For example, a CPA owns stock in a non-audit client, ABC Co., and XYZ Co., which is an audit client, also owns stock in ABC Co. Interpretations of e “joint th investor or investee relationship” when an audit client is either an investor or investee of a non-audit client in which a CPA has investment are as follows: (1) A client invested in a non-client– the CPA is a joint investor with the client. If t he client’s investment in the non-client is material, the CPA violates Rule 101 for having any client. However, if the client’s investment in the nondirect/material indirect investment in the nonclient is immaterial, the CPA violates Rule 101 only for material direct/indirect investment. (2) A non-client invested in a client - the CPA is a joint investee with the client. If the non-client investment in the client is material, the CPA violates Rule 101 for having any client’s investment in the direct/material indirect investment in the non-client. However, if the nonclient is immaterial, the CPA violates Rule 101 only when the CPA’s investment in the non-client allows the CPA to exercise significant influence over the non-client. A rule of thumb for determining “materiality” in a “joint investor-investee” relationship is (1) A CPA’s investment is presumed to be material if it exceeds either 5% of the CPA's net worth or the client’s investment is net worth of the CPA's firm, whichever is more restrictive. (2) A client/nonpresumed to be material if it exceeds either 5% of the client/nonclient’s total assets or 5% of the client/non-client’s income before taxes, whichever is more restrictive. Rule 101 permits a CPA to provide both auditing and accounting services for the same client if several conditions are met: (1) The auditor must not have any relationship with the client or any conflict of interest; (2) The client must accept responsibility for the financial statements; (3) The auditor must not assume the role of employee or management, and (4) The auditor must perform the engagement in accordance with generally accepted auditing standards. However, in practice, a CPA must also be aware of the SEC's regulations (Securities Exchange Act 1934) which do not permit a CPA to perform auditing and accounting services for the same SEC client. Therefore, in practice, a CPA may provide both accounting and auditing services to non-SEC clients provided the foregoing four conditions are met. A CPA may provide auditing and management advisory services to the same client if (1) the CPA just advises client and does not assume a decision-making role in the client's management, (2) the CPA’s engagement in both services is fully disclosed to the Audit Committee. Advisory services that would not entail a CPA assuming a decision-making role include conducting special studies and investigations, making suggestions to management, pointing out the existence of weaknesses, outlining various alternative corrective measures, and making recommendations. It should be noted that PCAOB Rulesindirectly prohibit auditing and management advisory services to an audit client by prohibiting eight types of non-audit services to an audit client. These are (1) bookkeeping services (2) information system design and implementation services (3) appraisal, valuation, and actuarial services (4) internal audit services (5) management functions or human resources (6) various investment services (7) legal services and (8) any other services that the PCAOB determines, by regulation, to be impermissible such as certain tax services. It should also be noted that PCAOB Rules require audit committee to pre-approve all audit and nonaudit services a CPA provides unless non-audit fees are less than 5% of total audit fees. Specifically, preapproved non-auditservices include tax services under PCAOB’s Rule 3524, Audit Committee Pre-approval of Certain Tax Services , and internal control services under Rule 3525,Audit


Interpretation

Brief Comments Committee Pre-approval of Non-audit services Related to Internal Control Over Financial Reporting. Accordingly, the PCAOB Rules that indirectly prohibit auditing and management advisory services to an audit client do not apply if the auditing and other non-audit services provided to an audit client are pre-approved by the audit committee. Moreover, this pre-approval requirement is waived if the aggregate fee of all such non-audit services constitutes less than 5% of the total audit fee paid to the auditor. Lastly, an exception to the preapproved tax services is that the auditor is not independent of the audit client if the preapproved tax services were to provide for persons in financial reporting oversight roles (e.g., the CEO) under PCAOB’s Rule 3523, Tax Services for Persons in Financial Reporting Oversight Roles. However, an amendment to this Rule in 2008 clarifies that if the auditor



Actual or threatened litigation



Unpaid fees

preceding the beginning provides such tax servicesthe forauditor persons financial reporting oversight roles of the audit engagement, is in independent. See Table 3-5 for a comparison of PCAOB and AICPA’s rules regarding management advisory services. The relationship between the auditor and the client is characterized by the auditor's objectivity in attesting the client's financial statements on one hand and the client's willingness to full disclosure on the other hand. Actual or threatened litigation against the auditor by the client or against the client by the auditor places the auditor and the client in an adversary position, thereby raising the questions about the client's willingness to disclose, about the auditor's objectivity and self-interest, and therefore about auditor independence. Consequently, in all cases in which an auditor is involved in actual or threatened litigation, he or she should carefully evaluate independence. Independence is considered impaired if billed or unbilled audit fees remain unpaid for auditing services provided to the client more than one year before the date of the report. Such unpaid fees are deemed to be a loan from the auditor to the client and are therefore a violation of Rule 101. Unpaid audit fees from a client in bankruptcy do not violate Rule 101. It should be noted that PCAOB Rules require public companies to disclose audit fees, audit related, tax, and all other services.

Table 3-4 A Summary of the Effect of Rule 101 on Family Members, Relatives, and Friends

Relative

Effect of Rule 101

Immediate family members are under the same restrictions as is the CPA. Accordingly, if a member violates a rule, interpretation, or ruling that applies to the CPA, the CPA is and not independent. For example, if an immediate family memberthe CPA owns some stocks (i.e. direct financial interest/investment ) in the CPA’s audit client, the CPA is PCAOB: Spouse, spousal equivalent (including cohabitant), and dependents (i.e., persons who not independent. received half or more support). The CPA and CPA firm independence is impaired if an individual on the audit team has  Close Family Relatives a close family relatives who has 1. A key position with the audit client, or 2. A material AICPA: Parent, siblings, and non-dependent indirect financial interest in the audit client of which the CPA has knowledge. children. PCAOB: Parents (including adoptive parents and step-parents), dependents (i.e., person who received half or more support), nondependent children (including step-children), and brothers and sisters (excluding grandchildren, grandparents, parents-in-law, and the spouses of each of these) Independence is only impaired when a reasonable person aware of all relevant facts  Other Relatives and Friends relating to a situation would conclude that there is an unacceptable threat to independence. This evaluation is made based on the AICPA Conceptual Framework for Independence Standards.



Immediate Family Members AICPA: Spouse, spousal equivalent, dependents (whether or not related).

Table 3-5A Comparison of PCAOB and AICPA’s Rules Regarding Management Advisory Services

PCAOB’s Position

AICPA’s Position

(1) Prohibits bookkeeping or other services related to the Allowed, providing the auditors do not: accounting records or financial statements of the audit client. (a) Determine or change journal entries without client approval. (b) Authorize or approve transactions. (c) Prepare source documents. (d) Make changes to source documents without client approval. (2) Prohibits financial information systems design and Auditors are allowed to: implementation. (a) Implement a system not developed by the auditor (e.g., off-the shelf accounting software packages). (b) Assist in setting up chart of accounts and financial statement format.

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PCAOB’s Position

(3) Prohibits appraisal, valuation, and actuarial services.

(4) Prohibits internal audit outsourcing services.

AICPA’s Position (c) Design, develop, install, or integrate an information system unrelated to the financial statements or accounting records. (d) Provide training to client employees on the information and control system. Allowed, providing the services do not: (a) Relate to a material portion of the financial statements, and (b) Involve a significant degree of subjectivity. Allowed, providing the client understands its responsibility for internal control and: (a) Designates competent individual(s) within company to be responsible for internal audit.

(b) Determines scope, risk, and frequency of internal audit activities. (c) Evaluates findings and results. (d) Evaluates adequacy of audit procedures performed. (5) Prohibits management functions or human resources. Auditors may provide various types of advice but may not perform management functions. (6) Prohibits various investment services such as broker or dealer, Certain investment services are allowed, including: investment adviser, or investment banking services. (a) Assisting in developing corporate finance strategies. (b) Recommending allocation of funds to investments. (7) Prohibits legal services and expert services unrelated to the Legal services are not directly addressed; various other services are audit. allowed if auditors do not make management decisions. (8) Prohibits any other services that the PCAOB determines, by No specific restrictions. regulation, to be impermissible such as certain tax services, which include tax planning for potentially abusive tax transactions and providing individual tax services for client officers in financial reporting oversight roles. Note: PCAOB allows non-audit services (including tax services and ICFR) providing: a. the services are preapproved by the audit committee, and b. the aggregate non-audit services fee is less than 5% of the total audit services fee. Note: PCAOB prohibits preapproved tax services that are to provide for persons in financial reporting oversight roles. However, an amendment to this Rule in 2008 clarifies that if the auditor provides such tax services for persons in financial reporting oversight roles preceding the beginning of the audit engagement, the auditor is independent.


Figure 3-2 provides a summary of the interpretations of Rule 101 Independence. Figure 3-2 Interpretations of Rule 101 Independence

Auditor

Auditing

Client XYZ Co.

No direct investment (e.g., stocks) Note: Include immediate family members Materiality not relevant

Be an accountant of the client? AICPA – Yes, if fulfills 4 requirements PCAOB – No, under the Securities Exchange Act

Be an officer or employee of the client? No, except honorary position/trustee for not-for profit organization Note: PCAOB– No hiring of auditor 1 year precedes the audit engagement

No indirect investment (e.g., mutual funds) Exception: Immaterial based on personal net worth Note: Include close family relatives PCAOB No compensation – for audit partner securing non-auditing services 5 –years engagement partner rotation (7 years in Rule 101)

Client Invested

Non-client Invested

Management Consulting services? AICPA – Yes, but not to make decision for the client and full disclosure to the audit committee PCAOB – Indirectly prohibits Exception: Preapproved by audit committee and < 5% of audit fee Exception: Preapproved tax services to persons in financial reporting roles preceding the audit engagement.

No loan to or from the client Exception: Home mortgages and secured loans Note: No favoritism Client is in loan business Loan negotiated prior to audit engagement Unpaid audit fee > 1 year is a loan

Investing

Non-client ABC Co.

“Joint Investor Client”

“Joint Investee Client”

If Client’s investment

If Non-client’s investment

Material

Auditor violation for

Any direct/material indirect investment in Non-client

Not Material


Material direct/indirect investment in Non-client

Material


Any direct/material indirect investment in Non-client

Not Material


Investment in Non-client that has significant influence

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Rule 102 - Integrity and Objectivity In the performance of any professional service, a member sha ll maintain objectiv ity and integrity, shall be free of conflicts of interest, and sha not knowingly misrepresent facts or subordinate his or her judgment to others.

ll

Under Rule 102, a CPA shall not knowingly misrepresent facts. An Interpretation of Rule 102 states that a CPA who knowingly makes - or directs another to make - false or misleading entries in an entity's financial records is considered to be knowingly misrepresent facts. Another interpretation of Rule 102 states that a CPA can be a client's advocate in tax and management services but not in auditing service. Moreover, in auditing services an auditor shall not subordinate his or her judgment to the client's best interest. Rule 201 - General Standards A member shall comply with the following standards and with any interpretations thereof by bodies designed by Council. A. Professional Competence. Undertake only those professional services that the member or the member's firm can reasonably expect to be completed with professional competence. B. Due Professional Car e. Exercise due professional care in the performance of professi onal services. C. P lanning and Supervision. Adequately plan and supervise the performance of professio nal services. D. Sufficient Relevant Data . Obtain sufficient relevant data to a fford a reasonable ba sis for conclusions or recomm endations in r elation to any professional services performed.

Rule 201 reinforces the importance of compliance with the Generally Accepted Auditing Standards for all CPAs in auditing services. The requirements for professional competence and due professional care relate to the first and third of the General Standards of the Generally Accepted Auditing Standards, while the requirements for planning and supervision, and sufficient relevant data relate to the first and third of the Standards of Field Work of the Generally Accepted Auditing Standards. Rule 202 - Compliance with Standards A member who performs a uditing, review , compilation, management consulting, tax, or promulgated bodies designated by Council.

other pr ofessional ser vices shall comply wi th stan dards

Rule 202 broadens CPAs' responsibilities to comply with all professional standards beyond that associated with auditing services in Rule 201. Under Rule 202, CPAs must comply with all relevant professional standards in all types of CPA services. Rule 203 - Accounting Principles A member shall not (1) express an opinion or state affirmatively that the financial sta tements or other financial data of any entity are presented in conformity with generally accepted accounting principles or (2) state that he or she is not aware of any material modifications that should be made to such statements or data in order for them to be in conformity with generally accepted accounting principles, if such statements or data contain any departure from an accounting principle promul gated by bodies design ated by Council to establish such principle s tha t has a material effect on the statements or data taken as a whole. If, however, the sta tements or da ta contain such a depar ture a nd the member can demonstrate that due to unusual circumstances the financial statements or data would otherw ise have been misleading, the mem ber ca n comply with the rule by describing the departure, its approximate effects, if practicable, and the reasons why compliance with the principle would result in a misleading statement.

An auditor shall not express unqualified opinion if a client's financial statements depart from GAAP. This means that departures from FASB Statements of Financial Accounting Standards, GASB Statements of Government Accounting Standards, Opinion of the Accounting Principles Board, and Accounting Research Bulletins are all prohibited under Rule 203. An interpretation of Rule 203 recognizes the difficulty for authoritative accounting bodies to anticipate all of the circumstances to which accounting principles might apply. Accordingly, a CPA may allow a client's financial statements to depart from GAAP due to unusual circumstances, for example, new legislation and the evolution of a new form of business transaction.


Rule 301 - Confidential Client Information A member in public practice shall not disclose any confidential client information without the specific consent of the client. This rule shall not be construed (1) to relieve a member of the member's professional obligations under rules 202 and 203, (2) to affect in any way the member's obligation to comply with a validly issued and enforceable subpoena or summons, (3) to prohibit review of a member's professional practice under AICPA or state CPA society authorization, or (4) to preclude a member from initiating a compliant with or responding to any inquiry made by a recognized investigative or disciplinary body. Members of a recognized investigative or disciplinary body and professional pr actice reviewers shall not use to their own advantage or disclose any member's confidential client inf ormation that comes to their attention in car rying out their offic ial r esponsibilities. However, this pr ohibition shall not restrict the exchange of information with a recognized investigative or disciplinary body or affect, in any way, compliance with a validly issued and enforceable subpoena or summons.

Rule 301 prohibits an auditor from disclosing any confidential client information, e.g. officers' salaries, unreleased advertisements, production cost information, tax returns etc. For the CPA to have the client in trust, the auditor must assure the client that matters discussed will be held in confidence. Closely related to the ethical concept of confidential client information is the legal concept of privileged communication. In contrast to attorney and physician, information communicated between a CPA and a client is not privileged under federal law. Therefore, the information can be requested as evidence by a court of law. Although, auditor-client confidential information is not privileged in federal jurisdiction, the information may be privileged in the status of some states. Rule 301 states four important exceptions: 1. A CPA's adherence to GAAS overrides confidentiality (e.g. subsequent discovery of facts by the auditor after the audit report has been issued). 2. The confidentiality rule does not apply when subpoenas or summonses enforceable by order of the court exist. 3. A CPA shall provide audit working papers requested by the Professional Ethics Executive Committee (PEEC) of AICPA or state CPA society (or association) for peer review (or quality review) programs. In doing so, the CPA is indirectly disclosing confidential client information. In addition, the CPA may release the working papers for peer reviews without the client's consent; presumably it would be a time burden to all concerned if permission from each client is needed for every peer review. It should be noted that AU 210), Terms of Engagement , requires a successor (incoming) auditor to request the client's consent in order to gain access to a predecessor (outgoing) auditor's working papers. Moreover, the successor auditor should also request the client to authorize (i.e., consent) the predecessor to release working papers to the successor auditor. Finally, in the case that a CPA sells the practice to another CPA, the buyer auditor must request the client to authorize the seller auditor to release audit working papers to the buyer auditor. 4. A CPA is permitted to disclose confidential client information in the event of initiating a complaint with or responding to any inquiry made by a recognized investigative or disciplinary body such as the Joint Trial Board or the Public Company Accounting Oversight Board. Figure 3-3 provides a summary of the interpretations of Rule 301 Confidential Client Information. Figure 3-3 Interpretations of Rule 301 Confidential Client Information Auditor

Working Papers

Auditing

Client XYZ Co.

No disclosure of confidential client information to anyone without the consent of the client Exceptions: Shipment of audit working papers under Peer Review Program (no client consent is needed) Successor/buyer auditor to request the client’s consent for predecessor/seller auditor to release audit working papers Working papers subpoenaed under law suits AUs overwrites CPC (e.g., reporting of known fraud under AUs) Working papers examined by the Professional Ethics Executive Committee (PEEC)

Note: PCAOB has no specific rule on auditor and confidential information. SEC requires the auditor to communicate confidential information on illegal acts.

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SEC on Confidential Information

An amendment to the Securities Exchange Act of 1934, the Private Securities Reform Act of 1995, includes a provision for whistleblowing by the auditor on confidential information. This law applies when the auditor obtained confidential information (e.g., obtained from an employee whistle blower) that the client has committed an illegal act and 1. It has a material effect on the financial statements. 2. Senior management and the board of directors have not taken appropriate remedial action. 3. The failure to take remedial action is reasonably expected to warrant a departure from standard unqualified audit report, or resignation by the auditor. In these circumstances, the auditor must, as soon as practical, communicate their conclusions based on the confidential information directly to the client’s board of directors. Within one day, the management of the client must send a notification to the SEC of having received such a communication from the auditor, and a copy of the notification should be sent to the auditor. If the auditor does not receive the copy within the one-day period, they have one day to directly communicate the matter to the SEC. The auditor’s responsibilities for illegal acts are further discussed in Chapter 6. Chapter 23 further discusses the auditor’s responsibilities for illegal acts under the Single Audit Act. Currently, the PCOAB has no specific rule concerning confidential client information and the auditor. Although Section 806 of the Sarbanes-Oxley Act of 2002 provides civil and criminal protections to employees of the audit client who whistleblow confidential information, such protections do not extend to the auditor. Rule 302 Contingent Fees A member in public practice shall not (1) Perform for a contingent fee any professional services for, or receive such a fee from a client for whom the member or the member’s firm performs (a) an a udit or r eview of financial statements; or (b) a compilation of a financial statement when the membe r expects, or reasonably might expec t, that a third pa rty will use the financial statement and the member’s compilation report does not disclose a lack of independence; or (c) an examination of prospective fi nancial information; or (2) Prepa re a n srcinal or amended tax return or cla im for a tax refund for a contingent fe e for any client. The prohibition in (1) above applies during the period in which the member or member’s firm is engaged to perform any ofservices the listed above and the period covered by any historical financial statements involved in any such listed services. Except as stated in the next sentence, a contingent fee is a fee established for the performance of any service pursuant to an arrangement in which no fee will be charged unless a specific finding or result is attained, or in which the amount of the fee is otherwise dependent upon the finding or result of such service. Solely for purpose of this rule, fees are not regarded as being contingent if fixed by courts or other public authorities, or, in tax matters, if determined based on the r esults of judic ial pr oceedings or the findings of g overnmental agencies. A member’s fee may vary depending, for example, on the complexity of the services rendered.

In 1990, the AICPA and the Federal Trade Commission reached an agreement that would eliminate the restriction on contingent fees for non-attestation services, unless a CPA was also performing attestation for the same client. The agreement also continues to prohibit tax return preparation on a contingent fee basis. An example of a prohibited contingent fee for attestation service is when a CPA’s audit is free (i.e., no audit fee is charged) contingent upon an unqualified audit report is issued to the client. An example of a prohibited contingent fee for tax return preparation is when a CPA’s tax return preparation is free (i.e., no preparation fee is charged) contingent upon a tax refund is obtained for the client. Under the agreement, an example of a prohibited contingent fee when a CPA performs both attestation and non-attestation services for the same client is when the CPA charges a client consulting service fees on a percentage of a bond issue while the CPA also performs audit service for the same client. Another example is when the CPA charges fees as an expert witness based on the amount awarded to the plaintiff (client) while the CPA also performs audit service for the same client. In addition, the agreement does not prohibit a CPA from charging an audit fee based on (contingent upon) the complexity or number of hours or days needed to complete the audit service. An exception to the rule is when courts or regulatory agencies fix the contingent fee. An example is when a court-appointed liquidator in the case of client liquidation fixes an audit fee. Another example is when the IRS fixes the contingent fee for an auditor who represents an audit client in an examination (i.e., a federal tax probe) of the client’s federal tax return by an IRS agent. However, this particular example is no longer valid (meaning it is no longer an exception to the rule) under the SEC’s Financial Reporting Release No. 65 in 2004. In services 2004, thewhen SEC’s Financial Reporting Release No. prohibits theservices use of for contingent for The tax preparation a CPA performs both attestation and 65 non-attestation the samefees client. release also states it is not a “contingent fee” if it is fixed by courts or other public authorities, or, in tax matters, if determined based on the results of judicial proceedings or the findings of governmental agencies. Under this definition, the AICPA has argued that a tax preparation services fee is not "contingent" because it is "considered


determined based on the findings of government agencies if the member can demonstrate a reasonable expectation, at the time of a fee arrangement, of substantive consideration of an agency with respect to the member's client." However, the SEC rejects this argument and clarifies that, "the release makes clear that the exception would apply only when the determination of the fee is taken out of the hands of the accounting firm and its auditor client and is made by a body that will act in the public interest, with the result that the accounting firm and client are less likely to share a mutual financial interest in the outcome of the firm's advice or service," and because "the fact that a government agency might challenge the amount of the client's tax savings and thereby altering the amount of the fee paid to the firm heightens, not lessens, the mutuality of interest between the firm and client. Accordingly, such fees impair an auditor's independence." In sum, the AICPA’s exception to its Rule 302 on contingent fee does not apply for tax preparation services fee that is fixed by the courts or regulatory agencies. Currently, PCOAB’s Independent Rule 3521 makes it very clear that a CPA firm is not independent of its audit client if the firm provides any service or product to the audit client for a contingent fee or a commission. See Figure 3-4 for an overview of Rule 302 Contingent Fees. Figure 3-4 An Overview of Rule 302 Contingent Fees

Attestation Services and Non-attestation Services

Client XYZ Co.

Prohibit contingent fee for auditing Exception: Allow contingent fee fixed by courts or regulatory agencies for auditing Allow audit fee contingent on hours and complexity of audit Prohibit contingent fee for tax services and other non-attestation services Exception: Allow contingent fee fixed by courts or regulatory agencies for non-attestation services (but not for tax services)

Auditor

Note: PCAOB Rule 3521 prohibits contingent fees for attestation & non-attestation services to the same client.

Non-attestation Services only

Client XYZ Co.

Allow contingent fee for tax services Allow contingent fee fixed by courts or regulatory agencies for tax services and other non-attestation services

Note: PCAOB Rule 3521 allows contingent fees for non-attestation services only to the client.

Rule 501 - Acts Discreditable A member shall not commit an act discreditable to the profession.

The term "discreditable" is not defined in the Rule. Eight Interpretations of Rule 501 define acts that would be considered to be discreditable: 1. A CPA retains client records after the client has demanded those records, especially in a situation where the client has not paid the CPA's audit fee. Audit fee outstanding for more than a year becomes a loan to the client, which is prohibited by Rule 101 Independence. Note that a CPA’s working papers, including analyses, schedules, and records prepared by the client at the request of the CPA, are not client records and need not be made available to the client. Note also that analyses, schedules, and records prepared by the CPA for the client, such as tax returns, are client records and need not be made available to the client. An exception exists in case the client experiences a loss of records due to a natural disaster or an act of war. In those situations, the auditor should make such records available to the client. 2. Discrimination by a CPA on the basis of race, color, sex, age, or national srcin in hiring, promotion, salary, or other employment practices constitutes an act discreditable to the profession.

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3. A CPA fails to follow standards and/or procedures in auditing governmental agencies unless the CPA discloses in the report the fact that such standards were not followed and reasons thereof. 4. Failure to follow the requirements of government bodies, commissions, or other regulatory agencies in performing attest or similar services. 5. Negligence in the preparation of financial statements or records. 6. Failing to file tax returns or remit payroll and other taxes collected for others (e.g., employee taxes withheld). 7. Making, or permitting others to make, false and misleading entries in records and financial statements. 8. Soliciting or disclosing CPA Examination questions and answers from the closed CPA Examination. One of the AICPA's bylaws states that a CPA's membership will be terminated if he/she commits a crime punishable by imprisonment for more than a year. Therefore, the one year jail term may be a yardstick for deciding whether an act is discreditable to the profession. Using this yardstick, unprofessional acts committed by a CPA such as fraudulently prepared tax returns, criminal offenses, excessive drinking, and rowdy behavior would be considered as discreditable acts if they resulted in more than a year's jail term. Rule 502 - Advertising and Other Forms of Solicitation A member in public practice shall not seek to obtain clients by adv ertising or other forms of solicitations in a manner that is false, misl eading, or deceptive. Solicitation by the use of coercion, overreaching, or hara ssing conduct is prohibited.

In the 1970s, the U.S. Justice Department and the Federal Trade Commission pressurized AICPA to relax advertising rules for the purpose of opening up competition among CPAs. In 1978, Rule 502 allows advertisement and solicitation that are not false, misleading, or deceptive. The Rule also states that the CPAs shall not use coercion, over-reaching, or harassment in conducting their advertisement and solicitation. An Interpretation of Rule 502 identifies four instances of false, misleading, or deceptive advertisement that a CPA must avoid: 1. Advertisement that creates false expectations of favorable results. 2. Advertisement that implies an ability to influence any court, tribunal, or regulatory body. 3. Advertisement that states a specific service will be performed for a stated fee or estimated fee when it is likely that the fee will be increased substantially. 4. Advertisement that contains and has other representation that would cause a reasonable person to misunderstand or be deceived. Rule 503– Commissions and Referral Fees 1. Pr ohibited commissions. A member in public practice sha ll not for a commission recomm end or r efer to a client any product or service, or for a commission recommend or refer any product or service to be supplied by a client, or receive a commission, when the member or the member's firm a lso perform for that client: a. An audit or review of a financial statement . b. A compilation of a financial statement when the member expects, or reasonably might expect, that a third party will use the financial statement and the member's compilation report does not disclose a lack of independence. c. An examination of prospective financial information. This prohibitio n applies during the period in which the membe r is engaged to perform a ny of the services listed above and the period covered by any historical financial statements involved in such listed services. 2. Disclosure of permitted commission. A member in public practice who is not prohibited by this rule from performing services for or receiving a commission and who is paid or expects to be paid a commission shall disclose that fact to any person or entity to whom the member recommends or refers a product or service to whi ch the commission relates. 3. Referral fees. Any member who accepts a referral fee for recommending or referring any service of a CPA to any person or entity or who pays a r eferral fee to obtain a client shall disclose such acceptance or pa yment to the client.

Rule 503 prohibits a CPA from receiving or paying a commission for service or product referrals to or from a client when the CPA is performing an attestation service for the same client. This is to prevent potential conflicts of interest. However, Rule 503 allows such a commission for any non-attestation service client provided disclosure is made to the client. Part 3 of Rule 503 permits referral fees. However, the CPA must disclose such fees to the client. Figure 3-5 provides a summary of the interpretations of Rule 503 Commissions and Referral Fees.


Figure 3-5 Interpretations of Rule 503 Commissions and Referral Fees

Commissions received Violation

e.g., Supplier

Goods (e.g., computers)

Auditor

Auditing

Client XYZ Co

Services (e.g., legal work)

Referral fees received No violation

e.g., CPA of a Law firm

Rule 505 - Form of Organization and Name A member may practice public accounting in a form of organization permitted by state law or regulation whose characteristics conform to resolutions of Council. A member shall not pr actice public accounting under a firm name that is misleading. Name s of one or more past owners may be included in the firm name of a successor orga nization. Also, an owner surviv ing the death or withdrawal of all other owners may continue to p ractice under such name which inclu des the name of past owners for up to two years after becoming a sole practitioner. A firm may not designate itself as "Members of the American Institute of Certified Public Accountants" unless all of its owners are members of the institute.

An audit firm shall practice only in the form of a proprietorship, a partnership, or a professional corporation. A professional corporation represents a corporation in form, but a partnership in substance, that is, it has no limited liability. A professional corporation provides a tax advantage to the individual CPAs by avoiding double taxation (i.e., corporate taxes to the professional corporation and individual taxes to the CPA shareholders). In 1991, the AICPA permits an audit firm to practice in the form of a limited liability partnership (LLP), which limits an individual partner’s liability to his/her investment in the firm, except in litigation, where a litigant can make claims against a partner’s personal assets for liability linked directly to his/her own negligent act (e.g., a partner-in-charge of an audit client issued a wrong audit opinion for that client). Under Rule 505, the name of a CPA firm can be fictitious or indicate a specialization, provided that the firm name or specialization is not deceptive or misleading. For example, "International Tax Specialists" is acceptable if the CPAs indeed specialized in International Tax Services. However, "International Tax Free Specialists" is unacceptable because the word "Free" may be misleading. Rule 505 states that a successor partnership or professional corporation may continue to include the names of one or more past partners or shareholders in its firm name. However, a sole successor of a partnership or corporation may do the same for up to two years after becoming a sole practitioner. Moreover, all partners or shareholders of a CPA firm must be members of AICPA if the firm wants to carry the designation "Members of the AICPA". Enforcers of the CPC

The AICPA has two key avenues by which members can be disciplined for violating the CPC. For violations that are not sufficient to warrant formal actions, the Professional Ethics Executive Committee (PEEC) can direct a member to take remedial or corrective actions. The committee can also refer a member to the Joint Trial Board. Furthermore, the State Board of Accountancy may revoke a CPA’s license for very serious violations of the CPC.

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In general, there are three levels of enforcement and disciplinary action as follows: 1. Less serious violations are handled by the PEEC of the AICPA and/or state society/association. Disciplinary actions are usually in the form of corrective actions e.g., to attend a number of continuing education hours. 2. More serious violations are handled by the Joint Trial Board. Disciplinary actions include suspension or expulsion of membership from AICPA and the name of the offending CPA published in the CPA Newsletter. It should be noted that expulsion of membership does not stop one from practicing as an accountant. 3. Very serious violations are handled by the State Boards of Accountancy. Disciplinary actions include suspension or revocation of a CPA certificate and/or the license to practice. Figure 3-6 shows the enforcers of the CPC and their disciplinary action. Figure 3-6 Enforcers of the CPC and Disciplinary Action

Enforcers of the CPC

AICPA

State Board of Accountancy

Professional Ethics Executive Committee

Joint Trial Board

Disciplinary action

Expulsion

Revoke CPA license

Enforcer of SEC’s Auditor Independent Rules

If the PCAOB determines that any registered CPA firm has engaged in practices in violation of the PCAOB’s Auditor Independent Rules, the Board may impose sanctions, including temporary suspension or permanent revocation of registration or association of individuals with a registered firm, monetary penalties, censure, and additional education or training.



Which of the following principles is not in the CPC? a. To serve the public interests. b. To exercise professional care. c. To be a responsible profession. d. To provide expert advice.

3-2

Which part(s) of the CPC is(are) enforceable? a. Interpretations. b. Rules Ethicalofrulings. c. conduct. d. Principles.

3-3

Which of the following statements is a violation of the rule on independence in fact and independence inappearance? a. A CPA acquired immaterial indirect investment in an audit client. b. A CPA holds a honorary directorship in a not-forprofit religious organization. c. A CPA secured a franchise loan from an audit client. d. A CPA disengaged from an audit client.

3-4

A CPA will not be independence in fact and in appearance if s/he is a. an honorary secretary of a not-for-profit client. b. a trustee of a not-for-profit client's pension fund. c. a part time accountant of an non-audit client. d. an immaterial direct investor in an audit client.

3-5

The rule on confidential client information will be violated if a CPA a. provides working papers to a succeeding auditor without the consent of an audit client. b. provides working papers of an audit client to internal revenue service who requested them. c. provides working papers of an audit client to a court of law which subpoenas them. d. provides working papers of an audit client to an AICPA peer review program without the consent of the client.

3-6

A CPA will violate the rule on contingent fees if s/he a. charges a fee according to what isstated in the engagement letter. b. charges a fee that is the same as the previous year's audit fee. c. charges a fee that is different from the previous year's audit fee. d. charges a fee that is based on the type of audit opinion to be issued.

3-7

The CPC prohibits a CPA to a. advertise for potential clients. b. pay commission to others for client referrals when the CPA is auditing the same client. c. charge a fee based on a particular outcome of theaudit. d. receive commission from others for client referrals when the CPA is auditing the same client.

3-8

Very serious violations of the CPC by a CPA are handled by a. the National Joint Trial Board. b. the National Ethics Committees. c. the State Boards of Accountancy. d. the National and State Ethics Committees.

3-9

The interpretations of the Rules of Conduct, Rule 101, define “materiality” for investor-investee relationships as: a. 5% of audit client’s total assets, b. 5% of audit client’s operating income before taxes. c. either 5% of audit client’s total assets or 5% of income before taxes, whichever is more restrictive. d. 5% of audit client’s net income after taxes.

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3-10

Generally, loansbetween a CPA and an audit client are prohibited becausethey create a financial relationship.Which of the following is not an exception to this rule? a. Secured automobile loans. b. Fully collateralized loans. c. Home mortgages. d. Unpaid credit card balances not exceeding $10,000.

3-11

or the Interpretations of the AICPA’s Code Which of the following is not defined as an act discreditable in either the Rules of Professional conduct?

a. A CPA firm issued a standard unqualified audit report after auditing a governmental agency, although GAAS was not followed because the government required procedures different from GAAS. b. A CPA firm discriminates in its hiring practices based on the age of the applicant. c. A CPA retains a client’s books and records to enforce past-due payment of the CPA’s audit fee. d. A CPA was arrested on his way home from the CPA firm’s holiday party. He was a passenger in a car driven by his wife and she was charged with “driving while intoxicated.” He was also charged with “lewd and indecent gestures towards an officer of the law.” 3-12

In which of the following instances would the independence of the CPA not be considered to be impaired? The CPA has been retained as the auditor of a a. charitable organization in which an employee of the CPA serves as treasurer. b. municipality in which the CPA owns $250,000 of the $2,500,000 indebtedness of the municipality. c. cooperative apartment house in which the CPA owns an apartment and is not part of the management. d. company in which the CPA’s investment club owns one-tenth interest.

3-13

In connection with a lawsuit, a third party attempts to gain access to the auditor’s working papers. The client’s defense of privileged communication will be successful only to the extent it is protected by the a. auditor’s acquiescence in use of this defense. b. common law. c. AICPA Code of Professional Conduct, Rule 301 on client confidential information. d. state law.

3-14

The AICPA Code of Professional Conduct requires compliance with accounting principles promulgated by the body designated by AICPA Council to establish such principles. The pronouncements comprehended by the code include all of the following except a. AICPA Accounting Research Bulletins. b. AICPA Accounting Research Studies. c. opinions issued by the Accounting Principles Board. d. interpretations issued by the Financial Accounting Standards Board.

3-15

A CPA is allowed to accept a referral fee for recommending a client to another CPA if a. the client approves of the transaction either before or after the event. b. payment of the referral fee is disclosed to the client. c. the client pre-approves the transaction. d. None of the above because referrals are never acceptable.

3-16

Rule 505 of the AICPA’s Code of Professional Conduct permits CPA firms to organize as

a. single proprietorships or partnerships only. b. single proprietorships, partnerships, or professional corporations. c. single proprietorships, partnerships, professional corporations or regular corporations if permitted by state law. d. single proprietorships, partnerships, professional corporations if permitted by state law, or regular corporations. 3-17

The interpretations to the Rules of Conduct permit a CPA to do both bookkeeping and auditing for the same client if three important requirements are satisfied. Which of the following is not one of those requirements? a. The CPA must conform to generally accepted auditing standards. b. The CPA must not assume the role of employee or of manager. c. The client must accept full responsibility for the financial statements. d. The client must file audited financial statements with the SEC.


3-18

The AICPA’s Code of Professional Conduct states that a CPA should maintain i ntegrity and objectivity. The Term “objectivity” in the Code refers to a CPA’s ability

a. to choose independently between alternate accounting principles and auditing standards. b. to distinguish independently between accounting practices that are acceptable and those that are not. c. to be unyielding in all matters dealing with auditing procedures. d. to maintain an impartial attitude on all mat ters that come under the CPA’s review. 3-19

Which of the following activities is not prohibited for the CPA firm’s att estation service clients?

a. Competitive bidding on audit jobs. b. Contingent fees on audit jobs. c. Commissions for obtaining client services on audit jobs. d. None of the above. 3-20

A violation of t he AICPA’s Code of Professional Conduct would most likely have occurred when a CPA

a. make arrangements to charge a client audit fee based on the complexity of the client’s accounting systems. b. make arrangements with a bank to collect notes issued by a client in payment of fees due. c. whose name is Choo formed a partnership with two other CPAs and uses Choo & Associates as the firm name. d. issued an unqualified opinion on the 2001 financial statements when audit fees for the 2000 audit were unpaid. 3-21

A CPA is permitted to disclose confidential clientinformation without the consent ofthe client to I. Another CPA whohas purchased the CPA’s tax practice. II. Another CPA if theinformation concerns suspected tax return irregularities. III. A state CPA society’s quality control review board for the purposeaofpeer review program. a. I and III b. II and III c. II d. III

3-22

In which of the following situations would a CPA’s independence be considered to be impaired? I. The CPA maintains achecking account that is ully f insured by agovernment deposit insurance agency at anaudit client’s financial institution. II. The CPA has a financial interest in anaudit client, but the interest is maintained in blind a trust. III. The CPA owns a commercial building and leases it to an audit client. The rental income is material tohet CPA.

a. I, II, and III. b. I and III c. II and III d. I and II 3-23

A CPA purchased stock in a client and placed it in a trust as an educational fund for the CPA’s dependent child. The trust securities were not material to the CPA but were material to the child’s personal net worth. Would the independence of the CPA be considered impaired with respect to the client?

a. Yes, because the stock would be considered a direct financial interest and, consequently, materiality is not an issue. b. Yes, because the stock would be considered an indirect financial interest that is material to the CPA’s child. c. No, because the CPA would not be considered to have a direct financial interest in the client. d. No, because the CPA would not be considered to have a material indirect financial interest in the client. 3-24

Which of the following would probably not be considered an “act discreditable to the profession”: a. Failing to file the CPA’s own tax return. b. Soliciting CPA Examination questions and answers. c. Numerous moving traffic violations. d. Refusing to hire Asian-Americans in an accounting practice.

3-25

According to the CPC, which of the following acts is generally prohibited? a. Purchasing a product from a third party and reselling it to a client. b. Writing a financial management newsletter promoted and sold by a publishing company. c. Accepting a commission for recommending a product to an audit client. d. Accepting engagements obtained through the efforts of third parties.

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3-26

Which of the following is required for a CPA firm to designate itself as “Members of the American Institute of Certified Public Accountants” on its letterhead?

a. All partners of the CPA firm must be member of AICPA. b. The partners whose names appear in the firm name must be members. c. At least one of the partners must be a member. d. The firm must be a dues-paying member. 3-27

The concept of materiality would be least important to an auditor when considering the a. adequacy of disclosure of a client’s illegal act. b. discovery of weaknesses in a client’s internal control. c. effects of a direct financial interest in the client on the CPA’s independence. d. decision whether to use positive or negative confirmations of accounts receivable.

3-28

A violation of the CPC most likely would have occurred when a CPA a. expressed an unqualified opinion on the current year’s financial statements when audit fees for the prior year’saudit were unpaid. b. recommended a controller’s position description with candidate specifications to an audit client. c. purchased a CPA firm’s practice of monthly write-ups for a percentage of fees to be received over a 3-year period. d. made arrangements with a financial institution to collect notes issued by a client in payment of audit fees due for the current year’s audit.

3-29

According tothe CPC, which of the following circumstances willprevent a CPA performing audit engagements from being independent? a. Obtaining a collateralized home loan from a financial institution client. b. Litigation with a client relating to billing for consulting services for which the amount is immaterial. c. Employment of the CPA’s spouse as a client’s internal auditor. d. Acting as an honorary trustee for a not-for-profit.

3-30

According tothe CPC, which of the following eventsmay justify a departure from a Statement ofFinancial Accounting Standards?

a. b. c. d. 3-31

New Legislation No Yes Yes No

Evolution of a New Form of Business Transaction Yes No Yes No

According to the CPC and prior to the SEC’s Financial Reporting Release No.65, which of the following acts is not generally prohibited? a. Issuing a modified report explaining a failure to follow a governmental regulatory agency’s standards when conducting an attest service for a client. b. Revealing confidential client information during a peer review of a professional practice by a team from the state CPA society. c. Accepting a contingent fee for representing a client i n an examination of the client’s federal tax return by an IRS agent. d. Retaining client records after an engagement is terminated prior to completion and the client has demanded their return.

3-32

With respect to client records in a CPA’s possession, the CPC provides that (Hint: Consider Rule 501)

a. an auditor may retain client records if fees due with respect to a completed engagement have not been paid. b. worksheets in lieu of general ledger belong to the auditor and need not be furnished to the client upon request. c. extensive analyses of legal expenses prepared by the client at the auditor’s request are working papers that belong to the auditor and need not be furnished to the client upon request. d. the auditor who returns client records must comply with any subsequent requests to again provide such information. 3-33

Which of the following is a violation of the SEC’s auditor independence rule onnon-audit services?

a. A CPA firm provides certain non-audit services that they are pre-approved by the audit committee. b. A CPA firm provides certain non-audit services that are not pre-approved by the audit committee but the aggregate fee of all such non-audit services constitutes less than 5% of the total audit fee paid to the CPA firm. c. CPA firm providesdisclose tax services to an audit client that are not by the audit committee. d. A The audit committee to investors in periodic reports itspre-approved decision to pre-approved non-audit services.


3-34

Which of the following is not a general principle used by the Public Company Accounting Oversight Board (PCAOB) in evaluating the effect of other services on auditor independence? a. The fee for the additional services must be less than the audit fee. b. An auditor cannot function in the role of management. c. An auditor cannot audit his or her own work. d. An auditor cannot serve in an advocacy role for the client.

3-35

In which of the following situations would a CPA be considered not independent with respect to an audit client under the independence Rules of the Sarbanes-Oxley Act? a. The CPA firm provides tax planning services to the audit client that were pre-approved by the audit committee. b. The audit client hires a partner of a CPA firm as its CFO who left the CPA firm one month earlier, and who was in charge of the most recent audit of that audit client. c. The audit partner-in-charge of an audit client has served in that capacity for the past four years. d. The CPA firm provides general business consulting services that were pre-approved by the audit committee.

3-36

In which of the following situationswould a CPA be in violation of the AICPA Code of Professional Conducton commissions and referral fees? a. A CPA discloses to anon-attestation service client that he hasreceived a commission from one of the suppliers of that client. b. A CPA discloses to an attestation service client that he has received a referral fee from oneof the lawyers of that client. c. A CPA discloses to an attestation service client that he has received a commission from one of the suppliers of that client. d. A CPA discloses to a non-attestation service client that he has receivedreferral a fee from one ofthe lawyers of that client.

3-37

Contrast the requirements of AICPA’s Independent Rule 101 and PCAOB’s Auditor Independent Rules, which of the following is a correct statement?

a. SEC requires the lead partner to rotate off the audit every seven years, whereas AICPA requires a rotation every five years. b. AICPA does not prohibits providing audit and management services to the same client, whereas SEC directly prohibits providing audit and management services to the same client. c. PCAOB allows a public company to employ a member of its external audit team one year after the audit engagement, whereas AICPA allows a public company to employ a member of its external audit team one year preceding the audit engagement. d. PCAOB requires audit committee to pre-approve non-audit services unless the non-audit service fees are less than 5 percent of the total fees. In contrast, AICPA contains no such requirement. 3-38

With regard to enforcement and disciplinary action, veryserious violations of the ethical rules are ordinarily handled by a. AICPA’s Professional Ethics Executive Committee. b. AICPA’s joint trial board. c. AICPA’s quality control standards committee. d. State Board of Accountancy.

3-39

Which of the following is not a correct statement regarding auditor’s independent?

a. An auditor’s spouse, spousalequivalent (i.e., cohabitant), and dependents are prohibited from having a direct financial interest in the audit client. b. An auditor is not independent of the audit client if any audit partner received compensation based on the partner securing with the client billable work for services other than audit or attestation. c. An auditor is not permitted to have a home mortgage loan from the audit client. d. An auditor is prohibited from being employed by the audit client one year preceding the audit engagement. 3-40

Which of the following is an example of a “familiarity” threat to an auditor’s independence?

a. An auditor has a material joint venture with the audit client. b. An audit has provided audit services to the same client for a prolonged period. c. An auditor establishes and maintains internal controls for the audit client. d. An auditor represents an audit client in U.S. tax court.

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3-41

In which of the following situations would a CPA be in violation of the PCAOB’s rules on providing auditing and management advisory services to the same audit client? a. The auditing and management advisory services provided to the same audit client are pre-approved by the audit committee . b. The aggregate fee of the auditing and management advisory services constitutes less than 5%the of total audit fee paid to the CPA. . c. The auditing and management advisory services are provided to the same audit client thatis a non-public company. d. The auditing and management advisory services provided to the same audit client are not pre-approved by the audit committee.

3-42

The PCAOB’s Auditor Independence Rule defines a CPA’s nondependent step-child as

a. a close family relative. b. another relative. c. an immediate family member. d. neither an immediate family member nor a close family relative. 3-43

With regard to an auditor providingauditing andtax services to the same audit client,there would be a violation ofthe PCAOB’s Auditor Independence Rules if a. The total tax services fee is less than 5% of the total audit fee. b. The tax services are provided for the client’s officers in financial reporting oversight roles after the audit engagement has begun. c. The tax services are preapproved by the audit committee. d. The tax services are provided for the client’s officers not in financial reporting oversight roles.

3-44

Which of the following is not a correct statement concerning both the PCAOB and AICPA’s independence rules? a. PCAOB prohibits actuarial service whereas AICPA allows it provided the service does not relate to a material portion of the financial statements. b. PCAOB prohibits implementing a financial information system whereas AICPA allows it provided the system is not developed by the auditor. c. PCAOB prohibits bookkeeping services whereas AICPA allows it provided the auditor does not authorizes or approves transactions. d. PCAOB prohibits internal audit outsourcing services whereas AICPA allows it provided the audit client is not responsible for internal control.

3-45

Under the current Federal laws, which of the following does not apply to an auditor who has obtained certain confidential information about an illegal act committed by the client? a. The illegal act has a material effect on the financial statements and warranted a qualified audit report, the auditor must communicate the act and confidential information to the client’s board of directors. b. Upon communicated of the illegal act and confidential information, the management must send a notification to the SEC of having received such a communication from the auditor, and a copy of the notification to be sent to the auditor. c. The SEC provides civil and criminal protections to employees of the audit client who whistleblow confidential information and provides the same protections to auditor who possesses such confidential information from the whistleblowers. d. Upon communicated of the illegal act and confidential information, if the management did not send the auditor a copy of the notification to the SEC of having received such a communication, the auditor must directly communicate the matter to the SEC.

3-46

With regard to contingent fees,which of the following is not an appropriate interpretationof Rule 302 Contingent fees when an auditor provides both attestation and non-attestation services to the same client? a. It prohibits contingent fee for audit services provided to the client. b. It prohibits contingent fee fixed by courts or regulatory agencies for audit services provided to the client. c. It prohibits contingent fee for tax services and other non-attestation services provided to the client. d. It prohibits contingent fee fixed by courts or regulatory agencies for tax services provided to the client.


Key to Multiple-Questions

3-1 d. 3-2 c. 3-3 c. 3-4 d. 3-5 a. 3-6 d. 3-7 c. 3-8 c. 3-9 c. 3-10 d. 3-11 d. 3-12 c. 3-13 b. 3-14 b. 3-15 b. 3-16 c. 3-17 d. 3-18 d. 3-19 a. 3-20 d. 3-21 d. 3-22 c. 3-23 a. 3-24 c. 3-25 c. 3-26 a. 3-27 c. 3-28 a. 3-29 c. 3-30 c. 3-31 c. 3-32 c. 3-33 c. 3-34 a. 3-35 b. 3-36 c. 3-37 d. 3-38 d. 3-39 c. 3-40 b. 3-41 d. 3-42 a. 3-43 b. 3-44 d. 3-45 c. 3-46 b.

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Simulation Question 3-1 Simulation Question 3-1 is an adaptation with permission from a case by Cullinan C.P. and G.B. WrightCases in From The SEC Files , a publication of the Pearson Education, Inc. in New Jersey. This simulation question is based upon a true set of facts from the SEC files.

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SEC Findings

SEC found PricewaterhouseCoopers (PwC) failed to comply with Rule2-01(b) of Regulation S-X, GAAS, SEC Independence Rules, and AICPA Code of Professional Conduct which require, among other things, that public accounting firms and their partners and certain professionals not have any direct or material indirect financial interest in their audit client. Details of the findings are as follows: 1. Professionals who owned securities of publicly held audit clients for which they provided professional services. the period 1996 through 1997,First, three Coopers &1996, Lybrand (C&L)taxCPAs ownedofthe securities of four publicly-held audit clients n iDecember a senior associate C&L’s Tampa, Florida, office (“Tampa Tax for which During they provided professional services. Associate”) owned the securities of a company (“Company A”) for which he provided professional tax services relating to certain engagements that were transferred from C&L’sJacksonville, Florida, office. Second, during November 1996 through April 1997, the Tampa Tax Associate also owned the securities of another company (“Company B”) for which he provided professional tax services relating to Company B’s initial public offering and other tax projects. Third, during December 1996 through February 1997, the Tampa Tax Associate also owned the securities of another company (“Company C”) for which he provided professional tax services relating to tax accrual in Company C’s 1996 financial statements. In addition, during October 1997 through July 1998, a consultant in C&L’s Human Resource Advisory Group also owned securities of Company C for which the consultant provided one hour of professional consulting services relating to a 401(K) plan offered by Company C. Fourth, during October 1996 through February 1997, another senior tax associate of C&L’s Tampa office (“Second Tampa Tax Associate”) owned the securities of a company (“Company D”) for which he provided professional tax services relating to pending IRS audits of Company D. 2. Partners who owned securities of publicly held audit clients for which the partners provided no professional services and managers who owned securities of publicly-held audit clients of their office for which the managers provided no professional services. During the period 1996 through 1998, five C&L partners or their spouses owned securities of, or had another direct or material indirect financial interest in, 31 publicly held audit clients for which the partners provided no professional services. In addition, three C&L managers or their spouses owned securities of, or had another direct or material indirect financial interest in, three publicly-held audit clients of their office for which the managers provided no professional services. 3. Investments by C&L’s retirement plan in securities of publicly-held audit clients of C&L and PwC. During the period of 1996 through 1998, C&L’s retirement plan owned securities of 45 publicly held audit clients in three types of instances. First, during the period 1977 through 1988, an independent fund manager that was not a C&L employee and that was retained to manage certain of C&L’s pension fund assets made 15 purchases of the securities of 11 different publicly held audit clients of C&L. C&L annually provided its fund manager with a list of its audit clients (“independent list”), the securities of which were not tobe purchased. However, C&L’s procedure of monitoring the fund manager’s compliance with C&L’s prohibition consisted of only a periodic comparison by personnel in its pension department of the fund holdings to C&L’s independent list. Second, during the period of 1966 through 1998, the same fund manager made three purchases of the securities of three different publicly held audit clients of C&L. The fund manager made these purchases prior to being provided by C&L with an updated independent list which identified these three clients. Third, from July 1, 1998, the date of the Price Waterhouse (PW) and C&L merger, through November 1998, C&L’s retirement plan held the securities of 32 PwC publicly held audit clients that had been clients of PW before the merger. Former C&L pension personnel, who became employees of PwC, failed to provide three different fund managers with a list of PW’s clients.

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SEC Sanctions (a) (b) (c) (d) (e)

(f)

SEC accepts PwC’s offer of Settlement and orders that: PwC is censured. PwC takes measures to provide reasonable assurance that it will comply with SEC’s Regulation S-X and Independent Rules to be independent, in fact and appearance, of their audit clients. PwC takes measures to provide reasonable assurance that it will comply with AICPA’s GAAS and Code of professional Conduct requiring CPA firms not have any direct or material indirect financial interest in their audit clients. Prior to accepting a new audit engagement, PwC checks its Securities Held List to determine whether any partner owns the securities of that prospective audit client. Annual reports to be filed by all PwC partners and professional staff indicating whether, over the prior year, they had acquired, or were committed to acquire, any direct financial interest or any material indirect financial interest in any securities on its Restricted Entity List. All PwC partners and professional staff complete a course of professional education and training on independence issues.

Required 1. Cite and discuss the specific part(s) of (i) Regulation S-X, (ii) GAAS, (iii) SEC Independence Rules, and (iv) AICPA Code of Professional Conduct that PwC failed to comply with professional independence. You should access Data File 3-1 i n iLearn, which contains the SarbanesOxley Act of 2002 . You should also search any relevant websites for more information. For example, search http://www.aspenpublishers.com/SECRULES/Regsx.pdf for Regulation S-X.


Simulation Question 3-2 Simulation Question 3-2 is an adaptation with permission from a case by Knapp, M. C. and C.A. Knapp in theIssues in Accounting Education , a publication of the American Accounting Association in Sarasota, Florida. This simulation question is based upon a true set of facts that was drawn from United States of America V. Charles I. Covey, No. 00-1768, United States Court of Appeals for the Eighth Circuit, 232 F.3d 641, 2000 U.S.

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A Prospective Client

Peter Kanah spent the early years of his professional career in a large city working on the auditing staff of a major accounting firm, and then serving as an assistant controller for a municipal hospital. In 1995, Kanah and his wife decided they wanted a different lifestyle for themselves and their three young children. After several months of searching for a new job, Kanah decided to accept an offer made to him by a CPA with whom he had become acquainted at local professional meetings. Kanah agreed to purchase theA’s CPaccounting practice that was located in a small suburb approximately 30 miles from the downtown business district where Kanah had worked for more than a decade. The purchase agreement required the former sole practitioner to remain with the firm during a three-year transitional period to minimize client turnover. In 1998, when Kanah assumed complete ownership of the firm, he had six full-time employees, including a receptionist and five ping services accounted for the bulk of Kanah’s revenues. accountants, three of whom were CPAs. Tax, compilation, and bookkee Computer manufacturers, e-commerce start-ups, and other high-tech businesses dominated the greater metropolitan area in which Kanah’s firm was located. As a result, the economy of that area was hit hard by the recession that rocked the nation’s high-tech sector shortly after the turn of century. In a span of 18 months, Kanah lost nearly one-third of his clients, forcing him to lay off two of his professional employees. Making matter worse, over that same time frame, Kanah lost more than 80 percent of his personal savings. He had invested those funds in the stocks of major e-commerce firms whose prices tanked in late 2000 and early 2001. On a late Friday afternoon in June 2001, while Kanah sat at his desk contemplating his seemingly bleak future, his receptionist brought a potential client to his door. “Hello, Mr. Kanah. I am Robin Ornan.” Ornan was a tall man with a sturdy physique and a firm ha ndshake. He was wearing a starched white shirt, blue jeans, and a frayed baseball cap. Immediately catching Kanah;s attention were large, diamond-encrusted rings in the shape of a horseshoe that Ornan wore on the pinkie finger of each hand. “What can I do for you, Mr. Ornan?” “I’m looking for some accounting help.” “Well, you certainly came to the right place.” Ornan proceeded to tell Kanah that he had recently inherited “a good deal of money” from his grandmother and planned to set up a business in his hometown that was some 60 miles away, on the other side of the metropolitan area. When Kanah seemed surprised that Ornan was searching for an accounting firm a considerable distance from his proposed business, Ornan quickly added that the planned to visit several accounting firms in the metropolitan area before choosing one. Because he had worked several years for an electrical contractor, Ornan believed that he had sufficient experience and contacts in that field to quickly develop a profitable electrical contracting business. “Coleman Services” was the name he intended to use for his new company. Ornan has settled on the generic name– Coleman was his grandmother’s maiden name - because he hope toexpand into other linesof business in the future. tunity to “sell” his firm to the prospective a client. Kanah described the As soon as Ornan paused, an anxious Kanah seized the oppor types of services he could offeraa clo new business, including bookkeeping, consulting services. He also stressed se relationship with histaxation, accountant. Because ofand his general firm’s small size, Kanah assured Ornan thatthe he importance would of a new entrepreneur having receive prompt and personalized service. Ornan listened politely to Kanah’s sales pitch, put the business card Kanah offered him in hi s shirt pocket,and then excused himself. As Ornan walked out the door, Kanah decided that he would likely never see Ornan again. Since Ornan had failed to ask any questions about Kanah’s services or fees, he had obviously been unimpressed with the small accounting firm.Kanah realized that Ornan had likely sensed that he was desperate to acquire new clients, which he was. A few minutes later, the disconsolate Kanah told his employees they begin their weekend early – there was little for them to do anyway.

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An Unusual Proposal

When Peter Kanah walked into his office the following Monday morning, he had a voice message waiting for him. Robin Ornan has selected his firm over several others. In the brief message, Ornan told Kanah that he would drop by the office that afternoon “to get the ball rolling.” During their conversation later that day, it soon became apparent to Kanah that Ornan had little understanding of what steps were necessary to set up a new business. Most of the questions Kanah directed to Ornan produced either a blank stare or an indifferent shrug of the shoulders. Finally, Kanah decided to take the initiative. “Robin, I think we should start by developing a business plan for you.” Ornan seemed bored by the length explanation of the nature and purpose of a business plan and only glanced momentarily at the example that Kanah spread out on his desk. When Kanah attempted to goad him into talking about the specific services his firm would provide, the restless Ornan finally spoke. “We don’t need to talk about that. What you really need to know is that I want to put together a business big enough to clearabout $20,000 per month.” Kanah was surprised by the naïve nature of Ornan’s remark. “I’m not sure what you mean , Robin. Do you mean $20,000 of revenues per month or $20,000 of profits per month or $20,000 of net cash flow per month?” “I mean $20,000 of cash, cash money, each month. I expect to operate on a cash basis and I want to know how much business aveI h to bring in every month to clear that much cash.” Even more confused now, Kanah responded, “You mean you aren’t going to extend credit to your customers?” “No. No credit. Just cash. I’m going to make them pay hard, cold cash.” Now, Kanah was just as frustrated as Ornan, but for a different reason. Over the previous few minutes, Kanah had realized that this promising new client was not so promising after all. Clearly, Ornan had no idea what was involved in operating a business, any type of business. “Are you sure that you have the background necessary to start a business, Robin?” “Yep. All I know is that the key to having a successful business is having customers willing to pay cash. And I have a lot ofcustomers lined up who are willing to pay me cash.”

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Kanah put down his pen and leaned back in his chair for several moments before responding. “Well, exactly what do you want meto do to help you? I’ll have to rely on you to tell me because I have to admit, I’m a little confused at this point.” “Okay, that’s fair. Why don’t we start like this?” Finally, Ornan seemed interested in the proceedings. “Over the next couple of days, you can set up a business on paper that would produce $20,000 of cash, or what did you say, ‘net cash flow’ per month. Why do n’t youfix up a set of financial statements or whatever you call them for a company of that size that does electrical contracting work. And, I think you should put together a list of documents that the company would need to have and the types of reports that it would have to file with the IRS and any other of those government-type organizations.” “Aren’t you going about this backward? Shouldn’t we …” Ornan cut off Kanah in midsentence. “Now wait a minute. You asked me what I wanted, didn’t you?” Kanah reluctantly nodded, which prompted Ornan to speak again. “Somewhere, you can find information on a typical electrical contracting business. And,you already know what types of documents and reports that a business like that would have to prepare every year. Soon as you get all of that information put together, then we can go from there.” “GO? Go where?” a flustered Kanah asked. “Go about getting’ the business started,” Ornan shot back quickly. “Now, what’s so hard about that? You said you’re a CPA. Iknow you can put together all of that stuff.” “Well, … you’re right. I can do what you asked. I just hope that is what you really need.” “Good,” the suddenly upbeat Ornan replied. “Now, what do you charge for your services?” “Well, for this type of work … I would have to charge $100 an hour.” Kanah expected that the first mention of his houly fee would stop Ornan in his tracks and possibly bring their awkward discussion to an abrupt conclusion. “Sound fair to me,” Ornan replied nonchalantly. “How about I start out by paying you $2,500 upfront. It’s called a retainer, isn’t it?” As Kanah sat dumbfounded and silent at his desk, Ornan stood and reached into his right front pocket and extracted a large roll of crisp $100 bills. He then counted out 25 of the bills andaid l them in a neat pile in front of Kanah. “There you are. I’ll be back on Friday afternoon around 1:00 to get that report.” Without offering to shake Kanah’s hand, Ornan turned and left, leaving his newly h ired accountant gawking at the stack of money in front of him.

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An Atypical Business

The always prompt Ornan returned to Kanah’s office at 1:00 PM on Friday. “Thomas, do you have my report?” “Yes, I do. Here you are.” Ornan spent several minutes thumbing through the 15-page report after Kanah had completed his explanation of the key items included in it. He then shook his head and tossed the report on the corner of Kanah’s desk. “Whew, I didn’t know that starting a business involved this much stuff.” “It gets more complicated all the time,” Kanah responded. After taking off his baseball cap and scratching his head for several moments, Ornan stood and closed the door to Kanah’s ice.off Ornan then sat down and learned forward as he began speaking in a forceful and unapologetic tone. “Listen Peter. here, I’m going to come clean with you.” Over the next several minutes, Ornan explained that the money he had inherited from his grandmother had been in th e form of cash– cash that she had literally hidden under a mattress, buried in cans in her backyard, and stashed in remote corners of remote cubbyholes of her large home. “Dang it, she had told me where it was all hid. But, I may have forgotten some of the spots. I spent the better part of two days tearing that old house apart. I just hope I got it all .” After a brief pause, Ornan shook his head and smiled. “That old lady was quite a hoot. Didn’t trust bankers a lick.”

Kanah was too shocked to interrupt his new client or to provide any commentary on the sudden and unexpected revelation. “Anyway, why don’t we just forget about you helping me set up the business. I think I can do that myself. And, I really don’t need an accountant. My brother has a friend who knows how to keep the books for a cash business.” Ornan paused for a moment as if toallow Kanah to recover. “Are you with me now? Peter, you with me?” Kanah’s gape -mouthed expression didn’t change, but when he blinked his eyes and took a breath, Ornan continued. “What I really need to do is run my money through a business. Any business. Here’s my plan.” The “plan” was for Kanah to loan Ornan $120,000 on a one-year promissory note. Ornan would use the cash flow from his business to make 12 monthly payments of $11,000, meaning that Kanah would earn approximately 10 percent interest on the loan. The loan agreement would indicate that the assets of Ornan’s business would serve as the collateral for the loan. But, to persuade Kanah to go along with the plan, Ornan would give him cash of $135,000 as the true collateral for the loan. Ehen the loan was paid off, Kanah would return only $120,000 of the cash, he would keep the remaining $15,000 as a “loan srcination fee.” By the time Ornan had finished laying out his proposal, Kanh’s head was spinning. Finally, he mustered enough breath to speak. “Robin, I can’t go along with this …” “C’mon, Peter. There’s nothing wrong here. Uncle Sam will be taken care of since I’ll be paying a lot of taxes on my money. And, you are going to make out like a bandit. You’ll get $12,000 in interest plus another $15,000. For what? For nothing. you’re not taking any risk whatsoever. If I don’t pay off the loan, you keep the cash collateral.” Again, Ornan waited to allow Kanah’s brain to catch up. “And then, after one year, we can do it all over again. You’ll be making nearly $30,000 a year for the next several years. I know you can use it. I know your business isn’t doing well. You basically admitted that the other day.” During the tedious pause that followed, Kanah stared at the wall to his left. He then leaned forward, propped his elbows on his desk, and clasped his hands together as if he wasseeking divine guidance. At that point, Ornan stood and took his wad of $100 bills out of his pocket . He slowly deliberately counted out 50 of the bills. “Here you are, Peter. Here’s a bonus for doing the deal. That’s $5,000. Now. Do we have a deal?” After studying the large stack of bills for several moments, Kanah extended his right to Ornan and meekly said,”Deal.”

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An Unexpected Outcome

Peter Kanah liquidated his remaining investmentsand borrowed $25,000 from his parents to finance the $120,000 “loan” to Robin Ornan. True to his word, Ornan delivered a large bundle of $100 bills held together with rubber bands as collateral for the loan. For nine months, Ornan made the monthly payments on the first day of each month. But, in the spring of 2002, two FBI agents arrived at Kanah’s firm to tell him that Ornan would not be making any further payments on the loan since he had been arrested for selling a variety of illegal drugs including marijuana and methamphetamines. The agents then informed Kanah he was being charged with conspiracy to commit money laundering and aiding and abetting money laundering. Kanah was then handcuffed, read his Miranda rights, and taken to the local county courthouse to be arraigned.


The principal witness against Kanah during his criminal trial was Ornan. With the coaxing of federal prosecutors, Ornan recounted the series of meeting himself and Kanah that had eventually led to the loan agreement between the two men. Under crossexamination by Kanah’s legal counsel, Ornan testified that he had never told Kanah the actual source of his cash “inheritance.” When given the opportunity to testify on his own behalf, Kanah insisted repeatedly that he did not know or suspect that Ornan was attempting to launder money from an illicit drug operation, but did admit that he had failed to report the receipt of more than $10,000 in cash to the IRS as required by deral a fe status. Kanah’s denials had little impact on the jury. Kanah was convicted on both federal charges files against him. He was sentenced to six years in federal prison, fined $19,000, and was required to forfeit $70,000 of cash he had received from Ornan that had been confiscated by law enforcement authorities.

Required 1. Use the internet to search for information and answer the following parts: a. Explain what does the phrase “money laundering” mean? Note: A useful site is http://en.wikipedia.org/wiki/Money_laundering b. Briefly describe six methods that are commonly used to money laundering. Note: A useful site is http://money.howstuffworks.com/money-laundering1.htm c. With regard to the particular money laundering method used by Robin Ornan, briefly explain: i. How would the Bank Secrecy Act of1970 prevent/detect the money laundering by Robin Ornan. ii. How would the Bank Secrecy Act of 1970 not prevent/detect the money laundering by Robin Ornan. Note: A useful site is http://www.irs.gov/businesses/small/article/0,,id=152532,00.html d. With regard to the criminal charges against Robin Ornan and Peter Kanah, briefly explain the criminal penalties that can be imposed on individuals and organizations that are convicted of money laundering under the Money Laundering Control Act of 1986. Note: A useful site is http://www.ffiec.gov/bsa_aml_infobase/documents/regulations/ML_Control_1986.pdf 2. Assume you were Peter Kanah. How would you have responded differently to the “loan” proposal laid out by Robin Ornan? Note: You must response appropriately as a professional CPA; not simply a “yes” or “no” answer.

3. Robin Ornan goaded Peter Kanah into becoming an active participant in his money laundering scheme. Discuss three general strategies that individual CPAs can use to prevent themselves from stepping onto a “slippery slope” that eventually result in them becoming involved in unethical and possibly illegal conduct. For example, you may discuss the self-awareness of greed as one possible general strategy. Note: A useful site is http://www.philforhumanity.com/Money_Can_Not_Buy_Happiness.html

Simulation Question 3-3 Simulation Question 3-3 is an adaptation with permission from a case by Grambling, A. A. and V. Karapanos inIssues the in Accounting Education , a publication of the American Accounting Association in Sarasota, Florida.

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The SEC Regulation S-X Rule 2-0 1 on Auditor Independence

On January 28, 2003, in response to SOX 2002, the SEC adopted amendments to strengthen requirements regarding auditor independence. The current SEC independence requirements, which include the 2003 amendments, found are in Regulation S-X Rule2-01. The Rule applies to public company auditors and their close family members, public company auditing firms and their associated entities, and publicly held companies and their affiliates. Rule 2-01 describes four overarching independence principles indicating that a relationship between the accountant and the audit client should not: 1. Create a mutual or conflicting interest between the accountant and the audit client; 2. Place the accountant in the position of auditing his or her own work; 3. Result in the accountant acting as management or an employee of the audit client; or 4. Place the accountant in the position of being an advocate for the audit client. Rule 2-01 prohibits specific relationships including financial relationships, employment relationships, business relationships, relationships whereby the audit firm provides non-audit services to the audit client, and relationships involving contingent fees. Finally, Rule 2-01 includes requirements regarding partner rotation and audit committee administration of the engagement.

Required Review Regulation S-X Rule 2-01 on Auditor Independence published by the University of Cincinnati College of Law at http: //www.law.uc.edu /CCL/ regS-X/SX2-01.html Based on your review of Regulation S-X Rule 2-01, answer the questions in each of the following two scenarios. Each scenario is to be considered separately. Scenario 1

Izumi, a public company, has a financial investment, 30 percent ownership, in Pearl, a private company. The investment in Pearl is not material to Izumi. Axiom Auditors audits Izumi and also has a financial investment, 15 percent ownership, in the same private company, Pearl. The investment in Pearl is not material to Axiom Auditors. Both Axiom Auditors and Izumi have invested in Pearl for the purpose of benefiting from the stock appreciation of Pearl, are not in business with Pearl, do not promote Pearlor its products, and do not receive any of Pearl’s operating revenues. You should access Data File 3 -3 in iLearn for Figure 1, which depicts the relationships among the three parties in scenario 1.

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1. Does the case represent an example of a violation of an SEC independence rule? If so, which rule and why? If not, why not? Note: Specifically consider whether Axiom Auditor’s independence is impaired because of its investment in Pearl. Scenario 2

Mills Corporation, a public company, purchased Clarke Company, another public company. Both companies are similar and operate in the same industry. A new holding company, Marathon Corporation, was created and owns all the stock of Mills and Clarke. After the merger, Marathon’s shares began pu blic trading and shares of Mills and Clarke ceased trading. Marathon has a newly formed board of directors. None of the srcinal board members of Mills or Clarke are part of Marathon’s new board. The management team from Mills will manage Marathon. After the merger, Mills constitutes 40 percent of the consolidated revenues and assets of Marathon; Clarke constitutes 60 percent of the consolidated revenues and assets of Marathon. Audit firm Favor and Hamilton had been the auditor of Mills for the last 15 years. Audit firm Kastor and Kastor had been the auditor of Clarke for the last 15 years. Marathon wants to hire Kastor and Kastor as the auditor of the newly formed holding company, Marathon. D. Drossin, an audit partner at Kastor and Kastor, has been the lead engagement partner of Clarke for the last 4 years. Drossin has a great deal of experience in the industry, and Kastor and Kastor wants him as the lead audit partner on the Marathon engagement. You should access Data File 3-3 in iLearn for Figure 2, which provides a diagram that depicts Scenario 2.

1. Would allowing Drossin to become the lead partner of Marathon Corporation result in a violation of the SEC independence rules? If so, which rule and why? If not, why not? 2. If your answer to Question 1 indicates that it would not be a violation of the independence rules to allow Drossin to become the lead partner of the Marathon audit, for how many years might Drossin be allowed to be the lead partner of the Marathon audit engagement? 3. The current SEC independence rules require partner rotation, but not audit firm rotation. In your opinion, should the SEC also require audit firm rotation? Why yes or why not? Note: Specifically consider the SEC independence rules on lead partner rotation.


Chapter 4 The Auditor’s Legal Environment Chapter Learning Outcomes (LOs) Checklist


LO4-1 Understand the auditor’s litigious environment.

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LO4-2 Explain the auditor’s liability to client under common law.

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LO4-3 Explain the auditor’s liability to third parties under common law.

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LO4-4 Differentiate between the auditor’s defense in client and third party law suits.

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LO4-5 Explain the auditor’s civil liability under the statutory law.

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LO4-6

Differentiate between the auditor’s defense in common and statutory law suits.

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LO4-7

Explain the auditor’s criminal liability under the statutory law.

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LO4-8

Discuss the Private Securities Litigation Reform Act of 1995 and its subsequent and future legal development.

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Chapter 4 The Auditor’s Legal Environment In the current legal environment, auditors may be sued under the common law and statutory law. Figure 4-1 provides an overview of the applicable law and legal concept. Figure 4-1 Applicable Law and Legal Concept 3. Public Law Suits -Under Statutory law -File civil/criminal action -Specific SA1933, SEA1934, -SOX2002 etc. for violating Federal laws

Stockholders & Otherparties 3rd

2. 3rd parties Law Suits -Under Common Law -File civil action -Specific Tort law for professional negligence

Client XYZ Co.

1. Client Law Suits -Under Common Law -File civil action -Specific Contract law for breach of contract

SEC

Auditor

Engagement letter (privity of contract)

Table 4-1 provides a summary of the applicable la w and legal concept. Table 4-1 Applicable Law and Legal Concept

Common Law

Statutory Law

Common law is unwritten law that evolves from legal precedent, that Statutory law is written law that is established by Congress at the is, in deciding a case, the court looks to judgments in prior court cases. federal level or by state legislative bodies at the state level. Federal Over time, the principles of common law are determined by the social and state courts are bound by federal and state status, unless the statute needs of the community. violates the federal or state constitution. A third party may file a civil Common law is state dependent. However, a court in one state may action against an auditor under the statutory law. In addition, federal look to cases decided in another state but is not obligated to follow or state government may file a criminal action against an auditor under such cases. Lower courts in a state are obligated to follow the legal the statutory law. A comparison of civil with criminal action is as precedents set by the higher state courts. However, the highest state follows: court is not bound by its own legal precedents. A client or a third party may file a civil action against an auditor under Characteristic Civil action Criminal action the Common Law of Contract (or Contract Law) or the Common LawWho brings the The plaintiff The government of Tort (or Tort Law): action?

 Contract Law Trial by whom? A civil action in contract is based on the privity of contract, that is, a contractual relationship that exists between two or more contracting What kind of parties. For example, an auditor is liable to a client for breach of Burden of proof? contract when s/he does not deliver the audit report by the agreed-upon date. How does jury When a breach of contract occurs, the plaintiff usually seeks one or vote? more of the following remedies: (1) Specific performance of the contract by the defendant. (2) Direct monetary damages for losses incurred due to the breach.

Trial by jury

Trial by jury

Preponderance of the evidence

Beyond a reasonable doubt

Judgment for plaintiff requires specific jury vote, e.g., 9/12 jurors

Conviction requires unanimous jury vote

(3) Incidental and consequential damages that are an indirect result of What type of Monetary damages, nonperformance. sanctions/penalties? equity remedies, e.g., injunction,  Tort Law specific performance A civil action in tort is based on one of the followings: (1) Ordinary negligence

Imprisonment, capital punishment, fine, probation


Common Law

Statutory Law

Failure to exercise a degree of care that an ordinary prudent person (a reasonable person) would exercise under similar circumstances. Failure to perform an audit in accordance with generally accepted auditing standards might be interpreted as ordinary negligence. In auditing, ordinary negligence may be viewed as "failure to exercise due professional care". (2) Gross negligence Failure to exercise even a slight care in the circumstances. Substantial failure to perform an audit in accordance with generally accepted auditing standards might be interpreted as gross negligence. Reckless behavior towards ones professional responsibilities is a form of gross negligence. (3) Fraud Intentional deception, such as the misrepresentation, concealment, or nondisclosure of a material fact, that results in injury to another person. For example, an auditor intentionally misrepresents his/her audit report.

Auditor’s Liability to Client under Common Law

In auditing, a CPA typically enters a direct relationship with the client by agreeing to perform an independent audit service for the client. The agreed-upon independent audit service to be performed by the auditor is detailed in an engagement letter and signed by both the auditor and the client. Accordingly, a contractual relationship or privity of contract exists between the two parties. Given this contractual relationship, the auditor is liable to the client for breach of contract when he/she: 1. Issues a standard unqualified audit report when the audit engagement has not been conducted in accordance with GAAS. 2. Does not deliver the audit report by the agreed-upon date. 3. Violates the client's confidential relationship. Key cases involving an auditor's liability to client (client law suits) are summarized in Table 4-2 and Table 4-3. Table 4-2 1136 Tenants’ Corporation Case (1976)

1136 Tenants’ Corporation Case (1976)

Facts: A CPA was orally engaged to perform accounting and auditing services for the 1136 Tenants Corporation. The CPA misunderstood the contract thinking that he was engaged to prepare accounting records only. Therefore, the CPA only prepared financial statements and related tax returns for the client. In the course of preparing the accounts for the client, the CPA came across some missing invoices which showed over $40,000 of disbursements that did not have supporting documents. However, the CPA, thinking that he was not engaged in auditing, did not follow-up the missing invoices and did not inform the plaintiff of the missing invoices. As it turned out, the management of the cooperative apartment embezzled significant funds of over $110,000. The tenants of the cooperative apartment sued the CPA for breach of contract and negligence for failure to detect the fraud.

Outcome: The court concluded that the CPA was liable because regardless of the type of services performed by the CPA (even if he misunderstood them), the standard of due professional care required him to follow-up the fraud and to inform the client of known wrongdoing.

Lesson: The AICPA issues a letter to strongly recommend a written contract (i.e., an engagement letter) to be signed by the auditor and the client that clearly defines the intention and scope of each audit engagement.

Table 4-3 Cenco Incorporated Case (1982)

Cenco Incorporated V. Seidman & Seidman (1982) Facts: A massive fraud was committed by the former top management of Cenco Incorporated by inflating inventory values to $25M. The new management of Cenco sued the auditors, Seidman & Seidman, for breach of contract. They claimed that the auditors failed to detect the fraud committed by the former top management in accordance with GAAS.

Outcome: The Seventh Circuit Court of Appeals in Chicago concluded that "auditors' aren't detectives hired to ferret out fraud" and although the auditors were responsible to follow-up any indications of fraud, in this case, the former management made fraud difficult to detect by turning the company "into an engine of theft against outsiders." The auditors were not negligent in the face of a well-orchestrated management fraud.

Lesson: The AICPA issues AU 316Consideration of Fraud in a Financial Statement A udit that clarifies and reinforces the auditor's responsibility for the detection of fraud in accordance with the four fundamental principles underlying an audit (AICPA).

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Auditor’s Liability to Third Parties under Common Law

Under common law, a third party is defined as an individual who is not in privity with the parties to a contract. There are two classes of third parties: 1. A primary beneficiary. Anyone specifically identified to the auditor prior to the audit who is to be the primary beneficiary of the auditor's report. For example, a client informs the auditor prior to the audit that the audit report is to be used to obtain a loan from a specified bank; the specified bank becomes a primary beneficiary. 2. Other beneficiary. Anyone not specifically identified to the auditor prior to the audit who may rely on the auditor's report, such as creditors and potential investors. A key case that establishes auditor's liability to a primary beneficiary is summarized in Table 4-4. Table 4-4 Ultramares Corporation Case

Ultramares Corporation V. Touche (1931) Facts : The auditor, Touche, discovered that its client, Fred Stern & Co, overstated assets and stockholders equity by $700,000 through fictitious transactions. However, Touche failed to report the fictitious transactions in the audit report. Relying on Touche's audited financial statements, Ultramares lent Stern money that Stern was unable to repay because it was actually insolvent. Ultramares sued Touche for negligence and fraud.

Outcome: The court ruled that a privity of contract did not extend to a third party unless the third party is a primary beneficiary. In this case, the court found that Touche was guilty of ordinary negligence but not gross negligence or fraud; and Touche was not liable to Ultramares for ordinary negligence because Ultramares was not a primary beneficiary.

Lesson: This case establishes the Ultramares doctrine by which auditors are not liable to a third party for negligence in the absence of a privity of contract. In addition, under the Ultramares doctrine, auditors are not liable for ordinary negligence but may be liable for gross negligence or fraud if the third party is a primary beneficiary.

The Ultramares doctrine remained unchallenged for many years, and it is still followed today in jurisdictions of some states. However, there has been a trend to broaden the auditor's liability in the case of other beneficiaries based on Section 552 of the Restatement (2 nd) of Torts. Under this Restatement (2 nd) of Torts, the other beneficiaries are separated into two categories: 1. A foreseen party. A user of a reasonably limited class or group of users of financial statements who have relied on the auditor's work; for example, if the client informed the auditor that the audit report is to be used to obtain a bank loan from a specified bank, all banks are foreseen parties but trade suppliers would not be part of the foreseen group. One identifiable (specific) user from a limited class or group of users must be known to the auditors, and the class or group of users to which he/she belonged must be reasonably limited. Furthermore, the foreseen party concept applies to past foreseen parties; it does not apply to a present or future foreseen parties. A key case that extends the auditor's liability to foreseen third parties is summarized in Table 4-5. Table 4-5 Rusch Factors Inc. Case

Rusch Factors Inc V. Levin (1968) Facts: Rusch Factor, a New York banker, asked the auditor to audit the financial statement of a Rhode Island corporation seeking a loan. B ased on the auditor's unqualified opinion on the financial statements, Rusch Factor lent $300,000 to the corporation which subsequently went into receivership. Rusch Factor sued the auditor for negligence and intentional misrepresentation.

Outcome: The court held that the auditor was liable for ordinary negligence in the case of a foreseen third party. The court ruled that the auditor should be liable "in negligence for careless financial misrepresentation relied upon by actually foreseen and limited class of people."

Lesson: The auditing profession is exposed to a broadened interpretation of the Utramares doctrine whereby foreseen third parties can successfully sue the auditors for ordinary negligence.

2. A foreseeable party. A user whom the auditor either knew or should have known would rely on the audit report in making business and investment decisions. A foreseeable party extends the auditor's liability to any unspecified party, such as a creditor, stockholder, and investor, who relies on the auditor's report and suffers a loss as a


consequence. Furthermore, the foreseeable party concept applies to all past, present or future foreseeable parties. A key case that extends the auditor's liability to foreseeable third parties is summarized in Table 4 -6. Table 4-6 Rosenblum Case

Rosenblum V. Adler (1983) Facts: Rosenblum acquired common stock of G iant Stores Corporation. The stock subsequently proved to beworthless after Giant's audited financial statements were found to be fraudulent. Rosenblum sued Alder (a partner of Touche) for negligence and that the auditor's negligence was a proximate cause to their loss.

Outcome: The court found the auditor liable in gross negligence for any third party whom he either knew or should have known (i.e., a reasonably foreseeable third party) would rely on his report in making investment decision.

Lesson: The auditing profession is exposed to an even more broadened interpretation of the Utramares doctrine whereby foreseeable third parties can successfully sue the auditors for gross negligence and fraud.

Throughout the 80s, the Rosenb lum case typifies the application of the foreseeable party concept to the auditor’s liability in the United States. However, in 1985, in a landmark case in New York, Credit Alliance Corp V Arthur Andersen & Co., the New York Court of Appeals reversed a lo wer court’s decision that prevented the defendant auditor from using lack of privity of contract as a defense. In doing so, the appellate court seemed to move back to the basic concept of privity established in the Ultramares doctrine. To date, four states – Arkansas, Illinois, Kansas, and Utah – have adopted legislation that follows the Credit Alliance approach in making an auditor liable for ordinary negligence only to those persons whom the auditor acknowledged in writing were known to be relying on the audit report. A summary of the Credit Alliance case is provided in Table 4-7. Moreover, starting in the 90s, California courts also seem to move away from the foreseeable party concept back to the Ultramares doctrine. A key case to illustrate this legal movement in California is Bily V Arthur Young (1990) shown in Table 4-8. Table 4-7 Credit Alliance Corp. Case

Credit Alliance Corp. V Arthur Andersen & Co. (1986) Facts: Credit Alliance Corp., a lending institution in New York, brought suit against Arthur Andersen & Co., who was the auditor of one of its borrowers. Credit Alliance Corp. alleged that it relied on the audited financial statements of the borrower, who was in default, in granting the loan. Thus, Arthur Andersen & Co was liable to Credit Alliance Corp., who was a foreseeable third party to the auditor.

Legal Issue: The New York appellate court rejected the foreseeable party concept and moved back to the Ultramares doctrine by establishing three criteria for ely on determining whether a plaintiff can bring a claim against an auditor for ordinary negligence: (1) the plaintiff did in fact r the auditor’s report, (2) the auditor knew that the plaintiff intended to rely on the audit report, and (3) the auditor, through some actions on his or her own part, evidenced understanding of the plaintiff’s intended reliance. Since this ruling, the AICPA has been promoting the passage of legislation embodying the Credit Alliance approach in all jurisdictions.

Table 4-8 Bily Case

Bily V. Arthur Young (1990) Facts: Osborne Computer Corporation obtained a $2.3 million loan from Security Pacific National Bank (later merged with the Bank of America) in 1983. To provide for theloan, several warrant investors executed irrevocable letters of credit in favor of Security Pacific, which guaranteed payment if Osborne did notrepay the loan. Also, several stock investors purchased sizable blocks of Osborne stock. Both the warrant investors and stock investors relied on Arthur Young's unqualified audit opinions of Osborne's financial statements. Osborne went into bankruptcy in 1983. The warrant investors were called upon to repay the bank loan and the stock investors lost their investment. The investors sued Arthur Young for negligence.

Legal issue: The California Court of Appeals applied the foreseeability test for holding Arthur Young liable to foreseeable third parties. The Jury found Arthur Young liable and awarded the plaintiffs over $3 million in damages. However, in 1992, the California Supreme Court reversed the Court that “an auditor of Appeals decision against Arthur Young by moving back to the Ultramares doctrine. In its decision, the Supreme Court stated owes no general duty of care regarding the conduct of an audit to persons other than the client,” and reasoned that the potential liability to auditors under the foreseeable party concept would be distinctly out of proportion to fault.

A diagrammatic summary of the legal concepts in third parties law suits is shown in Figure 4 -2.

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Figure 4-2 Legal Concepts in Third Parties Law Suits

parties 3rd

Ultramares Case Established Ultramares Doctrine that “no contract between auditor and 3rd parties, therefore, no liabilities”

Reinstatement (2nd) of Torts

parties Foreseen 3rd

Foreseeable 3

Rusch Factors Case Established auditor liabilities when “one identifiable (specific) user from a limited class or group of users is known to the auditor”

rd

parties

Rosenblum Case Established auditor liabilities when “any unidentifiable (non-specific) user whom the auditor knew or should have known”

The haveoffour defenses in client law 4-9. suits and three possible defenses in third party law suits. A briefauditors description thesepossible defenses is provided in Table Table 4-9 Auditor’s Defenses

Auditor’s Defense in 3rd Parties Law Suits

Auditor’s Defense in Client Law Suits



Lack of duty



Lack of privity of contract

An auditor can argue that the duty in question is not explicitly stated in the audit engagement letter. In this case, the scope and responsibilities detailed in the audit engagement letter are critical for a successful defense.

A lack of privity of contract defense is in effect invoking the Ultramares doctrine as a defense. Application of the Ultramares doctrine by the judicial jurisdiction varies across states. Therefore, a successful defense will depend very much on a particular state's judicial jurisdiction. Also, note that a lack of duty defense in suits by clients is in essence a lack of privity of contract defense in suits by third parties.





Nonnegligent performance

An auditor can argue that the audit is performed in according to GAAS. In particular, the audit gives no complete assurance that material errors or irregularities will be detected. According to AU 240 Consideration of Fraud in a Financial Statement Audit , the auditor is responsible for designing the audit to provide "reasonable assurance of detecting errors and fraud that are material to the financial statements". In addition, it states, "Because of the characteristics of frauds, particularly those involving forgery and collusion, a properly designed and executed audit may not detect a material fraud." The auditor's working papers are critical in this defense. Furthermore, the auditor hopes to convince the court that s/he has only a secondary responsibility to detect and report errors and frauds. The auditor's prime responsibility is to form an opinion about the fair presentation of the client's financial statements.

Nonnegligent performance

Although nonnegligent performance is a defense available to the auditor in third party law suits, it is often difficult to convince a jury of laypeople that the professional auditor is nonnegligent in an audit simply by following the GAAS. Also, note that a contributory negligent defense in suits by clients is generally not available to the auditors in suits by third parties because the latter is not in a position to contribute to the misstatement of the financial statements.


Auditor’s Defense in 3rd Parties Law Suits

Auditor’s Defense in Client Law Suits



Contributory negligence (best defense)



Contributory negligence

An auditor can argue that the client's management contributes to its A contributory negligent defense is generally not available to the own loss by its own negligence, e.g., the management has withheld auditors in suits by third parties critical accounting information from the auditor during the audit. In such a case, there is no basis for recovery because the negligence of one party nullifies the negligence of the other party. It should be noted that in most states, contributory negligence is a defense for the auditor only when the negligence directly contributes to the auditor's failure to detect misstated financial statements, e.g., Cenco Case.

Absence of causal connection None-proximate cause (best defense) An auditor can argue that there is a lack of a close causal connection  Even though an auditor might have been negligent in performing an between the auditor's breach of contract and the resultant damages suffered by the client, e.g., the loss of a client's major supplier is not directly related to the fact the auditor has not issued his/her audit report on time.

audit, the auditor will not be liable for the client's loss if the auditor's negligence was not the proximate cause of the loss. Under Tort law, a negligent party is not necessarily liable for all damages set in motion by his/her negligent act. The law establishes a point along the damage chain after which the negligent party is no longer responsible for the consequences of his/her negligent act. This limitation on liability is referred to as the proximate cause. A noneproximate cause defense is perhaps the best defense available to the auditors in third party law suits. Also, note that a defense of an absence of causal connection in client law suits is in essence a defense of none-proximate cause in third party law suits.

Auditor’s Liability for Civil Action under Statutory Law

Federal or state legislative bodies establish statutory law. Congress enacts federal statutes. The two most important federal statutes affecting auditors are the Securities Act of 1933 and the Securities Exchange Act of 1934 that regulate the issuing and trading of securities within a state. A brief description of the auditor’s liability under these two federal statutes is given in Table 4-10. Table 4-10 Auditor ’s Liability under the Securities Act of 1933 and Securities Exchange Act of 1934

Securities Act of 1933

Securities Exchange Act of 1934

The Securities Act of 1933 was enacted by Congress and administered The Securities Exchange Act of 1934 was enacted by Congress and by SEC. It is designed to regulate new securities offered by a administered by SEC. It is designed to regulate the public trading of company. Under this Act, a company intending to issue new securities securities on a national exchange or over the counter. The Act requires must file a registration statement and prospectus with the SEC. companies to file quarterly reports (Form 10-Q which include Accompanying the registration statement is the audited financial unaudited financial statements) and annual reports (Form 10-K which statements. include audited financial statements) with SEC. Auditors are usually sued under Section 11 of the 1933 Act, which Auditors are usually sued under Section 10 (b) and Rule 10b- 5 of the states, in part "In case any part of the registration statement, when such 1934 Act. Rule 10b-5 states, in part that it is unlawful for any person, part becomes effective, contained an untrue statement of a material fact directly or indirectly, to or omitted to state a material fact, the auditors are liable to any third (1) employ any device, scheme, or artifact to defraud, parties (purchasers) for losses resulting from the auditors' ordinary (2) make any untrue statement of material fact or omit to state a negligence, gross negligence or fraud relating to material false or material fact, and misleading financial statements contained in the registration (3) engage in any act, practice, or course of business that operates, or statement.” In addition, the auditor (the defendant) has the burden of would operate, as a fraud or deceit on any person in connection with proof that there is non-negligent (i.e., there is due diligence) and there the purchase or sale of any security. is non-reliance by the plaintiff on (i.e., no lossto the plaintiff resulted Under Rule 10b-5 of the 1934 Act, auditors are not liable to any seller from) the false or misleading registration statement. However, it or buyer (investor) of the securities for ordinary negligence but for should be noted that the plaintiff (purchaser) must bring a law suit losses resulting from the auditor's reckless behavior (a form of gross within 1 year of the discovery of the misstatement or omission and negligence) if the element of scienter (i.e. an intent to manipulate, within 3 years after the security was offered to the public (i.e., the deceive, or defraud the third parties) can be proven. statutes of limitations applies here). Finally, the auditor’s liability Under Rule 10b-5 of the 1934 Act, the investor (the plaintiff) has the extends to the effective date of the registration statement. burden of proof that (1) there is reliance on the misstatement or omission; (2) the transaction involved interstate commerce, the mail, or a national securities exchange; (3) there is the element of scienter, and (4) there is a loss resulted from the scienter element.

A key case on auditor’s liability for civil action under the Securities Act of 1933 is shown in Table 4-11. Table 4-11 Escott case

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Escott V. Bar Chris (1968) Facts: Bar Chris filed a registration statement in 1961 for the issuance of new debentures. In connection with the audit of Bar Chris, the auditor (Peat, Marwick and Mitchell, now KPMG Peat Marwick) needed to perform an S-1 review of events subsequent to balance date for the SEC. The purpose of the review was to ascertain whether, subsequent to the balance sheet date, any material changes had occurred that needed to be disclosed to prevent the balance sheet from being misleading. Seventeen months after the registration Bar Chris filed for bankruptcy. The purchasers of the debentures filed suit against the auditor under Section 11 of the 1933 Act. Outcome: The court concluded that the PMM's review program was in accordance to GAAS, but PMM was found liable because the senior who performed the S-1 review did not establish due diligence (i.e. the standard of reasonable care of a prudent man in the management of his own property) required under the 1933 Act.

Lesson: The AICPA issues AU 560 Subsequent Events and Subsequently Discovered Facts. This auditing standard helps auditors to avoid being sued under Section 11 of the 1933 Act.

A key case on auditor’s liability for civil action under the Securities Exchange Act of 1934 is shown in Tables 4 -12. Table 4-12 Hochfelder Case

Ernst & Ernst V. Hochfelder (1976) Facts: Ernst and Ernst (now Ernst and Young), the auditors of First Securities Co., a small brokerage firm, were sued by the investors (Hochfelder) in nonexistent escrow accounts allegedly kept by the president, Lester Nay. To prevent detection, all investors were instructed to make their checks payable to Nay and to mail them directly to him at First Securities. Nay imposed a "mail rule" that such mails were to be opened by him.The funds were not recorded onFirst Securities' book. Instead, he misappropriated the funds.The fraud was uncoveredin Nay's suicide note. The investors sued Ernst & Ernst under Rule 10b-5 of the 1934 Act for negligence in their audit because they have not detected and reported the "mail rule".

Outcome: The supreme court ruled that the auditors were not liable under Rule 10b-5 for reckless behavior (a form of gross negligence) in the absence of scienter (i.e. the auditors had no intent to deceive, manipulate or defraud the investors).

Lesson: Auditors should not commit the element of scienter if they were to avoid being charged for violation of Rule 10b-5 under the 1934 Act.In addition, although the auditors are not liable for ordinary negligence under the 1934 Act, they may be liable for recklessness (a form of gross negligence) and fraud if the element of scienter exists under those circumstances.

The Hochfelder case (1976) clearly indicates that an auditor is liable for recklessness (a form of gross negligence) only if scienter is present. However, in subsequent cases, there is a movement away from the presence of scienter. Two key subsequent cases show that an auditor is liable for recklessness even though scienter is absent. Tables 4-13 and 4-14 show these two cases. Table 4-13 Mclean Case

Mclean V. Alexander (1979) Facts: An investor purchased all the stock in a company based on the company's strong sales figure. However, the sales figure was based, in part, on 16 accounts receivable that were not true sales. The auditors did not conduct a thorough investigation of the accounts receivable. A thorough investigation of the accounts receivable would require the auditor to perform accounts receivable confirmation and to follow-up non-responses.

Outcome: The lower court held that the auditors were liable for reckless behavior (i.e. gross negligence under Rule 10b-5) in performing the audit even though the element of scienter was absent. Although the lower court's decision on reckless behavior was subsequently overturned by the court of appeals, this case indicates that the court (in this case the lower court) would hold auditor liable in the absence of scienter.

Lesson: Auditors should not conduct their audit in a reckless manner because they might be charged for gross negligence under the 1934 Act even though they have no intention to deceive, manipulate or defraud the buyers or sellers of securities.

Table 4-14 Howard Sirota case

Howard Sirota V. Solitron Devices, Inc. (1982) Facts: Solitron overstated its earnings by more than 30% by overstating its inventory account for the purpose of inflating its stock price issued on the American Stock Exchange. The scheme has apparently helped Solitron's management in acquiring new companies. The investors sued the


Howard Sirota V. Solitron Devices, Inc. (1982) auditor for reckless behavior in their audit of Solitron Devices, Inc.

Outcome: The lower court did not find the auditors guilty of reckless behavior because the case of reckless behavior required proof that the auditors had knowledge of the fraud by the management.The court of appeals established that the auditors knew about the fraud and that they failed to follow it up. The auditors were therefore found guilty of reckless behavior under rule 10b-5.

Lesson: An auditor is acting in a reckless manner if s/he knows about fraud and fails to follow it up. The auditor will be held liable for gross negligence under the 1934 Act even though the element of scienter is absent.

An auditor’s defense under the Securities Act 1933 and Securities Exchange Act 1934 is shown in Table 4-15. Table 4-15 Auditor’sDefense under the Securities Act 1933 and Securities Exchange Act 1934

Defense under the Securities Act 1933

Defense under the Securities Exchange Act 1934

The "lack of privity of contract" defense in common law suits by third The same two defenses available to auditors in suits by third parties parties is not available to the auditors under the 1933 Act because the under the 1933 Act are also available for suits under the 1934 Act. privity of contract concept isnot relevant under this Act. However, the These are the "nonnegligent performance" and the "none-proximate "nonnegligent performance" and the "none-proximate cause" defenses cause" defenses. in common law suits are available to the auditors. When an auditor uses "nonnegligent performance" as a defense under When an auditor uses nonnegligent performance as a defense, he/she the 1934 Act, s/he must prove the absence of reckless behavior. The must prove that he/she has made a reasonable investigation and test of reckless behavior under the 1934 act requires the auditor to accordingly had reasonable ground to believe that there were no prove that he/she performed in good faith and had no knowledge that material false or misleading financial statements contained in the the financial statements were false or misleading, that is, there is no registration statement. The test ofreasonable investigation under the element of scienter. This means that the minimum basis for liability is 1933 Act is due diligence, that is, the standard of reasonable care of a similar to gross negligence in common law. prudent man in the management of his own property. The auditor's When an auditor uses the "none-proximate cause" as a defense under defense is referred to as the due diligence defense. However, in the 1934 Act, the third parties (the plaintiff) must prove reliance on the contrast to common law cases, in which the plaintiff has to prove that false or misleading financial statements and damages resulting from the auditor was negligent, the auditor has to prove that he/she such reliance. performed the audit work with due diligence. When an auditor uses the none-proximate cause as a defense, the auditor (the defendant) must establish that the third parties loss resulted in whole or in part from causes other than the false or misleading financial statements contained in the registration statement.

A summary of auditor’s liability in relation to negligence is provided in Table 4-16. Table 4-16 Auditor’sLiability in Relation to Negligence

Ordinary Negligence (or Due Diligence)

Source of Law Ultramares Tort Law doctrine – No Tort parties Law – Foreseen 3rd Yes – Foreseeable 3rd Tort Law parties No The Securities Act of 1933 The Securities Exchange Act of 1934

Auditor Liable For Gross Negligence (or Reckless Behavior)

Yes Yes Yes Yes No

Fraud

Yes Yes Yes Yes Yes

Yes Yes

A summary of auditor’s defenses in common law and statutory law suits is provided in Table 4-17 Table 4-17Auditor’s Defense in Common Law and Statutory Law Suits

Source of Law

Plaintiff

Contract Law

Client

Tort Law

Third Party: 1. Primary beneficiary 2. Other beneficiary: a. Foreseen (past) b. Foreseeable (past, present and future)

Auditor’s (defendant’s) Defense 1. Lack of duty 2. Nonnegligent performance 3. Contributory negligence 4. Absence of causal connection 1. Lack of Privity 2. Nonnegligent performance 3. None-proximate cause

Burden of Proof Plaintiff

Plaintiff

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Source of Law

Plaintiff

The Securities Act 1933

Any person acquiring new securities

The Securities Exchanges Act 1934

Any person buying or selling securities

Auditor’s (defendant’s) Defense 1. Nonnegligent performance 2. None-proximate cause 1. Nonnegligent performance 2. None-proximate cause

Burden of Proof Defendant (Auditor) Plaintiff

Auditor’sLiability for Criminal Action under State and Federal Statutes

The Securities Act 1933, the Securities Exchange Act 1934, the Racketeer Influenced and Corrupt Organization Act (RICO), as well as several other federal statutes such as the Federal Mail Fraud Statutes and the Federal False Statements Status, are federal laws that make it a criminal offense for an auditor to defraud another person through knowingly being involved with false financial statements (i.e., guilty of knowing complicity). Auditors may be sued under Section 24 of the 1933 Act which makes it a criminal offense for any person to: 1. Willfully make any untrue statement of material fact in a registration statement filed with the SEC, 2. Omit any material fact necessary to ensure that the statements made in the registration statements are not misleading, or 3. Willfully violate any other provision of the Securities Act of 1933 or rule or regulation adopted there under. Auditors may also be sued under Section 32(a) of the 1934 Act which makes it a criminal offense for any person willfully and knowingly to make or cause to be made any false or misleading statement in any application, report, or other document required to be filed with the SEC pursuant to the Securities Exchange Act of 1934 or any rule or regulation adopted there under. Criminal Action under the Securities Act 1933 and Securities Exchanges Act 1934

There have been relatively few criminal actions involving auditors in securities-related litigation; a majority of cases have been for civil actions. A leading criminal case that involves auditors is U.S. v Simon 1969 (or Continental Vending Machine Case). Table 4-18 provides a brief description of this case. Table 4-18 U.S V Simmon (Continental Vending Machine Case)

Facts:

U.S V Simmon (1969) (or Continental Vending Machine Case)

The case involved loans made by Continental Vending to its affiliated company, Valley Commercial Corporation, which subsequently lent the money to the president of Continental, Harold Roth. Roth pledged collateral, about 80 percent of which was Continental stock. Although the accounts receivable from Valley was recorded by Continental, it was not collectible because Roth was unable to pay Valley, and the market value of Roth's collateral was less than the amount owed. Roth subsequently declared bankruptcy. The government sued the auditors. The action was brought under Section 32 of the Securities Exchange Act 1934 alleging that a footnote in Continental's financial statements did not adequately disclose the fact that Roth diverted corporate funds from Continental for private use through its affiliated Valley corporation. Two audit partners and an audit manager were prosecuted for allegedly participating in the conspiracy to defraud Continental's stockholders. The auditors argued that they had followed GAAP in the disclosure of the footnote and thus free of criminal liability.

Outcome: The auditors were found guilty. The court held that "Generally accepted accountin g principles instruct an accountant what to do in the usual case when he has no reason to doubt that theaffairs of the corporation are being honestly conducted.Once he has reason to believe that thisbasic assumption is false, an entirely different situation confronts him."The auditors were fined $17,000 and their licenses to practice as CPAs were revoked. However, they were pardoned by President Nixon in 1972.

Lesson: The AICPA provides guidance on procedures that should be considered by an auditor when s/he is performing an audit involving related party transactions in AU 550Related Pa rties. The auditors learned that demonstrating compliance with GAAP was not a successful defense in the case of a criminal charge of willfully and knowingly making a false statement. Therefore, auditors must make sure that thefinancial statements adequately disclose known and material management frauds.

Other key cases on an auditor’s liability for criminal action are presented in Tables 4-19 and 4-20 below. Table 4-19 U.S V Weiner (Equity Funding Case)

U.S V Weiner (1975) (or Equity Funding Case) Facts:


U.S V Weiner (1975) (or Equity Funding Case) With the help of a computer, the top management of the Equity Funding Corporation created fictitious insurance policies and overstated its net income and assets by over $100 million. Moreover, the management misstated the financial statements by recording fictitious commission income, borrowing funds without recording the corresponding liability, and creating the fictitious insurance policies. The auditors, an audit partner and two audit managers, were sued for failure to detect that $2.1 billion of the Equity Funding Corporation's $3.2 billion of assets were based on bogus insurance policies generated by the top management with the help of the computer.

Outcome: The management fraud was so glaring that the court decided that the auditor must have been aware of the fraud and therefore guilty of knowing complicity. Indeed, a special AICPA committee found that "the fraud was not based on a sophisticated application of data processing technology." The committee concluded, "that customary audit procedures properly applied would have provided a reasonable degree of assurance that the existence of fraud at Equity Funding would be detected."

Lesson: Consideration of Fraud in a Financial The AICPA re-examines the auditor's assumption about top management honesty and issues AU 240 Statement Audit. The standard states that "An audit of financial statements in accordance with generally accepted auditing standards should be planned and performed with an attitude of professional skepticism. The auditor neither assumes that management is dishonest nor assumes unquestioned honesty." In addition, the auditor learned that the best defense to a potential criminal charge is not to risk performing a sloppy audit.

Table 4-20 U.S V Natelli (National Student Marketing Corporation Case)

U.S V Natelli (1975) (or National Student Marketing Corporation Case) Facts: Natelli, an auditor of Peat, Marwick, Mitchell & Co, was in charge of the 1968 audit of the National Student Marketing Corporation. The company sold marketing programs (advertising contracts) to companies for promotional campaigns on college campuses. The company uses a percentage-of-completion method to recognize revenues. This resulted in some $1.7 million uncollectible accounts receivable on the books of the company, representing unconfirmed commitments from customers. Subsequently, approximately $1 million of the uncollectible accounts receivable were written off. However, the auditor neither disclosed the material effect of the uncollectible accounts receivables nor acknowledged the prior mistake made in recognizing uncollectible accounts receivable.

Outcome: The circumstances and actions of the auditor were construed by the court to be a willful violation of the Securities Exchange Act of 1934 and resulted in criminal liability.

Lesson: Criminal liability can be imposed under Section 32 of the Securities Exchange Act 1934 when an auditor willfully and knowingly conceals material prior errors. The auditors learnt that they couldn’t defense successfully by a plea of i gnorance whenthey have shut their eyes to what was plainly to be seen.

Criminal Action under the Racketeer Influenced and Corrupt Organization Act 1970 (RICO)

The Racketeer Influenced and Corrupt Organization Act 1970 (RICO) was srcinally drafted as part of the 1970 Organized Crime Control Act to curtail the inroads of organized crime into legitimate business. The Act permits a person victimized by a “pattern of racketeering activity” to sue for t reble damages and attorneys’ fees. The RICO states that a pattern of racketeering activity means at least two acts of racketeering activity within a two-year period. Despite its focus on organized crime, the provisions of the RICO have been extended to losses suffered from fraudulent securities offerings and failures of legitimate businesses. Auditors have often been named as codefendants on the basis that their involvement with the issuance of materially false financial statements for a minimum of two years out of a ten-year period constitutes a pattern of racketeering activity. A key case, ESM Government Securities V Alexander Grant & Co (1986) that illustrates criminal action against the auditors under the RICO is summarized in Table 4-21. Throughout the 80s, the case law applying the RICO to the auditors was mixed. Some courts make it clear that the RICO applies to an extensive participation by the auditors in the audit client’s racketeering activities beyond an annual audit, while other courts held that the issuance of a materially false audit report would constitute an act of racketeering activity. Legislation has been considered by Congress to clarify the applicability of the RICO to the auditors; but there was no action from Congress. Meanwhile, in 1993, The U.S. Supreme Court heard another RICO case involving auditors, known as Reves V Ernst & Young (1993) that essentially clarified the applicability of the RICO to the auditors. In this case, which involved investor losses related to a farmers’ cooperative that went bankrupt, the Court ruled that “requires some participation (of the auditor) in the operation or management of the enterprise (audit client) itself.” It further ruled that the auditor’s issuance of unqualified audit reports for two consecutive years on the farmers’ cooperative did not meet the “participation” test. In short, the Court ruled that external auditors who do not help run corrupt business cannot be sued under the provisions of the RICO. Many legal observers hope this decision will mark an end to a majority of RICO actions against auditors.

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Table 4-21 ESM Government Securities Case

ESM Government Securities V Alexander Grant & Co (1986) (or ESM case) Facts: The management of ESM devised a scheme of fictitious transactions to conceal operating losses from 1977 through to 1984. In 1978, the partner from Alexander Grant & Co (now Grant Thornton & Co) who was in charge of the ESM audit was informed by the management that the previous 1977 year’s audited financial statements contained a material misstatement that was not discovered by the auditor. aFced with potential embarrassment and damage to his auditing career, the partner agreed to not disclose the fraud to give the management one year to work its way out of the losses. The management failed to make up the losses, but the partner continued to cover up the fraudulent scheme until the company collapsed in 1985.

Outcome: The partner was convicted of criminal charges under the RICO for his role covering up the fraud and was sentenced to a 12-year prison term.

Lesson:

Several lessons can be learned from this case: (1) The auditor can be found criminally guilty in the conduct of an audit even if the auditor’s background indicates integrity in their personal and professional life. The criminal liability can extend to partners and staff. (2) Independence in appearance and fact by all individual auditors on the engagement is essential, especially in a defense involving criminal actions. (3) Good documentation may be just as i mportant in the auditor’s defense of criminal charges as in a civil suit. (4) The potential consequences of the auditor knowingly committing a wrongful act are so severe that it is unlikely that the potential benefits could ever justify the actions.

Private Securities Litigation Reform Act of 1995

In 1995, a federal law, the Private Securities Litigation Reform Act, was passed by Congress to curb frivolous securities-related litigation and to reduce significantly potential damages in securities-related litigation against the auditor. The key provisions of the Private Securities Litigation Reform Act of 1995 include:

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Doctrine of “proportionate liability” instead of “joint and several liability”. “Joint and several liability” is a doctrine that allows a successful plaintiff to recover the full amount of a damage award from the defendants who have money or insurance. In reality, when a group of defendants (e.g., auditors, management, and an audit client) are found liable for damages, the auditors are the only parties with “deep pockets” of money to pay damages. Thus, t he auditors usually pay the entire amount even though they may be only partially at fault. The Reform Act of 1995 seeks to replace “joint and several liability” with “proportionate liability”,

unless theliable violation is the willful; that is,damages. the auditors knowingly participated in a the fraud, thereby jointly anda severally for all plaintiffs’ Under “proportionate liability”, auditors areremaining only required to pay proportionate share of the court’s damage award, depending upon the degree of fault determined by a judge and jury (e.g., 20%, 30%, but not 100%). Specifically, civil lawsuits for damages under the Reform Act of 1995 now are governed by the following proportionate liability terms: 1. The total responsibility for loss is divided among all parties responsible for the loss. 2. If other defendants are insolvent, a solvent defendant’s (e.g., auditor’s) liability is extended to 50% more than the proportion found at the trial. For example, if an auditor is found 20% responsible for a loss and the audit client and its managers are insolvent, the auditor will have to pay 30% (20% + ½ of 20%) the loss, but not 100% as before. 3. An exception to compensate smaller investors is that all defendants remain jointly and severally liable to plaintiffs who have net worth of less than $200,000 and lost 10% or more of the net worth in the case.

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Cap on Actual Damages. The Reform Act of 1995 also caps the actual damages under the securities acts based on an investor purchase price of a security and the mean trading price during a 90-day period following the date on which information is released that corrects the misstatement or omission in the financial statements. For example, assume that an investor purchases a security at $40 per share. On the day of the release of the information that corrects the misstatement, the closing price for the security falls to $20. During the following 90-day period the security returns to a closing price of $30 per share with an average for the period of $25 per share. Actual damages would be capped at $15 ($40-$25) per share.

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Responsibility to Report Illegal Act.

Private Securities Litigation Reform 1995ofimposed newIfreporting on an auditors detect The or otherwise become aware of illegal actsAct by of issuers securities. an auditorrequirements concludes that illegalwho act has a material effect on the financial statements, senior management has not taken appropriate action, and the illegal act warrants a departure from a qualified audit report or a withdrawal from an engagement, the auditor should report these conclusions directly to the board of directors. The board should then notify the SEC within one day. If the


board does not file a timely report with the SEC, the auditor should make a report to the SEC. The Reform Act of 1995 explicitly states that the auditor will not be held liable in a civil action for any finding, conclusions, or statements made in such reports. Chapter 6 further discusses the reporting requirements on illegal acts. Securities Litigation Uniform Standards Act of 1998

The “proportionate liability” doctrine in the Private Securities Litigation Reform Act of 1995 applies only to lawsuits brought in federal courts under federal securities laws. Since the act applies only to lawsuits brought in federal courts, clever lawyers took their cases to state courts that follow the “joint and several liability” doctrine. This loophole was closed by Congress passing the Securities Litigation Uniform Standards Act of 1998. This

Uniform Standard Act of 1998 requires that class action lawsuits with 50 or more parties must be filed in the federal courts. Class Action Fairness Act of 2005

The Uniform Standard Act of 1998 requires that class action lawsuits with 50 or more parties must be filed in the federal courts. Since smaller class actions lawsuits with less than 50 parties can still be pursued in state court, clever lawyers took their cases to state court by filing multiple class actions lawsuits in state court with each lawsuit filed on behalf of fewer than 50 parties. For example, in an attempt to circumvent the Uniform Standard Act of 1998, attorneys brought a number of Enron-related lawsuits in Texas state court with each suit filed on behalf of less than 50 parties in Newby V Enron Corp. (2002). Consequently, Congress passed the Class Action Fairness Act of 2005 in response to attorneys’ attempt to circumvent the Uniform Standard Act of 1998 by filing nationwide multiple class actions lawsuits in various state courts. The Class Action Fairness Act of 2005 expands the federal jurisdiction to include most multistate class actions lawsuits where there is more than $5 million in dispute. It appears that the federal judges are more likely to dismiss dubious claims under the Act. Moreover, the Class Action Fairness Act of 2005 imposes increased judicial and regulatory scrutiny over the propriety of class action settlements because in some past settlements the only parties that actually benefited were the attorneys. Sarbanes-Oxley Act of 2002

In 2002, prompted by the Enron Corp. and Arthur Andersen case, Congress passed the Sarbanes-Oxley Act of 2002 to restore investor confidence in the securities markets and to deter future corporate frauds. The Act includes sections that create the PCAOB, stricter independent rules, and increased internal controls reporting responsibilities. The creation of the PCOAB is the most significant aspect of the Sarbanes-Oxley Act, which ends decades of selfregulation by the accounting profession. Table 4-22 provides a brief summary of the Enron Corp. and Arthur Andersen case. In this case, Arthur Andersen became the first major CPA firm ever convicted of a felony – one count of obstruction of justice in the Enron investigation. The indictment, which named only the firm and not any employees or partners, accused Arthur Andersen of the “wholesale destruction of documents” relating to the Enron Corp. collapse. Ironically, in 2005, the U.S. Supreme Court unanimously reversed Arthur Andersen’s conviction due to vague instructions provided to the jury for determining whether Arthur Andersen obstructed justice. However, the Supreme Court’s decision did little to resuscitate Arthur Andersen because the 2002 conviction was a fatal blow to the CPA firm. Table 4-22 Enron Corp. and Arthur Andersen Case

U.S. V. Enron Corp. and Arthur Andersen (2002) Facts: In 2001, after showing profit for the previous several years, Enron Corp. reported a third quarter loss of $618 million and a $1.2 billion reduction in owner’s equity related to off-balance sheet partnerships. The news resulted in a sharp drop in Enron’s stock price and a formal SEC investigation. On November 8, 2001, Enron Corp. announced that it had overstated profits by $586 million, erasing almost all its profits from the past five years, collapsing the stock price, and diminishing the confidence of its clients. Within a month of this announcement, Enron Corp. filed for Chapter 11 bankruptcy. ts. Enron’s The Enron collapse involved many players, including company executives, investment bankers, financial analysts, and accountan auditor Arthur Andersen, a“Big Five” CPA firm at the time, quickly became the source of government scrutiny. In 2002, the Justice Department accused top Arthur Andersen officials of directing employees to alter and/or shred Enron Corp.- related documents after it knew about the SEC investigation of Enron Corp. collapse. The accusation was centered on an e-mail message written by an Arthur Andersen attorney. In that e-mail message the attorney advised an Arthur Andersen partner to revise a memo to omit certain information, including a comment that an Enron Corp. press release that included an earnings announcement was misleading. Arthur Andersen argued that the firm was merely applying its document

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U.S. V. Enron Corp. and Arthur Andersen (2002) retention policy in destroying the documents. The government’s investigation of Enron Corp.’s accounting practices revealed a number of accounting frauds, including misuse of specialpurpose entities (SPE) to sell off underperforming assets at a profit. Because of undisclosed Enron Corp. guarantees related to the transactions, most of these “sales” were really schemes to overstate “paper” gains and understate liabilities. Meanwhile, the government’s investigatio n of Arthur Andersen’s document retention policy revealed a “wholesale destruction of documents” relating to its audit of Enron C orp.

Outcome: In 2002 Andrew Fastow, Enron’s former CFO and principal player in the company’s accounting schemes, pleaded guilty to two counts of conspiracy, and was sentenced to serve the maximum 10-year sentence. In 2006 former Enron chairman Kenneth Lay and former president Jeffery Skilling were convicted on numerous federal fraud and conspiracy charges. Shortly after the conviction, Lay died of a massive heart attack and his conviction was vacated. Skilling was sentenced to 24 years in prison.

In 2002, Arthur Andersen was found guilty of one count of obstruction of justice in the Enron Corp. investigation. However, in 2005, the U.S. Supreme Court unanimously overturned the felony conviction handed down against Arthur Andersen in 2002 due to vague instructions provided to the jury for determining whether Arthur Andersen obstructed justice. The Supreme Court’s decision to overturn Arthur Andersen’s felony conviction was little consolation to the more than 20,000 partners and employees who lost their jobs when the CPA firm was forced out of business by the felony conviction.

Lesson: In the wake of Arthur Anderson’s felony conviction, the Sarbanes-Oxley Act and the PCAOB Auditing Standard No.3 (AS 3) Audit Documentation require that all audit documentation s that “form the basis of the audit or review” are required to be retained for seven years from the date of completion of the engagement, unless a longer period of time is required by law. For example, in cases involving pending or threatened lawsuit, investigation, or subpoena. Prior to the Act and AS 3, CPA firms typically would not include in their working papers documentation that was inconsistent with the final conclusion of the audit team, nor would they include all internal correspondence leading up to a final decision. The Act and AS 3 now require that any document created, sent, or received, including documents that are inconsistent with a final conclusion, be included in the audit files. This includes any correspondence between engagement teams and national technical accounting or auditing experts in a CPA firm’s national office. In addition, this type of correspondence is required to be retained to facilitate any subsequent investigations, proceedings, and litigation. Many lessons in creative accounting can be gleaned from this case, including: (1) More than $8 billion in loans was misclassified as “trades of energy futures.” The borrowed funds were labeled cash flows fro m trading activities; the related liabilities were labeled price risk management liabilities and buried in an enormous derivatives trading budget that ran in the hundreds of billions of dollars. Readers of the financial statements had no way to know that Enron Corp. was borrowing such large amounts of money simply for basic operating funds. (2) Enron Corp. abused mark-to-market (MTM) accounting. MTM is typically used in the financial securities industry to include in income unrealized gains and losses in security positions. In other words, income is recognized when increases in value occur in mpany’s a co securities assets, and a loss is recognized when decreases in value occur. This does not follow the accounting principle of matching in which gains and losses are associated with the actual sales of a company’s security assets. In any case, SEC gave Enron Corp. permission to use MTM accounting for its natural gas trading business, but Enron Corp. abused the practice by applying it to business activities other than those relating to natural gas securities. It immediately recognized as current income the amounts of estimated future income from contracts signed. It also recognized as income “increases in value” from investments that were based on complex assumptions. For example, Enron Corp. used MTM to mark up the value of its investment in Mariner Energy (a private oil and gas exploration company) from $185 million to $367 million, thus creating $182 million in revenue. Enron Corp. later admitted that the markup had been greatly overstated. (3) Enron Corp. used “special-purpose entities” (SPEs) to hide enormous MTM losses by creating hedge agreements with the SPEs that were supposed to cover Enron Corp.’s MTM losses. The problem was that the SPEs were funded with revenue from sales of Enron’s ock, stso they were unable to cover MTM losses when Enron Corp.’s stock price declined. Eventually, Enron Corp.’s stock prices dropped, and the SPEs became insolvent. (4) Enron Corp. sold future income streams at their present value to generate cash and reported these proceeds as revenue. The problem was that Enron Corp. guaranteed the future income streams, thus creating accounting sales without real economic substance. Some of the guarantees were part of secret side agreements.

Future Legal Development

The threat of legal liability serves to prevent or limit inappropriate behavior, such as negligent, on the part of auditors. However, auditors cannot be expected to absolutely ensure the accuracy of either financial statements or the financial health of a business entity. Thus, the auditing profession has an interest in minimizing auditors’ exposure to legal liability. It is increasingly exploring the possibility of utilizing alternative dispute resolution procedures (i.e., arbitration and mediation) as a means of reducing litigation costs. Using arbitration and mediation to settle disputes does not remove legal liability (except perhaps punitive damages), but it may significantly reduce the administrative and legal support costs of litigation. For example, in 2005, Sun Microsystems Inc. disclosed in its proxy statement that the company’s engagement letter agreement with Ernst & Young LLP was “subject to alternative dispute resolution procedures and an exclusion of punitive damages.” A strict reading of this engagement letter to agreement suggests thatmediation Sun Microsystems Inc. is furthermore, barred from bringing suit against & Young need seek redress through and arbitration; it suggest that Ernst Ernst & Young wouldand be would liable only for compensatory (not the often more costly punitive) damages. Although the effectiveness of this engagement letter agreement in limiting auditors’ liability has not been legally tested, some negative publicity over these agreements has resulted in Ernst & Y oung’s deciding no longer to include language related to exclusion of punitive


damages in its engagement letters. However, it continues to include the language related to alternative dispute resolution. Audited financial statements are now being provided using XBRL (eXtended Business Reporting Language). In 2009, the SEC issued rules requiring public companies to provide financial information in a form that can be easily downloaded directly into interactive spreadsheets to make it easier for investors to analyze and to assist in automating regulatory filings. The SEC mandated that this form of financial information to be posted to a company’s website. Under the current SEC rules and professional auditing standards, auditors are not required to perform procedures or provide assurance on XBRL-tagged data in the context of audited financial statements. Accordingly, the auditor’s report on the financial statements does not cover the process by which XBRL-tagged data that results from this process, or any representation of XBRL-tagged data. However, auditors may choose to engage in XBRL-related assurance engagements (services) such as 1. Agree-upon procedures engagements on XBRLtagged data to assist management in its evaluation of the XBRL-tagged data and the audit committee in its oversight role. 2. Assurance engagements on the controls related to the XBRL-tagging process and examinations of the accuracy of the XBRL-tagged data itself. 3. Assurance engagements on financial information as presented in particular pre-defined instance documents.

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Multiple-Choice Question 4-1

The auditor's failure to exercise minimum care in an audit is the definition of a. fraud. b. gross negligence. c. ordinary negligence. d. due diligence.

4-2

A major outcome of the 1136 Tenants Corporation Case (1976) was that a. the auditor had no responsibility in detecting frauds. b. the auditor owed no contractual obligation to the client because it was not a written contract. c. the auditor was aware of frauds and failed to follow-up the frauds. d. the auditor misunderstood the terms of the contract.

4-3

The Ultramares doctrine establishes that the auditor is a. liable to clients for gross negligence. b. liable tothird parties forordinary negligence. c. liable to primary beneficiaries for gross negligence. d. liable to foreseeable third parties.

4-4

The concept of foreseeable third parties establishes that the auditor is liable to third parties whom a. the auditor is able to establish a privity of contract. b. the auditor has foreseen as a group of users who will rely on the audit report. c. the auditor has committed ordinary negligence. d. the auditor foresees a group of userswho will likely rely on the audit report.

4-5

Which of the following legal cases established the fact that the auditor had conducted the audit with reckless behavior? a. Howard Sirota V. Solitron Devices, Inc. (1982). b. Rosenblum V. Adler (1963). c. Continental Vending Machine case (1969) d. Ultramares case (1931).

4-6

Under the Securities Act of 1933, the auditor's responsibilityfor the fairness of the client's financial statements covers up to a. the date the client's financial statements. b. the effective dateof the client's registration statement. c. the date of the audit report. d. the date of the client's director report.

4-7

Under the Securities Exchange Act of 1934, most civil suits against the auditor relate to a. Section 10 (b) of the Act. b. Rule 10b-5 of the Act. c. Section 10(b) and Rule 10b-5 of the Act. d. Section 10 of the Act.

4-8

A leading case of criminal action against the auditor is a. the Equity Funding case b. the National Student Marketing case. c. the Continental Vending Machine case. d. the Bar Chris case.


4-9

Which of the following legal cases established a general awareness of the auditor's exposure to criminal prosecution? a. Escott V. Bar Chris (1968). b. Rosenblum V. Adler (1983). c. Continental vending machine case (1969). d. Rusch Factors V. Levin (1968).

4-10

The U.S. Supreme Court ruled in 1976 in Hochfelder V. Ernst & Ernst that before CPAs could be held liable for Rule 10b5 of the Securities Exchange Act of 1934, what would be required be to shown to the court was the auditor’s a. Ordinary negligence. b. gross negligence. c. knowledge and intent to deceive. d. recklessness.

4-11

The similarity which exists in both the United States V. Natelli case, aka National Student Marketing case of 1975, and the ESM Government Securities V. Alexander Grant & Co. case of 1986 is that in each case a. a partner in a national CPA firm served prison time. b. the partners were punished for the shoddy work of their subordinates. c. a presidential pardon kept them from serving time in prison and allowed them to retain their CPA licenses. d. the auditors were not convicted for failing to discover the problem in year 1, but for failing to disclose the problem when it was discovered in year 2.

4-12

Which of the following auditor’s defenses, when used in a third-party lawsuit, usually means non-reliance on the financial statements by the user? a. Absence of causal connections. b. Lack of duty. c. Non-negligent performance. d. Contributory negligence.

4-13

Which of the following statements about the Securities Act of 1933 is not true? a. It concerns only the reporting requirements for companies issuing new securities. b. The amount of the potential recovery is the srcinal purchases price plus punitive damages. c. It deals with the information in registration statements and prospectuses. d. The only parties that can recover from auditors under the 1933 act are srcinal purchasers of securities.

4-14

Which of the following resultedin a federal law passed in 1995 that significantly reducedpotential damagesin securitiesrelated litigation against the auditor? a. Public Securities Damages and Settlements Act. b. Racketeer Influenced and Corrupt Organization Act. c. U.S. Securities Claims Reform Act. d. Private Securities Litigation Reform Act.

4-15

Tort actions against CPAs are more common than breach of contract actions because a. the burden of proof is on the auditor rather than on the person suing. b. the amounts recoverable are normally larger. c. the person suing need prove only negligence. d. there are more torts than contracts

4-16

To be successful in a civil action under Section 11 of the Securities Act of 1933 concerning liability for a misleading registration statement, the plaintiff must prove

a. b. c. d.

Defendant’s Intent to Deceive Yes Yes No No

Plaintiff’s Reliance on the Registration Statement Yes No Yes No

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4-17

The Private Securities Litigation Reform Act 1995 resulted in a number of changes in statutory law that revised the SEC Acts of 1933 and 1934. Which of the following was not one of the major changes that resulted from the Reform Act of 1995? a. The statute introduced proportionate liability for auditors who were not found to knowingly commit a violation of the securities laws. b. The statute imposed a responsibility to report illegal acts to the SEC. c. The statute provided that auditors would not be held liable for civil actions for statements made in the reporting of illegal acts to the SEC. d. The statute created a cap ondamages based on the personal net worth ofthe auditors.

4-18

One of the elements necessary to hold an auditor liable to a client is that the auditor a. acted with scienter. b. was a fiduciary of the client. c. failed to exercise due care. d. executed an engagement letter.

4-19

Under the provisions ofthe Securities ExchangeAct of 1934, which of the following activitiesmust be proven by a stock purchaser in a suit against a CPA? I. Intention by the CPAto manipulate, deceive, or defraudinvestors. II. Gross negligence by the CPA. a. I only. b. II only. c. Both I and II. d. Neither I nor II.

4-20

An auditor lost a civil lawsuit for damages underthe Private Securities LitigationReform Act of 1995. The court found total losses of $5 million; the auditor was found 30% at fault, and the auditor was the only solvent defendant. The court would order the auditor to pay a. $5,000,000. b. $2,250,000. c. $1,500,000. d. $0.

4-21

X Corp. approveda merger plan with Y Corp. One of the determining factorsin approving themerger was the financial statements of Y that were audited by A, a CPA. X has engaged A to audit Y’s financial statements. While performing the audit, A failed to discover certain fraud that later caused X to suffer substantial losses. For A to be liable under common-law negligence, X at a minimum must prove that A a. knew of fraud. b. failed to exercise due care. c. was grossly negligent. d. acted with scienter.

4-22

If a CPA recklessly departsfrom the standards ofdue care when conductingan audit, theCPA will be liable to third parties who are unknown to the CPA (i.e., foreseeable rd3 parties) based on a. privity of contract. b. gross negligence. c. strict liability. d. criminal deceit.

4-23

Under common law, which of the statements is generally correct regarding the liability of a CPA who negligently expresses an opinion on audit of a client’s financial statements? (Hint: Consider the key word ‘negligently’) a. The CPA is liable only to those third parties who are in privity of contract with the CPA. b. The CPA is liable only to the client. c. The CPA is liable to anyone in a class of third parties who the CPA knows will rely on the opinion. d. The CPA is liable to all possible foreseeable users of the CPA’s opinion.


4-24

Under common law, which of the statements is generally correct regarding the liability of a CPA who fraudulently expresses an opinion on audit of a client’s financial statements? (Hint: Consider the key word ‘fraudulently’) a. The CPA is liable only to third parties in privity of contract with the CPA. b. The CPA is liable only to known users of the financial statements. c. The CPA probably is liable to any person who suffered a loss as a result of the fraud. d. The CPA probably is liable to the client even if the client was aware of the fraud and did not rely on the opinion.

4-25

The best descriptionof whether a CPA has met the required standardof due professional carein conducting anaudit of a client’s financial statements is a. the client’s expectations with regard to the accuracy of audited financial statements. b. the accuracy of the financial statements and whether the statements conform to generally accepted accounting principles. c. whether the CPA conducted the audit with the same skill and care expected of an ordinarily prudent CPA under the circumstances. d. whether the audit was conducted to investigate and discover all acts of fraud.

4-26

When performing an audit, a CPA will most likely be considered negligentwhen the CPA fails to a. detect all of a client’s fraudulent activities. b. sign a written audit engagement letter. c. warn a client of known material internal control weaknesses. d. warn a client’s customers of embezzlement by the client’s employees.

4-27

Which of the following facts must be proven for a plaintiff to prevail in a commonlaw ordinarily negligent action against an auditor’s (defendant’s) misrepresentations? a. The defendant made the misrepresentations with a reckless disregard for the truth. b. The plaintiff justifiably relied on the misrepresentations. c. The misrepresentations were in writing. d. The misrepresentations concerned opinion.

4-28

A, a CPA, expressed an unqualified opinion on C Corp.’s financial statements. Relying on thesefinancial statements, B Bank lent C $2 million. A was unaware that B would receive a copy of the financial statements or that C would use them to obtain a loan. C defaulted on the loan. To succeed in a common-law civil action against A, B must prove, in addition to other elements that B was

a. free from contributory negligence. b. in privity of contract with A. c. justified in relying on A’s financial statements. d. in privity of contract with C. 4-29

C Corp. orally engaged A, a CPA, to audit its financial statements. C’s management informed A that it suspected the accounts receivable were materially overstated. Though the financial statements A audited indeed included a materially overstated accounts receivable, A expressed an unqualified opinion. C used the financial statements to obtain a loan to expand its operations. C defaulted on the loan and incurred a substantial loss. If C sues A for negligence in failing to discover the overstatement, ’s A best defense will be that A did not a. have privity of contract with C (i.e., lack of duty). b. sign a written engagement letter. c. cause C’s substantial loss (i.e., absence of causal connection). d. violate GAAS in performing the audit (i.e., nonnegligent performance)

4-30

Y bought Z Corp. commonstock in an offering registeredunder the Securities Actof 1933. A, a CPA, gave an unqualified opinion on Z’s financial statements that were included in the registration statement filed with the SEC. Y sued A under the p rovisions of the 1933 act that deal with a false statement or an omission of fact required to be in the registration statement. Y must prove that a. there was fraudulent activity by A. b. there was a material misstatement in the financial statements. c. Y relied on A’s opinion. d. A was n egligent.

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4-31

Under Section11 of the Security Actof 1933, a CPA usually willnot be liable to the purchaser ofsecurities a. if the purchaser is contributory negligent. b. if the CPA can prove due diligence. c. unless the purchaser can prove privity with the CPA. d. unless the purchaser can prove scienter on the part of the CPA.

4-32

C Corp. made a public offeringsubject to the SecuritiesAct of 1933. In connection withthe offering, A,a CPA, rendered an unqualified opinion on C’s financial statements included in the SEC registration statement. P purchased 1000 of the offered shares. P has brought a civil action against A under Section 11 of the Securities Act of 1933 for losses resulting from misstatements of facts in the financial statements included in the registration statements. A’s weakest defense would be that a. P knew of the misstatements when P purchased the stock. b. P’s losses were not caused by the misstatements. c. A was not in privity of contract with P d. A conducted the audit in accordance with GAAS.

4-33

C Corp. engagedA, a CPA, to audit the financial statementsto be included in a registration statementC was required to file under the provision of the Securities Act of 1933. A, the CPA, failed to exercise due diligence and did not discover the omission of a fact material to the statements. P, a purchaser of C’s securities, may recover from A under Section 11 of the Securities Act of 1933 only if the P a. brings a civil action within 1 year of the discovery of the omission and within 3 years of the offering date. b. proves that the registration statement was relied on to make the purchase. c. proves that A was negligent. d. establishes privity of contract with A.

4-34

Under Section 11 of the Securities Actof 1933, which of the following may a CPA use as a defense?

a. b. c. d. 4-35

None-proximate clause Yes No Yes No

A, a CPA, audited the financial statements of C Corp. As a result of A’s negligence in conducting the audit, the financial statements included material misstatements. A was unaware of this fact. The financial statements and A’s unqualified opinion were included in a registration statement and prospectus for an srcinal public offering of stock by C. P, a purchaser, purchased shares in the offering. P received a copy of the prospectus prior to the purchase but did not read it. The shares declined in value as a result of the misstatements in C’s financial statements becoming known. Under which of the following acts is P most likely to prevail in alawsuit against A? (Hint: Think about the scienter element)

a. b. c. d. 4-36

Non-negligent Performance Yes Yes No No

Securities Exchange Act of 1934, Section 10(b), Rule 10b-5 Yes Yes No No

Securities Act of 1933, Section 11 Yes No Yes No

In a suit against an auditor underSection 10(b) and Rule 10b-5 of the Securities Actof 1934, an investor (buyeror seller of securities) must prove all the following except that a. the investor was an intended user of the financial statements that contained misstatement. b. the investor relied on the financial statements that contained misstatement. c. the transaction involved some form of interstate commerce. d. the auditor committed scienter.

4-37

A, a CPA, issued an unqualified opinionon the financial statementsof C Corp. Thesefinancial statementswere included in the C’s annual report, and Form 10K were filed with the SEC. As result, of A’s reckless disregard for GAAS, material misstatements in the financial statements were not detected. Subsequently, P, an investor, purchased stock in C in the secondary market without ever seeing C’s annual report or Form 10 -K. Shortly thereafter, C became insolvent, and the price of the stock declined drastically. P sued 5 of the Securities Exchange Act of 1934. A’s best defense is that A for damages based on Section 10(b) and Rule 10ba. There has been no subsequent sale for which a loss can be computed. b. P did not purchase the stock as part of an initial offering. c. on the with financial d. P P did wasnot notrely in privity A. statements or Form 10-K.


4-38

Under Section 10(b) of the Securities ExchangeAct of 1934, a CPA may be liable if the CPA acted a. without a written contract. b. with independence. c. without due diligence. d. without good faith (i.e., act with scienter)

4-39

A, a CPA, was engaged to audit C Corp.’s financial statements. During the audit, A discovered that C’s inventory contained stolen goods. C was indicted and A was subpoenaed to testify at the criminal trial. C claimed accountant-client privilege to prevent A from testifying. Which of the following statements is correct regarding C’s claim? (Hint: Criminal Law rather than Common Law applies here)

a. C can claim an accountant-client privilege only in states that have enacted a statute creating such a privilege. b. C can claim an accountant-client privilege only in federal courts. c. The accountant-client privilege can be claimed only in civil suits. d. The accountant-client privilege can be claimed only to limit testimony to audit subject matter. 4-40

The Sarbanes-Oxley Act and the PCAOB Auditing Standard 3 (AS 3) require that I. all audit documentations that “form the basis of the audit or review” are required to be retained for seven years. II. all audit documentations that arenconsistent i with the final conclusion ofthe audit team are not to be retained for seven years. III. all correspondences between the engagement teams and the CPA firm’s national office relating to the audit are not to be retained for seven years. IV. all correspondences between the engagement teams and the CPA firm’s national office relating to the audit are to be retained for seven years. a. I and II. b. II and IV. c. I and III. d. I and IV.

4-41

The auditing profession is increasingly exploring the possibility of utilizing alternative dispute resolution procedures (i.e., arbitration and mediation) as a means of reducing litigation costs. This future legal development does not a. reduce the administrative and legal support costs of litigation. b. minimize the auditor’s exposure to legal liability. c. remove the auditor’s legal liability except perhaps punitive damages. d. exclude the auditor from punitive damages.

4-42

As a result of Enron Corp. case (2002), attorneyscan only file class action lawsuits involvingmore than $5 million in dispute in federal courts under a. Sarbanes-Oxley Act of 2002. b. Private Securities Litigation Reform Act of 1995. c. Securities Litigation Uniform Standards Act of 1998. d. Class Action Fairness Act of 2005.

Key to Multiple-Choice Question

4-1 c. 4-2 c. 4-3 c. 4-4 d. 4-5 a. 4-6 b. 4-7 c. 4-8 c. 4-9 c. 4-10 c. 4-11 d. 4-12 a. 4-13 b. 4-14 d. 4-15 b. 4-16 d. 4-17 d. 4-18 c. 4-19c. 4-20 b. 4-21 b. 4-22 b. 4-23 c. 4-24 c. 4-25 c. 4-26 c. 4-27 b. 4-28 c. 4-29 d. 4-30 b. 4-31 b. 4-32 c. 4-33 a. 4-34 a. 4-35 c. 4-36 a. 4-37 c. 4-38 d. 4-39 a. 4-40 d. 4-41 c. 4-42 d.

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Simulation Question 4-1 Simulation Question 4-1 is an adaptation with permission from a case by Reisch, J. T. in Issues the in Accounting Education, a publication of the American Accounting Association in Sarasota, Florida. This simulation question is based upon a true set of facts.



Introduction



BX Buys the Rights to Bolsan

In the spring of 1993, David Winston found himself thinking, “What have I got to lose?” He was contemplating spending the last $10,000 of his company’s cash to purchase the mineral rights to a piece of land in Indonesia. Winston had just received a call from an old friend, John Feldman, who indicated that the land probably contained 2 to 3 million ounces of gold. A geologist by trade, Feldman had been exploring the jungles of Southeast Asia for mineral deposits for the previous two decades and had discovered a large copper and gold deposit in New Guinea. It was just one of many successful mines he had discovered in the region. Winston had filed for personal bankruptcy earlier in the year and he was struggling to keep his small company afloat. The company, Brodnax Minerals Co. (hereafter, BX), a Montana-based exploratory mining company, was founded by Winston in 1988. BX had struggled since mpany’s 1991 its inception, and at one point the financial lookout for BX looked so bleak that CEO Winston wrote to shareholders in the co annual report, “Yes, we are still in business!” Much of Winston’s personnel financial problems stemmed from nearly $60,000 in credit-card debt he had accumulated and an earlier court order for Winston to repay over $40,000 to a brokerage firm for a mishandled stock transaction. A broker had mistakenly credited Winston’s account with shares Winston had already sold. When the brokerage firm notified Winston of its mistake, he refused to refund the money gained when he resold the shares. In a statement about the transaction, Winston later explained, “You have to havepriorities. your I was constantly putting out ires f running an exploratory mining company and didn’t have the time to worry about things like bank statements.” Winston had been a stockbroker himself for over 20 years before he ventured in 1988 into the world of the exploratory mining industry. However, he had a vision of striking it rich with a big find, and perhaps most importantly, he had the ability to sell his dream to investors. Between 1989 and 1992, BX’s stock price averaged $0.27 per share and fell to as low as $0.02 per share after the company failed to find minerals on its most promising claim. But there was a reversal of fortune in 1993 when Winston received the fateful call from John Feldman. Winston and Feldman met initially in 1987 at a mining convention when Winston first became interested in the exploration business. Winston was impressed by Feldman’s successful finds and his enthusiasm for exploring. In fact, Feldman’s enthusiasm earmarkedhim in the mining industry as having “big arms,” meaning he had the tendency to show the upside potential of a project by stretching his arms farther and farther apart as he described the project. Feldman persuaded Winston to take a look at the Indonesian property when he called Winston on a spring day in 1993. Using most of BX’s remaining cash, Winston flew to Jakarta to meet Feldman. The pair spent nearly two weeks trekking through the rain fores t before Winston pair flew home, convinced there was a gold mine in the Indonesian jungle. Prior to Winston’s trip, Feldman had explored the area for an Australian company, Queensland Gold. Queensland had hired Feldman and another geologist, Michael DeAngelo, to assess the region for potential minerals. Feldman and DeAngelo estimated that the areas, known as Bolsan, contained 2 to 3 million ounces of gold, despite their finding only trace amounts of gold in 19 core drillings. They were convinced there was gold, based on favorable geological formations in the area, but that the holes were not drilled in the right places. Their report, however, conflicted with the findings of a dozen other companies who found the remote area, a thick jungle populated by clamorous monkeys and a few native tribesmen, to be economically unfeasible for mining. Despite the positive report from Feldman and DeAngelo, cash-strapped Queensland, wanting to pull out of the region, put the mineral rights to Bolsan up for sale at a price of $180,000. When Winston went back to Montana, he used his brokerage skills to laud the upside potential for striking it rich in Indonesia. Winston quickly raised over $250,000 through the sale of stock and in the summer of 1993 used the proceeds to purchase the mineral rights to Bolsan. Soon after BX obtained the mineral rights to the Bolsan property, Feldman officially joined the company as Vice President of Operations. Feldman also brought his exploring friend, Michael DeAngelo, abroad as the chief geologist. DeAngelo, who possessed a near-genius IQ, had previously developed a novel theory about the formation of gold deposits. The theory, rejected by conventional geologists, suggests that gold deposits are formed at fault line junctions by mineralized fluids transported to the earth’s surface during volcanic activity. DeAngelo convinced Feldman that his theory had merit, and the two geologists, using the theory as a basis for their exploratory work, began to assess the Bolsan region more closely in hopes of finding gold.



BX Finds the Motherlode

The first significant discovery of gold at Bolsan occurred in early 1994 when DeAngelo noted an outcrop of volcanic rocks with a yellowish tint along a riverbank in the area. With news of the find, Winston enticed Paul Krause, a former executive of mining giant Barrent Gold Corp., to join BX’s board of directors. The addition of the well -respected Krause helped transform the image of BX from a fledging venture company to a real player i n the market. Krause’s expertise in t he industry gave investors a high comfort level in BX’s operat ions. With Kraus on s in the brokerage business to obtain additional funding for BX’s exploration in the Bolsan region. By board, Winston began to use his contact March 1994, Winston had arranged a $6 million private placement of preferred stock for BX. The inflow of cash enabled BX to continue its drilling through1994, and by year’s end, BX estimated the property contained just over three million ounces of gold. It was not until January 1995, however, that BX geologists found what they were looking –fora dome-like geological structure, hidden under the entangled canopy of the rain forest, which lay at the crossroads of fault lines. The area was mapped and the geological abnormalities were confirmed by satellite imagery. When Feldman reported the findings to BX’s Montana headquarters, he told Winston, “I think we’ve got a monster by the tail.” BX continued to drill in the region and the findings were very promising. In October 1995, BX estimated the Bolsan mine contained 30 million1996, ounces of gold,announced making it one world’sounces largestofgold mines. As drilling in the increased, so did Kearn the estimates of gold. February Feldman thatof40themillion gold had been estimated byregion an independent firm, Labs Ltd. This In wellrespected firm processed the core samples, but did not do its own drilling. In July 1996, BX announced that the estimate had risen to nearly 47 million ounces, planning it slightly behind the world’s largest gold mine, which contained 51 million ounces. Before the end of that year, the Bolsan mine was thought to have beenworld’s the largest gold


mine at an estimated 57 million ounces. Investors wanted in on the gigantic deposit and BX needed cash to expand its drilling in the area. On March 4, 1997, the company raised nearly $30 million in an equity offering. The estimates continued to climb as the drilling continued. On March 17, 1997, BX announced that its estimated gold reserves were 71 million ounces, and the following day, Feldman told investors he was “extremely confident” in predicting that the mine wo uld eventually yield over 200 million ounces of gold. The stock market responded to the announcements, and BX’s stock price soared. Prior to the acquisition of the mineral rightsin Indonesia, BX shares traded for pennies. They traded for less than $0.25 in 1991, rose to over $1 in late 1993, and were trading at $3 by the end of 1994. As word of the gold find spread through the stock market during 1995, the stock reached $15 per share in August and rose to over $50 in October upon the announcement that Bolsan contained 30 million ounces of gold. By February 1996, shares were trading for over $200. The following month, BX announced a 10-for 1 stock split. Shares of BX reached their peak in September 1996 at $28.13, the equivalent of over $281 in pew-split terms. Shortly thereafter, and until March 1997, the stock price of BX had settled to around $20. The decrease in price was primarily attributable to uncertain political risk in Indonesia.

 Nearly every major business deal in Indonesia can be linked to a few politicians who control the central government. The mining industry is no exception. With billions of dollars at stake in the mine, these politicians wanted to lay claim to some or all of the gold in Bolsan. As an exploration company, BX had no expertise in actually extracting minerals. The company had to obtain a major mining partner or sell its claim to the highest bidder since it did not have the capability of operating the world’s largest gold mine The Indonesian government wanted the mining operations to begin as soon as possible and began to put pressure on BX in the fall of 1996 to find a partner or sell out. In fact, the government already had a proposal in mind for BX, which it had been working covertly on for months. The Indonesian government was aggressively pursuing an alliance between Barrent Gold and BX. Barrent, one of the world’s largest mining entities, had beenoperating mines in Indonesia for some 20 years; ties between Barrent and the Indonesia government were strong. In November 1996, the Indonesian government simply declared that Barrent would have a 75 percent interest in Bolsan while BX would have the remaining 25 percent. The government also indicated that it would “appreciate” a 10 percent interest in the si te, although it did not indicate from which party that share would come. In addition, the government threatened to revoke mining permits for the Bolsan property until the ownership dispute was resolved. However, the subtle threats made by the Indonesian government were never enforced because several key political advisers argued that the arrangement would act as a catalyst to erode foreign investment in Indonesia. Thus, the deal between Barrent and BX never proceeded. Barrent was not the only mining company interested in Bolsan. In January 1997, Vancoucer-based Placid Mines Inc. offered to acquire BX in a stock swap valued at $4.5 billion. While the offer was good, Placid did not have the necessary political ties to the Indonesian government to consummate the merger; however, a Houston based company, Freemont Copper & Gold Inc., did. Freemont has operated the largest copper and gold mine in Indonesia since 1972 and employed nearly 17,000 Indonesians. On March21, 1997, a deal was struck between BX and Freemont that was immediately approved by the Indonesian government. Under terms of the agreement, Freemont received a 15 percent stake in Bolsan, became sole operator of the mine, and committed to providing $1.6 billion in financing for the operation, all subject to due diligence testing of the gold reserves. BX maintained a 45 percent stake in Bolsan. The Indonesian government secured a 10 percent interest, with the remaining 30 percent interest split between Indonesian companies controlled by influential government officials. The agreement with Freemont reduced BX’s stake in Bolsan to only 45 percent, with BX receiving no tangible compensation for giving up 55 percent of the mine. However, Winston defended the deal, saying, “Brondnax ends up getting 45 percent of a potential 200 million class operator.” Many Indonesian businessmen ounces of gold without spending another dime, and the property will be managed by a firstindicated the lack of compensation for its reduced claim was the only means by which BX could clear the way to begin mining. Political Instability in Indonesia



The Golden Glitter is Gone

Shortly after agreeing in principle to operate the Bolsan mine, Freemont geologists were sent to Indonesia to begin their due diligence testing. This included takingindependent samples from the site as well as reviewing BX’s existing sampling data. The seven test holes drilled by Freemont indicated an insignificant amount of gold, although the geologists were aware that discrepancies often exist when a limited number of core samples, only a few inches wide, are drilled. Concerned over their findings, Freemont officials arranged a meeting with DeAngelo and the other BX’s geologists to reconcile the differences in the sample results. On April 18, 1997, DeAngelo boarded a helicopter at Bolsan that was to take him to Jakarta to meet with Freemont officials. However en route to the meeting, DeAngelo was killed when he took a mysterious plunge of some 800 feet into the jungle below. Although a suicide note was found indicating that DeAngelo could no longer bear the anguish of a debilitating liver disease and malaria, his family and friends suspect he was pushed from the helicopter. The death of DeAngelo started rumors about the Bolsan site. When many speculated that the amount of gold might have been overstated, the market began to react. The share price immediately slid some $5, to just below $15. But the slide was halted by remarks made by Feldman, who angrily dismissed notions that the size of the deposit was misstated and aids he was “110 percent confident” the gold was there. Freemont’s geologists tried to obtain sample data recorded by BX to continue their due diligence testing, but the BX geologists at Bolsan could not provide much information about their samples. Freemont learned that a fire had broken out a t the Bolsan mining compound on January 11, 1997, which destroyed several buildings, as well as thousands of pages of BX’s sample logs and other key data. eseTh items were critical for comparing the assay (analysis of ore) results to scientific descriptions of the cores and the locations from which the samples were taken. In addition to the fire, Freemont also learned about the unusual manner in which the cleanup took place. Rather than looking for the remains of records or other salvageable items, DeAngelo ordered a bulldozer to plow the site immediately after the fire was put out. The dam broke on April 25, 1997, when Freemont announced that its preliminary findings indicated there were only traces of gold in its samples, and that an independent mining laboratory, Strickland, would issue a final report a few weeks later. Freemont’s statement sent BX shares on a steep downward ride. The value of the stock plunged nearly 84 percent, from about $13 to $2 per share, erasing an equity value of $2.4 billion in a single day.



It’s Really a Salt Mine

The results of Strictland’s testing confirmed the doubts about the lack of gold at the Bolsan site. On June 5, 1997, Strickland said it found only “trace amounts of gold” at Bolsan and that there was “virtually no possibility of an economic gold deposit” at the site. In its report, Strickland noted, “the magnitude of the tampering with core samples taken at Bolsan, and the resulting falsification of assayvalues, is of a scale that, to our knowledge, is without precedent in the history of mining.”

97

98


In layman’s terms, the core samples taken from the property had been “salted” or adulterated; that is, the drilled cores werelaced with particles of gold from other sources. Both Winston and Feldman vehemently denied any involvement in the elaborate scheme to taint the core samples and placed the blame on DeAngelo. The mystery of how the Bolsan samples were salted and who was responsible is still a puzzle. But several pieces of the puzzle have come to light. The standard industry practice to prevent tampering with samples is to have geologists log the samples, place them in numbered plastic bags, seal the bags, and dispatch the samples immediately to an independent laboratory for assaying. BX, however, did not follow this practice. The owner of a trucking company that transported BX’s samples to Kearn, the independent lab, indicated that sampleswere warehoused by BX for a few days to month before being sent to the lab. Before being transported, witnesses said, the samples were opened and mixed with powders by BX geologists under the supervision of DeAngelo. In addition, no samples were sent to the lab unless they were personally checked by DeAngelo. This questionable handling of the samples suggests evidence of the salting operation used to inflate the gold claims. Moreover, Strickland found the gold particles in BX samples to be rounded, a common characteristic of gold found in riverbeds, rather than flaky, a physical trait of gold embedded deep within the earth. The day the Strickland report was released, the remaining values of the BX shares plunged another 97 percent, to close at $0.08 per share. Some 58 million shares were traded that day as skittish investors stampeded for the closest exit. The following day, BX shares were delisted by NASDAQ because the company no longer met certain listing requirements.



Shedding Light on the Saga

In the summer of 1996 (when the value of BX shares was skyrocketing), the officers of the company quietly began exercising options they owned. The exercise of the stock options increased the company’s equity by over $18 million, and gains realized by Winston and Feldman – approximately $125 million between the two. DeAngelo also took in nearly $5 from immediately reselling their new shares were substantial million form the exercise of options. Although disclosures of the transactions were made as required by the SEC, the information did not adversely impact the market’s value of BX. In the eight years since its inception, BX had never earned a dime from operations, although it did earn interest income on its cash holdings. As of December 31, 1996, BX had approximately $44 million in total assets, comprising mostly cash and fixed assets. You should access Data File 4-1 in iLearn for Table 1, which shows selected financial information of BX for 1995 and The 1996. gold claims were not included on the balance sheet because the deposits were not yet considered probable; that is, even though preliminary drillings indicated the existence of gold, the sampling data were not specific enough to adequately estimate the quantity and grade of the ore. Under GAAP, only proven and probable reserves that meet certain measurement criteria are recorded as assets (SFAS No.89). The company also had approximately $2 million in payables and $42 million in equity on its balance sheet. As of December 31, 1996, the market’s value of the compan y was nearly $4.5 billion; thus, the stock market clearly valued the large gold deposit, even though it was never included on the balance sheet. The auditor’s report, dated January 24, 1997 and included in the 1996 BX annual report issued on February 12, 1997, containeda standard unqualified opinion for the two-year comparative financial statements. You should access Data File 4-1 i n iLearn for Table 2, whi ch shows the independent auditors’ (Healy & Wallace LLP) unqualified No report. mention of the gold was explicitly included in the footnote disclosures, although the accounting treatment for the miningroperty p was described in the following note on the company’s operations: The Company is engaged in the acquisition, exploration and development of mining properties. The mining properties are recorded at cost. Acquisition, exploration, and related overhead expenditures are deferred and will be amortized over the estimated life of the property. The estimated life of the property depends on whether the property contains economically recoverable reserves that can be brought into production. The total amount recorded for mineral properties and deferred exploration expenditures represents costs incurred to date and does not reflect present or future values. If properties are determined to be commercially unfeasible, related costs will be expensed in the year that determination is made.

In addition to audited financial statements, BX included a management’s discussion and analysis (MD&A) section in its 1996 annual report. You should access Data File 4-1 in iLearn for Table 3, which shows excerpts from the MD & A section.



Shareholders File Lawsuits

BX filed for bankruptcy on June 9, 1997, shortly after the Strickland report was issued. Although the company had net assets of over $70 million (including the $30 million raised in March by the equity issuance) at the time of the bankruptcy filing, it sought protection from an onslaught of legal suits that were launched as a result of purported fraud. In addition to class-action lawsuits against BX and its officers and t Kearn Labs, the i ndependent assaying firm, various investment advisors, and BX’s external directors, shareholders of BX also filed suits agains auditor, Healy & Wallace LLP. Healy & Wallace LLP (hereafter, H&W) was included as a defendant in the lawsuits because shareholders believed the firm breached its duty to exercise due professional care and failed to uncover the fraud. Shareholders allege that H&W should have noticed that information contained in the MD&A section of the 1996 annual report was misleading, given the fact that H&W had copies of private quarterly reports issued by Kearn Labs to BX. Those reports explicitly stated that the core samples the lab tested were provided to it by BX and the thatlab’s estimates were not conclusive enough to consider the deposit to be a probable mineral reserve. In addition, shareholders contend that if H&W had a sufficient understanding of BX’s internal controls, the fraud would have been detected much earlier. In response to the suits alleging negligence, H&W announced it would vigorously defend itself and claimed that it followed generally accepted auditing standards (GAAS) while conducting its audit. In addition, the accounting firm maintained that the financial statements contained no material misstatements and were fairly presented in conformity with generally accepted accounting principles (GAAP). H&W is a large, well-respected regional firm with several audit clients in the mining industry, including the sixteenth largest American mining company. That particular audit client also has mines located in foreign countries; thus dealing with the international operations of a company is not new to the firm. Like many public accounting firms, H&W has, on occasion, been named as a defendant in litigation against clients and third parties. The firm has never had a judgment against it for negligence. Although during the last decade they have settled out of court two times. The firm was familiar with BX’s operations since H&W had audited the company each year since 1993, and a standard unqualified opinion had been expressed in each of those years. The engagement partner indicated that the control risk had always been assessed at the maximum because it was more economical to expand the scope of substantive tests given the nature of the accounts containedBX’ on financial statements than to rely on the company’s internal controls. There also had never been any unresolved disputes between the audi tors and management, and by all accounts the substantive audit procedures performed by H&W on the 1996 BX engagement were carried out with a high level of quality. You should access Data File 4-1 in iLearn for Table 4, which shows a timeline of significant developments involving BX, including events that transpired in 1996 and 1997.


Required Assume you are part of the legal teams involved in the class-action lawsuit brought by BX shareholders against H&W, the external auditor. Using the format below, answer the following questions from both the shareholders’ (the plaintiff’s) and the auditor’s (the defendant’s) point of view. Some viewpoints from both sides are provided to help you complete the rest. 1. Is H&W liable to BX’s shareholders for issuing an inappropriate audit report?

The Plaintiff (Shareholders) The Defendant (Auditors) 1. Some information included in the MD&A section was presented not 1. Information in BX’s annual report was presented in conformity with in conformity with GAASparagraph because the goldaudit wasreport. probable and should since GAAPit because gold was properly excluded from the balance sheet be noted as an explanatory to the was not the probable. 2. 2. 3. 3. 4. 4. 2. Is H&W liable to BX’s shareholders for improperly accepting the BX client? The Plaintiff (Shareholders) 1. If the defendant had performed thorough background checks on management, it would have discovered that management lacked integrity, for example, Winston’s mishandling of a stock transaction. 2. 3. 4.

The Defendant (Auditors) 1. Just because Winston filed for personal bankruptcy does not mean he lacked integrity. 2. 3. 4.

3. Is H&W liable to BX’s shareholders for not detecting the BX’s fraud?

The Plaintiff (Shareholders) The Defendant (Auditors) 1. The defendant overlooked obvious red flags such as the mysterious 1. The red flag concerning the fire that destroyed the 1997 sample fire in January 1997 that destroyed sample records. records did not have a material impact on the financial statements because the gold was excluded from the financials. 2. 2. 3. 3. 4. 4.

Simulation Question 4-2 This simulation question is based upon a true set of facts; however, the names and places have been changed. The simulation Question is developed by F. Choo inFinancial a nd Integrated Audits , a publication of CSU AcademicPub, California. In 2008, San Francisco Chronicle reported that a San Mateo Court was in the process of ruling on whether the public accounting firm of Rod Ferria & Associate, CPAs, LLP (hereafter, RFA), should be required to pay all or part of $20 million in damages relating to Jazer Co. for failing to detect a scheme to defraud the company. Jazer Co., an SEC registrant, charged that RFA was negligent in failing to discover fraud committed by the company’s controller and wanted RFA to foot the bill for all $20million in claims by and against the company. The company claimed that if it had known about the fraud, it could have stopped it and recovered financially. Bank of American, the bank involved in the case claimed that it granted a loan of $5 million based on misstated financial statements. The stockholders claimed that they purchased $5 million Jazer Co.’s stock on the American Stock Exchange at an inflated price due to the misstated financial statements. They acknowl edged that while stock had been outstanding and traded for many years prior to the fraud, they made their investment decisions relying upon the misstated financial statements. RFA’s general counsel said, “We anxiously await a decision that will show that CPAs are not guarantors for everything hat t goes on in the company.” Jazer Co.’s lawyer said that she anxiously awaited a decision because it will “clearly show that CPAs are liable for finding fraud.” The $20 million lawsuit was as follows: Claim Against Auditor Claim Against Auditor and Jazer Co. Jazer Co. ………………… $10 million None Bank of America …………. 5 $million $ 5 million Stockholders ……………… 5 million $ $ 5 million

Required

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“foreseeable’ concept but may move back to the 1. Assume that the case is brought under common law; that the San Mateo court follows the “Ultramares” concept in a third-party lawsuit, and that RFA canbe charged under different types ofnegligence in performing the audit, answer the following questions: a. Should RFA be found liable to Jazer Co.? Explain and cite prior legal case(s) to support your arguments. b. Should RFA be found liable to Bank of America? Explain and cite prior legal case(s) to support your arguments. c. Should RFA be found liable to the stockholders of Jazer Co.? Explain and cite prior legal case(s) to support your arguments.

2. Assume that the case is brought under the Securities Exchange Act of 1934, and that FRA can be charged under different types of negligence in performing the audit, answer the following questions: a. Should RFA be found liable to Jazer Co.? Explain and cite prior legal case(s) to support your arguments. b. Should RFA be found liable to Bank of America? Explain and cite prior legal case(s) to support your arguments. c. Should RFA be found liable to the stockholders of Jazer Co.? Explain and cite prior legal case(s) to support your arguments. 3. Assume that the case is brought under the Securities Act of 1933; that the stock involved are new stock issued to the public for the first time, and that the financial statements involved had been included in a registration statement for the securities, answer the following questions: a. Should RFA be found liable to Jazer Co.? Explain and cite prior legal case(s) to support your arguments. b. Should RFA be found liable to Bank of America? Explain and cite prior legal case(s) to support your arguments. c. Should RFA be found liable to the stockholders of Jazer Co.? Explain and cite prior legal case(s) to support your arguments. 4. Assume that the case is bro ught under the Private Securities Litigation Reform Act of 1995, and that according to the “Joint and Several Liability” doctrine, Jazer Co. is liable for 50% and RFA is liable for 50% of a $10 million damage awarded to the Bank of America and the stockholders, answer the following questions: a. If the co-defendant, Jazer Co., were insolvent, how much the remaining co-defendant, RFA, has to pay for the $10 million damage awarded to the Bank of America and the Stockholders? b. If the stockholders initiall y purchased Jazer Co.’s $5 million stock at $100 per share and that the average closing price of the stock was $20 per share during the 90-day period following the date of a press release about the misstated financial statements, how much damage per share could the stockholders claim against the auditor, RFA?

Simulation Question 4-3 Simulation Question 4-3 is an adaptation with permission from a case by McKnight, C. A., T. S. Manly, and P. S. Carr inIssues the in Accounting Education, a publication of the American Accounting Association in Sarasota, Florida. This simulation question is based upon a true set of facts; however, the names and places have been changed.

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Li and Associates, CPAs, LLP

In 1979, Jet Li graduated from college with an accounting degree. After seven years at an international accounting firm, Jet decided to start his own CPA firm, Li and Associates, CPAs, LLP (hereafter, L & A). This firm, located in San Francisco, caters to local clients; specifically, Jet and his staff of fourthe professionals specialize in non-public companies. majority the services provided purposes), by L & A and are tax planning and preparation; however, firm also performs bookkeeping services, auditsThe (mainly for of client debt compliance other attestation services. L & A has been a profitable and successful business for Jet. Tax returns are rarely questioned by the IRS, and banks and other lenders trust the attestation services provided by L & A. Clients have come to expect quality work from L & A, and they receive this quality.

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Two Clients of Li and Associates, CPAs, LLP

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Jeanne Thomson’s Employment and Education History

Ali Automotive Ali Automotive is the most profitable car dealership in San Francisco. The company, which sells approximately 100 new cars each month, has been a business leader in the city for 30 years. Ali Automotive sells about 20 percent more used cars than new ones each month. In addition to the margins made on car sales, Ali Automotive earns additional revenues through its finance and service departments. These revenues for service and parts average $200,000 each month. The dealership has a strong financial history and expects moderate growth in the future. Mohammad Ali leads this family-run automotive dealership. Outgoing and personable, he brings strong sales and customer service to this business, which he took over when his father retired ten years ago. Ali family members are responsible for all aspects of the business except the accounting department. Ali knew accounting was difficult and wanted a CPA firm to perform bookkeeping services and tax preparation. L & firm’s work. He was especially impressed with A has been Ali Automotive’s accountant for ten years. Ali has been very pleased with the CPA Karen Green, an L & A employee in charge of the bookkeeping services provided to Ali over the past two years. He trusted her completely and, although he did not understand accounting, felt she did an excellent job. Kim Jewelers Kim Jewelers is another important client of L & A. Founded and operated by renowned artist and silversmith Jung Kim, Kim Jewelers sells Jung Kim’s unique and highly demanded creations. As Kim’s reputation grew, he knew he needed a good partner to run the business side of the company. Therefore, he enlisted an M.B.A. to manage the production and finance departments, so he could concentrate on Kim Jewelers’ creative development. Based on his education and experience with manufacturing companies, the new partner quickly identified the need for internal controls at Kim Jewelers. Since the raw materials and finished goods inventory consisted of small but valuable pieces, he implemented a number of physical controls such as locks on the cases and security cameras. He also added other extensive controls, including policy and procedures manuals and training for the employees, formal accounting and finance documents, and an extensive computer system with limited access. Although a total separation of duties is not present at Kim Jewelers due to its small staff, both Jung Kim and his partner actively monitor the company’s daily activities. Each year, L & A reviews Kim Jewelers ’ annual and quarterly results and prepares its taxes. The L & A employees assigned to Kim Jewelers consider it an easy engagement, because Kim Jewelers presents impeccable, nearly error-free records. After working as a retail sales associate for ten years, Jeanne Thomson returned to college to complete her accounting degree. She put in many hours at her sales job, but had not received the compensation or respect she believed she deserved. She rarely missed work, was


punctual, and often exceeded her sales quota; however, she was never promoted or given a substantial raise. Therefore, Anna decided a college degree was the key to her financial success. Jeanne worked hard in college while continuing her sales job, looking after her two children, and supporting her husband who was injured at his job. Jeanne was determined tom ake life better for herself and her family. During college, she was willing to ‘‘get the j obdone’’ in . She often skipped class, but when she was her courses. Faculty members knew that Jeanne was bright, but her performance was often marginal there, she was an active participant in discussions and seemed to grasp concepts well. She often missed daily assignments, but she would compensate by earning higher scores on exams. Group assignments were particularly difficult for Jeanne, because they forced her to arrange meeting times outside of class. Luckily for Jeanne, her classmates always covered her responsibilities when she could not do the work. Most of them understood she could not work and complete all her homework assignments while watching her kids. They also enjoyed the baked goods she brought to meetings. Every once in a while, some fellow students would give her a poor peer evaluation because she did not complete her portion of the assignment; however, the good grades on the assignments outweighed the evaluations. She felt that most college students could not comprehend her position because they did not have the same ‘‘real-life’’ responsibilities. ’s father-in-law, a Jeanne completed her degree with 150 hours and a 3.00 GPA. She was thrilled; her family was very proud. Jeanne prominent attorney, was especially overjoyed. Despite his help, Jeannie and his son had struggled with their finances. He was so proud they had started taking responsibility for themselves. After graduation, Jeanne began her job search immediately. She had many bills to pay, including payments on a new convertible, a present she gave herself after graduation. She was glad to quit her sales position and hoped she would receive the respect she felt she rightfully deserved as an accountant.

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Jeanne Thomson Joins Li an d Associates, CPAs, LLP

Busy season was about to begin, and one of L & A’s best employees, Karen Green, gave her two-week notice. Karen was a smart, successful CPA who enjoyed the challenge and the camaraderie of working in an office. Although she did not need to work due to a large inheritance, Kate often worked 50-plus hours a week during her five years with the firm. Jet Li was sad to see such a valuable employee leave the firm. Jeanne’s resume could not have come to Jet Liat a better time. Although Anna’s grades were not outstanding, Jet was impressed that Jeannie did have a 3.00 GPA while working full-time and maintaining a family. Jeannie appeared able to multi-task, a skill demanded of ’s Jet Li staff. Jet Li was also pleased that Jeanne came from a distinguished family in San Francisco ; he didn’t feel the need to check her references, because the Thomson family was well known and respected. Therefore, he hired Jeanne immediately. When Jeanne started working, she was immediately assigned to Ali Automotive to take Karen Green ’s place. This client was small and required only one staff accountant. Jet Li not only introduced Jeanne to Mohammad Ali and the other Ali Automotive employees, but also spent the first day with Jeanne on the job. Previously, he had spent three days training Karen Green at Ali Automotive, but since it was busy season, he had to focus his attention on tax returns. He was thankful that Jeanne was a fast learner. Jeanne could not believe all of the information needed just to perform bookkeeping services. Although she felt she learned a lot in her accounting courses, they were nothing like actual on-thejob experience. While Mohammad Ali did not expect a new graduate to take over Karen Green ’s job, he trusted Jet Li’s judgment. After all, Jeanne had worked hard for years before obtaining her degree, appeared eager to learn, and was eager to pass the CPA examination.

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Jeanne Thomson’s Performance at Li and Associates, CPAs, LLP

Jeanne worked for three years for L & A with Ali Automotive as one of her main responsibilities. She performed bookkeeping services for Ali Automotive, visiting the automotive dealership once a week. She was fortunate that a lot of the work could be done from L’s& A office. After the initial learning curve, Jeanne excelled in the eyes of Mohammad Ali. She always got her job done on time and in spotless order. Her job responsibilities included journal and entries, preparing checks for bills for to be paid by by Ali. Ali, After and making tripsJeanne to theforwarded bank and post weekly office. Monthly, Anna prepared bankrecording reconciliations compiled financial statements review approval, Automotive’s line of credit open. Within a few months, Mohammad the financial statements to the bank, which were a requirement to keep Ali Ali completely trusted Jeanne, just as he had trusted Karen Green . He didn’t need to review the financial statements, journal entries, or the supporting documents for payments. He did not understand accounting, and he believed in Jeanne. In fact, he was about to approach Jeanne about working for Ali Automotive full-time. She really seemed to be a part of the Ali family and dedicated to the job. When Ali employees put in extra hours, Jeanne followed suit. Even during her vacations, Jeanne took time to help at the dealership. Jet Li was pleased with the high praise from Mohammad Ali. He was relieved that he did not have to frequently review her work. Since the client was happy, he worked on other projects and stayed out of Jeanne’s way. Jeanne was also assigned to Kim Jewelers. This client required the work of two staff accountants and a senior. At first, Jeanne was glad to have colleagues available to answer questions, share the work, and help her get started. She learned a lot from the senior accountant during the first year, although it was odd to be supervised by someone younger than she was. Jeanne was impressed with the internal controls at Kim Jewelers and often commented on the impressive hands-on management style in every aspect of the business. Jeanne liked working at Kim Jewelers, but often suggested to her colleagues there that it was Ali Automotive where she was the most needed. To the detriment of her Kim Jewelers audit team, Jeanne often delayed working on the engagement whenever Ali Automotive needed her. She was the only staff accountant on the Ali Automotive job; it was her top priority. After three years, Jet Li began to receive mixed reviews from clients for Jeanne Thomson. He was content with her praise from Ali Automotive, but other clients, including Kim Jewelers, were less impressed. Jeanne seemed to perform at or below expectations for a third-year staff on her other jobs. Her intelligence and confidence were evident, but her work and effort did not convey her abilities. In addition, she often complained that her friends at large international accounting firms were making quite a bit more money than she was. On the positive side, Jeanne recently passed the CPA examination. She was professional at work and in the community; her expansive wardrobe always reflected the role of a professional, and her demeanor was a positive reflection on L & A. Jeanne also was making some new business contacts for L & A through her membership at the country club and the gated neighborhood where she lived. In fact, she had brought in two new clients for the firm, a feat that was unheard of for a staff accountant. Jeanne was well liked by her coworkers at L & A. She often had them over to her new home to socialize after working hours. They enjoyed her company and were impressed that she was juggling her career and family. Since her husband was ’s father-in-law was footing the bill for some of their luxuries. still collecting disability, they assumed Jeanne Unfortunately, Jeanne had a car wreck during busy season of her fourth year. Although she did not have any permanent injuries, of Jeanne’s Jeanne had to stay in the hospital for three weeks. During that time, Jet Li covered her work responsibilities. During the second week absence, Jet collected Ali’s mail from the post office and began preparing checks for payment. Jet was surprised to see a very large credit card bill. Upon examination of the bill, Jet noticed large charges at a home improvement store. Was Ali Automotive expanding its business? Jet was curious, and when he brought flowers to the hospital for Jeanne, he asked her about the charges. Jeanne could not answer ’s Jet questions and seemed rattled by the discussion. Jet contacted the credit card company to determine if the charges were valid. He discovered that the charges

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were authorized by Jeanne Thomson. Further investigation revealed that the charges were for personal items for Jeanne. In response to these charges, Jet meticulously examined the dealership’s accounting records and found that Jeanne had been making personal charges and cash withdrawals on Ali’s credit card for two and a half years. Jet swiftlycontacted Ali’s credit card company to terminate a pending payment of $200,000 that was fraudulently charged by Jeanne Thomson to Home Upgrade, a home improvement store. Consequently, Home Upgrade suited L & A for professional negligence under a third party liability lawuit. s Lastly, Jet also investigated Jeanne’s work with her other clients, including Kim Jewelers. He was relieved that he did not find any additional irregularities; nevertheless, he was overwhelmed and distraught over Jeanne’s fraudat Ali Automotive.

Required 1. List and discuss three personal or situational factors that might have triggered Jeanne Thomson to commit fraud at Ali Automotive. 2. List and discuss three personal or situational factors that might not have triggered Jeanne Thomson to commit fraud at Kim Jewelers. 3. Assume that Ali Automobile files a civil common lawsuit against Li and Associates, CPAs, LLP for breach of contract and Jeanne Thomson for fraud, answer the following questions: a. Should L & A be found liable to Ali Automobile? Explain and cite prior legal case(s) to support your arguments. b. Should Jeanne Thomson be found liable to Ali Automobile? Explain and cite prior legal case(s) to support your arguments. 4. Assume that Home Upgrade files a third-party joint liability common lawsuit against Li and Associates, CPAs, LLP and Ali Automobile; that the San Franciscocourt follows the “foreseeable’ concept but may move back to t he “Ultramares” concept in a ht ird-party lawsuit, and that L & A can be charged under different types of negligence in performing professional services, answer the following questions: a. Should L & A be found liable to Home Upgrade? Explain and cite prior legal case(s) to support your arguments. b. Should Ali Automobile be found jointly liable to Home Upgrade? Explain and cite prior legal case(s) to support your arguments.


Chapter 5 Audit Plan – Preplan and Documentation Chapter Learning Outcomes (LOs) Checklist


LO5-1 Describe the four main considerations of preplan in a financial audit.

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LO5-2

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LO5-3 Explain the external auditor’s consideration of the internal auditor’s involvement in preplanning an audit.

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LO5-4 Compare and contrast the general documentation requirements between the SEC’s SOX 2002 and AICPA’s AU 230.

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LO5-5 Compare and contrast the specific documentation requirements between PCAOB’s AS No.3 and AICPA’s AU 240.

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LO5-6 Identify the content of the auditor’s permanent and current files.

Describe the six main considerations of preplan in an integrated audit.

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Chapter 5 Audit Plan – Preplan and Documentation Preplan in a Financial Audit

Preplan in a financial audit involves four main considerations as shown in Figure 5-1. Figure 5-1 Main Considerations of Preplan in Financial and Integrated Audits

The Audit Process

Audit Plan

Preplan and Documentation CH 5

Tests of Controls

Tests of Balances

Completing the Audit

Financial Audit

Audit Report

Integrated Audit

Objectives CH 6 1. Investigate the Client

Evidence CH 7 2. Understand the Client’s Business

Internal Control CH 8 3. Assign Staff to the Engagement Materiality and Risk CH 9 4. Sign the Engagement Letter Program and Technolo CH 10 5. Considers Matters Specific to An Integrated Audit

6. Consider the Risk of Fraud and Management Override of Controls


Table 5-1 provides some comments on the four main considerations of preplan in a financial audit. Table 5-1 Four Main Considerations of Preplan in a Financial Audit

Consideration (1) Investigate the client

(2) Understand the client’s business

(3) Assign staff to the engagement

Comments For new client: Prior to accepting a new client, AU 210Terms of Engagement requires the successor auditor to communicate, either orally or in writing, with the predecessor auditor. The initiative in communication rests with the successor auditor. The inquiry of the predecessor auditor is important because the predecessor auditor may be able to provide the successor auditor with information that assists him/her in determining whether to accept the engagement. The successor auditor shouldworking also request theincluding client to documentation authorize the predecessor auditor to allow a review of the predecessor's papers, of planning, internal control, audit results, and other matters of continuing accounting and auditing significance, such as the working paper analysis of balance sheet accounts, and those relating to contingencies. In addition, the client's consent to the review is needed in accordance with Rule 301 of the Code of Professional Conduct on confidential client information. The auditor may hire a professional investigator to obtain information about the reputation and background of the potential new client’s management. The auditor may also use the internet to search and learn more about the potential new client. Table 5-2 describes some useful sites for the electronic search. The auditor should assess the legal and financial stability of the potential new clients and reject it if it poses a high risk of litigation. For old client: The incumbent auditor should review prior experience with the existing client and decide whether to continue auditing the client. KPMG LLP has developed and implemented an innovative technology-enabled auditor decision aid, known as KRisksm, for making acceptance and continuance risk assessments of both new and old clients. The auditor should obtain a knowledge of the nature of the client's business, its code of ethics, organization, and its operating characteristics, such as the type of business, types of products and services, capital structure, related parties, locations, and production, distribution and compensation method. Some procedures to accomplish these are: (a) A tour of the client's plant and offices. (b) A review the client's legal documents, policies and the auditor's working papers from prior years. Legal documents that the auditor should examine include corporate charter and bylaws, minutes of corporate meetings, and contracts. (c) Consult the AICPA Industry Audit Guide, industry publications, periodicals and financial statements of other business entities in the industry to obtain knowledge of the business environment in which the client operates, such as economic conditions, government regulations, and changes in technology. (d) Gain knowledge of the client’s values and ethical standards through policy statements and code of ethics. In response to the Sarbanes-Oxley Act of 2002, the SEC now requires each public company to disclose whether it has adopted a code of ethics that applies to senior management, including the CEO, CFO, and principal accounting officer or controller. A company that has not adopted such a code must disclose this fact and explain why it has not done so. Accordingly, as a part of the understanding of the client’s business, the auditor should gain knowledge of the company’s code of ethics. (e) Identify related parties of the client through inquiry of management, review of SEC filings, and contacting the stock registrar to identify principal stockholders. A related party transaction is any transaction between the client and a related party (Discussed in Chapter 20). Related party transactions increase inherent risk of a client because they are not at arm’s length and may not be valued at the same amount as they would have been if the transactions had been with an independent third party. Accordingly, Sarbanes-Oxley Act of 2002 specifically prohibits related party transactions that involve personal loans to executives. It is now unlawful for any public company to extend or maintain credit, to arrange for the extension of credit, or to renew the extension of credit in the form of personal loan to any director or executive officers. These restrictions do not apply to any loan, such as a home loan or credit card agreement, made by a bank or other insured financial institution under normal banking operation using market terms offered to the general public. In light of these prohibitions, the auditor should now be alert of any such loans to directors or executives that are illegal acts. (f) Perform analytical procedures (Discussion in Chapter 7) Considerations for assigning staff to the engagement are: (a) In the case of a new client, the key members of the audit team are identified; this will allow the prospective client to assess the credentials of the proposed audit team whose resumes are usually enclosed with the pre-engagement proposal. (b) In the case of an old client, ensure the continuity of the assigned audit staff to the client and maintain the familiarity of the assigned audit staff with the client.

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Consideration

(4) Sign the engagement letter

Comments (c) In the case of a client with computerized accounting systems, and if specialized computer skills are needed, the auditor should seek a professional possessing such skills, who may be an individual with the audit firm or an outside professional. (d) When outside expert help is needed, AU 620Using the Work of a n Auditor’s Specialist requires the auditor to satisfy himself/herself concerning the professional qualification and reputation of the specialist, such as computer analysts, lawyer, and appraiser, by inquiry or other procedures, as appropriate. There are more discussions on using the work of a specialist in Chapter 20. (e) Recall in Chapter 2 that the partner-in-charge of an audit should be rotated at least every seven years as per the Firms Division of the AICPA and every five years as per the Sarbanes-Oxley Act 2002. Recall Table 2-10 in Chapter 2 that under Section 301 of the Sarbanes-Oxley Act, audit committees (or charged withexternal governance) are Moreover, now directly responsible theSarbanes-Oxley appointment, compensation, and those oversight of the auditor. Section 202 offorthe Act amends Section 10A of the Securities Exchange Act of 1934 to require that the audit committee must also pre-approve all audit and non-audit services provided by the external auditor. This means that the auditor should now establish an understanding with the audit committee (or those charged with governance) regarding services to be performed in the audit engagement. Since that understanding is usually established through an engagement letter, the auditor should obtain signed engagement letters directly from the audit committee (or those charged with governance). An understanding with the client regarding an audit of the financial statements generally includes the following matters: (a) The objective of the audit is the expression of an opinion on the financial statements. (b) Management is responsible for the entity’s financial statements and the selection and application of the accounting policies. (c) Management is responsible for establishing and maintaining effective internal control over financial reporting. (d) Management is responsible for designing and implementing programs and controls to prevent and detect fraud. (e) Management is responsible for identifying and ensuring that the entity complies with the laws and regulations applicable to its activities. (f) Management is responsible for making all financial records and related information available to the auditor. (g) At the conclusion of the engagement, management will provide the auditor with a letter (management representation letter) that confirms certain representations made during the audit. (h) Management is responsible for adjusting the financial statements to correct material misstatements and for affirming to the auditor in the management representation letter that the effects of any uncorrected misstatements aggregated by the auditor during the current engagement and pertaining to the latest period presented are immaterial, both individually and in the aggregate, to the financial statements taken as a whole. (i) The auditor is responsible for conducting the audit in accordance with generally accepted auditing standards. Those standards require that the auditor obtain reasonable rather than absolute assurance about whether the financial statements are free of material misstatement, whether caused by error or fraud. Accordingly, a material misstatement may remain undetected. Also, an audit is not designed to detect error or fraud that is immaterial to the financial statements. If, for any reason, the auditor is unable to complete the audit or is unable to form or has not formed an opinion, s/he may decline to express an opinion or decline to issue a report as a result of the engagement. (j) An audit includes obtaining an understanding of the entity and its environment, including its internal control, sufficient to assess the risks of material misstatement of the financial statements and to design the nature, timing, and extent of further audit procedures. An audit is not designed to provide assurance on internal control or to identify significant deficiencies. However, the auditor is responsible for ensuring that those charged with governance are aware of any significant deficiencies that come to his/her attention. An understanding with the client also may include other matters, such as the overall audit strategy; involvement of the internal auditor, if applicable (a more detailed discussion of the internal auditor’s involvement is provided in a separate section below); involvement of a predecessor auditor; fees and billing; any limitation of or other arrangements regarding the liability of the auditor or the client, such as indemnification to the auditor for liability arising from knowing misrepresentations to the auditor by management; condition under which access to audit documentation may be granted to others; additional services to be provided relating to regulatory requirements, and other services to be provided in connection with the engagement, for example, non-attestation services, such as accounting assistance and preparation of tax returns subject to the limitations CPC Rule 101. After a decision is made to accept or continue an engagement, an engagement letter is drafted by the auditor for the audit committee’s signature. Such an engagement letter is not required by the professional standards. However, the AICPA recommends the preparation of an engagement letter for every audit engagement in light of the potential risk of misunderstanding between the parties. Recall 1136 Tenant's Corp case in Chapter 4. An example of an engagement letter is shown in Figure 5-2. After accepting the engagement, the senior auditor responsible for coordinating the field work usually schedules a pre-audit conference with the audit team primarily to give guidance to the staff regarding


Consideration

Comments both technical and personnel aspects of the audit.

Table 5-2 Auditor’s Electronic Search for Information about a Prospective Client Electronic Search

Resources

Accounting and auditing standards This information may be searched and retrieved from : relevant to a prospective client.  FASB FASB provides its standards on its web site, www.fasb.org. Also, FASB’s Financial Accounting Research System provides a CD ROM that contains Statements on Financial Accounting Standards, Emerging Issues Task Force Abstracts, and FASB Implementation Guides.

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AICPA AICPA’s reSOURCE ONLINE Accounting and Auditing Literature provides access to all AICPA professional standards, audit and accounting guides, and technical practice aids over the Internet. Financial information about companies This information may be searched and retrieved from: in a prospective client’s industry.  Compustat and Disclosure SEC Database (Disclosure) Subscribers to Compustat and Disclosure may search and retrieve financial data that have been extracted from SEC filings and annual reports of public companies.

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EDGAR (Electronic Data Gathering and Retrieval System) Auditors may access EDGAR via the Internet to obtain the SEC filings of certain public companies, including their financial statements. Current development relevant to prospective client.

a The Internet provides online access to newspaper and journal articles. Also, many companies and industry associations have WWW home pages that describe current developments and statistics. Some useful Internet resources are as follows:

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Public Company Accounting Oversight Board (PCAOB), www.pcaobus.org

Securities and Exchange Commission’s Home page, www.sec.gov/ EDGAR page, www.sec.gov/edgarhp.htm Securities Act of 1933, www. law.uc.edu/CCL/33Act/Index.html Securities Exchange Act of 1934, www. law.uc.edu/CCL/34Act/Index.html

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Accounting and Auditing Web Sites

American Institute of CPAs (AICPA), www.aicpa.org Association of Certified Fraud Examiners (CFE), www.acfe.com The Institute of Internal Auditors (IIA), www.theiia.org Tax and Accounting, http://taxsites.com

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Large Accounting Firms PricewaterhouseCoopers, LLP, www.pwcglobal.com Ernst & Young, LLP, www.ey.com Deloitte & Touche, LLP, www.deloitte.com KPMG, LLP, www.us.kpmg.com Grant Thornton, LLP, www.gt.com BDO Seidman, www.bdo.com McGladrey & Pullen, LLP, www.rsmmcgladrey.com

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Figure 5-2 Example of an Engagement Letter M & M, CPAs, LLP San Francisco, CA 94321

Jan 4, 20xx

Mr. A, Chair of Audit Committee XYZ Company San Francisco, CA 94321 Dear Mr. A, Chair of Audit Committee This letter is to confirm our arrangement for our audit of XYZ Company for the year ended December 31, 20xx. We will audit the consolidated balance sheet of XYZ Company and its subsidiaries, YZ Company and XY Company, as of December 31, 20xx, and the related consolidated statements of earnings, retain ed earnings, and cash flows for the year then ended.Our audit will be made in accordance with the standards of the Public Company Accounting Oversight Board and in compliance with the Sarbanes-Oxley Act of 2002. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financialstatements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We direct your attention to the fact that management is responsible for the fair presentation of financial statements and the establishment and maintenance of adequate internal control in compliance with the Sarbanes-Oxley Act of 2002. The standards of the Public Company Accounting Oversight Board require us to obtain reasonable assurance, but not absolute, assurance that the financial statements are free of material misstatement. Accordingly, we cannot guaranty that our audit will detect all errors, fraud, and illegal acts that might be present. Our findings regarding your internal control, including information regarding material weaknesses, will be reported to the audit committee in a separate letter. We will also perform a review, but not an audit, of the Company's financial statements for each of the first three quarters of the financial year ended December 31, 20xx. Our review will be in accordance with standards established by the American Institute of Certified Public Accountants as set forth in Statement on Auditing Standards AU 930, titled "Interim Financial Information". Assistance to be provided by your accounting department personnel, including the preparation of the detailed trial balance and supporting schedules, is described in a separate attachment. Our examination is scheduled for performance and completion as follows: Begin field work Completion of field work Delivery of audit report

May 31, 20xx February 15, 20xx March 1, 20xx

Our fee will be based on the time spent by various members of our staff at our regular rates, plus travel and other out-of-pocket costs (photocopying, telephone, etc.). Invoices will be rendered every two weeks and are payable on presentation. We will notify you immediately of any circumstances we encounter which could significantly affect our initial fee estimate of $160,000. If the above arrangement is in accordance with your understanding, please sign and return to us the duplicate copy of this letter. We are pleased to have this opportunity to serve you. Very truly yours, ____________________ M & M, CPAs, LLP

Arrangement Accepted: ___________________________ Mr. A, Chair of Audit Committee

______________ Date

External Auditor Consideration of the Internal Auditor’s Involvement

AU 610 Using the Work of Internal Auditors requires the external auditor to consider the involvement of the internal auditor at the preplan phase of an audit. The decision process the auditor follows is outlined in Figure 5-3. The


major issue for the external auditor is considering the competence and objectivity of the internal auditors and the effect of their work on the audit. Factors that the auditor should consider include:

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Competence 1. Educational level and professional experience. 2. Professional certification and continuing education. 3. Audit policies, procedures, and checklists. 4. Practices regarding their assignments. 5. The supervision and review of their audit activities. 6. The quality of their working paper documentation, reports, and recommendations. 7. Evaluation of their performance.



Objectivity 1. The organizational status of the internal auditors responsible for the internal audit function. For example, the internal auditor reports to an officer of sufficient status to ensure that the audit coverage is broad and the internal auditor has access to the board of directors or the audit committee. 2. Policies to maintain internal auditors’ objectivity about the areas audited. For example, internal auditors are prohibited from auditing areas to which they have recently been assigned or are to work upon completion of responsibilities in the internal audit function. The internal auditors’ work may affect the nature, timing, and extent of the audit procedures performed by the independent auditor. For example, as part of their regular work, internal auditors may review, assess, and monitor controls of the client’s the accounting system. Similarly, part of their work may include confirming receivables or observing certain physical inventories. If the internal auditors are competent and objective, the external auditor may use the internal auditors’ work in these areas to reduce the scope of audit work. The materiality of the account balance or class of transactions and its related audit risk may also determine how much the external auditor can rely on the internal auditors’ work. When internal auditors provide direct assistance, the external auditor should supervise, review, evaluate, and test their work. Preplan in an Integrated Audit

Preplan in an integrated audit is coordinated with the preplan in a financial audit. For both audits, the auditor considers matters related to the client’s industry, business, and regulatory environment and so on (see Figure 5-1 and Table 5-1). In addition, the auditor considers preplan matters specific to an integrated audit that includes 1. Knowledge of the entity’s internal control over financial reporting (ICFR) obtained during other engagements. 2. Matters affecting the industry in which the client operates, such as financial reporting practices, economic conditions, laws and regulations, and technological changes. 3. Matters relating to the client’s business, including its organization, operating characteristics, and capital structure. 4. The extent of recent changes in the client, its operations, or its ICFR. 5. Preliminary judgments about materiality, risk, and other factors relating the determination of material weaknesses. 6. Control deficiencies previously communicated to the audit committee or management. 7. Legal or regulatory matters of which the client is aware. 8. The type and extent of available evidence related to the effectiveness of the client’s ICFR. 9. Preliminary judgments about the effectiveness of ICFR. 10. Public information about the client relevant to the evaluation of other likelihood of material financial statement misstatements and the effectiveness of the client’s ICFR. 11. Knowledge about risks related to the client’s evaluated as part of the audit’s client acceptance and retention evaluation. 12. The relative complexity of the client’s operations. The auditor also considers preplan matters specific to the risk of fraud and the risk of management override of controls in an integrated audit such as: 1. Controls over significant, unusual transactions, particularly those that result in late or unusual journal entries. 2. Controls over journal entries and adjustments made in the period-end financial reporting process. 3. Controls over related-party transactions. 4. Controls related to significant management estimates. 5. Controls that mitigate incentives for, and pressures on, management to falsify or inappropriately manage financial results. Lastly, to effectively plan an integrated audit, PCAOB’s AS 5 recommends 1. “Scaling the audit” which means the auditor takes into consideration the size and complexity of the client, its business processes, and business units that affect the way in which the client achieves effective internal control objectives. 2. “Using the work of others” which means the auditor uses the work performed by, or receives direct assistance from, internal auditors (consistent with AU 610), company personnel, and third parties working for management (e.g. valuation specialist discussed in Chapter 19) or the audit committee.

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Figure 5-3 The External Auditor’s Consideration theofInternal Auditor’s Work 1. Obtain an understanding of the internal audit function: a. Gather information about its activities b. Consider the relevance of the internal audit activities to the audit of the financial statements

No

Are internal audit activities relevant to the external audit?

Yes

No

Is it efficient to consider the work of internal auditors? Yes

2. Assess the competence and objectivity of the internal auditors.

Yes

Are internal auditors competent and objective?

No

Yes 3. Consider the effect of the internal auditors’ work on the audit: a. Understanding internal control. b. Risk assessment. c. Test of controls and test of balances procedures. 4. Consider the extent of the effect of the internal auditors’ work. 5. Coordinate external audit work with internal auditors. 6. Evaluate and test t he effectiveness of the internal auditors’ work

Does the auditor plan to request direct assistance from internal auditors?

Yes

7. Apply the procedures outlined in AU 610 Using the Work of Internal Auditors

END

No


Documentation in Financial and Integrated Audits

The audit preplan, the audit program, the tests performed, the collection and evaluation of evidence, and the conclusions reached by the auditors are documented in the audit working papers in compliance with AICPA’s AU 230 Audit Documentation in a financial audit and PCOAB’s Auditing Standard No.3 (AS 3) Audit Documentation in an integrated audit. At the completion of audit, auditors at the supervisory level review these working papers prepared by the audit staff. The primary function of the working papers is to provide the principle support for the auditor's opinion and to aid the auditor in the conduct and supervision of the audit. Moreover, the information contained in the working papers is the auditor's primary means for proving due diligence under Section 11 of the Securities Act of 1933 and Section 18 of the Securities Exchange Act of 1934. Working papers are the property of the auditor. However, the auditor's right of ownership is subject to the limitations of AICPA Rule of Conduct 301 on confidential client information. In a financial audit, completed working papers are typically retained in the auditor's office for at least two years following an engagement, after which the papers are moved to a remote location for storage, sometimes on microfilm form and sometimes on computer disk. The retention period thereafter should be sufficient to meet the audit firm's needs and consistent with applicable federal and state statutes of limitations. In an integrated audit, an applicable federal status is the Corporate and Criminal Fraud Accountability Act of 2002 which requires the auditor to maintain working papers for seven years. Moreover, under this Act, it is a felony for the auditor to knowingly destroy or create working papers to impede, obstruct or influence any existing or contemplated federal investigation; an offense subject to financial fines and imprisonment up to 10 years. In February 2003, the SEC, under the Sarbanes-Oxley Act of 2002, issued a set of rules on the retention of records for audits and reviews. The rules require the auditor to maintain the following documentation: 1. Working papers or other documents t hat form the basis for the audit of the company’s annua l fina ncial statements or review of the company’s quarterly financial statements. 2. Memos, correspondence, communications, other documents, and records, including electronic record, that meet the following criteria: a. the materials are created, sent, or received in connection with the audit or review, and b. the materials contain conclusions, opinions, analyses, or financial data related to the audit or review. Accordingly, The SEC’s rule significantly increases the audit documentation that must be retained. For example, auditors will now be required to retain email correspondence that contains information meeting the above crite ria. In addition, the SEC’s rule acknowledges that administrative records and other documents not containing relevant financial data or the auditor’s conclusions, opinions, or analysis, do not meet the retention criteria. For example, superseded drafts of memos, duplicates, previous copies of working papers that have been corrected for typographical errors or errors due to training of new employees, or voice-mail messages do not need to be retained. Audit Documentation under AICPA’sAU 230 in a Financial Audit

AICPA’s AU 230 Audit Documentation states that “the auditor should maintain working papers, the form and content of which should be designed to meet the circumstances of a particular engagement.” In addition, the standard states that the quantity, type, and content of working papers will depend on: 1. The anticipated nature of the auditor’s report. 2. The nature of the engagement. 3. The nature of the financial statements, schedules, or other information reported. 4. The nature and co ndition of the client’s records. 5. The assessed control risk. 6. The needs for supervision and review of the audit work. Concerning the quantity of working papers, the standard further stipulates that the working papers “should be sufficient to show that the accounting records agree or reconcile with the financial statements or other information reported on and that the applicable standards of field work have been observed.” Finally, concerning the content of working papers, the standard further stipulates that “certain of the auditor’s working papers may sometimes serve as a useful reference source for the client, but the working papers should not be regarded as a part of, or a substitute for, the client’s accounting records.” Although the form and content of working papers vary with the circumstances, they are typically divided into two categories of files: permanent and current. Figure 5-4 shows the two categories of working papers files: permanent and current files.

Table 5-3 describes the content of the permanent and current files.

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112


Figure 5-4 Two Categories of Working Papers

Working papers

Permanent files Include: Corresponding file Tax file

Current files

Contain

Contain

1. Copies of articles of incorporation, bylaws, bond indentures and contracts. 2. Analyses of previous year’s accounts. 3. Organization charts, flowcharts, and internal control questionnaires. 4. Analytical procedure results of previous year’s audit

Audit Program

Copy of financial statements

Working trial balance

Lead Schedule

Detailed supporting schedule

Table 5-3 Permanent and Current Files

File Permanent Files

Description Permanent files contain information that is of continuing interest and relevance to the auditor in performing in performing recurring engagement on an audit client. The permanent files are typically separated into three bundles: (1) Corresponding file: It is also known as the administrative file. It contains all correspondence to, from, or on behalf of a client. For example, the auditor's client advisorycomments letter oninsignificant control deficiencies. Information contained in this file is useful for planning the following year's audit. (2) Permanent file: This file contains information of continuing interest and relevance an to audit engagement. For example, the filemay include a client's articles and bylaws of incorporation, terms of capital stock and bond issues, chart of accounts, organization charts, flow charts of internal control structure, schedule of amortization of long-term debt and depreciation of assets, lease agreements, labor-management agreements, pension plan, copies of contracts, excerpts from minutes, and analysis of business industry and economy. The permanent file should be updated during each engagement. (3) Tax file: The tax file contains information relevant to a client's past, current, and future income tax obligations. For example, the file may include a client's prior year state and federal income tax returns and schedule of significant temporary differences between pretax accounting income and taxable income. This file serves as a basis for preparing current


File Current Files

Description year returns or for performing other tax-related services, such as representing the client in an IRS audit. Current files are also known as the analysis files and they contain information relevant to a given audit client for a particular year's audit. Working papers in the current files typically include the: (1) Audit program. A detailed listing of all audit procedures to be performed during the engagement. (2) Copy of financial statements.A draft copy of the current year’s financial statements. (3) Working trial balance. A list of all the account balances from the general ledgers. It includes columns for adjustment and reclassification. The working trial balance may be prepared by the client or the auditor. If the client prepared a working trial balance, the auditor should verify the trial balance by footing the columns and tracing the account balances to the general ledgers. (4) Lead schedules. A lead schedule details each individual account balance within a major account category on the financial statements, e.g., petty cash and cash at bank under cash account. The lead schedule also summarizes the audit adjustments the schedules. accounts. A detailed supporting schedule documents specific audit procedures and tests (5) Detailed affecting supporting performed on individual account balances.The tests, the results, andthe conclusions constitute the body of "sufficient appropriate evidential matter" supporting the auditor's opinion on the financial statements. The detailed supporting schedules typically include: (a) An analysis schedule (e.g. allowance for doubtful debts) (b) A reconciliation schedule (e.g. bank reconciliation) (c) A reasonableness test schedule (e.g. provision for depreciation) (d) Internal documents (e.g. memorandum) (e) External documents (e.g. SEC Form 10-K) (6) Audit adjustment and reclassification entries. Audit adjustments are journal entries proposed by the auditor to the client. The purpose of the entries is to correct for material errors discovered during the audit (e.g. to write off obsolete inventories that are not written off by the client). The "adjustments" column of the working trial balance lists the journal entries. Audit reclassifications are items requested by the auditor to be reclassified to ensure proper presentation of the financial statements. The "reclassifications" column of the working trial balance lists the audit reclassifications (e.g. reclassification of material current installments of long-term liabilities as current liabilities). Figure 5-5 shows an example of working paper organization. Figure 5-6 shows an example of working paper content.

Expanded Audit Documentation under AICPA’sAU 240 in a Financial Audit

In 2002, the Auditing Standard Board issued AU 240 Consideration of Fraud in a Financial Statement Audit that expands the auditor’s documentation requirements. AU 240 requires the auditor to discuss and identify fraud risk factors at the planning phase of the financial statement audit. It also requires the auditor to perform additional testing procedures on suspected fraud. Finally the auditor is required to discuss fraud with the management and audit committee. thisworking work relating the 5-4 auditor’s consideration fraud inofa the financial statement audit must be documentedAll in the papers. to Table provides some brief of comments expanded audit documentation relating to the consideration of fraud in a financial statement audit. Table 5-4 Expanded Documentation in Relation to the Consideration of Fraud

Expanded Documentation



Discussions among engagement team members in planning the audit regarding the susceptibility of the client’s financial statements to fraud. Documentation should include (1) how and when the discussion occurred, (2) description of audit team members who participated, and (3) subject matter discussed.

Brief Comments The discussion should include: (1) An exchange of ideas or “brainstorming” among the audit team members. (2) A consideration of the known external and internal conditions that might (a) create incentives/pressures for management and others to commit fraud, (b) provide the opportunity for fraud to be penetrated, and (c) indicate a culture or environment that enables management’s attitude/rationalization to commit fraud. (3) An emphasis on the need to maintain a questioning mind and to exercise professional skepticism in gathering and evaluating evidence throughout the audit. (4) Inputs from key team members from different locations and specialists assigned to the team.

These procedures include: Procedures performed to obtain (1) Make inquiries of management and others about the risk of fraud. These inquiries include: (a) information necessary to identity and Management’s knowledge about suspected fraud. (b) Audit committee’s view about the risk of assess the risks of material fraud. (c) Internal auditors about their views about the risk of fraud. (d) Other employees’ misstatements due to fraud. perspective regarding the risk of fraud. (2) Consider the results of procedures relating to the acceptance and continuance of the audit engagement (Discussion in Chapter 5). (3) Consider the results of the analytical procedures performed in planning the audit (Discussion in



Chapter 7). (4) Reviews of interim financial statements. identification of a risk of material misstatement due to fraud involves professional judgment  Specific risks of material The and includes the consideration of: misstatements due to fraud that were (1) The type of risk that may exist, i.e., whether it involves fraudulent financial reporting or identified, and a description of the

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Expanded Documentation auditor’s response to those risks.

Brief Comments misappropriation of assets. (2) The significance of the risk, i.e., whether it is of a magnitude that could lead to material misstatements. (3) The likelihood of the risk, i.e., the likelihood that it will result in material misstatements. (4) The pervasiveness of the risk, i.e., whether it affects the financial statements as a whole or is restricted to certain accounts or class of transactions. The auditor’s response to the risks of material misstatement involvesprofessional skepticism in gathering and evaluating audit evidence and involves the consideration of: (1) The overall effect on how the audit is conducted, i.e., general considerations such as assignment of personnel and supervision, management’s selection and application of accounting principles, and predictability of auditing procedures.

(2) Changing the nature, These procedures include:timing, and extent of auditing procedures (Discussion in Chapter 10). The results of additional (1) Perform substantive analytical procedures relating to revenue using disaggregated data, e.g., procedures performed to address the risk comparing revenue reported by mouth and by product line. of improper revenue recognition. (2) Confirm with customers certain relevant contract terms and agreements, e.g., acceptance criteria, delivery and payment terms, cancellation or refund provisions. (3) Inquiry of the sales and marketing personnel or legal counsel regarding sales or shipments for unusual terms associated with the transactions. (4) Be present at one or more locations to observe goods being shipped at period end. (5) Test controls on revenue transactions that are processed electronically for existence and occurrence. These procedures include:  The results of additional (1) Review inventory record to identify specific locations for inventory count observation on an procedures performed to address the risk announced basis. of improper inventory quantities. (2) Apply more rigorous procedures during the inventory count observation, e.g., examine the purity, grade, or concentration of inventory in liquid form. (3) Comparison of quantities for the current period with prior periods by class or category of inventory to test the reasonableness of the quantities counted. These procedures include:  The results of additional (1) Engage a specialist/expert or develop independent estimates for comparison to management procedures performed to address the risk estimates, e.g., comparing the fair value of a derivative. of biased management estimates. (2) Retrospective review of similar management estimates in prior periods for the reasonableness of judgments and assumptions supporting management estimates. auditor should use professional judgment to determine additional procedures to examine  The results of additional The journal entries and other adjustments for evidence of management override of internal controls. procedures performed to address the risk These procedures include:



of management controls.

override

internal (1) Assess the risk of material misstatement associated with a specific class of journal entries. (2) Assess the effectiveness of specific internal controls associated with a specific class of journal entries. (3) Gather both manual and electronic evidence for a specific class of journal entries. (4) Identify unique characteristics of fraud associated with a specific class of journal entries such as entries (a) made to seldom used accounts, (b) made by individuals who typically do not make journal entries, (c) made pre- or post-period with little or no explanation, (d) made pre- or postperiod with no account number, and (e) made containing round numbers or a consistent ending number. (5) Examine other accounts affected by a specific class of journal entries at different locations. (6) Examine journal entries or other adjustments processed outside the normal course of business, e.g., entries used to record nonrecurring transactions, such as business combinations and nonrecurring estimates, such as asset impairment. communication process includes:  The nature of the communication The (1) Fraud involving senior management should be reported directly to the audit committee. about fraud made to management, the (2) Fraud resulting from significant deficiencies in the design and operation of internal controls audit committee, and those charged with should be reported to those charged with governance as“material weakness” AU 265 governance. Communicating Internal Control Related Matters Identifie d in an Audit (Discussion in Chapter 8). (3) Ordinarily, the auditor is not responsible to disclose fraud to outside parties except in the following situations: (a) To comply with legal and regulatory requirements. (b) To a successor auditor when the successor makes inquiries in accordance with AU 210 Terms of Engagement. (c) In response to a subpoena. (d) To a funding agency or other specified agency in accordance with requirements for the audits of entities that receive governmental financial assistance.

Specific Documentation Requirements under PCAOB’s AS in 3 an Integrated Audit

PCOAB’s Auditing Standard No.3 (AS 3) Audit Documentation contains specific documentation requirements for audits of public companies for significant findings or issues, actions taken to address them (including additional evidence obtained), the basis for the conclusions reached. Examples of significant findings or issues that required documentation under PCAOB’s As 3 include:


1. Significant matters involving the selection, application, and consistency of accounting principles, including related disclosures. For example, accounting for complex or unusual transactions, accounting estimates and uncertainties related to management assumptions. 2. Results of auditing procedures that indicate a need for significant modification of planned auditing procedures or the existence of material misstatements or omissions in the financial statements or the existence of significant deficiencies in internal control over financial reporting. 3. Audit adjustments and the ultimate resolution of these items. 4. Disagreement among members of the engagement team or with others consulted on the engagement about conclusions reached on significant accounting or auditing matters. 5. Significant findings or issues identified during the review of quarterly financial information. 6. Circumstances that cause significant difficulty in applying auditing procedures. 7. Significant changes in the assessed level of audit risk for particular audit areas and the auditor’s response to those changes. 8. Any other matters that could result in modification of the audit report. In addition, the auditor must identify all significant findings or issues in an engagement completion memorandum. This memo should be specific enough for a reviewer to gain a thorough understanding of the significant findings or issues.

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Figure 5-5 An Example of Working Paper Organization

Balance Sheet 12/31/0x Cash $15,000 Accounts Receivable 35,000 X X X ABC Company Ref: TB

Working Trial Balance

Lead Schedule

DR

|

CR

Working Trial Balance |Adjust|Reclass | Adjusted Cash $15,000 Trial Balance X X X ABC Company Ref: A-lead Cash Lead Schedule Account No. W/P Ref Adjusted Balance 101 A-1 Petty cash $ 500 102 A-2 Cash-General 12,000 103 A-3 Cash-Payroll 2,500 $ 15,000 To: TB ====== ABC Company Ref: A-2 Bank Reconciliation W/P Ref Balance per bank $ 14,000 A-2.1 Add: Deposits in transit 2,000 Less: Outstanding checks 4,000 A-2.2 Balance per book $ 12,000 To:A-lead ====== Bank Confirmation

Detailed Supporting Schedules

Cash balance at bank

Ref: A-2.1

$ 14,000 To: A-2 ======

Listing of Outstanding Checks Check No. 688 689 X X X

Ref: A-2.2

Amount $ 168 863 x x x ______ $ 4,000 To: A-2 ======


Figure 5-6 An Example of Working Paper Content ABC Company Bank Reconciliation 12/31/20xx

Schedule:

Client Reviewed by: FC Prepared by:

A-2

Date: 1/10/20xx Date: 1/18/20xx

Acct. 101 – General account, Bank of America $ 109,713 T

Balance per Bank Add: Deposit in transit 12/30

$ 10,017

12/31

11,100

# #

A-2.1

21,117

Deduct: Outstanding checks # 8008

12/16

8013

12/16

8016

12/23

8028

12/23

8033

12/28

8036

12/30

^ ^ 11,916 ^ 14,717 ^ 37,998 ^ 10,000 ^ 3,068

9,763

(87,462)

X

Other reconciling items: Bank error Deposit for another bank customer credited (15,200) A-3

to General account by bank, in error

TB

Balance per bank, adjusted

28,168 =====

Balance per books before adjustments

32,584

A-1

(4,416)

C 3.1 A-1

F

Adjustments:

Unrecorded bank service charge NSF check returned by bank, not collectible from customer Balance per books, adjusted

216 4,200

A-1 28,168 =====

F T = Traced and agreed to bank confirmation # = Traced deposit to the December 200x cash receipts and to the January 200x bank cutoff statement. ^ = Traced check to the December 200x cash disbursements and to the January 200x bank cutoff statement. X = Cross-footed TB = Traced to 12/31 adjusted trial balance. C = Cross-index to working paper 3.1 F = Footed

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Which of the following procedures does not belong to the preplan phase of an audit engagement? a. Establishing the management's assertion. b. Establishing the client's reason for audit. c. Establishing contact with the preceding auditor. d. Establishing contract with the client.

5-2

What is the responsibility ofa successor auditor with respect to communicating withthe predecessor auditorin connection with a prospective new audit client? a. The successor auditor has no responsibility to contact the predecessor auditor. b. The successor auditor should obtain permission form the prospective client to contact the predecessor auditor. c. The successor auditor should contact the predecessor auditor regardless of whether the prospective client authorizes contact. d. The successor auditor need not contact the predecessor if the successor is aware of all available relevant facts.

5-3

5-4

The current file of the auditor's working papers should include a. copies of client's contracts. b. client's organization charts. c. client's chart of accounts. d. client's SEC Form 10-k. The primary purpose of the auditor's working papers is to a. support a client's financial statements. b. support the adjustment and reclassification entries recommended by the auditor. c. support the auditor's tests of controls and tests of balances. d. support the auditor's opinion about the client's financial statements.

5-5

An audit working paper that shows the auditor's reasonablenesstest on a client's provision for depreciation is known as a(an) a. adjustment and reclassification entries. b. detailed supporting schedule. c. lead schedule. d. working trial balance.

5-6

Which of the following eliminates voluminous details from the auditor’s working trial balance by classifying and summarizing similar or related items?

a. Account analyses. b. Lead schedules. c. Control accounts. d. Supporting schedules. 5-7

An auditor who accepts an audit engagement and does not possess the industry expertise of the audit client should a. engage financial experts familiar with the nature of the business entity. b. refer a substantial portion of the audit to another CPA who will act as the principal auditor. c. inform the client’s management that an unqualified opinion cannot be issued. d. obtain knowledgeof matters that relate to the nature of the client’s business.

5-8

The engagement letter a. affects the CPA firm’s responsibility to external users of audited financial statements. b. can be used to alter the auditor’s responsibility under generally accepted auditing standards. c. can affect legal responsibilities to the client. d. affects only an audit engagement, but does not affect review or compilation services.

5-9

After audit preplan, an engagement letter should be sent to the client. The letter usually would not include a. a statement that management advisory services would be made available upon request. b. a reference to the auditor’s responsibility for the detection of errors or frauds. c. an estimation of the time to be spent on the audit work by audit staff and management. d. a reference to management’s responsibility for adequate internal controls.


5-10

Ordinarily, the working papers can be provided to someone else only with the express consent of the client. This is the case even if a. the papers are subpoenaed by a court. b. the papers are used as a part of an AICPA quality review program. c. the papers are requested as evidence in an AICPA Joint Trial Board hearing. d. the papers are transferred as a result of a CPA selling his/her practice to another CPA firm.

5-11

Which of the following is the most likely first step an auditor would perform at the preplan phase of the audit process? a. Provide the audit t eam’s credentials to a potential new client. b. Evaluate the internal controls of a potential new client. c. Tour a potential new client’s plants and facilities. d. Consult and review the work of the predecessor auditor.

5-12

Which of the following would not be included in the auditor’s working papers?

a. The accounting manual. b. The results of the preceding year’s audit. c. Descriptions of the internal controls. d. A time budget for the various audit areas. 5-13

Which of the following wouldnot be a consideration ofa CPA firm in deciding whetherto accept a new client? a. Client’s standing in the business community. b. Client’s probability of achieving an unqualified opinion. c. Client’s relation with its previous CPA firm. d. Client’s financial stability.

5-14

Which of the following statement would least likely appear in an auditor’s engagement letter? a. Fees for our services are based on our regular per diem rates, plus travel and other out-of-pocket expenses. b. During the course of our audit we may observe opportunities for economy in, or improved controls over, your operations. c. Our engagement is subjected to the risk of that material errors or irregularities, including fraud and defalcations, if they exist, will not be detected. d. After performing our analytical procedures we will discuss with you the other audit procedures we consider necessary to complete the engagement.

5-15

At the preplan phase, an auditor obtains knowledge about a new client’s business to a. provide constructive suggestions concerning improvements to the client’s internal control. b. develop an attitude of professional skepticism concerning management’s financial statement assertions. c. understand the nature of the client’s business organization and its operating characteristics. d. evaluate whether the aggregation of known misstatements causes the financial statements to be materially misstated.

5-16

At the preplan phase, an auditor most likely would a. identify specific internal control activities that are likely to prevent fraud. b. evaluate the reasonableness of the client’s accounting estimates. c. discuss the scheduled time for the performance and completion of the audit. d. inquire of the client’s attorney for unrecorded pending litigation.

5-17

At the preplan phase, a successor auditor should request the new client to authorize the predecessor to allow a review of the predecessor’s

a. b. c. d.

Engagement letter Yes Yes No No

Working papers Yes No Yes No

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5-18

At the preplan phase, would the following factors ordinarily be considered inassigning stafffor a new engagement?

a. b. c. d. 5-19

Credential of the staff in the audit team Yes Yes No No

Continuity and periodic rotation of personnel Yes No Yes No

Which of the following factorsmost likely would cause an auditor not to accept a new audit engagement? a. The auditor is not able to review the predecessor auditor’s working papers. b. The prospective client does not permit the auditor to enquire its legal counsel concerning the risk of any pending litigation. c. The auditor does not fully understand the prospective client’s operations and industry. d. The prospective client does not assess the credentials of the proposed audit team.

5-20

In creating lead schedules for an audit engagement, a auditor often uses automated working paper software. What client information is needed to begin this process? a. Interim financial information such as third quarter sales, net income, and inventory and receivables balances. b. Specialized journal information such as the invoice and purchase order numbers of the last few sales and purchases of the year. c. General ledger information such as account numbers, prior-year account balances, and current-year unadjusted information. d. Adjusting entry information such deferrals and accruals, and reclassification journal entries.

5-21

An auditor ordinarily uses a working trial balance resembling thefinancial statements without footnotes, but containing columns for a. cash flow increases and decreases. b. audit objectives and assertions. c. reconciliations and tick-marks. d. reclassifications and adjustments.

5-22

At the preplanphase, a matter mostlikely to be agreed uponbetween theauditor andthe client before implementation of testing procedures is the determination of a. evidence to be gathered to provide a sufficient basis for the auditor’s opinion. b. procedures to be undertaken to discover litigation, claims, and assessments. c. pending legal matters to be included in the inquiry of the client’s attorney. d. timing of the auditor’s physical inventory observation.

5-23

Which of the following documentation isrequired for an audit in accordance with generally accepted auditingstandards? a. A flowchart of an internal control questionnaire that evaluates the effectiveness of the client’s internal controls. b. A client engagement letter that summarizes the ti ming and details of the auditor’s planned field work. c. An indication in the working papers that the accounting records agree or reconcile with the financial statements. d. The basis for the auditor’s conclusions when the assessed level of control risk is at the maximum level for all financial statement assertions.

5-24

Which of the following statements concerning audit working papers is false? a. An auditor may support an opinion by other means in addition to working papers. b. The form of working papers should be designed to meet the circumstances of a particular engagement. c. An auditor’s working papers may not serve as a reference source for the client. d. Working papers should show that the auditor has obtained an understanding of internal control.

5-25

In planning a new audit engagement, which of t he following is not a factor that affects the auditor’s judgment as to the quantity, type, and content of working papers?

a. The type of report to be issued by the auditor. b. The content of the client’s representations letter. c. The nature and condition of the client’s records. d. The auditor’s preliminary evaluation of control risk based on discussions with the client.


5-26

Althoughthe quantity and content of audit working papers vary with each particular engagement, an auditor’s permanent file most likely includes a. schedules that support the current year’s adjusting entries. b. prior years’ accounts receivable confirmations that were classified as exceptions. c. documentation indicating that the audit work was adequately planned and supervised. d. analyses of capital stock and other owners’ equity accounts.

5-27

The audit working paperthat reflects the major components ofan amount reported inthe financial statementsis the a. interbank transfer schedule. b. carryforward schedule c. supporting schedule. d. lead schedule.

5-28

Which of the following factors would least li kely affect the content of an auditor’s workingpapers? a. The condition of the client’s records. b. The assessed level of control risk. c. The nature of the auditor’s report. d. The medium used to record and maintain the working papers.

5-29

The permanent file of an auditor’s working papers most likely would include copies of the

a. lead schedules. b. attorney’s letter. c. bank statements. d. debt agreements. 5-30

The current file of an auditor’s working papers ordinarily should include

a. a flowchart of the internal control procedures. b. organization charts. c. a copy of the financial statements. d. copies of bond and note indentures. 5-31

The current file of an auditor’s working papers most likely would include a copy of t he

a. Bank reconciliation. b. pension plan contract. c. articles of incorporation. d. flowchart of the internal control activities. 5-32

Which of the following statementsordinarily is true concerning thecontent of working papers? (Hint: Think of the standard’s requirement about quantity) a. Whenever possible, the auditor’s staff should prepare schedules and analyses rather than the entity’s employees. b. It is preferable to have negative figures indicated in red figures instead of parentheses to emphasize amounts being subtracted. c. It is appropriate to use calculator tapes with names or explanations on the tapes rather than writing separate lists onto working papers. d. The analysis of asset accounts and their related expense or income accounts should not appear on the same working paper.

5-33

Before accepting anaudit engagement, a successor auditor should make specific inquiries of the predecessor auditor regarding the predecessor’s a. opinion of any subsequent events occurring since the predecessor’s audit report was i ssued. b. understanding as to the reasons for the change of auditors. c. awareness of the consistency in the application of GAAP between periods. d. evaluation of all matters of continuing accounting significance.

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5-34

A, CPA, has been retained to audit the financial statements of C Company. C’s predecessor auditor was B, CPA, who has been notified by C that B’s services have been terminated. Under these circumstances, which party should initiate the communi cations between A and B? a. A, the successor auditor. b. B, the predecessor auditor. c. C’s controller or CFO. d. The chairman of C’s board of directors.

5-35

Ordinarily, the predecessor auditor permits the successor auditor to review the predecessor’s working paper analyses relating to

a. b. c. d. 5-36

Contingencies Yes Yes No No

Balance Sheet Accounts Yes No Yes No

Which of the following factorsmost likely would cause an auditor not to accept a new audit engagement? a. The prospective client has no formal written code of conduct. b. The integrity and reputation of the prospective client’s management are very bad. c. Procedures requiring segregation of duties are subject to management override. d. Management fails to modify prescribed controls for changes in conditions.

5-37

The scope and nature of an auditor’s contractual obligation to a client is ordinarily set forth in the

a. management representation letter. b. scope paragraph of the auditor’s report. c. engagement letter. tor’s report. d. introductory paragraph of the audi 5-38

Which of the following documentationis not required for an audit in accordance withgenerally accepted auditing standards (GAAS)? a. A client engagement letter that summarizes the timing and details of t he auditor’s planned fieldwork. b. The basis for the auditor’s conclusions when the assessed level of control risk is below the maximum level. c. A written audit program setting forth procedures necessary to accomplish the audit’s objectives. d. An indication that the accounting records agree or reconcile with the financial statements.

5-39

At the preplan phase of an audit, which of the following procedures wouldan auditor least likely perform? a. Coordinating the assistance of the prospective client’s in gathering evidence. b. Tour the prospective client’s plant and facilities. c. Selecting a sample of vendors’ invoices for comparison with receiving reports. d. Reading the current year’s interim financial statements.

5-40

At the preplan phase of an audit, a auditor most likely would a. identify specific internal control activities that are likely to prevent fraud. b. evaluate the reasonableness of the client’s accounting estimates. c. discuss the timing of the audit procedures with the client’s management. d. inquiry of the client’s lawyer as to whether any unrecorded claims are probable of assertion.

5-41

The senior auditor responsible for coordinating thefield work usually schedules a pre-audit conferencewith the audit team primarily to a. give guidance to the staff regarding both technical and personnel aspects of the audit. b. discuss staff suggestions concerning the establishment and maintenance of time budget. c. establish the need for using the work of specialists and internal auditors. d. provide an opportunity to document staff disagreements regarding technical issues.


5-42

To obtain an understanding of a continuing client’s business at the preplan phase of an audit, an auditor most likely would

a. perform tests of details of transactions and balances. b. review prior-year working papers and the permanent file for the client. c. read specialized industry journals. d. re-evaluate the client’s int ernal control. 5-43

Which of the following auditdocuments would not have to be retained in the audit working paper files? a. Working papers used to form the basis for the audit opinion. b. Memos exchanged between audit team members that contain analyses of client financial data. c. Emails summarizing conclusions about client business risks. d. Superseded drafts of documents corrected for errors made by audit staff.

5-44

Which of the following isnot a criteria that the SEC would use to determine the retention ofaudit documents? a. Documents that are created, sent, or received in connection with the audit or review services. b. Documents contain conclusions, opinions, analyses, or financial data related to the audit or review services. c. Documents that are created, sent, or received in connection with the AICPA’s peer review program. d. Documents that are electronic, such as email and voice mail, which contain conclusions, opinions, analyses, or financial data related to the audit or review services.

5-45

The Sarbanes-Oxley Act of 2002 changed several elements ofthe audit preplanphase. Which of the following isnot a correct statement regarding these changes? a. The auditor should now establish an understanding with the management regarding services to be performed in the audit engagement. b. The auditor-in-charge of an audit engagement should now be rotated at least every five years. c. The auditor should now alert to any personal loans to directors or executives of the company that are illegal acts. d. The auditor should now gain knowledge of the company’s code of ethics.

5-46

Auditing standards on consideration offraud in a financial statement audit expanded the requirements of documentation in working papers. Which of the following is not one the expanded requirements? a. The results of additional procedures performed to address the risk of improper revenue recognition. b. The results of additional procedures performed to address the risk of improper inventory pricing. c. The results of additional procedures performed to address the risk of biased management estimates. d. The results ofadditional procedures performed to address the risk of management override internal controls.

5-47

With regard to assigning staffto an engagement in the preplan phase of an audit, which of the following is unlikely to be considered by the audit firm? a. Rotation of the partner-in-charge of the audit of a privately held company every seven years. b. Rotation of the partner-in-charge of the audit of a publicly held company every five years. c. Rotation of the partner-in-charge of the audit of all companies every seven years or five years depending on the size of the companies. d. Rotation of the partner-in-charge of the audit of a company as per the Sarbanes-Oxley Act of 2002.

5-48

Which of the following statements concerning audit working papers is false? a. Working papers are the property of the audit client. b. Working papers contain adjustment and reclassification entries recommended by the auditor. c. Working papers of a predecessor auditor should be made available to the successor auditor. d. Working papers support the auditor’s opinion about the client’s financial statements.

5-49

If the external auditor considersthe internal auditors to be competence andobjective, theexternal auditor will not proceed to a. consider the extent of the effect of the internal auditors’ work. b. coordinate external audit work with internal auditors. c. evaluate and test the effectiveness of the internal auditors’ work. d. appoint the internal auditors as team members of the external auditor.

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5-50

PCOAB’s Auditing Standard No.3 (AS 3) Audit Documentation requires the auditor to document significant findings or issues in an audit. Which of the following is not an example of a significant finding or issue that required documentation?

a. Results of auditing procedures that indicate a need for significant modification of planned auditing procedures. b. Disagreement among members of the engagement team about conclusions reached on insignificant accounting transactions. c. Unusual and significant accounting estimates identified during the review of quarterly financial information . d. Significant changes in the assessed level of audit risk for particular audit areas. 5-51

Which of the following is not a characteristic of preplan in an integrated audit? a. Preplan in an integrated audit is coordinated with the preplan in a financial audit. nowledge of the entity’s internal control over b. The auditor considers preplan matters specific to an integrated audit that includes k financial reporting (ICFR) obtained during other engagements. “using the work of others.” c. To effectively plan an integrated audit, the auditor should not consider d. The auditor considers preplan matters specific to the risk of fraud and the risk of management override of controls in an integrated audit


5-1 a. 5-2 b. 5-3 d. 5-4 d. 5-5 b. 5-6 b. 5-7 d. 5-8 c. 5-9 a. 5-10 d. 5-11 d. 5-12 a. 5-13 b. 5-14 d. 5-15 c. 5-16 c. 5-17 c. 5-18 a. 5-19 b. 5-20 c. 5-21 d 5-22. d. 5-23 c. 5-24 c. 5-25 b. 5-26 d. 5-27 d. 5-28 d. 5-29 d. 5-30 c. 5-31 a. 5-32 c. 5-33 b. 5-34 a. 5-35 a. 5-36 b. 5-37 c. 5-38 a. 5-39 c. 5-40 c. 5-41 a. 5-42 b. 5-43 d. 5-44 c. 5-45 a. 5-46 b. 5-47 c. 5-48 a. 5-49 d. 5-50 b. 5-51 c.


Simulation Question 5-1 Simulation Question 5-1 is an adaptation with permission from a case by Jenne, S. E. in Issues the in Accounting Education , a publication of the American Accounting Association in Sarasota, Florida. This simulation question is based upon a true set of facts; however, the names and places have been changed. An opening for partnership had just been announced in the local office of Novogardac & Co, a regional CPA firm. The new partnership position, justified by increased revenues, was cause for celebration among the managers aspiring to become partners in the firm. Competition mounted for the new position once the announcement was made. Bill Siegel, one of the senior audit managers, was the current favorite for admission to the partnership. Bill has consistently received favorable performance evaluations from his superiors and had been viewed as being technically competent throughout his career. In his last annual performance review as a senior manager, he was told that the only obstacle he had to overcome in order to be admitted to the partnership was to demonstrate an ability to attract new clients. Bill had been making himself very visible in the business community joining business and not-for-profit he was becoming a local leadernew in a respected civic organization. This activity had by helped Billlocal identify prospective clients and,organizations in fact, had and resulted in the addition of several clients to the firm. At this point he needed just one or two new clients to ensure his admission as a partner.

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Part 1

During a round of golf with the controller of a local automobile dealership, Bill asked his golf partner, Tom, for possible new business leads. Tom thoughtfully considered the question and finally came up with a name. The automobile dealership frequently sold purchase contracts to local financial institutions. Recently, Sabrina Phil, the president of Provident Credit Union (hereafter, PCU) had mentioned to Tom that she was unhappy with her current auditor and was considering a change. She complained about high audit fees and noted some difficulties working with her current auditor. Tom suggested that Bill contact Sabrina to determine whether she was serious about switching auditors, but he warned that Sabrina was a tough businesswoman with a reputation for being shrewd. Bill was so delighted with the new lead that he happily picked up the tab for golf and lunch. Bill wasted no time arranging a meeting with Sabrina. Just as Tom said, Sabrina was unhappy with her current auditor and very willing to consider a change. Bill noted that a reputable firm had audited PCU the previous year and, as far as he could tell, the accounting records appeared to be in reasonable order. Based on his experience with similar clients, Bill developed a tentative proposal to perform the audit of PCU for a fee slightly less than the previous year’s fee. Sabrina quickly consented and agreed to notify her prior auditor . Permission was granted for the prior auditor talk freely with Bill regarding PCU. According to Bill’s best estimates of time required and personnel to be assigned, Novogradac & Co would be able to recover its normal billing rates for services performed at the proposed fee amount. Bill told Sabrina that the engagement, including the proposed audit fee, could not be finalized until he performed a more thorough background investigation of PCU and had obtained approval of the Novogradac partners. This investigation, required by Novogradac prior to acceptance of all new clients, was to include a more in-depth financial review of the past five years, a credit check, and an evaluation of the general reputation of PCU and Sabrina. Novogradac required Bill to inform the partner-in-charge of audit, Lucy Ball, and to obtain a favorable vote of the local office partners prior to acceptance of the new client.

Required 1 a. Given Bill’s technical competence, why is he being required to demonstrate an ability to bring new clients into the firm in order to be admitted to the partnership? 1 b. What information and procedures does Novogradac require prior to acceptance of a new audit client?

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Part 2

The background review produced the following information: 1. PCU is a small, closely held, and wellestablished financial institution. It has operated successfully for 20 years under Sabrina’s leadership. Sabrina currently serves as Chairman of the Board of Directors and CEO of PCU. PCU weathered a recent business recession and still maintained net income comfortably above the average for peer financial institutions. “lands on her feet.” She has used sales of short 2. Sabrina has a reputation as an aggressive businesswoman who always -term certificates of deposit (CDs) to raise cash quickly to take advantage of new business opportunities. Similarly, she has sold large portfolios of loans to avoid reissuing CDs when interest rates were favorable. She personally supervises collection activities on difficult loans and one collection agency owner familiar with PCU commented that there was not much opportunity left for collection after Sabrina got through. 3. As of the previous audit, total assets of PUC were approximately $10 million. Within the past five years, the total assets had fluctuated from a low of $8 million to a high of nearly $20 million. Stockholders’ equity was slightly larger than average when compared to similar financial institutions. Virtually all the debt of PCU was related to depositor accounts, primarily CDs. 4. Bill visited the predecessor auditor and was allowed to examine and copy some of the working papers from the prior year audit. He noted that there had been a few more adjusting journal entries proposed than he normally would have expected. In discussing the adjustments with the predecessor auditor, Bill noted that it had been difficult for the predecessor auditor to convince Sabrina that the adjustments were necessary. However, Sabrina eventually agreed to make a sufficient number of the proposed adjustments to receive an unqualified audit opinion. As Bill reached the end of his meeting, the predecessor auditor said, “Of course, you hate to lose any client, but if we had to choose one to give up it would be PCU.” 5. Most of the loans held by PCU came from used car dealers, small home repair and remodeling contractors, and door-to-door sales people in the area. These types of loans were often difficult to collect. Sabrina discounted the loans heavily, paying only a fraction of their face value, and usually bought them with recourse. Because Sabrina had demonstrated an ability to collect a high percentage of these loans, she always has an ample supply of sales people and small businesses willing to sell her their loans receivable. 6. Talks with the controller of PCU went reasonably well. The controller was very friendly and tried to be helpful. Overall, the accounting records appeared to be in reasonably good order. However, Bill was not impressed with the knowledge and abilities of the controller. The controller had completed a few accounting courses, but did not have a degree in accounting and had not completed any professional certification program in accounting (e.g., CPA, CMA, CIA, CFE).

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7. Bill’s business contacts were willing to freely discuss their experience with Sabrina and with PCU. They consistently depicted Sabrina as disciplined, aggressive, and shrewd. Within PCU she was viewed as direct, overbearing, and intolerant of error. 8. PCU generally had a reputation for paying obligations on time or shortly after the due date. However, it was common for Sabrina to take exception to the charges billed and it was common for her to attempt to renegotiate the charges prior to making payment. The prior auditor had been paid within a reasonable time after completion for the engagement. Bill summarized his background review for Lucy, noting the above points. All things considered, he concluded that PCU would be an acceptable audit client and recommended to Lucy that Novogradac accept the engagement. Bill fully understood the importance of increased firm revenues to justify the new partnership position. Annual employee reviews were scheduled the following week and this woul d be Bill’s last opportunity to add another client prior to his evaluation for a partnership position. If Bill were not admitted to the partnership soon, he would likely be asked to leave the firm to make room for other promising candidates.

Required 2 a. Prepare a list of specific factors/reasons to accept the PCU audit engagement. One factor/reason is provided to help you complete the rest of about eleven factors/reasons. i. Successful operation of the business for 20 years. Continuing businesses usually present less audit risk than startup companies with no record of success. ii. … iii … 2 b. Prepare a list of specific factors/reasons to reject the PCU audit engagement. One factor/reason is provided to help you complete the rest of about seven factors/reasons. i. Management control is centered in one person, Sabrina. This situation makes it easier for Sabrina to commit fraud without being detected, thereby increasing audit risk. ii. … iii …

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Part 3

Based on the recommendations of Bill and Lucy, the vote of the local office partners, the PCU audit engagement was accepted. With the acceptance of PCU, Bill’s goal to become a partner was realized. Bill acquired a loan (not from PCU) and bought into the partnership. This was a crowning achievement inBill’s career and he was justifiably proud of his promotion. Unfortunately, all did not go well with the audit of PCU. The controller quit shortly after the client’s year-end and the new controller was less qualified for the position than his predecessor. He apparently overstated his abilities and experience to obtain the position. The new controller often struggled to understand the unique accounting practices within the financial institution industry. This was an obvious frustration to Sabrina. Since her own knowledge of detailed accounting procedures was limited, she was unable to resolve technical accounting issues herself. Sabrina appeared to be looking to the auditors to resolve technical accounting issues as part of the audit. It became apparent that neither –related questions that were likely to arise during the the controller nor Sabrina would be of great help in answering the more difficult accounting audit.

Reconciliation of the beginning balances in the general ledger with the prior year audited financial statements for PCU turned out to be a major challenge. While Bill was fortunate enough to get copies of the audited trial balance numbers and proposed adjusting entries from the prior auditor, there was neither a record of which entries had been posted and which had not, nor was there a reconciliation between the audited trial balance numbers and the resulting financial statements. Either there was a deficiency in the predecessor’s working papers, or they purposely withheld critical information. Attempts to obtain additional information from the predecessor auditor were futile. In some cases it was discovered that an adjustment was made to the books for a different amount from that proposed by the predecessor auditor. In other cases, incorrect adjustments were made or no entries were made at all. Account balances were combined under headings on the financial statements different from those used on the trial balance and there was no documentation detailing the combination of accounts. It took manyurs hoof searching the cli ent’s journals and ledgers to finally track all the entries and to reconcile the client’s beginning account balances with the prior year audited financial statements. For most of their audit clients, this reconciliation was unnecessary because the account balances in the ledger closely matched the amounts reported on the financial statements and numbers from the trial balance were typically traced to the financial statements in the working papers. The audit of fixed assets exceeded the budget by a significant amount of time due to the lack of records. The prior controller of PCU had calculated depreciation expense for depreciable assets for the year under audit before leaving PCU. Unfortunately, he did not leave a copy of his calculations to support depreciation expense. All efforts to contact the previous controller for an explanation failed. The new controller was unable to explain how depreciation expense was derived and, due to lack of confidence in his accounting abilities, he was afraid to make any changes to the amounts calculated by the prior controller. The disclosure of depreciation methods on the prior year financial statements was too vague to determine which methods were used for each asset or asset group. The professional staff assigned to audit fixed assets obtained srcinal purchase documentation for each of the fixed assets and by trial and error attempted to determine the method of depreciation employed. Straight line, sum-of-the-years digits, double declining balance, declining balance at 1.5 times the straight-line rate, and MACRS (Modified Accelerated Cost Recovery System, a depreciation method used for tax purpose and defined in the Tax Reform Act of 1986), were all attempted using various estimates of useful lives and salvage values. Unfortunately, the audit team was unsuccessful in determining the depreciation methods used for any of the assets. It noted that the amounts recorded for depreciation expense and for accumulated depreciation were consistently between straight-line and double declining balance amounts. Footnote disclosures were somewhat vague, noting the use of “an accelerated method of depreciation for most fixed assets.” The depreciable assets were about 10 percent of total assets on the balance sheet. Most of the assets consisted of the various receivables held by the financial institution. Thus, it was determined that, in spite of the problems described above, no material error existed in depreciation expense or accumulated depreciation. A recommendation was made to the client to select a generally accepted method of calculating depreciation and to document the calculation in the future.


Evidence suggesting the existence of a related party surfaced early in the audit. The building owned and occupied by PCU also housed a travel agency by the name of East & West Travel (hereafter, EWT). The travel agency operated in the main lobby of the financial institution with no signs or dividers between the space occupied by PCU and the space occupied by EWT. In fact, it was necessary for employees of both organizations to pass through the working areas of the other business to enter and exit the building and to access the shared break room and restrooms. On one occasion, Sabrina was observed correcting the manager of the travel agency and appeared to be threatening his employment with the agency. Employees of the travel agency would not reveal anything to the auditors. Discussions with employees of PCU indicated that Sabrina had regular conversations with the manager of the travel agency similar to the one observed by the audit staff. However, the employees of PCU were unable to verify any direct relationship between the two entities other than the shared building space. Sabrina denied any ownership, managerial responsibility, or other relationship with EWT. A thorough search was made for transactions between the two entities. The only transactions noted were the rental payments made by EWT to PCU at an amount considered by the auditors to approximately fair market value for the space used. Stockholders’ equity presented another problem during the audit. When asked whether she had an ownership interest in PCU, Sab rina flatly denied any ownership whatsoever. When the stock book was examined, however, the audit team found that Sabrina owned approximately 2.5 percent of the outstanding stock in PCU. Due to the obvious misrepresentation by Sabrina to the concern regarding related-party transactions, Bill made an appointment to talk to Sabrina to review the ownership of PCU. Armed with the stock records, Bill questioned Sabrina regarding each owner of PCU. At this point, Sabrina acknowledged the ownership noted in the stock records, but quickly countered that it was really a’s aged mother owned approximately 57.5 percent of the outstanding shares of stock. insignificant. Further questioning revealed that Sabrin Sabrina was frequently leaving work at PCU to care for her mother. Discussions with the PCU employees revealed that Sabrina’smother was very old, in poor health, and dependent on Sabrina for transportation and daily care, including assistance with doctor appointments, grocery shopping, and meal preparation. There was no evidence that Sabrina’s mother had been actively involved i n the management over sight of PCU, participation with the board of directors, or communication with the auditor. No reason was ever discovered for Sabrina’s evasive and obviously incorrect answers.

Required 3 a. When Bill was admitted as a new partner, he acquired a loan to make a substantial financial investment in Novogardac & Co. Why are new partners required to make a substantial financial investment in the firm as specified in the partnership agreement? 3 b. Audit evidence indicates that EWT may be related to PCU. Why is the possible existence of a related party of concern to the auditors? 3 c. Audit evidence indicates that Sabrina was evasive about her ownership interests in PCU and that her mother owned a majority interest in PCU. What are the implications of these findings to the audit of PCU?

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Part 4

As a result of the issues that arose, the required audit hours greatly exceeded the time budget srcinally prepared by Bill. Even though there was not a promised completion date, Sabrina began to be eager to receive the audit opinion and get the auditors out of the building. At one point she called Lucy Ball and complained that the audit was taking too long. She said that she had made numerous calls to Bill during the past week and that none of her calls had been returned. But the office receptionist verified that Sabrina had not called the office during the past week at all. In fact, Bill had been in the PCU building talking to Sabrina the previous day during which time Sabrina had not expressed any concerns related to the audit or Bill’s work. Finally, sufficient appropriate evidence had been gathered to conclude the audit. A number of adjusting journal entries were proposed and Sabrina fought nearly allof them. Neither she nor hercontroller demonstrated a sufficient understanding of accounting to challenge the merits of the entries proposed. When it became clear that Sabrina’s challenges had no basis, she finally agreed to a sufficient number of adjusting entries to allow the financial statements, in the opinion of the auditors, to be fairly stated in all material respects. The audit was concluded and an unqualified opinion issued. Sabrina waited until she received a “30-day-past-due” notice before she contacted the Novogradac & Co office. She argued over the amount of the bill and again complained about the “excessive” time thatthe auditors took to complete their work. The partners in Novogradac & Co ultimately discounted the bill by 15 percent and Sabrina paid the discounted amount when the bill was approximately 90 days past due. Partners in Novogradac & Co each received a salary based on the number of hours they worked and a partnership distribution based on the size of their partnership investment. The level of salary received was determined by an annual review conducted by the senior partners in the firm. In order to receive a higher salary, Bill and other partners needed to maintain and increase their client base and charge a higher proportion of their hours worked to their clients. Note that hours worked for the firm in administrative functions or other activities that could not billed to a client engagement did not contribute to the revenue of the firm. An increased client base and a higher proportion of hours billed to clients both resulted in more revenue to Novogradac & Co, and thus justified an increase in salary. In spite of his increased income as a partner, Bill often found himself a little short of cash. His increase in income as a new partner was more than offset by the large payments he was required to make on his loan to buy an ownership interest in the firm. It would soon be time to begin the second audit of PCU and Bill was eager to renew the engagement for another year in order to justify a much-needed increase in salary.

Required 4 a. What factors/reasons might Novogardac & Co have for rejecting to provide future audit services to PCU? 4 b. What factors/reasons might Novogardac & Co have for continuing to provide future audit services to PCU? Note: You must answer all 4 Parts to earn the extra credit point.

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Simulation Question 5-2 Simulation Question 5-2 is an adaptation with permission from a case by Jones, A. and C. S. Norman inIssues the in Accounting Education , a publication of the American Accounting Association in Sarasota, Florida. This simulation question is based upon a true set of facts; however, the names and places have been changed.

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Part 1

The CPA Firm

As of March 2005, Johnson Keith Niemeyer LLP (hereafter, JKN), a large, regional public accounting firm, had offices in 45 U.S. cities in the West and Midwest, as well as several international affiliations. Firm headquarters are located in the Midwest, and the professional staff at the headquarters provides outstanding support to the local offices. JKN has a total of 225 partners and approximately 2,000 supporting professionals and administrative staff. U.S. offices of the firm generally are staffed with 3-10 partners and 20-100 supporting professional accountants and administrative personnel. The firm provides a full array of audit, tax, and consulting services for its clients; these are mostly privately held, owner-managed companies with revenues ranging from $1 million to $50 million, although JKN also serves approximately 80 public companies. JKN has a reputation for being very conservative in its audit practice. Management has been very careful in its client acceptance and continuance policies. Before submitting proposals to perform audit services, prospective engagement partners must obtain extensive information about the potential client to make an informed decision about whether to accept or reject the engagement. If the prospective engagement partner ’s decision were to accept the client; then, at least one additional audit partner must agree with the decision to accept the client. In the course of evaluating prospective clients, JKN personnel assess their potential exposure from being associated with a particular client or engagement (engagement risk).1 JKN’s acceptance procedures allow the acceptance of high-risk clients only if the risk can be controlled. That is, the engagement team must have relevant expertise and experience to manage the risk, as well as adequate compensation for the risk assumed. Potential clients are evaluated for integrity, industry competence, management experience, and financial condition. If the prospective client is a public company, then additional due diligence procedures are required. These procedures include evaluating underwriters and legal counsel, performing background checks on members of management and the board of directors, and evaluating the financial viability of proposed transactions and investor returns. Inese th situations, JKN’s firm policy requires the approval of the partner responsible for firm-wide audit and accounting policy, as well as the approval of a concurring partner. Engagement partners re-evaluate existing audit clients on an annual basis to determine whether any events since completion of the last audit might cause the firm to discontinue its relationship with the client. If an existing client is planning a public offering of its securities, then additional due diligence procedures are necessary. In addition, the re-evaluation of existing clients requires concurrence by another audit partner when certain events or circumstances occur. These events include: a change in majority ownership or management, management’s refusal to sign a representationletter, discovery of fraud or other misrepresentations, a client’s unwillingness to pay fees, and regulatory investigations. Traditionally, audit and tax services have been the core business of the firm. However, for the past five years, JKN management has not been satisfied with the firm’s financial results, and its new strategy focuses on non-audit services, primarily management consulting and personal financial services. Therefore, JKN now promotes itself as a business services firm and as a “one-stop shop” for its clients’ business needs. Recently, the firm formed alliances with other financial services providers around the country and is aggressively promoting its ability to help with retirement plan administration, insurance, wealth management, and information systems needs for small- and medium-size, closely held business and their owners. The Briarwood City Office

The Briarwood City office of JKN is located in the Pacific Northwest and is one of the oldest offices in the firm. Three partners, 30 professional staff (mostly CPAs), and five administrative staff make up the Briarwood City team. The partners all graduated from highly rated accounting programs in the U.S. Their areas ofspecialization/responsibility are as follows: Andrew (Andy) Stevens: office administration and attest services, including small audits, reviews, and compilations. Andy is very much in tune with the current JKN strategy and is actively involved in promoting non-audit services and establishing alliances with other professional service providers. Andy joined the firm 20 years ago and has been a partner for ten years. Frank Clement : Attest services consisting of large and small audits, reviews, and litigation supporting. Frank also serves as a regional quality control resource, conducting concurring reviews for other offices and serving four publicly listed clients from Briarwood City. Frank moved to Briarwood City 18 years ago, after eight years with a national firm in its Chicago office. Bernard (Bernie) Richards : Tax services. Bernie is known as one of the firm’s best tax partners. He has excellent corporate and individual client relationships and is one of the most sought-after instructors at firm-wide training sessions. Bernie has been with the firm for 27 years. Frank and Bernie are very proud of their long careers as audit and tax partners and the firm’s rich history providing these services. However, both men have a number of concerns about the future of the firm. They are not very pleased with the firm’s new strategyto be a business services firm. In addition, they are very concerned about living up to the firm’s responsibilities under the Sarbanes-Oxley Act of 2002. On the other hand, Andy is trying his best to follow the firm strategy of being a one-stop financial service provider, despite the high chargeable hour goals and pressure to grow the practice in his respective area. Mark Grumbles, the regional managing partner for JKN, is very supportive of the firm’s strategy and frequently reminds everyone about the need to grow the firm and to sell nontraditional services. Luckily, the Briarwood City office has several very competent audit and tax managers to assist in the administration of client engagements and to train junior staff members. Stuart Harrison, Paula White, Tom Fitch, and Sue Tracey are very experienced and knowledgeable managers and have great relation ships with the partners and the staff.Stuart is a tax manager and Paula, Tom, and Sue handle the audit, review, and compilation work. The partners are currently looking to hire at least two more capable managers since everyone is stretched thin. Grumbles would really like to find someone who is experienced at selling non-audit financial services. An organization chart depicting the hierarchy for the firm is shown in Figure 1. You should access Data File 5-2 in iLearn for Figure 1, which hows s JKN’s organization chart. The Client

Riverside Communications Company (hereafter, RCC) commenced business operations in 1925 as a local exchange telephone service provider in the southwestern part of the state. In 1958, RCC conducted its initial public offering (IPO), and many local residents in its service area became shareholders. Later, in 1980, a second public offering was conducted, and subsequently the RCC common stock was listed on NASDAQ. The primary business of RCC still consists of local exchange (or wireline services) to customers in the southwestern part of the state. However, over 1

Engagement risk is the risk that the audit firm will suffer harm because of a client relationship, even though the audit report issued to the client was correct.


the past ten years, RCC has significantly expanded its local territory. Furthermore, passage of the Telecommunications Act of 1996 (targeted at increasing competition in the industry) encouraged RCC to increase its coverage area and the services offered to its customers. Through its various wholly owned subsidiaries and nonconsolidated equity investees, RCC provides the following services: local telephone service (wireline), cellular and paging communications services (wireless), cable television services, telecommunications equipment sales, leasing of a fiber-optic cable network and tower space, financing services, and directory assistance services. RCC has a history of successful operations and has a long history of paying dividends. Financial information for the past five years is presented in Table You 1. should access Data File 5-2 in iLearn for Table 1, which shows recent financial results for Riverside Communications Company. During that period, revenues have increased due to RCC’s continued growth into new lines of business; at the same time, net income has declined mainl y because of investments required for the startup of these new lines of business. Key personnel of RCC are as follows: Warren England , Chief Executive Officer (CEO): Warren is a CPA and has been with RCC for 20 years. He started working at RCC as the Chief Financial Officer (CFO) after spending 13 years in a national public accounting firm, the last three as a partner. Larry Cashman , CFO: Larry has an M.B.A. and was hired as the CFO ten years ago. At the time he was hired at RCC, he has over 20 years of experience as either a controller or a CFO for public companies in other industries. Greg Lowman, Controller: Greg is a CPA and was hired five years ago from JKN after serving as the audit senior on the account for four years. Additional information and firm characteristics of RCC may be found in TableYou 2. should access Data File 5-2 in iLearn for Table 2, which shows firm characteristics and selected data for Riverside Communications Company. History of the Audit-Client Relationship

JKN has been serving the audit and tax needs of RCC since the 1950s when the firm assisted the Company with its IPO. The relationship between JKN and RCC has been very good over the years. Because of its good reputation in the community and because of the prestige of performing audit and tax services for this client, JKN has been able to attract other sizable clients, including three other small public companies. One of these public clients is also a telecommunications company with lines of business similar to RCC. There are no other significant telecommunications company clients in any office of the firm. Frank Clement has been handling the audit partner responsibilities on RCC for each of the three years, ending December 31, 2004. Tom Fitch has just completed his second year as the engagement manager. Total fees from RCC have averaged approximately $250,000 per year for the past three years under a fixed –fee arrangement for the annual and quarterly audit and tax services, exclusive of services required in connection with the attestation reporting on internal controls beginning in 2004, as required by Section 404 of the Sarbanes-Oxley Act and for which an additional $75,000 was billed. The total RCC fees represent approximately 4 percent of total fees for the Briarwood City office of JKN, placing RCC in the top five of all clients based on total fees billed and collected. Occasionally, Larry Cashman will call with questions about how to handle the accounting entries and reporting for non-routine or unusual transactions. In these special situations, Frank Clement often consults with Michael Bryan from the headquarters office, who has performed the concurring review of the RCC audit for the past three years. When Frank submits a bill to the audit committee for these extra services, a minor argument or “negotiation” often takes place between Frank and Larry regarding the size of the bill. Larry argues that these consultations should be covered in the fixed-fee audit as defined in their engagement letter with JKN. Since RCC has a calendar year, the audit takes place during JKN’s busy season (January and February). Although the firm prefers not to accept work for less than standard rates during this period, an exception is made for this client, whose fees average only 80 percent of standard rates. One of the main reasons for this exception is that the senior members of the RCC management team are very crafty negotiators. Warren England and Larry Cashman both realize that RCC is an important client to JKN. Warren, having been a partner in a public accounting firm, knows how to play the game. Therefore, because of the significant fee and the prestige of having this client, JKN makes an exception to its usual policy of demanding full rates for busy season work. Staff members enjoy working on this audit even though the timetable for fieldwork is tight and the hours are long. Working on this engagement presents a great opportunity to learn and the audit is clean because of good internal controls and the competent management and accounting staff of RCC. The audit is always on time with no material audit adjustments ever required. Client personnel prepare the annual report to stockholders and the Form 10-K for filing with the SEC; the JKN staff has no problems with the adequacy or format of disclosures, or referencing the financial information in their workpapers. A management letter (i.e., a client’s advisory comments letter) is prepared each year with suggestions for improvements in internal controls or for more efficient methods of handling operations. However, no material weakness on internal controls has ever been reported to management or to the audit committee of the board of directors pursuant to Statement on Auditing Standards No. 112 (AU 325) Communication of Internal Control Related Matters Identified in an Audit. In addition, the attestation report on management’s assessment of int ernal controls in 2004, as required bySection 404 of the Sarbanes-Oxley Act, was unqualified. Frank Clement and Tom Fitch meet with the audit committee twice each year, once before the audit to obtain their input and to discuss the audit plan, and once after completion of the fieldwork to discuss the audit findings and the client’s advisory commentsetter. l Larry Cashman and Warren England are especially sensitive to the matters mentioned in the client’s advisory comments letter and always insist thathey t see the letter before the audit committee meeting. Frank and Tom have no problem with that procedure because they want to be sure that the facts are correct and that their staff has reported everything correctly. However, sometimes these discussions are difficult. Larry and Warren sometimes object to certain information in the letter, claiming that the information is not significant enough to be communicated to the audit committee of the board of directors.

Required 1. JKN has a risk assessment policy on a client’s acceptance/continuance decision. This policy requires the assessment of three types of risk: a. Engagement risk – the risk that JKN will suffer harm because of a client relationship, even though the audit report issued to the client was correct. b. Business risk– the risk that JKN will suffer economic loss due to inappropriate business strategy or other business decisions. c. Audit risk – the risk that JKN may fail to appropriately modify the opinion issued to the client, even though the financial statements are materially misstated. Assume you are following JKN’s risk assessment policy in making RCC’s continuancedecision, identify and explain each type of risk involved based on the information regarding the Briarwood City office and the history of the audit client relationship with RCC. Use the following format to answer:

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Type of Risk a. JKN’s engagement risk

b. JKN’s business risk

c. JKN’s audit risk

Risk Factors Identified

Explain the Risk involved

1. … 2. … … 1. … 2. … … 1. … 2. … …

2. Based on your risk assessment, should JKN continue with this client? Explain why or why not? In your isresponse, should considerfor Section 301 and 407 offor theexample, Sarbanes-Oxley NASDAQ rules, and anySarbanes-Oxley AICPA guidance you believe relevant. you Search the internet relevant information, websites Act, that offer information on the Actthat of 2002 include: http://cpcaf.aicpa.org/Resources/Sarbanes+Oxley/ http://www.sarbanes-oxley.com http://www.theiia.org/iia/guidance/issues/sarbanes-oxley.pdf http://www.sec.gov/spotlight/sarbanes-oxley.htm

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Part 2

Growth Strategy for RCC It is now Spring 2005, and Frank Clement is presented with a series of transactions contemplated by Larry and Warren. RCC’s management is

eager to grow the company into one of the leading providers of wireless communications and Internet services in the North-west. The overall economy and the stock market have been performing well for the past three years, and RCC stock has been trading at all-time highs, ranging from $75-$80 per share. Senior management and the board of directors have already met with officials from the investment banking division of Morton Stosch (hereafter, MS), a very large Wall Street securities firm, and with Whipple Killjoy (hereafter, WK), a large private equity firm from San Francisco, both of which appear to be excited to be part of an arrangement to grow RCC. The transactions contemplated involve, among other things, a series of mergers and acquisitions to be financed by various public and private debt and equity offerings. Briefly summarized, these transactions include: 1. Issue high-yield debt of $550 million. $275 million will be loaned by WK, and the remaining $275 million will be underwritten by MS in a public offering. 2. Issue $250 million convertible preferred stock. All of this stock will be issued to MS and to WK. In three years, the preferred stock will be convertible into common stock, and a secondary public offering will likely take place at that time so that the current financiers will be able to liquidate their investment. 3. Dispose of the directory assistance business for $68 million. Although this business is profitable, it does not fit into the strategic plan as a core service. RCC has a company that is interested in buying the directory assistance business. 4. Acquire FirstCo, a wireless digital communications company, for $650 million. Since the service area is only about 150 miles from RCC, it seems to fit with the strategy of expanding the company’s “wireless footprint.” This acquisition will also add 300 employees. 5. Acquire the remaining minority interests in two wireless unconsolidated subsidiaries for $75 million. Currently, RCC is a 25 percent shareholder in each company and carries these as equity investments. Seven other telecommunications companies own the remaining 75 percent, with no one company owning more than 15 percent. The plan is to buy out the other seven shareholders. 6. Merge with A&D Telecommunications Company, A&D is a company that is very similar to RCC, but is only about 30 percent of the size of RCC, based on total revenues. A&D is privately owned by approximately 100 shareholders, mostly members of the Manley family, with Christ Manley as its CEO. The merger plan is to exchange 40 shares of RCC for each share of A&D. As added inducement for pushing this merger to the A&D shareholders, RCC is promising to make Chris Manley the Chief Operating Officer (COO) of RCC and to grant him a cash bonus of $1.2 million if the transaction is approved. 7. “Buildout” the wireless system. This process requires the purchase of licenses and equipment, as well as the construction of towers. Warren and Larry explain that RCC is especially ready to take advantage of these “ripe” times in the telecommunications industry. The accounting department has assembled projections covering the next five years and, although large losses (as much as $90 million in one year) are projected in the years 2006-2010, the company expects a profit and positive cash flows in 2010. Borrowings will be sufficient to create cash reserves in the early periods to meet debt requirements. Frank Clement sees this project as a tremendous opportunity for the Briarwood office, although it will involve some very difficult accounting and reporting issues that will include filing several registration statements with the SEC. He will surely need the assistance of Michael Bryan from the headquarters office. Luckily, most of the immediate work will take place in the summer, which is usually slow; however, this work might also require individuals to postpone planned vacations. The fees from this type of high-risk work will be billed at premium rates, and they will provide an opportunity to make up for all those years at 80 percent of standard rates. Therefore, this work for RCC should contribute to great financial results in 2005 for the Briarwood City office. The other two partners in the Briarwood office, Andy Stevens and Bernie Richards, are also excited about the opportunity. Mark Grumbles is delighted. He has been pressuring Frank to sell some of JKN’s value-added services, such as wealth management, to the RCC executives and board members. Grumbles comments that after these transactions take place RCC should be a prime candidate for the firm to provide other non-audit services. This situation should also help the Briarwood office attract more audit clients.

Required 3. The growth strategy for RCC is very ambitious and aggressive. Identify and explain risk factors associated with RCC’s growth strategy in addition to those that you have identified in Part 1. Use the following format to answer:


Risk Factors Associated with RCC’s Growth Strategy 1. RCC’s increasing complexity. 2. Relationship with Morton Stosch. 3. Relationship with Whipple Killjoy. 4. The telecommunication industry. 5. The size of RCC with respect to the other clients in the Briarwood office. 6. The expertise required of the Briarwood office with respect to RCC merger and acquisitions. 7. Other risk factors …

Explain the Risk Involved

4. Based on your risk assessment of RCC’s growth strategy and your risk assessment on RCC’s acceptance/continuancedecision in Part 1, should JKN continue with this client? Explain why or why not? In your response, refer to Chapter 3 for a discussion on relevant professional ethics, for example, Rule 101 on independence of thePA’s AIC Code of Professional Conduct and the PCOAB’s Auditor Independence Rules.

Note: You must answer both Parts 1 and 2 to earn the extra credit point.

Simulation Question 5-3 Simulation Question 5-3 is an adaptation with permission from a case by Jones, A. and C. S. Norman inIssues the in Accounting Education , a publication of the American Accounting Association in Sarasota, Florida. This simulation question is based upon a true set of facts; however, the names and places have been changed.

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Introduction

The CPA Firm

As of March 2005, Johnson Keith Niemeyer LLP (hereafter, JKN), a large, regional public accounting firm, had offices in 45 U.S. cities in the West and Midwest, as well as several international affiliations. Firm headquarters are located in the Midwest, and the professional staff at the headquarters provides outstanding support to the local offices. JKN has a total of 225 partners and approximately 2,000 supporting professionals and administrative staff. U.S. offices of the firm generally are staffed with 3-10 partners and 20-100 supporting professional accountants and administrative personnel. The firm provides a full array of audit, tax, and consulting services for its clients; these are mostly privately held, owner-managed companies with revenues ranging from $1 million to $50 million, although JKN also serves approximately 80 public companies. JKN has a reputation for being very conservative in its audit practice. Management has been very careful in its client acceptance and continuance policies. Before submitting proposals to perform audit services, prospective engagement partners must obtain extensive information about the potential client to make an informed decision about whether to accept or reject the engagement. If the prospective gagement en partner’s decision were to accept the client; then, at least one additional audit partner must agree with the decision to accept the client. In the course of evaluating prospective clients, JKN personnel assess their potential exposure from being associated with a particular client or engagement (engagement risk).2 JKN’s acceptance procedures allow the acceptance of high-risk clients only if the risk can be controlled. That is, the engagement team must have relevant expertise and experience to manage the risk, as well as adequate compensation for the risk assumed. Potential clients are evaluated for integrity, industry competence, management experience, and financial condition. If the prospective client is a public company, then additional due diligence procedures are required. These procedures include evaluating underwriters and legal counsel, performing background checks on members of management and the board of directors, and evaluating the financial viability of proposed transactions and investor returns. In these situations, JKN’s firm policy requires h t e approval of the partner responsible for firm-wide audit and accounting policy, as well as the approval of a concurring partner. Engagement partners re-evaluate existing audit clients on an annual basis to determine whether any events since completion of the last audit might cause the firm to discontinue its relationship with the client. If an existing client is planning a public offering of its securities, then additional due diligence procedures are necessary. In addition, the re-evaluation of existing clients requires concurrence by another audit partner when certain events or circumstances occur. These events include: a change in majority ownership or management, management’s refusal to sign esentations, a client’s unwillingness to pay fees, and regulatory investigations. a representation letter, discovery of fraud or other misrepr Traditionally, audit and tax services have been the core business of the firm. However, for the past five years, JKN management has not been satisfied with the firm’s financial results, and its new strategy focuses on non-audit services, primarily management consulting and personal financial services. Therefore, JKN now promotes itself as a business services firm and as a “one-stop shop” for its clients’ business needs. Recently, the firm formed alliances with other financial services providers around the country and is aggressively promoting its ability to help with retirement plan administration, insurance, wealth management, and information systems needs for small- and medium-size, closely held business and their owners. The Briarwood City Office

The Briarwood City office of JKN is located in the Pacific Northwest and is one of the oldest offices in the firm. Three partners, 30 professional staff (mostly CPAs), and five administrative staff make up the Briarwood City team. The partners all graduated from highly rated accounting programs in the U.S. Their areas ofspecialization/responsibility are as follows: Andrew (Andy) Stevens: office administration and attest services, including small audits, reviews, and compilations. Andy is very much in tune with the current JKN strategy and is actively involved in promoting non-audit services and establishing alliances with other professional service providers. Andy joined the firm 20 years ago and has been a partner for ten years.

2

Engagement risk is the risk that the audit firm will suffer harm because of a client relationship, even though the audit report issued to the client was correct.

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Frank Clement : Attest services consisting of large and small audits, reviews, and litigation supporting. Frank also serves as a regional quality control resource, conducting concurring reviews for other offices and serving four publicly listed clients from Briarwood City. Frank moved to Briarwood City 18 years ago, after eight years with a national firm in its Chicago office. axt partners. He has excellent corporate and individual client Bernard (Bernie) Richards : Tax services. Bernie is known as one of the firm’s best relationships and is one of the most sought-after instructors at firm-wide training sessions. Bernie has been with the firm for 27 years. Frank and Bernie are very proud of their long careers as audit and tax partners and the firm’s rich history providing these services. However, both men have a number of concerns about the future of the firm. They are not very pleased with the firm’s newegy strat to be a business services firm. In addition, th ey are very concerned about living up to t he firm’s responsibilities under the Sarbanes-Oxley Act of 2002. On the other hand, Andy is trying his best to follow the firm strategy of being a one-stop financial service provider, despite the high chargeable hour goals and pressure to grow the practice in his respective area. Mark Grumbles, the regional managing partner for JKN, is very supportive of the firm’s strategy and frequently reminds everyone about the need to grow the firm and to sell nontraditional se rvices. Luckily, the Briarwood City office has several very competent audit and tax managers to assist in the administration of client engagements and to train junior staff members. Stuart Harrison, Paula White, Tom Fitch, and Sue Tracey are very experienced and knowledgeable managers and have great relation ships with the partners and the staff.Stuart is a tax manager and Paula, Tom, and Sue handle the audit, review, and compilation work. The partners are currently looking to hire at least two more capable managers since everyone is stretched thin. Grumbles would really like to find someone who is experienced at selling non-audit financial services. An organization chart depicting the hierarchy for the firm is shown in Figure 1. You should access Data File 5-2 in iLearn for Figure 1, which hows s JKN’s organization chart. The Client Riverside Communications Company (hereafter, RCC) commenced business operations in 1925 as a local exchange telephone service provider in the southwestern part of the state. In 1958, RCC conducted its initial public offering (IPO), and many local residents in its service area became shareholders. Later, in 1980, a second public offering was conducted, and subsequently the RCC common stock was listed on NASDAQ. The primary business of RCC still consists of local exchange (or wireline services) to customers in the southwestern part of the state. However, over the past ten years, RCC has significantly expanded its local territory. Furthermore, passage of the Telecommunications Act of 1996 (targeted at increasing competition in the industry) encouraged RCC to increase its coverage area and the services offered to its customers. Through its various wholly owned subsidiaries and nonconsolidated equity investees, RCC provides the following services: local telephone service (wireline), cellular and paging communications services (wireless), cable television services, telecommunications equipment sales, leasing of a fiber-optic cable network and tower space, financing services, and directory assistance services. RCC has a history of successful operations and has a long history of paying dividends. Financial information for the past five years is presented in Table You 1. should access Data File 5-2 in iLearn for Table 1, which shows recent financial results for Riverside Communications Company. During that period, revenues have increased due to RCC’s continued growth into new lines of business; at the same time, net income has declined mainl y because of investments required for the startup of these new lines of business. Key personnel of RCC are as follows: Warren England , Chief Executive Officer (CEO): Warren is a CPA and has been with RCC for 20 years. He started working at RCC as the Chief Financial Officer (CFO) after spending 13 years in a national public accounting firm, the last three as a partner. Larry Cashman , CFO: Larry has an M.B.A. and was hired as the CFO ten years ago. At the time he was hired at RCC, he has over 20 years of experience as either a controller or a CFO for public companies in other industries. Greg Lowman, Controller: Greg is a CPA and was hired five years ago from JKN after serving as the audit senior on the account for four years. Additional information and firm characteristics of RCC may be found in TableYou 2. should access Data File 5-2 in iLearn for Table 2, which shows firm characteristics and selected data for Riverside Communications Company. History of the Audit-Client Relationship JKN has been serving the audit and tax needs of RCC since the 1950s when the firm assisted the Company with its IPO. The relationship between JKN and RCC has been very good over the years. Because of its good reputation in the community and because of the prestige of performing audit and tax services for this client, JKN has been able to attract other sizable clients, including three other small public companies. One of these public clients is also a telecommunications company with lines of business similar to RCC. There are no other significant telecommunications company clients in any office of the firm. Frank Clement has been handling the audit partner responsibilities on RCC for each of the three years, ending December 31, 2004. Tom Fitch has just completed his second year as the engagement manager. –fee arrangement for the Total fees from RCC have averaged approximately $250,000 per year for the past three years under a fixed annual and quarterly audit and tax services, exclusive of services required in connection with the attestation reporting on internal controls beginning in 2004, as required by Section 404 of the Sarbanes-Oxley Act and for which an additional $75,000 was billed. The total RCC fees represent approximately 4 percent of total fees for the Briarwood City office of JKN, placing RCC in the top five of all clients based on total fees billed and collected. Occasionally, Larry Cashman will call with questions about how to handle the accounting entries and reporting for non-routine or unusual transactions. In these special situations, Frank Clement often consults with Michael Bryan from the headquarters office, who has performed the concurring review of the RCC audit for the past three years. When Frank submits a bill to the audit committee for these extra services, a minor argument or “negotiation” often takes place between Frank and Larry regarding the size of the bill. Larry argues that these consultations should be covered in the fixed-fee audit as defined in their engagement letter with JKN. Since RCC has a calendar year, the audit takes place during JKN’s busy season (January and February). Although the firm prefers not to accept work for less than standard rates during this period, an exception is made for this client, whose fees average only 80 percent of standard rates. One of the main reasons for this exception is that the senior members of the RCC management team are very crafty negotiators. Warren England and Larry Cashman both realize that RCC is an important client to JKN. Warren, having been a partner in a public accounting firm, knows how to play the game. Therefore, because of the significant fee and the prestige of having this client, JKN makes an exception to its usual policy of demanding full rates for busy season work. Staff members enjoy working on this audit even though the timetable for fieldwork is tight and the hours are long. Working on this engagement presents a great opportunity to learn and the audit is clean because of good internal controls and the competent management and accounting staff of RCC.

The is always on filing time with with the no SEC; material auditstaff adjustments ever required. personnel prepare the annual report to stockholders andaudit the Form 10-K for the JKN has no problems with theClient adequacy or format of disclosures, or referencing the financial information in their workpapers. A management letter (i.e., a client’s advisory comments letter) is prepared each year with suggestions for improvements in internal controls or for more efficient methods of handling operations. However, no material weakness on internal controls has ever been reported to management or to the audit committee of the board of directors pursuant to Statement on Auditing


Standards No. 112 (AU 325) Communication of Internal Control Related Matters Identified in an Audit. In addition, the attestation report on management’s assessment of int ernal controls in 2004, as required bySection 404 of the Sarbanes-Oxley Act, was unqualified. Frank Clement and Tom Fitch meet with the audit committee twice each year, once before the audit to obtain their input and to discuss the audit plan, and once after completion of the fieldwork to discuss the audit findings and the client’s advisory commentsetter. l Larry Cashman t see the and Warren England are especially sensitive to the matters mentioned in the client’s advisory comments letter and always insist thathey letter before the audit committee meeting. Frank and Tom have no problem with that procedure because they want to be sure that the facts are correct and that their staff has reported everything correctly. However, sometimes these discussions are difficult. Larry and Warren sometimes object to certain information in the letter, claiming that the information is not significant enough to be communicated to the audit committee of the board of directors. Growth Strategy for RCC It is now Spring 2005, and Frank Clement is presented with a series of transactions contemplated by Larry and Warren. RCC’s management is

eager to grow the company into one of the leading providers of wireless communications and Internet services in the North-west. The overall economy and the stock market have been performing well for the past three years, and RCC stock has been trading at all-time highs, ranging from $75-$80 per share. Senior management and the board of directors have already met with officials from the investment banking division of Morton Stosch (hereafter, MS), a very large Wall Street securities firm, and with Whipple Killjoy (hereafter, WK), a large private equity firm from San Francisco, both of which appear to be excited to be part of an arrangement to grow RCC. The transactions contemplated involve, among other things, a series of mergers and acquisitions to be financed by various public and private debt and equity offerings. Briefly summarized, these transactions include: 1. Issue high-yield debt of $550 million. $275 million will be loaned by WK, and the remaining $275 million will be underwritten by MS in a public offering. 2. Issue $250 million convertible preferred stock. All of this stock will be issued to MS and to WK. In three years, the preferred stock will be convertible into common stock, and a secondary public offering will likely take place at that time so that the current financiers will be able to liquidate their investment. 3. Dispose of the directory assistance business for $68 million. Although this business is profitable, it does not fit into the strategic plan as a core service. RCC has a company that is interested in buying the directory assistance business. 4. Acquire FirstCo, a wireless digital communications company, for $650 million. Since the service area is only about 150 miles from RCC, it seems to fit with the strategy of expanding the company’s “wirelessfootprint.” This acquisition will also add 300 employees. 5. Acquire the remaining minority interests in two wireless unconsolidated subsidiaries for $75 million. Currently, RCC is a 25 percent shareholder in each company and carries these as equity investments. Seven other telecommunications companies own the remaining 75 percent, with no one company owning more than 15 percent. The plan is to buy out the other seven shareholders. 6. Merge with A&D Telecommunications Company, A&D is a company that is very similar to RCC, but is only about 30 percent of the size of RCC, based on total revenues. A&D is privately owned by approximately 100 shareholders, mostly members of the Manley family, with Christ Manley as its CEO. The merger plan is to exchange 40 shares of RCC for each share of A&D. As added inducement for pushing this merger to the A&D shareholders, RCC is promising to make Chris Manley the Chief Operating Officer (COO) of RCC and to grant him a cash bonus of $1.2 million if the transaction is approved. 7. “Buildout” the wireless system. This process requires the purchase of licenses and equipment, as well as the constructionof towers. Warren and Larry explain that RCC is especially ready to take advantage of these “ripe” times in the telecommunications industry. The accounting department has assembled projections covering the next five years and, although large losses (as much as $90 million in one year) are projected in the years 2006-2010, the company expects a profit and positive cash flows in 2010. Borrowings will be sufficient to create cash reserves in the early periods to meet debt requirements. Frank Clement sees this project as a tremendous opportunity for the Briarwood office, although it will involve some very difficult accounting and reporting issues that will include filing several registration statements with the SEC. He will surely need the assistance of Michael Bryan from the headquarters office. Luckily, most of the immediate work will take place in the summer, which is usually slow; however, this work might also require individuals to postpone planned vacations. The fees from this type of high-risk work will be billed at premium rates, and they will provide an opportunity to make up for all those years at 80 percent of standard rates. Therefore, this work for RCC should contribute to great financial results in 2005 for the Briarwood City office. The other two partners in the Briarwood office, Andy Stevens and Bernie Richards, are also excited about the opportunity. Mark Grumbles is delighted. He has been pressuring Frank to sell some of JKN’s value-added services, such as wealth management, to the RCC executives and board members. Grumbles comments that after these transactions take place RCC should be a prime candidate for the firm to provide other non-audit services. This situation should also help the Briarwood office attract more audit clients.

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Part 1

The Project

The next few months are very busy for Frank, Tom, and several JKN staff people assigned to the project. Feelings in the office are mixed about the impact of RCC. Everyone wants to be in a successful environment, but not everyone is willing to be challenged by such a large project that involves overtime hours and postponing vacations. Frank and Tom work very well together and are very keen about the success of this project. In fact, they want to exceed RCC’s expectations. The project involves many meetings with the executive team from RCC and the underwriters from MS and WK, along with the professional who represent their interests. Several meetings are held at the MS offices in San Francisco. Since MS is accustomed to working with very large national accounting firms, they are somewhat skeptical of JKN. However, since JKN has been the independent auditor for RCC during the years to be reported in the offering statements, no changes are feasible. Nevertheless, MS hires specialists from the mergers and acquisitions group of a national firm to monitor JKN’s work. These specialists are expected to be heavily involved in the preparation of the pro forma financial information that will be included in the registration statements to be filed with the SEC as part of the planned transactions. Frank and Tom are challenged like they never have been before. Not only are they involved with the RCC project, but they are also maintaining other client responsibilities, including a fraud investigation concerning another client with international operations that will require several trips to Asia in the coming months. Frank and Tom find themselves working weekends and nights and are frequently out of town at meetings. Some tricky audit and accounting issues come up for the RCC project, such as business combinations, accounting for intangible assets, asset impairments, early debt extinguishment, revenue recognition, accounting for derivatives, and issuance of comfort letters to underwriters. Additionally, Frank and Tom discover that the financial statements of A&D must be restated because of errors in previous years that were not

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detected by the local CPA firm. Nevertheless, they receive help from Michael Bryan when needed, and they get through the project. During the period from May to November of 2005, RCC files ten Form 8-Ks, a Form S-3, a Form S-4, and two Form 10-Qs with the SEC. All of these steps require the involvement of JKN. Total billings for the project were approximately $1.2 million, an average of 110 percent of standard rates because firm policy is to bill high-risk SEC work at a premium. Tom comments that he got more public company experience during this six-month period than he had in the entire eight years of his career prior to that time. Frank told the other partners in Briarwood City how lucky he was to have Tom on the project, because Tom really demonstrated his technical talent while gaining the respect of the other outside professionals on the project. Apparently, Larry Cashman and Greg Lowman felt the same way. On one occasion during a meeting at RCC, they hinted very strongly to Tom that they would certainly enjoy having someone with his skills on their team.

Required 1. As the project unfolds, you can see that the client relationship between RCC and JKN is changing in a number of ways. Identify these changes in the auditor-client relationship and explain what might be Frank Clement’s concerns for JKN in the next 12-18 months with respect to the RCC audit? Use the following format to answer: JKN (Auditor)– Client (RCC) Relationship 1. The outside specialists hired by MS on behalf of RCC. 2. Restatement of the A&D’s financial statements. 3. Billing of the project at 110 percent of standard rates. 4. Impact of Section 206 of the Sarbanes-Oxley Act if Tom decided to pursue the “invitation” to take a position on the RCC management team.

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Frank Clement’s Concerns in the Next 12-18 months

Part 2

Year-End Audit

In November 2005, when it came time to plan the year-end audit, Larry Cashman asked Frank and Tom to prepare a fee estimate, knowing that the audit would take on a new dimension because of the recent transactions. Larry also told Frank that RCC would seek proposals from several national accounting firms. Frank had already given RCC’s expansion some thought, and realized that JKN would probably have to compete with the national firms for continued business with RCC. However, Frank also had other business concerns. For example, there was the impact of the client on office attitude and morale. Now, RCC would be the largest and most complex client for the Briarwood City office. No longer would fees averaging 80 percent of standard rates. Some staff would rather not be involved in such a complex pressure situation. On the other hand, more ambitious staff would be disappointed if they could not participate in such an important assignment. Finally, after discussions with Mark Grumbles, Stevens, and Richards, Frank quotes a fee of $750,000 for the 2005 audit and tax work, including $200,000 applicable to the attestation report on internal controls as required by Section 404 of the Sarbanes-Oxley Act of 2002. Frank and Tom estimate that this fee will result in 100 percent of standard rates, but they cannot be as sure of themselves as in the past because of the uncertainty about how the new RCC will function. The proposal is sent to the RCC audit committee; very soon thereafter, Larry calls Frank and tells him to reduce the quote. Frank agrees to reduce the quote to $700,000, but no more. He believes that 93 percent of standard rates will still be acceptable, assuming an accurate estimate. After all the fee quotes are in, which includes JKN and two of the national firms, Frank receives a call from Warren England, the CEO at RCC, who mentions that he would really like to see JKN continue as auditors, but explains the pressure from the new investors, who have a representative on the audit committee. Warren also says the JKN quote is substantially higher than the competitors’ quotes and wants to know if line pricing. Frank is sure that the larger firms are attempting to “buy the business,” but he also realizes that they this quote really reflects bottomhave substantially greater resources and are in a better position to negotiate. Nevertheless, he agrees to reduce the estimate once more, this time to $650,000.

Required 2 a. Identify some JKN’s engagement risks based on the information regarding the Briarwood City office and the history of the audit client relationship with RCC. Engagement risk is the risk that JKN will suffer harm because of a client relationship, even though the audit report issued to the client was correct. 2 b. Identify somerisk factors associated with RCC’s growth strategy 2 c. With respect ot the identified JKN’s engagement risks in 2 a. and the identified risk factors associated with RCC’s growth strategy in 2 b., explain any concerns you have regarding the following issues: 1. JKN’s willingness to negotiate its fee estimate to RCC. 2. JKN’s ability to successfully complete the year-end audit for RCC. 3. JKN’s ability to continue with this client. Use the following format to answer: 1. JKN’s willingness toIssues negotiate its fee estimate to RCC. 2. JKN’s ability to successfully complete the yearend audit for RCC. 3. JKN’s ability to continue with this client.

Explain any Concern You Have


In your response, refer to Chapter 3 for a discussion on relevant professional ethics, for example, Rule 101 on independence f the o AICPA’s Code of Professional Conduct and the PCOAB’s Auditor Independence Rules. Note: You must answer both Parts 1 and 2 to earn the extra credit point.

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Chapter 6 Audit Plan - Objectives Chapter Learning Outcomes (LOs) Checklist


LO6-1 Distinguish between overall audit objective and specific audit objectives.

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LO6-2 Explain the auditor’s responsibility to detect and report errors and fraud.

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LO6-3 Identify the fraud risk factors (the Fraud Triangle) relating to fraudulent financial reporting and misappropriation of assets.

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LO6-4 Explain the auditor’s responsibility to detect and report illegal acts.

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LO6-5 Discuss specific audit objectives.

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LO6-6

Understand the relationships among the five basic categories of management assertions, the eight categories of specific audit objectives, and the three aspects of information reflected in the financial statements.

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Chapter 6 Audit Plan – Objectives In conducting either a financial audit or an integrated audit, the auditor accomplishes two categories of audit objectives: an overall audit objective and specific audit objectives. The overall audit objective relates to the auditor’s responsibilities for detecting material misstatements, whereas the specific audit objectives relate to the audit procedures that the auditor uses to detect material misstatements. Figure 6-1 shows the two categories of audit objectives Figure 6-1 Two Categories of Audit Objectives

The Audit Process

Audit Plan

Tests of Controls

Tests of Balance


Audit Report


Objectives CH 6

Financial Audit

Integrated Audit

Evidence CH 7

1. Overall Audit Objective Internal Control CH 8

a. Form an Audit Opinion b. Detect and Report Errors and Fraud c. Detect and Report Illegal Act

Materiality and Risk CH 9 2. Specific Audit Objectives

Audit Program CH 10

a. Divide the Financial Statements into 5 Major Transaction Cycles b. Identify 5 Basic Categories of Management Assertions within each Transaction Cycle c. Map the 5 B asic Categories of Management Assertions into 8 Types of Specific Audit Objectives d. Group the 5 Basic Categories of Management Assertions and the 8 Types of Specific Audit Objectives into 3 Aspects of Information Reflected in the Financial Statements


Overall Audit Objective Form an Audit Opinion

AU 200 Overall Objectives of the Independent Auditor and the Conduct of an Audit in Accordance With Generally Accepted Auditi ng Standar ds states: The objective of the ordinary audit of financial statements by the independent auditor is the expression of an opinion on the fairness with which they present fairly, in all material respects, financial position, results of operations, and its cash flows in conformity with generally accepted accounting principles .

In order to accomplish this overall objective, the auditor is responsible for detecting material misstatements in the financial statements as AU 200 further states The auditor has a responsibility to plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether caused by error or fraud. Because of the nature of audit evidence and the characteristics of fraud, the auditor is able to obtain r easonable, but not absolute, assura nce that material misstatements are detected.

Detecting Errors and Fraud

AU 240 Conside ration of Fr aud in a Financial Statement Audit defines “misstatements” into “error and fraud”, and provides expanded guidance on the auditors’ responsibility for fraud det ection (also known as fraud audit). Errors are unintentional misstatements (e.g., mistakes in journal entries) or omissions in financial statements. Fraud, in contrast, is intentional fraudulent financial misstatement (e.g., falsification of accounts) or omission in financial statements, and misappropriation of assets (e.g., theft of inventory). As indicated by the definitions, intent is the primary difference between an error and a fraud. AU 240 requires the auditor to:

 Consider the risk of errors and frauds (also known as fraud risks) in an audit plan. An auditor should consider the risk that errors or frauds may occur while planning an audit engagement. The auditor should consider the risk factors at both the financial statement level and at the individual account balance or class of transactions level. The fraud risk factors relating to fraudulent financial reporting is presented in Table 6-1. The fraud risk factors relating to misappropriation of assets is presented in Table 6-2. For each of these two types of fraud, the fraud risk factors are further classified based on three characteristics generallytopresent fraud to occur: 1. Incentives/Pressures or other employees have incentives or pressures commitfor fraud. – Management 2. Opportunities – Circumstances provide opportunities for management or employees to commit fraud. 3. Attitudes/Rationalization – An attitude, character, or set of ethical values exist that allow management or employees to commit a dishonest act or they are in an environment that causes them to rationalize committing a dishonest act. These three conditions are often referred to as the “Fraud Triangle.” The auditor should also consider the risks of material misstatement due to three common fraud conditions throughout the audit. These common fraud conditions may be identified during fieldwork that change or support a judgment regarding the assessment of the fraud risks. Table 6-3 presents examples of the three common fraud conditions that the auditor should consider throughout the audit.

 Increase emphasis on professional skepticism. Professional skepticism is an attitude that includes a questioning mind and a critical assessment of audit evidence. Putting aside any prior beliefs as to management's honesty, members of the audit team must exchange ideas or brainstorm how frauds could occur. These discussions are intended to identify fraud risks and should be conducted while keeping in mind the characteristics that are present when frauds occur: incentives, opportunities, and ability to rationalize. Throughout the audit, the engagement team should think about and explore the question, "If someone wanted to perpetrate a fraud, how would it be done?" From these discussions, the engagement team should be in a better position to design audit tests responsive to the risks of fraud.  Discuss fraud with management. The engagement team is expected to inquire of management and others in the organization as to the risk of fraud and whether they are aware of any frauds. The auditors should make a point of talking to employees in and outside management. Giving employees and others the opportunity to "blow the whistle" may encourage someone to step forward. It might also help deter others from committing fraud if they are concerned that a co-worker will turn them in. 

Perform unpredictable audit test.

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During an audit, the engagement team should test areas, locations and accounts that otherwise might not be tested. The team should design tests that would be unpredictable and unexpected by the client.

 Respond to management override of controls. Because management is often in a position to override controls in order to commit financial-statement fraud, the standard includes procedures to test for management override of controls on every audit. Three fraud testing procedures that the auditor must perform in every audit are briefly described in Table 6-4. AU 240 Consideration of Fraud in a Financial Statement Audit suggests a 10-step approach to integrate fraud audit into the audit of financial statements. Typically, this 10-step fraud audit is to be integrated as an ongoing audit process throughout the audit of financial statements as follows: 1. Understand the nature of fraud and the manner in which fraud may be committed at the audit preplan. 2. Develop and maintain professional skepticism throughout the audit process. 3. Brainstorm and share knowledge of fraud with other audit team members at the audit preplan and throughout the audit process. 4. Obtain information useful in identifying and assessing fraud risks at the audit plan. 5. Identify specific fraud risk factors at the audit plan (see Table 6-1 and Table 6-2). 6. Evaluate the eff ectiveness of client’s internal control against the specific fraud risk factors at the audit plan and tests of controls (TOC). 7. Perform and adjust audit procedures relating to the specific fraud risk factors at the tests of controls (TOC) and tests of balances (TOB) (see Table 6-4). 8. Evaluate evidence and consider common fraud conditions and determine whether fraud specialists are needed to complete the fraud audit at the completing the audit (CTA) (see Table 6-3). 9. Communicate and report fraud to management, audit committee, and the board of directors at the audit report (see Table 6-5). 10. Document Step 1 through to Step 10 above throughout the audit process. Finally, it should be noted that AU 240 states that even a properly planned and performed audit may not detect a material misstatement resulting from fraud because of 1. The concealment aspect of fraudulent activity such as fraud often involves collusion or falsified documents and 2. The need to apply professional judgment in the identification of evaluation of fraud risk factors and other conditions. Table 6-1 Fraud Risk Factors Relating to Misstatement Arising from Fraudulent Financial Reporting

Fraud Risk Factors for Fraudulent Financial Reporting Incentives/Pressures (1) Financial stability or profitability is threatened by economic, industry, or client operating conditions, such as:

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High degree of competition or market saturation, accompanied by declining margins. High vulnerability to rapid changes, such as changes in technology, product obsolescence, or interest rates. Significant decline in customer demand and increasing business failures in either the industry or overall economy. Operating losses making the treat of bankruptcy, foreclosure, or hostile takeover imminent.

Recurring negative cash flows from operations or an inability to generate cash flows from operations while reporting earnings and earnings growth.

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Rapid growth or unusual profitability especially compared to that of other companies in the same industry. New accounting, statutory, or regulatory requirements.

(2) Excessive pressure exists for management to meet the requirements or expectations of third parties due to the following:

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Profitability or trend level expectations of investment analysts, institutional investors, significant creditors, or other external parties, including expectations created by management in, for example, overly optimistic press releases or annual report messages.

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Need to obtain additional debt or equity financing to stay competitive – including financing of major research and development or capital expenditures.

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Marginal ability to meet exchange listing requirements or debt repayment or other debt covenant requirements.

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Perceived or real adverse effects of reporting poor financial results on significant pending transactions, such as business combinations or contract awards. (3) Information available indicates that management or the board of directors’ personal financial situation is threatened by the entity’s financial performance arising from the following:


Fraud Risk Factors for Fraudulent Financial Reporting

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Significant financial interests in the entity.

Significant portions of their compensation (e.g., bonuses, stock options, and earn-out arrangements) being contingent upon achieving aggressive targets for stock price, operating results, financial position, or cash flow.

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Personal guarantees of debts of the entity.

(4) There is excessive pressure on management or operating personnel to meet financial targets set up by the board of directors or management, including sales or profitability incentive goals.

Opportunities (1) The nature of the industry or t he client’s operations provides opportunities to engage in fraudulent financial reporting thatcan arise from the following:

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Significant related-party transactions not in the ordinary course of business or with related entities not audited or audited by another firm.

A strong financial presence or ability to dominate a certain industry sector that allows the entity to dictate terms or conditions to suppliers arm’s length transactions. or customers that may result in inappropriate or non-

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Assets, liabilities, revenues, or expenses based on significant estimates that involve subjective judgments or uncertainties that are difficult to corroborate.

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Significant, unusual, or highly complex transactions, especially those close to period end that pose difficult “substance over form” questions.

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Significant operations located or conducted across international borders in jurisdictions where differing business environments and cultures exist.

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Significant bank accounts or subsidiary or branch operations in tax-haven jurisdictions for which there appears to be no clear business justification. (2) There is ineffective monitoring of management as a result of the following:

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Domination of management by a single person or small group without compensating controls. Ineffective board of directors or audit committee oversight over the financial reporting process and internal control.

(3) There is a complex or unstable organizational structure, as evidenced by the following:

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Difficulty in determining the organization or individuals who have controlling interest in the entity. Overly complex organizational structure involving unusual legal entities or managerial lines of authority. High turnover of senior management, counsel, or board members.

(4) Internal control components are deficient as a result of the following:

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Inadequate monitoring of controls, including automated controls and controls over interim financial reporting. High turnover rates or employment of ineffective accounting, internal audit, or information technology staff. Ineffective accounting and information systems, including situations involving material weaknesses.

Attitudes/Rationalizations Risk factors reflective of attitudes/rationalizations by board members, management, or employees that allow them to engage in and/or justify fraudulent financial reporting may not be susceptible to observation by the auditor. Nevertheless, the auditor who becomes aware of the existence of such information should consider it in identifying the risks of material misstatement arising from fraudulent financial reporting. For example, auditors may become aware of the following information that may indicate a risk factor:

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Ineffective communication, implementation, support, or enforcement of the client’s values or ethical standards by managementor the communication of inappropriate values or ethical standards.

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Nonfinancial management’s excessive participation in or preoccupation with the selection of accounting principles or the determination of significant estimates.

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Known history of violations of securities laws or other laws and regulations, or claims against the client, its senior management, or board members alleging fraud or violations of laws and regulations.

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Excessive interest by management in maintaining or increasing the entity’s stock price or earnings trend.

A practice by management of committing to analysts, creditors, and other third parties to achieve aggressive or unrealistic forecasts. Management failing to correct known material weaknesses on a timely basis. An interest by management in employing inappropriate means to minimize reported earnings for tax-motivated reasons. Recurring attempts by management to justify marginal or inappropriate accounting on the basis of materiality.

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Fraud Risk Factors for Fraudulent Financial Reporting

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The relationship between management and the current or predecessor auditor is strained, as exhibited by the following: (1) Frequent disputes with the current or predecessor auditor on accounting, auditing, or reporting matters. (2) Unreasonable demands on the auditor, such as unreasonable time constraints regarding the completion of the audit or the issuance of the auditor’s report. (3) Formal or informal restrictions on the auditor that inappropriately limit access to people or information or the ability to communicate effectively with the board of directors or audit committee. (4) Domineering management behavior in dealing with the auditor, especially involving attempts to influence the scope of the auditor’s work or the selection or continuance of personnel assigned to or consulted on the audit engagement.

Source: AU 240

Table 6-2 Fraud Risk Factors Relating to Misstatements Arising from Misappropriation of Assets

Fraud Risk Factors for Misappropriation of Assets Incentives/Pressures (1) Personal financial obligations may create pressure on management or employees with access to cash or other assets susceptible to theft to misappropriate those assets. (2) Adverse relationships between the entity and employees with access to cash or other assets susceptible to theft may motivate those employees to misappropriate those assets. For example, adverse relationships may be created by the following:

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Known or anticipated future employee layoffs. Recent or anticipated changes to employee compensation or benefit plans. Promotions, compensation, or other rewards inconsistent with expectations.

Opportunities (1) Certain characteristics or circumstances may increase the susceptibility of assets to misappropriation. For example, opportunities to misappropriate assets increase when there are the following:

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Large amounts of cash on hand or processed. Inventory items that are small in size, of high value, or in high demand. Easily convertible assets, such as bearer bonds, diamonds, or computer chips. Fixed assets that are small in size, marketable, or lacking observable identification of ownership.

(2) Inadequate internal control over assets may increase the susceptibility of misappropriation over those assets. For example, misappropriation of assets may occur because there is the following:

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Inadequate segregation of duties or independent checks.

Inadequate management oversight of employees responsible for assets, for example, inadequate supervision or monitoring of remote locations.

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Inadequate job applicant screening of employees with access to assets. Inadequate record keeping with respect to assets. Inadequate system of authorization and approval of transactions, for example, in purchasing. Inadequate physical safeguards over cash, investments, inventory, or fixed assets. Lack of complete and timely reconciliations of assets. Lack of timely and appropriate documentation of transactions, for example, credits for merchandise returns. Lack of mandatory vacations for employees performing key control functions.

Inadequate management understanding of information technology, which enables information technology employees to perpetrate a misappropriation.

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Inadequate access of controls over automated records, including controls over and review of computer systems event logs.

Attitudes/Rationalizations Risk factors reflective of employee attitudes/rationalizations that allow them to justify misappropriations of assets, are generally not susceptible to observation by the auditor. Nevertheless, the auditor who becomes aware of the existence of such information should consider it in identifying the risks of material misstatement arising from misappropriation of assets. For example, auditors may become aware of the following attitudes or behavior of employees who have access to assets susceptible to misappropriation:

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Disregard for the need for monitoring or reducing risks related to misappropriations of assets. Disregard for internal control over misappropriation of assets by overriding existing controls or by failing to correct known internal


Fraud Risk Factors for Misappropriation of Assets control deficiencies.

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Behavior indicating displeasure or dissatisfaction with the company or its treatment of the employee. Changes in behavior or lifestyle that may indicate assets have been misappropriated.

Source: AU 240

Table 6-3 Examples of the Three Common Fraud Conditions the Auditor Should Consider Throughout the Audit

Common Fraud Conditions

Examples

(1) Transactions that are not recorded in a complete or timely manner. Discrepancies in the accounting (2) Transactions that are improperly recorded as to amount, accounting period, or classification. records. (3) Unsupported or unauthorized balances or transactions. (4) Last-minute adjustments that significantly affect financial results. (5) Evidence of employees’ access to systems and records inconsistent with their authorized duties. (6) Tips or complaints to the auditor about alleged fraud. Missing documents.  Conflicting or missing evidential (1) (2) Documents that appear to have been altered. matter. (3) Photocopied or electronically transmitted documents when srcinal documents are expected. (4) Significant unexplained items on reconciliations. (5) Inconsistent, vague, or implausible responses from management or employee to inquiries. (6) Unusual discrepancies between the client’s records and confirmation replies. (7) Missing inventory or physical assets of significant magnitude. (8) Unavailable or missing electronic evidence inconsistent with the record retention policies. (9) No record of key systems development, program changes, and implementations. (1) Denial of access to records, facilities, certain employees, customers, vendors, or others.  Problematic or unusual (2) Undue time pressure imposed by management to resolve complex or contentious issues. relationships between the auditor and (3) Complaints by management about the conduct of the audit. management. (4) Management intimidation of audit team members in resolution of disagreements. (5) Unusual delays by the management in providing requested information. (6) Unwillingness to facilitate auditor’s testing using computer-assisted audit techniques (CAATs). (7) Denial of access to key IT operations staff and facilities. (8) Unwillingness to add or revise disclosures in the financial statements.

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Table 6-4 Three Fraud Testing Procedures the Auditor Must Perform to Test for Management Override of Controls on Every Audit

Procedure

Brief Description

Fraud often involves the recording of inappropriate or unauthorized journal entries even when Examine journal entries and other there are effective internal controls in place. The auditor is required to: adjustments for evidence of possible (1) Obtain an understanding of the client’s financial reporting process and the controls over journal misstatements due to fraud. entries and other adjustments. (2) Identify and select journal entries and other adjustments for testing. (3) Determining the timing of the testing. (4) Inquire of individuals involved in the financial reporting process about inappropriate or unusual activity in processing journal entries and other adjustments. financial reporting is often accomplished through intentional misstatement of  Review accounting estimates for Fraudulent accounting estimates. The auditor is required to: biases that could result in material (1) Consider the potential for management bias when reviewing current year estimates. misstatement due to fraud. (2) Perform a retrospective review of prior year estimates to identify any changes in the management’s judgments and assumptions that might indicate a potential bias. (3) Evaluate whether circumstances producing bias estimates represent a risk of a material misstatement due to fraud. auditor should gain an understanding of the client’s rational for significant unusual  Evaluate the business rationale for The transactions that suggest fraudulent financial reporting or misappropriation of assets. The auditor is significant unusual transactions. required to consider whether: (1) The form of such transactions is overly complex. (2) Management has discussed the nature of and accounting for such transactions with the audit committee.

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(3) Management is placing more emphasis on the need for a particular accounting treatment (i.e., its form) than on the underlying economics of the transaction (i.e., its substance). (4) Transactions that involve unconsolidated related parties, including special purpose entities, have been properly reviewed and approved by the audit committee. (5) Transactions involve previously unidentified related parties that do not have the substance or the financial strength without assistance from the client.

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Reporting Errors and Fraud

Errors detected by the auditor should be corrected through journal entries, whereas frauds detected by the auditor, in contrast, should be handled as shown in Table 6-5. Table 6-5 Auditor's Reporting of Fraud

Condition

Reporting Requirement

(1) The auditor determines that the fraud The auditor should: has no material effect on the financial (b) (a) Refer the fraud a level management that isfor at other least one above those involved. statements. Be satisfied thattothe fraudofhas no implications partslevel of the audit. (2) The auditor determines that the fraud The auditor should: has material effect on the financial (a) Insist that the financial statements be revised. If management agrees, should issue an statements. unqualified opinion. If management refuses, should issue a qualified or an adverse opinion. (b) Report the fraud to the board of directors or the audit committee. (3) The auditor is precluded from The auditor should: investigating the effect of the fraud. (a) Issue a qualified opinion or disclaimer on the basis of a scope limitation. (b) Report the matter to the board of directors or the audit committee

Detecting Illegal Acts

An auditor's professional responsibility to illegal acts by clients first surfaced in the late 1970s, after Congress passed the Foreign Corrupt Practices Act of 1977. This Act requires public companies to refrain from making bribes to foreign governments and to maintain adequate internal control to prevent bribes from occurring. Arguing that auditors generally lack the expertise in detecting illegal acts, the AICPA issued AU 328 Illegal Acts by Clients, which stated that the auditors have no responsibility for detecting illegal acts committed by their clients. They are only responsible for reporting suspected illegal acts to the appropriate authorities of their clients. In 1988, the AICPA issued AU 317 Illegal Acts by Clients, which superseded AU 328. AU 317 defines illegal acts by clients as violations of laws or governmental regulations. It also expands and clarifies an auditor’s responsibility to illegal acts by clients. Recently, u nder the Auditing Standards Board’s “Clarity Project,” this standard is now known as AU 250 Considerations of Laws and Regulations in an Audit of Financial Statements , which requires the direct auditoreffects to detect twofinancial differentstatements. types of illegal acts committed by clients: 1. Illegal acts with on the These are material illegal acts relating to laws and governmental regulations that have a direct effect on the financial statements, for example, whether a provision for income taxes has been properly reflected in the financial statements in conformity with the IRS. Here, the auditor has the responsibility to design the audit to provide reasonable assurance of detecting such illegal acts. In other words, the responsibility to detect illegal acts that have a direct effect on the financial statements is the same as the responsibility to detect errors and frauds. 2. Illegal acts with indirect effects on the financial statements. These are material illegal acts relating to laws and governmental regulations that have only an indirect effect on the financial statements, for example, activities that violate regulations under the Food and Drug Administration (FDA), environmental protection agencies and equal employment opportunity agencies. These activities should be accrued or disclosed as contingent liability in the financial statements. However, the auditor may not be aware of such illegal acts unless s/he is informed about them. An example is insider trading. While the direct effects of the purchase or sale of securities may be disclosed, their indirect effect, the possible contingent liability for violating securities laws, may not be disclosed. If the auditor is informed or aware of illegal acts that indirectly affect the financial statements, s/he has the responsibility to apply audit procedures specifically directed to ascertaining the probability of such illegal acts as follows:

 When there is no suspicion (no probability) of illegal acts. The auditor should inquire of management concerning: 1. the client's compliance with laws and regulations, 2. the client's policies that may prevent illegal acts, and 3. directives issued by the client and periodic representations obtained by the client concerning compliance with laws and regulations. The auditor should also request a written representation from the client's management (also known as a client's representation letter) stating that no violation or possible violation of laws or regulations has occurred that need to be disclosed or accrued (i.e., provision for contingency).


 When there is suspicion (probability) of illegal acts. The auditor should 1. Inquire of management at a level above the persons involved to obtain information on the nature of the acts and the circumstances surrounding the acts. 2. Consult with the client's legal counsel or other specialists about applications of law and possible effects of the act on the financial statements. 3. Perform additional audit procedures as necessary to obtain a further understanding of the nature of the acts such as a. Examine supporting documentation and compare with accounting records, b. Confirm information with third parties, c. determine if the transaction has been properly authorized, and d. Consider whether similar transactions have occurred and perform procedures to identify them. Finally, it should be noted that AU 250 requires the auditor to provide reasonable assurance that direct effect illegal acts are detected (the same reasonable assurance that error and frauds are detected), but it has no such requirement for indirect effect illegal acts. Reporting Illegal Acts

The auditor is responsible to communicate and report illegal acts as follows:

 Communication The auditor should inform the audit committee or any other group inside the client having equivalent authority about the illegal acts. The communication may be oral or written. If oral, the auditor should document it. Moreover, if it is necessary to disclose the illegal acts to outside parties such as the SEC, a successor auditor or a subpoena issued by a court, the auditor should seek legal advice.  Reporting The auditor must report illegal acts by clients whether the illegal acts have material direct or indirect effects on the clients' financial statements. The reporting requirements are as shown in Table 6 -4 below: TABLE 6-4 Auditors' Reporting of Illegal Acts

Illegal Acts

Reporting Requirement

(1) Material illegal acts are not accrued for or disclosed by the client.

Issue a qualified or an adverse opinion depending on the extent of materiality. (2) The auditor is prevented by the client from obtaining sufficient appropriate evidenceIssue a disclaimer opinion. concerning the illegal acts. (3) The auditor is not prevented by the client but is unable to obtain sufficientIssue a qualified opinion. appropriate evidence concerning the illegal acts. (4) The client refuses to accept the qualified, adverse, or disclaimer opinion issued byContact the audit committee and consider the auditor concerning the illegal acts. withdrawing from the engagement.

Specific Audit Objectives

In conducting either a financial audit or an integrated audit, the auditor accomplishes specific audit objectives in four distinctive steps: 1. Divide the financial statements into five major transaction cycles. 2. Identify five basic categories of management assertions within each transaction cycle. 3. Map the five basic categories of management assertions into eight specific audit objectives. 4. Groups the five basic categories of management assertions and the eight specific audit objectives into three aspects of information reflected in the financial statements. Divide the Financial Statements into Five Major Transaction Cycles

In a typical financial statement audit, a client's financial statements are divided into smaller segments. The division makes the audit more manageable and facilitates the assignment of members of the audit team to each segment. A conventional way to segment the financial statements is to keep closely related types of transactions and account balances in the same segment, also known as the Transaction Cycle Approach. An example of the transaction cycles approach is to group related class of transactions, such as sales and sales returns, and account balances, such as accounts receivable and cash in bank, in the trial balance to a revenue cycle. A client's financial statements are usually divided into the following five interrelated transaction cycles:

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1. Capital cycle. A client begins by obtaining capital, usually in the form of cash which links the capital cycle to the general cash. 2. Expenditure cycle. Cash is used to purchase raw materials to produce goods and services which link the general cash to the expenditure cycle. 3. Payroll cycle. Cash is also used to hire labor and administrative personnel which link the general cash to the payroll cycle. 4. Inventory cycle. The combined output of the expenditure and payroll cycles is the input to the inventory cycle. The inventory is subsequently sold and the billings and collection activities link the inventory cycle to the revenue cycle. 5. Revenue cycle. The cash generated in the revenue cycle is used to pay dividends and interest in the capital cycle and to restart the cycles again. General cash and investments are usually not stand alone transaction cycles. They are usually audited as part of the above five transaction cycles. Identify Five Basic Categories of Management Assertions within each Transaction Cycle

Assertions are explicit and implicit representations by management that are embodied in financial statements. Much of an auditor's work during a financial audit or an integrated audit is to attest these financial statement assertions made by the management. AU 500 Audit Evidence and AS 15 Audit Evidence identify five basic categories of implicit or explicit assertions made by the management: 1. Existence or Occurrence. Implicit or explicit assertion made by the management that asset and liability balances stated in the balance sheet actually exist at the balance sheet date and that revenue and expense transactions stated in the income statement actually occurred during the accounting period. For example, management asserts that inventories in the balance sheet actually exist at balance date and that sales in the income statement actually occurred during the accounting period. 2. Completeness. Implicit or explicit assertion made by the management that all accounting transactions and balances that should have been recorded in the financial statements have been recorded. For example, management asserts that there are no unrecorded inventories and that all sales occurred are included in the income statement. 3. Rights and Obligations. Implicit or explicit assertion made by the management that assets stated in the financial statements are actually owned by the client and liabilities stated in the financial statements are actually owed by the client. For example, management asserts that inventories are owned by the company and that accounts payable are owed to other parties. 4. Valuation and Allocation. Implicit or explicit assertion made by the management that asset and liability balances stated in the balance sheet, and revenue and expenses transactions stated in the income statement have all been recorded in the financial statement at the appropriate amount. For example, management asserts that inventories are valued at the lower of cost or market and that depreciation is made to plant and equipment in the appropriate amount. 5. Presentation and Disclosure. Implicit or explicit assertion made by the management that all components of the financial statements are properly classified, described, and disclosed in conformity with GAAP. For example, management asserts that amounts presented as extraordinary items in the income statement are properly classified and described. The auditor identifies the above five basic categories of implicit or explicit assertions for each account within a particular transaction cycle. Map the Five Basic Categories of Management Assertions into Eight Types of Specific Audit Objectives

The auditor maps the management's assertions that have been identified into specific audit objectives. These specific audit objectives are almost identical to the management's financial statement assertions because the auditor's work is to attest these financial statement assertions made by the management. The reasons that specific audit objectives and management assertions are not identical are management's assertions are not always those of the auditor and the auditor needs additional guidance (specific audit objectives) in considering the client's internal control and in accumulatingprinciples sufficientunderlying appropr iate evidence required by the “Performance” category of the AICPA’s four fundamental an audit. The eight types of specific audit objectives are: 1. Validity. The specific objective of verifying that the financial items included in the financial statements should actually be included.


2. Completeness. The specific objective of verifying that the financial items that should be included in the financial statements have actually been included. 3. Ownership. The specific objective of verifying that assets included in the financial statements are indeed owned by the client. 4. Valuation. The specific objective of verifying that financial items included in the financial statements are properly valued. 5. Classification. The specific objective of verifying that financial items have been properly classified in the financial statements. 6. Cutoff. The specific objective of verifying that transactions occurring near the balance sheet date have been recorded in the proper accounting period. 7. Accuracy. The specific objective of verifying that account balances agree with related subsidiary ledger amounts and the total in the general ledger. 8. Disclosure. The specific objective of verifying that financial items are properly presented in the financial statements and the related disclosures are clearly expressed. The five basic categories of management assertions are mapped into the eight types of specific audit objectives as follows: Management Assertions 1. Existence or Occurrence 2. Completeness 3. Rights and Obligations 4. Valuation or Allocation

5. Presentation and Disclosure

Specific Audit Objectives 1. Validity (change to Existence or Occurrence) 2. Completeness 3. Ownership (change to Rights and Obligations) 4. Valuation (change to Valuation and Allocation) 5. Classification 6. Cutoff 7. Accuracy 8. Disclosure (change to Understandability)

Group the Five Basic Categories of Management Assertions and the Eight Types of Specific Audit Objectives into Three Aspects of Information Reflected in the Financial Statements

In 2006, consistent with international auditing standards (ISAs), AU 500 Audit Evidence groups the five basic categories of management assertions and the eight types of specific audit objectives into three aspects of information reflected in the financial statements as follows: 1. Transaction-related information. Assertions (objectives) about classes of transactions and events during the period under audit. 2. Balance-related information. Assertions (objectives) about account balances at period end. 3. Presentation-related information. Assertions (objectives) about presentation and disclosure. Under these three aspects of information, the specific audit objectives of “validity” is now changed to “existence or occurrence”; “ownership” to “rights and obligations”; “valuation” to “valuation and allocation,” and “disclosure” to “understandabilit y.” The eight types of specific audit objectives are now defined as follows: 1. Existence – the specific audit objective of verifying that all assets, liabilities, and equity interests included in the financial statements actually exist at the date of the financial statements. Occurrence – the specific audit objective of verifying that all transactions and events that have been recorded have occurred, disclosed, and pertain to the client. 2. Completeness – the specific audit objective of verifying that all transactions and events, assets, liabilities, and equity interests that should have been recorded and included in the financial statements have been recorded and included. 3. Rights and Obligations – the specific audit objective of verifying that the client holds or controls the rights to assets and that liabilities are the obligation of the client. 4. Valuation and Allocation – the specific audit objective of verifying that all assets, liabilities, and equity interests are included in the financial statements at appropriate amounts and any resulting valuation or allocation adjustments areClassification recorded appropriately. 5. – the specific audit objective of verifying that all transactions and events have been recorded in the proper accounts and that financial and other information is presented and described appropriately. 6. Cutoff – the specific audit objective of verifying that all transactions and events have been recorded in the correct accounting period.

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7. Accuracy – the specific audit objective of verifying that amounts and other data relating to recorded transactions and events have been recorded appropriately and that financial and other information are disclosed fairly. 8. Understandability – the specific audit objective of verifying that financial and other information in disclosures are expressed clearly. Table 6-5 describes the five management assertions and the eight specific audit objectives grouped into the three aspects of information reflected in the financial statements. Table 6-5 Management Assertions and Specific Audit Objectives Grouped into Three Aspects of Information Reflected in the Financial Statements 1. Transaction-Related Information Assertions (Objectives) about Classes of Transactions and Events during the Period under Audit

Assertions (Objectives) about Account Balances at Period End

3. Presentation-Related Information Assertions (Objectives) about Presentation and Disclosure

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Occurrence Transactions and events that have been recorded have occurred and pertain to the client. Completeness All transactions and events that should have been recorded have been recorded. Accuracy Amounts and other data relating to recorded transactions and events have been recorded appropriately.

Classification Transactions and events have recorded in the proper accounts.

2. Balance-Related Information

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Existence Assets, liabilities, and equity interests exist. Completeness All assets, liabilities, and equity interests that should have been recorded have been recorded. Valuation and Allocation Assets, liabilities, and equity interests are included in the financial statements at appropriate amounts and any resulting valuation or allocation adjustments are recorded appropriately.

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been

Occurrence Disclosed events and transactions have occurred. Completeness All disclosures that should have been included in the financial statements have been included. Accuracy and Valuation Financial and other information are disclosed fairly and at appropriate amounts.

Classification and Understandability Financial and other information is presented and described appropriately, and disclosures are expressed clearly.

Cutoff Transactions and events have been recorded in the correct accounting period.

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Rights and Obligations The client holds or controls the rights to assets, and liabilities are the obligation of the client.

An Audit Program for Transaction-, Balance-, and Presentation-Related Information

Following a certain audit test methodology, auditors develop an audit program (to be discussed in Chapter 10) that contains all the audit procedures they would use to test the three aspects (transaction-, balance-, and presentationrelated) of information reflected in the financial statements. For example, an audit program may prescribe audit procedures for transaction-related information such as transactions relating to inventory actual occurred (i.e., occurrence), that they are completed (i.e., completeness or no valid transactions were left out), that they are classified properly (i.e., classification, e.g., as an asset rather than an expense), and that they are recorded accurately (i.e., accuracy) and in the correct period (i.e., cutoff). Similarly, the audit program may prescribe audit procedures for balance-related information such as inventory represented in the inventory account balance exists (i.e. existence), the client owns (i.e., rights and obligations) the inventory, that the balance is complete (i.e., completeness), and that the inventory is properly valued (i.e., valuation and allocation). Finally, the audit program may prescribe audit classify procedures for the presentation-related information such as the financial properly and present classification) inventory (e.g., inventory is appropriately presentedstatements as a current asset on the balance sheet) (i.e., and that all required disclosures (i.e., understandability) having to do with inventory (e.g., footnote indicating that the client uses the LIFO inventory method) are complete (i.e., completeness), accurate (i.e., accuracy), and understandable (i.e., understandability).


Finally, it should be noted that: 1. Auditors in practice may use different terms to express the management assertions and specified audit objectives as long as all the three aspects of information (i.e., transaction-, balance, and presentation-related) in Table 6-7 are addressed by prescribing the appropriate audit procedures. 2. There are overlaps among some of the transaction-related and balance-related information. For example: a. If some sales were recorded in the current year that should have been recorded in the subsequent year (i.e. transaction-related cutoff), the related accounts receivable do not exist at the balance sheet date (i.e., balance-related existence). b. If some sales that took place in the current year were not recorded until the subsequent year (i.e., transactionrelated cutoff), current year sales and accounts receivable are not complete (i.e., balance-related completeness ). c. If some expenses are inappropriately capitalized (i.e., transaction-related classification ), the related expenses are not complete (i.e. transaction-related completeness ) and the related assets for not exist ( i.e., balance-related existence). 3. Although all balance-related assertions (objectives) apply to nearly every account, not every assertion (objective) is equally important for each account. Recognizing the assertions (objectives) that deserve the most emphasis depends on an understanding of the client’s business and of the particular type of account being audited. For example, auditors typically consider the completeness assertion (objective) to be the most important assertion (objective) for liability accounts for two reasons. First, when all obligations are not properly included in the liability account, the result is an understatement of liabilities and often an overstatement of net income. Second, management is more likely to have an incentive to understate a liability than to overstate it.

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Which of the following statements is true? a. The auditor is responsible to search for errors and frauds. b. The auditor is responsible to provide complete assurance of detecting errors and fraud. c. The auditor is not responsible for detecting errors and frauds. d. The auditor is responsible to provide reasonable assurance of detecting errors and fraud.

6-2

When an auditor is informed or aware of illegal acts that indirectly affect the client's financial statements, the auditor has the responsibility to a. design the audit to provide reasonable assurance of detecting such illegal acts. b. apply audit procedures specifically directed to ascertaining the probability that such illegal acts have occurred. c. design the audit to provide complete assurance of detecting such illegal acts. d. apply specific audit procedures thatwill ferret out such illegal acts.

6-3

Implicit or explicit assertionmade by the management that asset and liability balances statedin the balance sheetactually exist at the balance sheet date and that revenue and expense transactions stated in the income statement actually occurred during the accounting period is classified as a. valuation and allocation assertion. b. rights and obligation assertion. c. completeness assertion. d. existence or occurrence assertion.

6-4

Confirmation of accounts receivable by the auditor is a. a test of control. b. a test of transaction. c. a test of balance. d. a test of control and transaction.

6-5

Which of the following confirmations is least likely used by an auditor in connection withthe tests of balances? a. Bond trustees on bond payable. b. Customers on accounts receivable balances. c. IRS on refundable income taxes. d. Suppliers on accounts payable balances.

6-6

ant concerning an auditor’s responsibility to detect errors and frauds? Which of the following factors is most import

a. The susceptibility of the accounting records to intentional manipulations, alterations, and the misapplication of accounting principles. b. The probability that unreasonable accounting estimates result from unintentional bias or intentional attempts to misstate the financial statements. c. The possibility that management fraud, defalcations, and the misappropriation of assets may indicate the existence of illegal acts. d. The risk that mistakes, falsifications, and omissions may cause the financial statements to contain material misstatements. 6-7

An auditor should recognize that the application of auditing procedures may produce evidential matter indicating the possibility of errors or frauds and therefore should a. plan and perform the engagement with an attitude of professional skepticism. b. not depend on internal accounting control features that are designed to prevent or detect errors or frauds. c. design audit tests to detect unrecorded transactions. d. extend the work to audit most recorded transactions and records of an entity.

6-8

When using the transaction cycle approach in the audit plan, the reason for treating the capital cycle separately from expenditure cycle is that a. the transactions are related to financing a company rather than to its operations. b. most capital cycle accounts involve few transactions, but each is often highly material and therefore should be audited extensively. c. both a and b above. d. neither a nor b above.


6-9

Which of the following statements best describes the auditor’s responsibility with respect to illegal acts that do not have a material effect on the client’s financial statements?

a. Generally, the auditor is unde r no obligation to notify parties other than personnel within the client’s organization. b. Generally, the auditor is under an obligation to see that stockholders are notified. c. Generally, the auditor is obligated to disclose the relevant facts in the ditor’s au report. d. Generally, the auditor is expected to compel the client to adhere to requirements of the Foreign Corrupt Practices Act. 6-10

Which of the following is not a proper match of an auditor’s specific objective with management’s assertion?

a. Ownership matches with rights and obligations. b. Existence matches with existence or occurrence. c. Classification matches presentation and disclosure. d. Completeness matches with completeness. 6-11

Which of the following statements is not true? a. Balance-related audit objectives are applied to account balances. b. Transaction-related audit objectives are applied to classes of transactions. c. Balance-related audit objectives are applied to the ending balance in balance sheet accounts. d. Balance-related audit objectives are applied to both beginning and ending balances in balance sheet accounts.

6-12

Which of the following statements is true? a. The auditor’s specific objectives follow and are closely related to management assertions. b. Management’s assertions follow and are closely related to the auditor’s objectives. c. The auditor’s primary responsibility is to find and disclose fraudulent management assertions. d. Assertions about presentation and disclosure deal with whether the accounts have been included in the financial statements at appropriate amounts.

6-13

Which of the following statements is not true? a. An example of a completeness assertion would be that the notes payable account in the balance sheet includes all such obligations of the entity. b. An example of a valuation or allocation assertion would be that property, plant, and equipment are recorded at current market value. c. An example of an existence or occurrence assertion would be that sales in the income statement represent exchanges of goods or services that actually took place. d.represent An example of a of rights and obligations assertion would be that amounts capitalized for leases in the balance sheet the cost the entity’s rights t oleased property.

6-14

When planning theaudit, if the auditor has no reason to believe that illegal acts exist, the auditor should a. include audit procedures which have a strong probability of detecting illegal acts. b. include some audit procedures designed specifically to uncover illegalities. c. make inquiries of management regarding their policies and regarding their knowledge of violations, and then rely on normal audit procedures to detect errors, frauds, and illegalities. d. do nothing.

6-15

If a long-term note receivable is included on an accounts receivable listing, there is a violation of the a. completeness objective. b. existence objective. c. timing objective. d. classification objective.

6-16

Which of the following procedures would an auditor most likely perform in planning a financial statement audit? a. Inquiring the client’s legal counsel concerning pending litigation. b. Identifying the client’s management assertions relating to individual accounts. c. Searching for unauthorized transactions that may aid in detecting unrecorded liabilities. d. Examining control procedures to verify the effectiveness of internal controls.

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6-17

At the planning phase, whichof the following ismost likely to be agreed uponwith the audit clientbefore implementation of the audit procedures? a. Evidence to be gathered to provide a sufficient basis for the auditor’s opinion. b. Timing of inventory observation procedures to be performed. c. Procedures to be undertaken to discover litigation, claims, and assessments. d. Procedures to be included in the testing the internal controls.

6-18

When an auditor becomes aware of a probable illegal act by a client, the auditor should a. consult with theclient’s legal counsel or other specialists about the effect of t he act on the financial statements. b. determine the reliability of the management’s representations in the client’s representation letter. c. consider whether other similar acts may have occurred. d. recommend remedial actions to the audit committee.

6-19

Which of the following immaterial amount of misstatement could most likely have a material effect on a client’s financial statements?

a. A piece of obsolete office equipment that has not retired. b. A petty cash fund disbursement that was not properly authorized. c. An illegal payment to a foreign official that was not recorded. d. An uncollectible account receivable that was not written off. 6-20

Which of the following information discovered during an audit most likely would raise a question concerning a possible illegal act? a. Related party transactions, although properly disclosed, were pervasive during the year. b. The entity prepared several very large checks payable to cash during the year. c. Material internal control weaknesses previously reported to management were not corrected. d. The entity was a campaign contributor to several local political candidates during the year.

6-21

Which of the following circumstances most likely would cause an auditor to consider whether material misstatements due to fraud exist in an entity’s financial statements? a. Differences are discovered during the client’s annual physical inventory count. b. Material weaknesses previously communicated to those charged with governance have not been corrected. c. Clerical errors are listed on a monthly computer-generated exception report. d. Supporting accounting records and documents are frequently denied access to the auditor when requested.

6-22

What assurance should an auditor provide on direct effect illegal acts and indirect effect illegal acts that are both material toient’s a cl financial statements?

a. b. c. d. 6-23

Direct effect illegal act Reasonable Reasonable Limited Limited

Indirect effect illegal act None Limited None Limited

The primary objective of tests of transactions performed as substantive tests is to a. comply with generally accepted auditing standards. b. attain assurance about the reliability of the accounting system. c. detect material misstatements in the financial statements. d. evaluate whether management’s policies and procedures operated effectively.

6-24

Which of the following is a false statement about specific audit objectives? a. There should be a one-to-one relationship between specific audit objectives and procedures. b. Specific audit objectives should be developed in light of management assertions about the financial statement components. c. Selection of tests to meet audit objectives should depend upon the understanding of internal control. d. The auditor should resolve any substantial doubt about any of management’s material financial statement assertions.


6-25

The objective of tests of transactions performed as substantive tests is to a. comply with generally accepted auditing standard. b. attain assurance about the reliability of the accounting system. c. detect material misstatements in the financial statements. d. evaluate whether management’s policies and procedures operated effectively.

6-26

An auditor observes the mailing of monthly stat ements to a client’s customers and reviews evidence of follow -up on errors t of controls most likely is performed to support management’s financial assertion(s) of reported by the customers. This tes

a. b. c. d. 6-27

Presentation and Disclosure Yes Yes No No

Existence or Occurrence Yes No Yes No

Each of the following might,by itself, forma valid basis for an auditor to decide to omit an audit test exceptfor the a. difficulty and expense involved in testing a particular item. b. assessment of control risk at a low level (i.e., small %). c. inherent risk involved. d. relationship between the cost of obtaining evidence and its usefulness.

6-28

Which of the following statements reflects an auditor’s responsibility for detecting errors and fraud?

a. An auditor is responsible for detecting employee errors and simple fraud, but not for discovering fraudulent acts involving employee collusion or management override. b. An auditor should plan the audit to detect errors and fraud that are caused by departure from GAAP. c. An auditor is not responsible for detecting errors and fraud unless the application of GAAS would result in such detection. d. An auditor should design the audit to provide reasonable assurance of detecting errors and fraud that are material to the financial statements. 6-29

Which of the following circumstancesmost likely would cause an auditor to consider whether material misstatements exist in a client’s financial statements? a. The client is in a declining industry with increasing business failures and a significant decline in customer demand. b. Employees who handle cash receipts are not bonded. c. Bank reconciliations usually include in-transit deposits. d. Equipment is often sold at a loss before being fully depreciated.

6-30

Which of the following characteristics most likely would heighten an auditor’s concern about the risk of intentional manipulation of financial statements? a. Turnover of senior accounting personnel is low. b. Insiders recently purchased additional shares of the client’s stock. c. Management places substantial emphasis on meeting earning projections. d. The rate of change in the entity’s industry is slow.

6-31

Disclosure of illegal acts to parties other than a client’s senior management and its audit committee or board of directors ordinarily is not part of an auditor’s responsibility. However, to which of the following outside parties may a duty to disclose illegal acts exist?

a. b. c. d.

To the SEC when the Client reports an Auditor change ___ Yes Yes No Yes

To a Successor Auditor when the Successor makes appropriate inquiries_____ Yes No Yes Yes

To a Governmental Agency from which the Client receives financial assistance_________ No Yes Yes Yes

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6-32

An auditor concludesthat a client has committed an illegal act that has not been properly accountedfor or disclosed. The auditor should withdraw from the engagement if the a. auditor is precluded from obtaining sufficient appropriate evidence about the illegal act. b. illegal act has an effect on the financial statements that is both material and direct. c. auditor cannot reasonable estimate the effect of the illegal act on the financial statements. nts is material, and the client refuses to accept the auditor’s report as d. effect of the illegal act on the financial stateme modified for the illegal act.

6-33

Three conditions generally present for fraud tooccur are often referto as the “fraud triangle.” Which of the following conditions is not present in this “fraud triangle”?

a. Management or other employees lack professional skepticism to commit fraud. b. Circumstances provide opportunities for management or employees to commit fraud c. Management or other employees have incentives or pressures to commit fraud d. An attitude exist that allows management or employees to commit fraud. 6-34

Management isoften in a position to override internalcontrols in order to commit fraud. Which of the following procedures is not required to test for management override of controls on every audit? a. Review accounting estimates for biases that could result in material misstatement due to fraud. b. Evaluate the business rationale for significant unusual transactions. c. Test the existence and occurrence of separation of duties. d. Examine journal entries and other adjustments for evidence of possible misstatements due to fraud.

6-35

An auditor must assess the risks of material misstatement due to common fraud conditions throughout the audit. Which of the following is not a common fraud condition that the auditor must assess throughout the audit? a. Conflicting or missing evidential matter. b. Unrealistic audit time budget constraint. c. Discrepancies in the accounting records. d. Problematic or unusual relationships between the auditor and management.

6-36

An independent audithas the responsibility todesign the audit to provide reasonable assurance ofdetecting errors and fraud that might have a material effect on the financial statements. Which of the following, if material, is a fraud as defined in auditing standards? a. Misappropriation of an asset or groups of assets. b. Clerical mistakes in the accounting data underlying the financial statements. c. Mistakes in the application of accounting principles. d. Misinterpretation of facts that existed when the financial statements were prepared/

6-37

What assurance doesthe auditor provide that errors, fraud, anddirect-effect illegalacts that are material to the financial statements will be detected?

a. b. c. d. 6-38

Errors Limited Reasonable Limited Reasonable

Fraud Negative Reasonable Limited Limited

Direct-Effect Illegal Act Limited Reasonable Reasonable Limited

If some sales were recorded inthe current year that should have been recorded in the subsequent year,the related accounts receivable do not exist at the balance sheet date. Which of the following overlaps between transaction- and balance-related information is true?

a. b. c. d.

Transaction-related Information Rights and Obligation Valuation and Allocation Occurrence Cutoff

Balance-related Information Completeness Classification Accuracy Existence



6-1 d. 6-2 b. 6-3 d. 6-4 c. 6-5 d. 6-6 d. 6-7 a. 6-8 c. 6-9 a. 6-10 c. 6-11 c. 6-12 a. 6-13 b. 6-14 c. 6-15 d. 6-16 b. 6-17 b. 6-18 a. 6-19 c. 6-20 b. 6-21 d. 6-22 a. 6-23 c. 6-24 a. 6-25 c. 6-26 c. 6-27 a.

6-28 d. 6-29 a. 6-30 c. 6-31 d.

6-32 d. 6-33 a. 6-34 c. 6-35 b. 6-36 a. 6-37 b. 6-38 d.

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Simulation Question 6-1 Simulation Question 6-1 is an adaptation with permission from a case by Strand, C. A., S.T. Welch, S.A. Holmes, and S.L. Judd inIssues the in Accounting Education , a publication of the American Accounting Association in Sarasota, Florida. This simulation question is based upon a true set of facts; however, the names and places have been changed.

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Background Information for all Scenarios

Crystal Smith had been the Director of the Finance Department of Junction Falls, USA, for nearly eight years. On a recent trip to Florida, she visited her sister and decided that she would like a change of scenery. Crystal interviewed for several jobs and accepted an accounting position in the Finance Department of a large Florida city. Her replacement in Junction Falls is Joe Metros. Joe, who had been the Deputy Director of the Finance department in a nearby town for the past five years, is very pleased with this new position because it represents a promotion.A reporter from theJunction Falls Daily Observer interviewed Joe for a feature article in the business section. Joe talked about his family and the many civic activities that he supported, both financially and by volunteering his time. He also discussed his vision for the future of the Finance Department and identified a number of short-term and long-term goals. Initially, Joe wants to implement a number of changes designed to improve the efficiency and effectiveness of departmental operations. He plans to eliminate a number of accounts that are rarely used. He also hopes that financial information can be provided more quickly when requested by citizens or other city agencies. He notes that prompt responses should increase public confidence in the Finance Department. Joe is especially concerned about the extent of employee turnover. Five of the seven department employees have held their current positions less than one year, and training costs can be rather significant. Joe has been told that the previous Director, Crystal Smith, was very controlling and task-oriented, and that this may have caused employees to seek employment elsewhere. Joe notes that the city does not have an internal audit staff. However, the local accounting firm of Watson & Watson, LLP has audited the city’s Comprehensive Annual Financial Report for each of the past 13 years. The city has been growing steadily for the past several decades and currently has a population just over 73,000. Last year, Junction Falls collected over $89 million in gross operating revenues. In addition to Joe, the Finance Department includes the following personnel:

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You should access Data File 6-1 in iLearn for Figure 1, which presents the organizational chart of the Finance and Accounting Services of Junction Falls.

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Libby Jones, Chief Accountant. She manages and maintains the General Ledger. Libby is also responsible for general office management and day-to-day operations in the department. She earned a degree in accounting from the local university and has worked for the department for 15 years. Libby is 37; her husband owns a local hardware store.

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Marsee Weston, Senior Accountant. She is responsible for monitoring fixed assets. She also maintains all records of city fixed/real assets and maintains/monitors all city construction and acquisition of real asset contracts. Marsee has been employed by the department for eight months. She is 39; her husband teaches mathematics at the local high school.

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Scott Smyth, Senior Accountant. He is the Cash Manager; maintains bank relations; manages all city investments; monitors debt-service requirements; performs all wire transfers of city funds; and reconciles all bank accounts. Scott is 32 and has been employed by the department for seven months. Scott’s wife is a sales associate at one of the local automobile dealers.

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Cathy Elign, Staff Accountant. She maintains all records pertaining to Accounts Receivable; invoices those who owe funds; maintains control of all Petty Cash Funds within the city; accounts for all daily deposits from departments and divisions within the city; and is also the secondary payroll clerk. Cathy is 27 and has been employed by the department for almost nine months. Her husband is employed by the U.S. Postal Service.

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Bob Thomas, Accounts Payable Clerk. He processes all city payments to payees for last names beginning with A through L. Bob is 36 and has worked in the department for almost two years. He is single and has lived in town his entire life except for the five years he served in the U.S. Navy.

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Nora Stewart, Accounts Payable Clerk. She processes all city payments to payees for last names beginning with M through Z. Nora is 20, and has been employed by thedepartment for six months. She is single and lives in an apartment complex near an university campus.

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Chuck Sanchez, Payroll Clerk. He processes all bi-weekly and monthly payrolls and maintains all payroll records. Chuck is 31, recently divorced, and has been working in the department for ten months. Chuck lives in an older neighborhood with his 7-year-old son.

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Scenario #1

Joe has recently implemented several changes within the Finance Department; changes he believes will improve operations and boost morale. First, he informed all employees that he expects them to take full advantage of all of their earned vacation days. Since employees must work in the department for at least one year before they can apply for vacation, Bob and Libby are currently the only employees who are eligible to take any paid vacation days. Bob is planning a one-week fishing trip to Lost Pines Lake this summer, but Libby insists that she cannot take nay vacation because “there are so many new employees.” Libby does appear to be busy. She is usually the first to arrive at work each day and the last to leave at night. However, Libby will lose quite a few days of leave time if she does not take a vacation soon. Joe has insisted that she take a break. Libby agrees to do this, but only takes one day at a time. Joe has also created new controls within the accounts payable function. First, the two accounts payable clerks (Nora and Bob) check each other’s documents for accuracy at the close of each workday. Each Tuesday, Libby collects the invoices to be paid for that week and prepares the documentation so that checks can be drawn and mechanically signed in the nightly cycle. The following morning, Libby collects the printed checks, verifies the amount of each check with the register, confirms that all supporting documentation is attached, sends the checks to the mailroom for delivery to the vendors, forwards the daily check register to Scott for use in the bank reconciliation, and returns the invoices to Nora and Bob for inclusion in the vendor files. Libby is also responsible for periodically reconciling the Accounts Payable subsidiary ledger to the control account. Joe arrives at work on Wednesday and is surprised to find the office locked. As he opens the door, he hears the phone ringing. It is Libby’s husband, who informs Joe that Libby had an automobile accident on the way to work and is being admitted to Junction alls F Hospital for


observation. Joe plans to take over Libby’s duties until she recovers. He begins by collecting the checks that were printed the previous night, along with their supporting documentation. After completing the necessary reconciliation, he hands over the paid invoices to Bob and Nora for filing. Nora is surprised to find an invoice made payable to Zenith Enterprises. She does not recall processing this invoice the previous day.

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Scenario #2

In addition to his other duties, Chuck makes arrangements for the hiring of temporary help for Junction Falls. Departments submit formal request forms to Chuck a week in advance detailing what type of temporary help is needed and estimating how long the associated labor shortage would persist. Chuck then relays the information to Manpower Staffing Services, a local temporary agency that provides Junction Falls with the needed employees. Manpower bills the city once a month for all services provided since the last billing period. Chuck receives the bill directly from the temporary agency. After examining the accompanying documentation for accuracy, he forwards the bill to Nora for payment. Joe recently asked Libby to compile a list of significant budget variances for his review. Libby noted that a problem appeared to be developing in personnel services (which represented more than 10 percent of all expenditures). She did some quick calculations and discovered that two-thirds of the budgeted amount for salaries and benefits was spent in just seven months. Overall, personnel-related expenditures are 15 percent greater than they were at this same time last year. When asked if he had any ideas on what could have caused this budget shortage, Chuck suggested that perhaps the hiring of additional employees and the 3 percent across-the-board pay raise that was awarded everyone at the start of the fiscal year were not reflected in the current year budget. Each Tuesday evening, the city runs checks for the invoices that are due that week. Then, on Wednesday morning, Libby verifies the amount of each check with the register and confirms that all supporting documents are attached. After conducting the reconciliation, Libby forwards the paid invoices to Bob and Nora for filing. Nora is curious. The documentation attached to the Manpower Staffing Services check is vague. There are no specifics as to the days worked or the work performed. She has placed a call to the temp agency requesting more information, but has not yet received a reply.

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Scenario #3

In an attempt to discover new areas where cost savings might be achieved, Joe has spent much of his spare time examining the files containing the Junction Falls RFPs (Requests for Proposal). Joe concludes that most low bidders are awarded a contract. Occasionally, however, the low bid is not accepted. For example, because the low bidder was notorious for delivering spoiled merchandise, they did not get the contract. Instead, the Lone Start Farm Patch was awarded the bid to supply fruits and vegetables to the Junction falls Jail. Joe notes that most files contain several bids, some as many as a dozen. Joe finds one file (to supply computers to certain city offices) that contains only a solitary bid from Able Computers. Joe asks Marsee, who prepares all specs for fixed asset RFPs and approves all contracts, what caused such a poor response from potential suppliers. Marsee points out to Joe that the RFP specified that supplier personnel must be able to respond to a city call for maintenance, upgrades, or repairs within 30 minutes. She suggests that perhaps many suppliers were not willing to guarantee such a prompt response time. In preparation for the upcoming annual audit, Bill Watson, the external auditor, asked Marsee to provide him with a list of all fixed assets, including the inventory identification number, date of purchase cost, and current location of each item on the list. After a week, Marsee still has not printed out the list for the auditor. The audit starts in two weeks. When asked about the delay, Marsee says that she has been so busy that she “has not had time to think about any new projects.” Marsee is busy, and often arrives very early for work and leaves the office late at night. One Monday during lunchtime, Bob receives a phone call from Able Computers, asking whether Able’s last request for payment has been processed. Since Marsee is unavailable to respond to this query, Bob calls the city office that was to have received the computers and learns that no such delivery from Able Computers.

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Scenario #4

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Scenario #5

Joe is collecting information to start the annual Junction Falls budget. By next week he should have a detailed budget request package from each operating department, which contains not only financial and statistical data about prior periodvities, acti but also “wish lists” for the next fiscal year. Joe notes thatad valorem taxes (levied as a percentage of the value of the property being taxed) have provided the major source of city funds for several years. One trend disturbs him, however. Cash collections have declined this year, despite the fact that the mayor had announced a significant increase in the tax base. Joe decides to spend the weekend checking out this anomaly. He discovers one possible explanation: numerous modifications or credits of billed tax amounts have been recorded in the receivable ledger. The following week, Joe asks Cathy about the large number of tax adjustments. She explains that an apparent computer glitch in the individual taxpayer assessment software created the need to reduce srcinally recorded amounts to their lower, correct totals. Cathy calls in sick with a virus one Thursday and Scott agrees to substitute as the cashier. At the end of the day he is exhausted. He never has a minute to even catch his breath. He wonders what caused people to pick this day to come in and pay their taxes. He tells Joe they must have known that Cathy was absent and decided to take this opportunity to pick on Scott. As he is preparing the deposit, Scott confirms that it has indeed been a busy day. The deposit is much larger than usual. The following Wednesday, Libby receives a phone call from a taxpayer who is very irritated about an overdue notice that has just come in the mail for property taxes that, according to the county, are now 60 days delinquent. According to the caller, these taxes were paid several weeks ago and the taxpayer has a receipt to prove it. Libby asks Cathy to print out a copy of the taxpayer’s accounts receivable record. After some searching, Cathy informs Libby that she cannot locate any record to the account. The auditors from Watson & Watson, LLP have just started their work on the Comprehensive Annual Financial Report for Junction Falls. Bill Watson, the partner-in-charge of the city audit, is chatting with Scott Smyth and discovers that they share a mutual interest in investing. Scott says that he particularly enjoys investing in options, futures, and commodities. He notes that his investing interest is what attracted him to his current position in Junction Falls. Scott indicates that he was pleasantly surprised to discover that Junction Falls needed someone to manage its investment portfolio. He admits that even though the pay is not particularly great, he really likes the autonomy inherent in the position. He decides what to buy and when to sell (within certain very broad guidelines), and apart from creating a report of his investing activities for the Junction Falls Council each quarter, he manages the investment portfolio as he sees fit. Bill notes in his working papers that Scott also has broad authority to make wire transfersbetween each of the city’s four bank accounts. No external approval is required. Bill, Scott, Joe, and Marsee decide to go to a local café for lunch. Scott offers to drive his Jaguar sedan since it can easily accommodate four individuals. Marsee, Scott, and Joe have been with the Department for less than one year, so the luncheon conversation centers on where everyone worked before coming to the Finance Department, and how long each has lived in Junction Falls. Joe and Marsee discover that they grew up in Junction Falls, just three blocks from each other. Scott only recently moved here from Big City. At that point, the waitress arrives with their orders, and the conversation turned to other topics for the duration of the meal.

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Later that afternoon, Bill continues his conversation with Scott about his move to Junction Falls, and the many differences between Junction Falls and Big City. Scott admits that he misses the fast pace of his former hometown, but says that it was best that he left Big City to gain a fresh start on life. Although he owned a consulting firm in Big City, he had overextended his credit cards by taking too many cash advances. Ultimately, he filed for personal bankruptcy.

Required For each of the five scenarios above answer the following three questions: 1. List all the fraud risk factors in each of the five scenario. 2. Identify all other circumstances or information that are of concern in each of the five scenario 3. Explain whether it is “probable,” “reasonably possible,” or “remote” that fraud (misappropriation of assets) may be occurring in the Finance Accounting for Contingencies , to learn more Department in each of the five scenario. You should research FASB SFAS No.5 (AICPA 1975), about the distinction between these terms. Note: Probable is a future event(s) that is (are)likely to occur; reasonably possible means the possibility of the event more is than remote but less than likely; and, remote means the chance of the event isslight .

Simulation Question 6-2 Simulation Question 6-2 is an adaptation with permission from a case by Ballou, B. and J. M. Mueller inIssues the in Accounting Education , a publication of the American Accounting Association in Sarasota, Florida. This simulation question is based upon a true set of facts; however, the names and places have been changed.

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Humble Beginning

Brian Techno, CEO and founder of Speedcom, was born in 1938 in San Jose, California. The first in his family to attend college, Brian earned good grades in his engineering curriculum at The California Institute of Technology. This was also where he discovered his natural ability to build and wire just about anything. After graduating in 1960, Brian married Mindy, his high school sweetheart, and moved to Modesto about 100 miles north of San Jose. This was where it all began, through the haphazard purchase of a farm lot in the neighboring town of Tracy. It just happened to have on it an 18-foot tall antenna. In his spare time, Brian put his wiring skills to use and convinced nearby residence to let him string some wires to their television sets. Soon Brian was urging the rest of Tracy to trade their rabbit ears for wires to his antenna, making Brian an early pioneer of the cable television industry. Over the next several years, Brian acquired other plots of land in neighboring towns and built more antennas and strung more wires. One week before quitting his job with a factory, he went into the First National Bank at Tracy to borrow $45,000 to purchase a failing cable franchise in Tracy. Brian convinced several local businessmen to contribute $25,000, and the local bank agreed to lend the remaining $20,000. Brian told Mindy that they would “either make a mint or go broke.” Mindy had no idea that Brian would make that claim many mo re times in the future. By the late 1960s, Brian’s cable business was doing well and he purchased a 60-acre farm property in Tracy and built a large home for Mindy and their two sons, Tony and Sam. Brian and Mindy were easily the most “successful” residents in the history of Tracy,and the more successful they became, the less popular they became. As in most small towns, all 2,900 townspeople in Tracy were at about the same socioeconomic level, at least until Brian’s success. Brian and Mindy wanted to feel at home in Tracy and tried everything to earn acceptance in – and lost. He hosted barbeques at his home– few came. He went as far as attending the the town. Brian ran for a position on the school board church preferred by the mayor, which differed from his own religious denomination. Finally, in 1975, his goal to be accepted in the community was realized when he was invited to sit on the board of the local bank. Not only was this a great personal triumph, but also he foresaw needing a loan from time to time.

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Growing Pains

f Technology. Brian’s ambition Tony and Sam both returned to the family business after finishing their degrees at California Institute o was contagious, and as it grew, the family took significant risks and leveraged the company in order to acquire and develop more rural cable systems in Central California. Often, they were only one step ahead of the creditors. By the mid-1980s, as a result of several large acquisitions, the company had 160,000 subscribers and 250 employees. Based on Brian’s financial management strategy, there was not a bank ithinwa 200mile radius to which he was not in debt. Frankly, he had borrowed about as much as he could. Over a plate of Mindy’s meatloaf one fall evening in 1987, they decided to go public– Speedcom was born.

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Success

By the late-1990s, Speedcom was among the five largest cable companies in the country, with over 15,000,000 subscribers. The public offering had given Brian the cash needed to take the company to the next level. Although the greatest cluster of subscribers was in the Central California, Brian had developed other clusters in the Northern California. Sam developed the strategy of clustering subscribers in geographic areas, which was lauded by analysts. Clustering helped to keep operating costs low and gave Speedcom a much greater cash margin than its competitors. Based on age, experience, and interests, the topSpeedcom’s governance hierarchy was structured with Brian as CEO, Sam as COO, and Tony as CFO and Chair of the Audit Committee. Based on the requirements in the Sarbanes-Oxley Act of 2002, Tony later resigned from the Audit Committee, and the President ofFirst National Bank at Tracy, Jonny Kinsey, took Tony’s place as Chair.

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Brian and Tony designed the IPO such that Class A shares with one vote each were issued. The Techno family retained all Class B shares, with five votes per share, five the Techno family final word on who would hold board seats. Most other members of the Board of Directors were good friends of Brian. Mindy’s cousin from San Jose also held a seat. Coincidentally, these were about the only shareholderswilling to travel to small town Tracy for board meetings or annual shareholder meetings. Board and shareholder meetings alike were mostly informational where


Brian shared with those present about the company’s recent victories and the deals put together by the two sons and him. Figure 1 provides an organizational chart for Speedcom’s directors and senior executives. You should access Data File 6-2 in iLearn for Figure 1, which presents the organizational chart of Speedcom. Outside the boardroom, the Techno family continued to run the business just as they always had – at the dinner table over Mindy’s cooking – with little thought to investors, analysts, or other stakeholders. Brian continued to make the deals that had made Speedcom successful. He sought smaller competitors within geographic clusters for acquisition, most of which had unused capacity that could be developed by Sam to further expand Speedcom’s subscriber base. In November 2002, Brian had six to eight deals on the table, most with commitments to purchase stock at some agreed upon price. Brian’s deal-making required him to keep Speedcom highly leveraged. But, in his mind, he had mastered that art and he knew that Speedcom’s goal to become industry giant depended on it. At times, Speedcom’s debt was ten times its marketcapitalization and ten times that of any competitor. However, annual revenues approached $4 billion, and the stock price continued to climb. Brian, Sam, and Tony increased their ownership by purchasing a large volume of stock. Brian had faith that the company would continue to prosper, enabling him to divest some of his shares upon retirement. Like his father, Sam was always looking for a profitable deal in new service lines such as wireless and digital. In 2000, for example, Sam discovered Neo Wireless, a new cellular company in rural Southern California. Though available at quite a discount, Neo Wireless was in the midst of a lawsuit with the FCC (Federal Communications Commission) over a disputed tie bid for a wireless spectrum (the FCC auctions wireless “airspace” to wireless companies). Sam believed that although Neo Wireless was much smaller than the other tie-bidder, it would eventually come out of the lawsuit with the spectrum and would be a profitable company with high growth potential. Sam wanted to create a new cluster in the Southern California, where Neo Wireless would be a stand-alone entity and a personal project for Sam.

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Brian also had established various privately owned business over the years. He insisted upon keeping his salary from Speedcom at a conservative amount, for example, his average salary over the years 1998 to 2004 was $800,000 per year, and these businesses allowed him to subsidize his personal income. In addition, Brian insisted that Tony and Sam also draw modest salaries; Tony was earning an average of $550,000 and Sam an average of $400,000 per year. One of Brian’s businesses, MediaMarket LLC, was an advertising company thatthat focused –area clients and Speedcom. MediaMarket handled the majority of Speedcom’s primarily on telemarketing services. It had several small Tracy marketing to potential subscribers for services in areas where it had services available. Brian also created ServiceLink LLC, a customer service outsourcing agency. Its primary revenue stream was from Speedcom, but other clients included the local First National Bank and two other banks from surrounding towns. Both MediaMarket and ServiceLink were located in Speedcom’s office building. Mindy and Sam’s wife, Emily, also Often, Brian would redecorate Speedcom’s offices to provide business for Mindy and Emily. Brian operated a florist and home interiors business. could see the value in his small companies. MediaMarket and ServiceLink lowered Speedcom’s operating costs and both of the companies received professional management services from Speedcom. Figure 2 presents a summary of Speedcom’s financial statements. You should financial statements. access Data File 2 6-in iLearn for Figure 2, which presents a summary of Speedcom’s

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By 2003, the sentiment toward the Techno family was warm. After all, the Techno family treated folks in Tracy like extended family. They built youth recreation facilities, sponsored an annual fair, and built a library and seniors’ center. Brian was rumored to have never turned away anyone who came to him in financial difficulty. Further, townsfolk were often invited as personal guests of the Techno family to San Francisco 49ers’ pro football games and shows at the historic San Francisco Theatre (they had acquired both in the 1990s). Brian was finally admired by all and wealthy beyond belief. He had realized his dreams –hose for his company and for himself.

Required 1. AU 240 Consideration of Fraud in a Financial Statement Audit suggests a 10-step approach to integrate fraud audit into the audit of financial statements. Step 1 requires the auditor to understand the nature of fraud and the manner in which fraud may be committed at the audit preplan. This understanding is to be integrated with the auditor’s understanding of a client’s business at the audit preplan phase (refer to Chapter 5). Research the Internet or other relevant sources for a better understanding of Speedcom’s telecommunication industry. Using the format below, document at least three pieces of information of your understanding of the history, products, regulation, and risk of telecommunication industry. Reference/cite the source of your information. One piece of information is provided under each of the four subheadings to help you complete the rest. Your Understanding of Speedcom’s Telecommunication Industry A. History of the Telecommunication Industry 1. The telecommunication industry experienced unprecedented, rapid growth in the mid-1990s, introducing an array of services and competitors to an industry once known only for home phone service and the industry giant AT&T. 2. … (source: http://...) 3. … 4. … B. Products in the Telecommunication Industry 1. Products offered by the telecommunication industry can be sorted into three categories: phone-related, television-related, and Internet-related. 2. … (source: http://...) 3. … 4. … C. Regulation of the Telecommunication Industry 1. The telecommunication industry is regulated by the Federal Communication Commission’s variousActs: the Communications Act of 1934, the Cable Communications Policy Act of 1984, the Cable Television Consumer Protection Competition Act of 1992, and the Telecommunications Act of 1996. 2. 3. … … (source: http://...) 4. … D. Risks in the Telecommunication Industry 1. Telecommunications historically has been an industry with a high level of merger-and-acquisition activity. Larger companies frequently ever, the acquiring firms’ share prices acquire smaller companies for their capacity or existing customer revenue streams. In the late 1990s, how

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began to tumble as the purchased capacity could not be turned into revenue. 2. … (source: http://...) 3. … 4. … 2. AU 240 Consideration of Fraud in a Financial Statement Audit suggests a 10-step approach to integrate fraud audit into the audit of financial statements. Step 5 requires the auditor to identify specific fraud risks at the audit plan. This identification of fraud risks is to be integrated with the auditor’s consideration of the “Fraud Triangle” at the audit plan phase (refer to Table 6-1 and Table 6-2 in Chapter 6). Based on your understanding and documentation of the telecommunication industry in 1. above, state what you believe to be factors that would increase the risk of fraud at Speedcom. Using the format below, state at least three fraud risk factors of Speedcom for each of the three characteristics of the “Fraud Triangle.” If you make any assu mption for your answer, state your assumption. Your Identification of Speedcom’s Fraud Risk Factors

A. Incentives/Pressures 1. … (assumption, if any) 2. … 3. … B. Opportunities 1. … (assumption if any) 2. … 3. … C. Attitudes/Rationalization 1. … (assumption, if any) 2. … 3. …

Simulation Question 6-3 Simulation Question 6-3 is an adaptation with permission from a case by Knapp, M. C. and C. A. Knapp inIssues the in Accounting Education , a publication of the American Accounting Association in Sarasota, Florida. This simulation question is based upon a true set of facts; however, the names and places have been changed.

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Humble Beginning

As a small child, Brooklyn native David Brooks loved horses. In 1969, when he was 14 years old, Brooks went to work at a local racetrack as a groom to help support his family. Brooks loved the tough job, which involved arriving at the racetrack in the wee hours of the morning, wiping down sweaty horses, wrestling large balesencouraged of hay, and him “mucking” (cleaning horse Although he want to graduated spend his from life working in the horseracing industry, Brooks' family to pursue a moreout) stable andstalls. pragmatic career afteredhe high school. Because he was intrigued by the stock market, David Brooks eventually decided to major in business at one of New York City's prominent universities. The young extrovert relied on a variety of part-time jobs to finance an undergraduate business degree with a concentration in accounting at New York University. Ironically, Brooks' successful business career provided the path for him to return to his first love. More than three decades after having worked at one of the lowest ranking jobs in horseracing, David Brooks quickly rose to the pinnacle of that sport by spending tens of millions of dollars to establish his own stable, Bulletproof Enterprises. At its height, Brooks' stable included more than 400 racehorses. In 2004, one of Brooks' horses, Timesareachanging, won the Little Brown Jug, which is the equivalent of the Kentucky Derby for standardbred horses that specialize in pacing.1

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The Brooks Brothers Tangle with the SEC

In the mid-1980s, Jeffrey Brooks, David Brooks' brother and best friend, founded a small brokerage firm, Jeffrey Brooks Securities. Jeffrey recruited David to join the firm and become his right-hand man. Several years later, in 1992, the two brothers ran afoul of the Securities and Exchange Commission (SEC) when one of their subordinates was charged with insider trading. The SEC alleged that the Brooks brothers had failed to establish proper control procedures to prevent their subordinates from improperly using material non-public information obtained from their clients. In addition to a $405,000 fine, the SEC filed separate injunctions against the brothers. The SEC banned David Brooks from serving as a director, officer, or employee of a brokerage firm or an investment company for five years. The injunction did not prohibit him from serving as an executive of an SEC registrant that was other than a brokerage or investment company. A few months before the SEC sanctioned the Brooks brothers, David, with the financial backing of his brother, organized a small company based in Westbury, New York, a Long Island suburb of New York City. That company, DHB Capital Group, Inc., which was subsequently renamed DHB Industries, Inc. (DHB is David Brooks' initials), was intended to serve as the umbrella organization for a corporate conglomerate that Brooks hoped to build. Brooks' goal was to identify and then purchase small, underperforming companies and convert them into profitable operations by retooling their business models. In 1994, Brooks attempted to register DHB on the NASDAQ stock exchange to provide it greater access to the nation's capital markets. The NASDAQ denied Brooks' application because of the sanctions that had been levied against him by the SEC. In defending that decision, the NASDAQ observed that “given the extremely serious nature of the SEC allegations made against Brooks, and the fact that he was only recently enjoined” it was necessary to exclude his company from the NASDAQ “to protect investors and the publ ic interest and to maintain 1

Standardbreds are a breed of horses developed in North America that dominates harness racing. There are two types of harness races: trotting and pacing races.


public confidence” in that market. Brooks appealed the NASDAQ's decision to the SEC. After reviewing the matter, the SEC ruled in favor of the NASDAQ: The facts remain that Brooks has a history of serious securities laws violations and a significant ownership interest in DHB, and proposes to retain his position as a DHB director. We do not find it unreasonable that the NASD2 reviewing both Brooks' past conduct and his proposed level of involvement in DHB, remains uneasy about the potential for illicit conduct in connection with the operation of DHB or the market for its securities, and unwilling to expose public investors to that possibility. Despite being rejected by the NASDAQ, the strong-willed Brooks persevered in his effort to have DHB's securities listed on a national stock exchange. A few years later, he finally accomplished that goal when those securities were registered on the American Stock Exchange.

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Timing is Everything

Brooks used the initial financing provided to him by his brother and the capital that DHB raised through a public stock offering to acquire five small firms during the 1990s. DHB's principal operating unit would become Point Blank Body Armor, a Florida-based firm purchased out of bankruptcy for a cash payment of $2 million. Throughout the existence of DHB, the Point Blank subsidiary accounted for upward of 95 percent of its annual consolidated revenues. Point Blank's primary product was the Interceptor Vest, a bullet-resistant vest used by all branches of the U.S. military and by law enforcement agencies. Brooks' acquisition of Point Blank was a timely decision. The small company had struggled for decades, but three circumstances ultimately triggered a surge in the demand for bullet-resistant vests after Point Blank was acquired by DHB. First, the September 11, 2001, terrorist attacks convinced law enforcement agencies throughout the nation to increase their budgets for weaponry and protective equipment for their personnel. Second, in early 2003, President George W. Bush's launching of Operation Iraqi Freedom, commonly referred to by the press as the Second Gulf War, prompted the U.S. Army and U.S. Marine Corps to purchase large quantities of bullet-resistant vests. Finally, one of Point Blank's primary competitors, Second Chance Body Armor, was forced into bankruptcy in 2004 after being sued repeatedly by law enforcement agencies for allegedly manufacturing a large number of defective protective vests. Brooks relied on his outgoing personality, persistent manner, and, most importantly, three Washington, DC-based political lobbyists to outmaneuver his competitors when vying for protective vest contracts put up for competitive bids by the U.S. military. Between 2001 and 2005, the U.S. military purchased nearly one million protective vests from DHB, accounting for the majority of the company's revenues during that time frame. In a period of only six months in 2004, Brooks landed three large contracts for body armor from the Pentagon totaling nearly $500 million. By comparison, DHB's total revenues in 2000 had been only $70 million, while the company's total stockholders' equity at the end of that year had been a negative $5 million due to a retained earnings deficit of more than $29 million. The rapid expansion of DHB's Point Blank subsidiary caused the company's revenues and profits to soar. By 2004, DHB's annual revenues were approaching $350 million, and the company's net income had topped $30 million. Despite those impressive figures, some analysts were concerned by the company's weak operating cash flows. In 2004, for example, the company had a negative net operating cash flow of $10 million despite reporting the $30 million profit. You should access Data File 6-3 in iLearn for Exhibit 1, which presents the audited income statements and balance sheets included in DHB's 2004 Form 10-K, filed with the SEC in early 2005.

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Patriot or Profiteer?

DHB's sudden financial success focused considerable attention on David Brooks, the company's chairman of the board and chief executive officer (CEO). The Industrial College of the Armed Forces, a military agency administered by the Joint Chiefs of Staff, lauded Brooks for developing life-saving body armor technology for hundreds of thousands of U.S. soldiers. Military officials also praised Brooks for establishingNot a charitable that provided financial assistance forwas wounded veterans. all of the foundation attention focused on Brooks and his company favorable. In 2003, a group of DHB employees maintained that the company's protective vests suffered from flaws similar to those evident in the products of Second Chance Body Armor. In November 2004, Brooks and his two top subordinates, Sandra Hatfield, DHB's chief operating officer (COO), and Dawn Schlegel, DHB's chief financial officer CFO), were disparaged by the press when they received financial windfalls upon selling most of their DHB stock. Brooks, alone, received more than $180 million from the sale of the majority of his DHB stock, an amount that was six times greater than DHB's net income for 2004. News l him a “body armor profiteer.” A DHB spokesperson responded by reports of Brooks' huge stock market gain caused one organization to labe defending Brooks' sale of his stock. “The American economic system rewards those who take great risks with commensurate benefits. The compensation Mr. Brooks received is directly attributable to the risk he undertook in aiding the capitalization of DHB and achieving extraordinary results for the company .” The large stock sales by Brooks, Hatfield, and Schlegel were followed by a sharp decline in DHB's stock price. More bad news was soon to follow for the company. Within a few months, additional allegations surfaced that a large number of Point Blank vests being used by military personnel in Iraq had “critical, life-threatening flaws.” Those allegations were followed by the U.S. military recalling more than 20,000 Point Blank vests. Then, in April 2005, DHB's audit firmesigned, r citing “deficiencies” in the method used by the company to value its inventory. The announcement was particularly unsettling to investors because it was the third time since 2001 that a DHB audit firm had resigned after commenting on major problems involving the company's internal controls. David Brooks' public image was sullied even more in November 2005, when several major publications reported that he had spent more than $10 million on a bat mitzvah party for his 13-year-old daughter in the elegant Rainbow Room in midtown Manhattan. Brooks used DHB's corporate jet to fly several famous musicians to the party to serenade invited guests, including 50 Cent, Aerosmith, Kenny G, Stevie Nicks, and Tom Petty. Brooks, who was decked out in a hot pink suede bodysuit during the affair, also handed out party bags to the bat mitzvah guests that contained a wide range of merchandise, including a digital camera and an Apple iPod, allegedly purchased with DHB corporate funds.

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“Hurricane Brooks”

In July 2006, amid growing concerns regarding the reliability of DHB's accounting records, the company's board dismissed David Brooks and hired a team of forensic accountants to investigate those records. That investigation revealed that Brooks and his two top subordinates, Sandra Hatfield and Dawn Schlegel, had orchestrated a large-scale accounting fraud that had grossly inflated DHB's reported

2

At the time, the National Association of Securities Dealers (NASD) oversaw the operations of the NASDAQ.

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3 operating results and financial condition. In addition to uncovering the massive fraud, the year-long forensic investigation yielded disturbing insights into the company's corporate culture during David Brooks' reign:

Brooks exercised absolute control over every aspect of DHB's business, using the company's weak corporate governance and almost nonexistent internal controls to facilitate and hide the financial fraud he directed through Schlegel and Hatfield … Brooks' control extended to DHB's board of directors, which consisted of Brooks' friends and neighbors and Schlegel. At all times, Brooks had a chokehold over DHB's board which exercised no real oversight … Brooks also controlled the flow of information with DHB's outside auditors, who regarded Brooks as the key decision-maker. Brooks used threats of physical harm to enforce his policies and directives. “When anyone questioned the accounting and financial reporting ious and threatening.” During one board meeting, Brooks told a board member who practices underlying the fraud at DHB, Brooks became fur questioned one of his decisions, “You know what we do to outsiders … you know what we do t o people that are not on the team.” A primary target of Brooks' anger and threats was the company's independent auditor. When DHB's audit engagement partner questioned the authenticity of certain journal entries, Brooks told another company official that “if she [the audit partner] were not careful, she would be wearing cement blocks on her feet in the Atlantic Ocean .” Later, during that same audit, the audit engagement partner questioned Brooks directly regarding circumstances that took place during the company's prior audit, which was performed by a different accounting firm. During this conversation, Brooks stated that “someone should … put a bullet”in the brain of the previous year's audit engagement partner. Brooks also routinely withheld critical information from DHB's auditors, including information regarding significant related-party transactions. DHB purchased many of the components used to manufacture its protective vests from Tactical Armor Products (TAP), a privately owned company based in Florida. In early 2003, after discovering that Brooks' wife was TAP's CEO, DHB's auditors insisted that the company issue an amended Form 10-K for fiscal 2002 to disclose that fact. In truth, Brooks exercised total control over TAP's operations, a fact that was 4 not divulged to the auditors nor disclosed in the amended Form 10-K. In addition to repeatedly failing to disclose that TAP was a related-party entity, Brooks also failed to disclose in DHB's SEC registration statements that he had been sanctioned by the federal agency in 1992. This information was allegedly a material fact that would have been of significant interest to DHB's stockholders, prospective investors, and a wide range of other parties involved with the company. According to a federal prosecutor, a principal goal of Brooks' accounting fraud “was to ensure that DHB consistently reported gross profit margins of 27 percent or more and increased earnings, to correspond to the expectations f professional o stock analysts.” One facet of the fraud was a series of bogus journal entries. From 2003 through 2005, Dawn Schlegel instructed her subordinates on DHB's accounting staff to record multimillion-dollar entries that reclassified components of cost of goods sold as operating expenses. Although these reclassification entries did not improve the company's “bottom line” profits, they did serve the purpose of significantly inflating DHB's gross profitratio each period. The major focus of the DHB fraud was the company's inventory accounts. From 2003 through 2005, DHB's period-ending inventories year period, “Hatfield was responsible for assigning values to inventory and were consistently and materially inflated. Throughout that threeSchlegel was responsible for reviewing and approving the inventory valuation before incorporating it into the company's consolidated financial statements.” Brooks “directly supervised Schlegel and Hatfield in performing all their duties, and demanded to review all financial statements and disclosures DHB included in its [SEC] filings .” Near the end of fiscal 2004, Hatfield realized that DHB would fall well short of the 27 percent gross profit margin that Brooks believed was necessary to satisfy financial analysts tracking the company's stock. To solve this problem, Hatfield increased the already overstated value of the company's year-end inventory by several million dollars t hrough various “pricing manipulations.” The offsetting reduction of cost of goods sold allowed DHB to reach the 27 percent threshold for gross profit margin and to inflate its reported net income. When DHB's controller reviewed the company's year-end inventory values for 2004, he immediately realized that they were overstated. After preparing schedules documenting the inventory overstatements, the controller went to Hatfield and Schlegel, who “acknowledged that the inventory was overstated.” Despite that acknowledgment, the two executives refused to correct the inventory values. “Troubled by concerns over the company's inflated inventory values, the controller turned in his resignation.” Before leaving DHB, the controller informed the company's independent auditors that he believed the year-end inventory values were overstated. The auditors then raised this matter directly with Brooks. “Brooks and Hatfield told the auditors that the contro ller's inventory analysis was incorrect and that there were ‘no real problems in the inventory.” After meeting with the auditors, Brooks stormed into the controller's office. During Brooks' subsequent trial, the controller testified that an “enraged” Brooks called him a “___ snake” and “flung … water all over me.” While an unidentified man blocked the door to the controller's office, Brooks shouted “I am going to kick your ___.” Brooks then “confiscated the controller's inventory analysis and violently ejected him from the premises.” When DHB's auditors subsequently questioned Brooks regarding the controller's ejection from the company's headquarters, Brooks responded that the controller “had violated … internal policies and procedures”when he had told them of his concerns regarding the valuation of inventory. The circumstances surrounding the resignation of DHB's controller served to heighten the auditors' concern regarding the valuation of year-end inventory. Making matters worse, Brooks instructed his subordinates to file the company's 2004 Form 10-K with the SEC before the auditors had concluded their investigation of DHB's inventory, a decision that deeply troubled the auditors. To placate the auditors, Brooks 5 amended the company's 2004 Form 10-K. This amendment disclosed a material weakness in DHB's inventory valuation process. DHB's “Management Report on Internal Control over Financial Reporting” in the amended 2004 Form 10-K noted that “there existed certain significant deficiencies in the Company's systems of inventory valuation rendering it inadequate to accurately capture cost of materials and labor components of certain work in progress and finished goods inventory .” The report went on to observe, however, that the material weakness “did not affect the Company's financial statements or require any adjustment to the valuation of its inventory or any other item in its financial statements.” DHB's auditors insisted on including an updated version of their report on the company's internal controls in the amended Form 10-K. This updated report identified two additional material weaknesses in internal controls that were not documented in DHB's management report on

3

Hatfield had worked for Brooks in several capacities after he organized the company in 1992. Brooks eventually appointed her as DHB's COO in December 2000. Schlegel's first connection with DHB was as an independent auditor. In late 1999, Brooks hired her to serve as DHB's CFO. Schlegel, who was a CPA, also served on the company's board of directors. 4 Brooks used his control of both companies to funnel millions of dollars from DHB to himself via TAP. 5 The amended Form 10-K was filed with the SEC prior to the date that the srcinal 2004 Form 10-K was released to the public.


internal controls.You should access Data File 6-3 in iLearn for Exhibit which 2, contains excerpts from the auditors' updated internal control report that described these two items. The first item involved DHB's decision to file its srcinal 2004 Form 10-K prior to the auditors completing their final review of key financial statement amounts in that document. The second of the two additional material weaknesses indicated that DHB's audit committee did not have a proper understanding of its important oversight role for the company's financial reporting process. To mitigate the damage caused by the reporting of these two additional material weaknesses, Brooks took the unusual step of including an insert in the amended 2004 Form 10-K that challenged the auditors' updated internal control report. In this insert, DHB maintained that the two additional material weaknesses identified by the auditors were not, in fact, true material weaknesses . See Exhibit 3 of Data File 6-3 in iLearn.DHB's auditors resigned shortly after this contentious disagreement was aired in the company's SEC filings. —the company's net operating cash flow for DHB's Form 10-Q for the first quarter of fiscal 2005 reported a net income of $7.6 million that period was a negative $5.0 million. The company's gross profit margin for that quarter was 27.4 percent, a figure that was almost identical to the gross profit margins realized by the company for fiscal 2003 and 2004. DHB surpassed the “magic” 27 percent gross profit threshold for the first quarter of 2005 because Hatfield and Schlegel had inflated the quarter-ending inventory by adding 63,000 nonexistent vest components to the company's inventory accounting records. The decision to add fictitious items to DHB's inventory posed a vexing problem for the co-conspirators that they had not anticipated; namely, how to conceal that fact from the company's new auditors, the company's fourth audit firm in four years. (In prior periods, the three executives had overstated DHB's inventory values by increasing the cost-per-unit assigned to individual inventory items rather than by adding fictitious items to the accounting records.) Near the end of 2005, Brooks came up with a plan for solving the problem posed by the fictitious inventory. Brooks told Schlegel to include the cost of the $7 million of bogus vest components in a large write-off entry that was necessary for a 6 line of business that DHB was discontinuing. A few months later, during the fiscal 2005 audit, DHB's auditors questioned Brooks regarding the inventory included in the loss from discontinued operations. Brooks told the auditors that the $7 million of vest components had to be written off because the U.S. military had changed its color requirements for the vests in which those components were to be incorporated. When asked where the obsolete vest components were, the quick-thinking Brooks replied that they no longer existed because the warehouse in which they had been stored had been destroyed by a hurricane a few months earlier. Brooks later relayed this bogus explanation to Schlegel so that she would be prepared to corroborate it with the auditors. “In exasperation, Schlegel asked Brooks why he had told that story, since they had nothing to support it, and the auditors would want support and details.” Despite her concern, Schlegel did as she was instructed and confirmed the story when DHB's auditors queried her regarding the $7 million inventory item. When the auditors continued to press for additional details regarding the written-off inventory, a flummoxed Brooks altered his story. He told the auditors that the “hurricane” explanation was a lie made up by his subordinates, which he had not known when he passed that information to the auditors. This troubling about-face and the inability of Brooks or his subordinates to account for the mysterious $7 million of inventory caused DHB's auditors to begin seriously questioning whether they could issue an opinion on the company's 2005 financial statements. In early March 2006, the auditors told Brooks that they would not be able to release their audit report on DHB's 2005 financial statements in time for the company to meet the SEC filing deadline for its 2005 Form 10-K. Law enforcement authorities subsequently discovered that Brooks attempted to “shop for a favorable audit opinion” by replacing those auditors with another audit firm that he had secretly contacted. That effort proved unsuccessful. A few months later, in July 2006, Brooks' turbulent tenure as DHB's founder and top executive came to an end when he was dismissed by the company's board. The following month, DHB recalled its audited financial statements for 2003 and 2004 and warned third parties that they should no longer rely on them. DHB issued restated financial statements for those two years that radically altered the company's previously reported operating results. DHB's restated income statement for 2004, for example, reported a $9.5 million net loss, compared to the $30 million net income the company had srcinally reported for that year.Y ou should access Data File 6-3 in iLearn for Exhibit 4, which presents DHB's restated income statements and balances sheets for 2003 and 2004. The SEC filed a civil complaint against Hatfield and Schlegel on August 18, 2006. The SEC alleged that the two individuals had participated in an accounting fraud that had grossly inflated DHB's reported operating results and financial condition. Law enforcement authorities subsequently filed criminal fraud charges against both Hatfield and Schlegel. On October 25, 2007, the SEC filed a civil complaint against David Brooks that alleged he was the master architect of the DHB fraud. Later that morning, federal law enforcement authorities arrested Brooks in his lavish home on Long Island, and then filed more than one dozen criminal charges against him during his arraignment. Two days prior to Brooks' arrest, his former close friend and confidante, Dawn Schlegel, had pleaded guilty to two criminal charges, conspiracy to defraud the government, and conspiracy to conceal tax information. In exchange for sentencing considerations, Schlegel agreed to serve ashet government's “star witness” during the criminal trial of Brooks and Hatfield.

Required 1. AU 240 Consideration of Fraud in a Financial Statement Audit suggests a 10-step approach to integrate fraud audit into the audit of financial statements. Step 5 requires the auditor to identify specific fraud risks at the audit plan. This identification of fraud risks is to be integrated with the auditor’s consideration of the “Fraud Triangle” at the audit plan phase (refer to Table 6-1 and Table 6-2 in Chapter 6). Based on your reading of the case above, document what you believe to be factors that would increase the risk of fraud at DHB. Using the format below, document at least three fraud risk factors of DHBfor each of the three characteristics of the “Fraud Triangle.” If you make any assumption for your answer, state your assumption. ’s Fraud Risk Factors Your Identification of DHB A. Incentives/Pressures 1. … (assumption, if any) 2. … 3. … B. Opportunities 1. … (assumption if any) 6

In August 2005, a government agency “decertified” the bullet-resistant material being used in the manufacture of a certain product line of DHB's vests, which caused DHB to discontinue that product line.

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Your Identification of DHB ’s Fraud Risk Factors 2. … 3. … C. Attitudes/Rationalization 1. … (assumption, if any) 2. … 3. … 2. Exhibits 1and 4 in iLearn present DHB's srcinal 2003–2004 balance sheets and income statements and the restated balance sheets and income statements for those two years, respectively. Review the srcinal and restated financial statements for 2004 and ntify ide the “material” differences between them. Using the format below, identify at least four material differences and state what could be the probable cause of these material differences. If you make any assumption for your answer, state your assumption.

Material Differences 1. … 2. … 3. … 4. …

Probable Cause of the Material Differences … (state assumption, if any) … (state assumption, if any) … (state assumption, if any) … (state assumption, if any)


Chapter 7 Audit Plan - Evidence Chapter Learning Outcomes (LOs) Checklist


LO7-1 Understand the terminology of audit evidence.

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LO7-2 Distinguish between vouching and tracing for evidence.

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LO7-3 Describe the relationships among seven broad categories of evidence, eight categories of specific audit objectives, and sixteen prescriptive terms of audit procedures.

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LO7-4 Apply analytical procedures in audit plan.

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LO7-5 Apply analytical procedures in tests of balances.

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LO7-6 Understand Benford’s Law in tests of balances.

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LO7-7 Apply analytical procedures in completing the audit.

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LO7-8 Apply other audit procedures to assess a client’s going concern status.

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Chapter 7 Audit Plan - Ev idence This chapter discusses the auditor’s main consideration of audit evidence in financial and integrated audits. Figure 7-1 presents the auditor’s main consideration of audit evidence. Figure 7-1 Main Considerations of Audit Evidence in Financial and Integrated Audits

The Audit Process

Audit Plan


Tests of Controls

Tests of Balances


Financial Audit

Audit Report

Integrated Audit

Consider Persuasiveness of Evidence Objectives CH 6

Consider Appropriateness (Reliability and Relevant)

Evidence CH 7

Internal Control CH 8

External Evidence (More Reliable)

Consider Sufficiency (Quantity or Sample size)

Internal Evidence (Less Reliable)

Strong Internal Control (More Reliable)

Materiality and Risk CH 9

Program and Technolo CH 10

Weak Internal Control (Less Reliable)

Obtain Indirectly (Less Reliable)

Obtain directly (More Reliable)

From Qualified Person (More Reliable)

Objective Nature (More Reliable)

Obtain Timely (More Reliable)

From Unqualified Person (Less Reliable)

Subjective Nature (Less Reliable)

Obtain Untimely (Less Reliable)


Terminology of Audit Evidence

In practice, an auditor typically finds it necessary to rely on evidence that is persuasive rather than convincing beyond all doubt in issuing an audit opinion. The “persuasiveness” of evidence is the degree to which the auditor is convinced that the evidence supports the a udit opinion. The AICPA’s third Fundamental Principle underlying an audit requires the auditor to consider two determinants of the persuasiveness of evidence – “appropriateness” and “sufficiency”. The “appropriateness” of evidence is the measure of the quality of audit evidence in providing support for, or detecting misstatements in, the classes of transactions, account balances, and disclosures and related assertions. The “sufficiency” of evidence is the measure of the quantity of evidence. AU 500 Audit Evidence and AS 15 Audit Evidence s refer "appropriateness" to the “reliability” and “relevance” of evidence, and "sufficiency" to the “quantity” of evidence. In practice, the auditor uses the term “reliability of evidence” as being synonymous to “appropriateness of evidence”. In addition, the auditor uses the term “sample size” as being synonymous to “sufficiency of evidence.” The “reliability” of evidence depends upon several factors that are briefly discussed in Table 7-1. Table 7-1 Factors Affecting the Reliability of Evidence

Factors Affecting the Reliability of Evidence

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Source

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Internal Control

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Direct Knowledge

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Qualification of Provider

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Objectivity

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Timeliness

Evidence obtained from independent external source is more reliable than evidence obtained from within the client's organization. For example, external evidence such as communications from banks, attorneys, or customers is more reliable than internal evidence such as answers obtained from inquiries of the client. Similarly, external documents such as a bank statement from external source are more reliable than internal documents such as a check. When the client’s internal controls are strong, evidence obtained is more reliable than when they are weak. For example, if internal controls over sales and billing are strong, the auditor can obtain more reliable evidence from sales invoices and shipping documents than if the controls are weak. Evidence obtained directly by the auditor through examination, observation, computation, or inspection is more reliable than evidence obtained indirectly via the client. For example, if the auditor calculates the gross profit margin and compares it with previous periods, the evidence would be more reliable than if the auditor relied on the calculations of the controller. Evidence obtained from a qualified person is more reliable than evidence obtained from an unqualified person. For example, an accounts receivable confirmation from an accountant is more reliable than that from a person who is is more not familiar businessevidence world. that requires judgment. Examples of objective Objective evidence reliablewith thanthe subjective evidence include the confirmation of accounts receivable and bank balances and the physical count of securities and cash. Examples of subjective evidence include the observation of obsolescence of inventory and the inquiry of allowance for uncollectible accounts receivable. The timeliness of audit evidence can refer either to when it is obtained or to the period covered by the audit. Evidence is more reliable for balance sheet accounts when it is obtained as close to the balance sheet date as possible. For example, the auditor’s count of marketable securities on the balance sheet date would be more reliable than a count few months earlier. Evidence is more reliable for income statement accounts when there is a sample from the entire period under audit rather than from only a part of the period. For example, a random sample of sales transactions for the entire year would be more reliable than a sample from only the first six months.

The “relevance” of evidence means that evidence must be pertinent to the auditor’s specific objective or the management assertion being tested. An example is if the auditor’s specific objective were to examine the existence (i.e. existence objective) of inventory, the auditor would obtain relevant evidence by observing the client’s physical inventory count (inventory-taking). However, such evidence would not be relevant in determining whether the goods were owned by the client (i.e., rights and obligations objective) or their costs (i.e. valuation and allocation objective). Another example is if an auditor were concerned that a client was failing to bill customers for shipments (i.e., completeness objective), the auditor would select a sample of shipping documents and traced each to recorded sales transactions in the sales journal to determine whether shipments have been billed; the evidence would be relevant for testing the specific audit objective of completeness. However, if the auditor were to select a sample of sales transactions from the sales journal and vouched each to shipping documents to determine whether sales were supported by (but adequate documentations occurrence objective), the evidence would not beforrelevant for completeness relevant for occurrence)(i.e., and therefore would not be considered reliable evidence the specific audit objective of completeness. Figure 7-2 presents an overview the relationships among vouching and tracing (the direction of testing) and occurrence and completeness (the specific objectives).

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Figure 7-2 Relationships among Vouching and Tracing (the direction of testing), and Occurrence and Completeness (the specific audit objective)

Tracing for Completeness

Source Documents

Accounting Records

For example, the auditor traces a sample of sales invoices to their entries in the accounts receivable balance in the general ledgers to test the completeness assertion (completeness objective).

Vouching for Occurrence

Source Documents

Accounting Records

For example, the auditor vouches the accounts receivable balance in the general ledger to the related sales invoices to test the existence or occurrence assertion (occurrence objective).

The “quantity” of evidence is determined primarily by the sample size the auditor selected. For a given TOC or TOB procedure, the evidence obtained from a sample of 100 would ordinarily be more sufficient than from a sample of 50. The “persuasiveness” of evidence can be evaluated only after considering the combination of reliability, relevance and quantity of evidence. A large sample of evidence provided by an independent party is not persuasive unless it is relevant to the audit objective being tested. A large sample of evidence that is relevant but not objective is also not persuasive. Similarly, a small sample of only one or two pieces of highly reliable evidence also typically lacks persuasiveness. The auditor must evaluate a combination of all factors influencing appropriateness and sufficiency when determining the overall persuasiveness of evidence. Finally, both “persuasiveness” and “cost” must be considered in deciding the type or types of evidence for a given audit. The persuasiveness and cost of all alternative types of evidence should be considered before selecting the best type or types of evidence. In practice, the auditor’s goal is to obtain a sufficient amount of appropriate evidence at the lowest possible total cost. However, it should be noted that cost is never an adequate justification for omitting a necessary evidence gathering procedure or not gathering an adequate sample size of evidence. Seven Broad Category of Evidence

When planning an audit, the auditor considers seven broad categories of evidence. Brief comments on these seven broad categories of evidence are provided in Table 7-2. Table 7-2 Seven Broad Categories of Evidence

Category of Evidence (1) Physical evidence

(2) Confirmations

Comments Two common types of physical evidence obtained by the auditor are (a) examination of tangible assets, and (b) observation of a client's activities. For example, the auditor counts and examines inventory to determine that the inventory existed. Or, the auditor observes the receipt of incoming mail to determine that all checks received through the mail are properly banked. In general, physical evidence meets the audit objective of existence but it does little to meet the audit objective of valuation and allocation, and rights and obligations. Confirmations are written evidence obtained by the auditor through direct communication with


Category of Evidence

Comments independent third parties outside of the client's organization. Typically, confirmations meet the audit objective of existence. In general, the reliability of evidence obtained through confirmations depends upon the third party's qualification and willingness to cooperate. The auditor frequently confirms with third parties for the following evidence: Third parties

(a) Bank (b) Bond trustees (c) Customers (d) Lessors (e) Public warehousemanagers (f) Vendors or suppliers (3) Documentary evidence

(4) Written representation

(5) Oral evidence

(6) Mathematic evidence

(7) Analytical evidence

Items Confirmed

.........Checking account balances and cash in bank .........Bond payable .........Accounts receivable balances .........Lease terms .........Inventory storedin pubic warehouse .........Accounts payable balances

Two common types organization of documentary by the are:statements, (a) externalvendors' documents createdand outside the client's andevidence held byobtained the client, suchauditor as bank invoices statements, contracts, and customer purchase orders, and (b) internal documents created by and held within the client's organization which either (i) have been transmitted to and returned by outsiders to the client, such as paid checks, or (ii) have never been transmitted to outsiders but have only been circulated within the client's organization, such as copies of purchase orders, copies of sales invoices, receiving reports, credit memoranda, bank reconciliation and trial balance. The auditor reads, inspects, examines, traces, vouches or compares these documents to meet the audit objectives of occurrence, completeness and rights and obligations. In general, external documentary evidence is more reliable than internal evidence. Table 73 presents some common internal and external documents. Written representation is evidence in the form of a signed statement by responsible and knowledge persons within or outside the client's organization. The auditor routinely asks for a signed management (client) representation letter from the client's management revealing, among other things, the existence of contingent liability or possible violation of laws or regulations by the client's personnel. The auditor also requests the client's lawyer for a lawyer's representation letter regarding any pending litigation, claims and assessments known to the lawyer. Written representation may pertain to any of the audit objectives. Oral evidence is evidence obtained by the auditor through inquires of the client's key personnel. Oral evidence is not sufficient appropriate evidence by itself. The auditor normally obtains further corroborating evidence through other audit procedures. Mathematical evidence involves re-computations, extensions, footings and cross-footings, reconciliation and tracing by the auditor to verify the mathematical accuracy of the client's financial records. Mathematical evidence provides reliable evidence for the audit objectives of valuation and allocation, classification, cutoff and accuracy, but it does little to meet the audit objectives of existence or occurrence and understandability. Analytical evidence obtained by the auditor involves the use of ratio and comparisons of relationships among financial items, such as industrial averages and prior year financial information, and non-financial items, such as number of employees and direct labor hours. The auditor scans, compares, and analyzes financial and non-financial information for analytical evidence. Analytical evidence meets the audit objectives of existence or occurrence, completeness, valuation and allocation, and accuracy. In general, the reliability of analytical evidence depends upon the plausibility of the relationships among the data, and the availability and reliability of the data.

Table 7-3 Common Internal and External Documents

Common Internal Documents

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Business Documents Sales invoices Purchase orders Canceled checks Payment vouchers EDI agreements

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Legal Documents Labor and fringe benefit agreements Sales contracts Lease agreements Royalty agreements Maintenance contracts

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Accounting Documents Estimated warranty liability schedules Depreciation and amortization schedules Standard cost computations and schedules Management exception reports

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Other Documents Employee time cards

Common External Documents

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Business Documents Vendor invoices and monthly statements Customer orders Sales and purchase contracts Loan agreements

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Third-party documents Confirmation letters from legal counsel Confirmation statements from banks Confirmation replies from customers

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Other Documents Industry trade statistics Credit rating reports Data from computer service bureaus

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Common Internal Documents

Common External Documents

Shipping and receiving reports Scrap or obsolescence inventory reports Market research surveys Pending litigation reports Variance reports

The Relationships between Seven Categories of Evidence and Eight Types of Specific Audit Objectives

Recall the eight types specific objectives discussed in Chapter 6: 1. Existence – the specific audit objective of verifying that all assets, liabilities, and equity interests included in the financial statements actually exist at the date of the financial statements. Occurrence – the specific audit objective of verifying that all transactions and events that have been recorded have occurred, disclosed, and pertain to the client. 2. Completeness – the specific audit objective of verifying that all transactions and events, assets, liabilities, and equity interests that should have been recorded and included in the financial statements have been recorded and included. 3. Rights and Obligations – the specific audit objective of verifying that the client holds or controls the rights to assets and that liabilities are the obligation of the client. 4. Valuation and Allocation – the specific audit objective of verifying that all assets, liabilities, and equity interests are included in the financial statements at appropriate amounts and any resulting valuation or allocation adjustments are recorded appropriately. 5. Classification – the specific audit objective of verifying that all transactions and events have been recorded in the proper accounts and that financial and other information is presented and described appropriately. 6. Cutoff – the specific audit objective of verifying that all transactions and events have been recorded in the correct accounting period. 7. Accuracy – the specific audit objective of verifying that amounts and other data relating to recorded transactions and events have been recorded appropriately and that financial and other information are disclosed fairly. 8. Understandability – the specific audit objective of verifying that financial and other information in disclosures are expressed clearly. Table 7-4 presents a summary of the relationships between the seven categories of evidence and the eight types of specific audit objectives Table 7-4 Relationships between Seven Categories of Evidence and Eight Types of Specific Audit Objectives

Category of Evidence (1) Physical evidence (2) Confirmations (3) Documentary evidence (4) Written representation (5) Oral evidence (6) Mathematic evidence (7) Analytical evidence

Types of Specific Audit Objectives Existence but not valuation and allocation, and rights and obligations. Existence. Occurrence, completeness and rights and obligations. Any specific audit objectives. None on its own. Valuation and allocation, classification, cutoff, and accuracy but not existence or occurrence and understandability. Existence or occurrence, completeness, valuation and allocation, and accuracy.

The Relationships among Seven Categories of Audit Evidence, Eight Types of Specific Audit Objectives, and Sixteen Prescriptive Terms of Audit Procedures

When planning an audit, the auditor prescribes audit procedures for obtaining audit evidence pertinent to specific audit objectives. The auditor uses sixteen prescriptive terms to prescribe the audit procedures. These sixteen prescriptive terms are based on the seven categories of evidence. Table 7-5 presents the sixteen prescriptive terms based on the seven categories of evidence. Table 7 -6 provides comments on the sixteen prescriptive terms.


Table 7-5 Sixteen Prescriptive Terms of Audit Procedures based on Seven Categories of Evidence

Category of Evidence (1) Physical evidence (2) Confirmation (3) Documentary evidence (4) Written representation (5) Oral evidence (6) Mathematic evidence (7) Analytical evidence

Prescriptive Terms of Audit Procedures Count, Inspect, Observe, Examine. Confirm. Compare, Examine, Read, Trace, Vouch, Inspect. Request, Confirm Inquire. Foot, Cross-foot, Re-compute, Reconcile, Trace, Extend. Compute, Scan, Compare, Analyze.

Table 7-6 Comments on the Sixteen Prescriptive Terms of Audit Procedures

Prescriptive Terms (1) Analyze (2) Compare (3) Confirm

(4) Count (5) Examine (6) Extend (7) Foot & Cross-Foot

(8) Inquire

(9) Inspect (10) Observe

(11) Read (12) Re-compute (13) Reconcile

(14) Scan (15) Trace

(16) Vouch

Comments A procedure used by the auditor to study and compare relationships among financial and non-financial items. For example, the auditor performs a trend analysis of the sales data. A procedure used by the auditor to compare financial items from two different sources. For example, the auditor compares the unit-selling price on the invoice to the standard price list. A procedure used by the auditor to obtain information from an independent party outside the client's organization. For example, the auditor confirms accounts receivable and payable with debtors and creditors, respectively. A procedure used by the auditor to provide physical evidence of the quantity of the financial items on hand. For example, the auditor counts the cash on hand at the balance sheet date. A procedure used by the auditor to conduct a detailed study of documents, records and tangible assets. For example, the auditor examines a sample of vouchers to determine whether they are properly authorized. A procedure used by the auditor to multiply a set of figures. For example, the auditor extends the client's inventory listing by multiplying the quantities in units by the cost per unit. A procedure used by the auditor to add a column of figures (footing) and a row of figures (cross-footing) to determine whether a client's calculation is correct. For example the audit foots the accounts receivable aging schedule to determine its accuracy. A procedure used by the auditor to produce oral or written evidence of financial items. For example, the auditor obtains a management representation letter, which states that the client's management has made all accounting records available to the auditor. A procedure used by the auditor to carefully scrutinize documents, records and tangible assets. For example, the auditor inspects the physical condition of certain inventories. A procedure used by the auditor to watch or witness the performance of some activities. From these observations the auditor obtains direct evidence about the existence of physical evidence. For example, the auditor observes the client's inventory count procedure. A procedure used by the auditor to determine the facts of a written document. For example, the auditor reads the minutes of the client's corporate meetings. A procedure used by the auditor to independently recalculate financial items to determine their mathematical accuracy. For example, the auditor re-computes the depreciation schedule. A procedure used by the auditor to explain the differences between the balances of financial items shown in the client's bank and that provided by the outside party. For example, the auditor reconciles the client's cash on hand as per the cash-book with the cash in bank as per the bank statement. A procedure used by the auditor to perform a less detailed scrutiny of documents, records and tangible assets. For example, theauditor scans the salesjournal for largeand unusual transactions. A procedure used by the auditor to test financial items from the source documents to the accounting records. For example, the auditor traces a sample of sales invoices to their entries in the accounts receivable balance in the general ledgers to test the completeness assertion (completeness objective). A procedure used by the auditor to test financial items from the accounting records to the source documents. For example, the auditor vouches the accounts receivable balance in the general ledger to the related sales invoices to test the existence or occurrence assertion (occurrence objective).

Figure 7-3 depicts the relationships among the seven categories of audit evidence, the eight types of specific audit objectives, and the sixteen prescriptive terms of audit procedures. Note that there is not necessary a one-to-one relationship among audit evidence, specific audit objective and prescribed audit procedure. Audit evidence pertinent to a specific audit objective is ordinarily obtained by prescribing several audit procedures. For example, evidence pertinent to the specific audit objective of existence of inventory is ordinarily obtained by prescribing several audit procedures such as count, inspect, observe, and examine physical inventory.

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Figure 7-3 Relationships among Seven Categories of Audit Evidence, Eight Types of Specific Audit Objectives, and Sixteen Prescriptive Terms of Audit Procedures

Specific Audit Objectives (8 broad types)

Pertinent to

Audit Evidence (7 Broad Categories)

To obtain

Audit Procedures (16 Prescriptive Terms)

Evaluation of Audit Evidence

Once the seven categories of evidence have been gathered (see Tables 7-2 through to 7-6), the auditor evaluates their reliability (low, medium, or high) based on the factors that affect their reliability (see Table 7-1). For example, if the auditor tested for the specific audit objective of existence of inventory and used the audit procedure of inquiry with the warehouse manager to obtain the evidence, then the reliability of the evidence is generally regarded as low because not only internal source of evidence is less reliable (see Table 7-1) but also oral evidence gathered through inquiry alone is not sufficient to accomplish any specific audit objective (See Table 7-4 and Table 7-5). In other words, to accomplish the existence objective, the auditor would need to corroborate the oral evidence with more reliable direct knowledge evidence (see Table 7-1) such as conducting test counts of the inventory for physical evidence (see Table 7-4 and Table 7-5). Analytical Procedures

Recall in Table 7-5 the 7 th category of evidence (analytical evidence) and the audit procedures associated with it (compute, scan, compare, and analyze). The audit procedures for gathering the analytical evidence are collectively known as analytical procedures. Analytical procedures are defined in AU 520 Analytical Procedures as "evaluations of financial information made by a study of plausible relationships among both financial and non-financial data." These procedures are based on the presumption that plausible relationship among data may reasonably be expected to exist. For example, accounts receivable and sales should bear a plausible relationship to one another. Thus, if gross sales for a company decrease substantially from one period to the next, an auditor might reasonably expect a substantial decrease in accounts receivable as well. Analytical procedures range from simple comparisons to complex statistical models. Auditor uses six common types of analytical procedures in the audit process. These are: 1. Compare client and industry data. 2. Compare client data with similar prior-period data. 3. Compare Compare client client data data with with auditor-determined client-determined expected 4. expectedresults. results. 5. Compare client data with expected results, using non-financial data. 6. Perform financial ratio analysis on client data. These six common types of analytical procedures are commonly used in the audit process as shown in Figure 7-4.


Figure 7-4 Analytical Procedures used in the Audit Process

The Audit Process

Audit Plan

Analytical Procedures #1, #2 #5, #6

Tests of Controls

Not Applicable

Tests of Balance

Analytical Procedures #3, #4, #5


Analytical Procedure #6, Benford’s Law

Audit Report

Not Applicable

Analytical Procedures in Audit Plan

An auditor uses analytical procedures in planning an audit to: 1. Enhance an understanding of the client's business. 2. Identify areas that may represent risk of misstatement. 3. Direct attention to areas of greater risk, and to plan for more effective and efficient audit procedures. Analytical procedures used in planning an engagement include reviewing financial information to identifying unexpected relationships or trends. For example, a comparison of general ledger balances with similar balances from prior periods and with budgeted or forecasted balances. Various ratios or trends may also be computed to facilitate the analysis. In addition to financial data, non-financial data may be used as part of the analytical procedures. For example, quality control reports prepared near year-end may identify production problems, which may suggest that significant amounts of inventory sold during the latter part of the year may be returned or may significantly increase future warranty claims. The use of analytical procedures in planning an audit typically involves five steps as shown in Table 7-7. Table 7-7 Analytical Procedures in Audit Plan Phase

Steps in Analytical Procedures (1) Determine computations/comparisons to be made

(2) Develop expectations

Comments Types of calculation and comparison commonly used include the following: (a) Absolute data comparisons. For example, comparing the amount of an account balance with an expected or predicted amount. (b) Common-size financial statements. This involves calculating the percentage of a related total that a financial statement item represents. For example, cash as a percentage of total assets. The percentage is then compared with an expected amount. (c) Ratio analysis. Ratios can be analyzed individually or in related groups such as activity, profitability, liquidity, leverage, and solvency. Table 7-8 provides a summary of the common ratios and their interpretations under each category of ratios. (d) Trend analysis. Trend analysis involves comparing certain data (absolute, common-size, or ratio) across accounting periods. Typical information that an auditor uses for developing expectations include: (a) Financial information from comparable prior periods. For example, an expectation that total payroll costs will equal last year's amount adjusted for a predictable increase resulting from higher wage rates and/or higher payroll taxes. (b) Anticipated results, such as projections or forecasts. For example, an expectation that current year data can be extrapolated from prior interim or annual data. (c) Relationships among elements offinancial information. For example, an increase in the average amount of debt outstanding would lead to an expected increase in interest expense. (d) Information regarding theindustry in which the client operates. For example, an expectation that

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Steps in Analytical Procedures

(3) Perform the computations/comparisons

(4) Analyze data and identify significant differences (5) Determine effects on audit planning.

Comments inventory turnover should be reasonably consistent across companies in the same industry. Data of other companies within an industry may be obtained from sources such as Dun & Bradstreet, Robert Morris Associates, and Standard & Poor (e) Relationship between financial and non-financial information. For example, a client's share of the market may be used to develop expectation about its sales. This step involves gathering data to be used in computing the absolute amount, the common-size percentage, ratios and so on. It also includes gathering the industry data for comparison purposes. Computer software is commonly used in making the calculations and comparisons, and may also be used in extracting information from company and industry databases. This typically involves reconsidering the methods and variables used in developing the expectations and making inquiries of management. Management's response should ordinarily be corroborated with other evidential matter. When an explanation for the difference cannot be obtained, the auditor must determine the impact on the audit plan. Unexplained significant differences ordinarily indicate increase risk of misstatement in the account or accounts involved in the computation and comparison. The auditor will then plan to perform more effective and efficient tests on the accounts.

Table 7-8 Common Ratios Used for Ratio Analysis

Category

Ratio

Interpretation

Asset Turnover = Net Sales / Total Assets Measures capital intensity: the larger the number the more a Activity client is able to generate sales with its asset base. Activity ratios measure the management’s effectiveness in Inventory Turnover = Cost of Goods Sold / Measure inventory management: the larger the number the managing available resources. Average Inventory faster a client is able to turn over its inventory. Trends in the inventory turnover ratio are used by auditors to identify potential inventory obsolescence.



Days in Inventory Turnover = 365 days / Measure inventory management: the larger the number the Inventory Turnover longer a client is holding on the inventory. Accounts Receivable Turnover = Net Sales Measure credit effectiveness: the larger the number the faster / Average Accounts Receivable a client is able to turn over its credit sales. Trends in the accounts receivable turnover ratio are used by auditor to assess the reasonableness of the allowance for uncollectible accounts. Days in Accounts Receivable Turnover = 365 days/ Accounts Receivable Turnover Return on Total Assets = Operating Income  Profitability Before Interest and Taxes/ Average Total Profitability ratios measure the Assets management’s effectiveness in generating returnon investment Return on Common Equity = Operating in assets and equity. Income Before Interest and Taxes / Average stockholders’ Equity

Measure credit effectiveness: the larger the number the longer a client takes to collect accounts receivable. Measure asset management: the higher the number the higher the rate of return on investment in assets.

Measure equity management: the higher the number the higher the rate of return on stockholders’ investment in the company.

Profit Margin = Operating Income Before Measure operating profitability: the higher the number the Interest and Taxes / Net Sales higher the rate of return on operations. This ratio is useful to auditors in assessing potential misstatements in operating expenses and related balance sheet accounts.

 Liquidity Liquidity ratios measure the management’s ability to meet current obligations.

Gross Profit Margin or Percentage = (Net Measure operating profitability: the larger the number the Sales – Cost of Goods Sold )/ Net sales larger the portion of the net sales available to cover all expenses after deducting the cost of product. This ratio is useful to auditors in assessing misstatements in sales, cost of goods sold, and inventory. Current Ratio = Current Assets / Current Measure working capital management: the larger the ratio Liabilities the greater adequacy of current assets to cover current liabilities. Quick Ratio = (Cash + Marketable Measure working capital management: the larger the ratio Securities + Net Accounts Receivable) / the greater a company is ability to meet its current liabilities Current Liabilities with cash or and near-cash assets.


Category

Ratio

Interpretation

Free Cash Flow = Cash Flow from Measure the cash flow remaining after covering cash Operations – Capital Expenditure outflows for operations and capital expenditures: the larger the number the higher a company has the capacity to finance operations and capital expenditures with operating cash flows. Debt to Equity = Total Liabilities/ Measure long-term debt management: if the ratio is too high,  Solvency (Leverage) Stockholders Equity, or a company may have used up its borrowing capacity; if the Solvency ratios measure the Debt to Total assets = Total Debt/Total ratio is too low, available debt leverage to a company is not management’s effectiveness in being used to the stockholders’ benefit. Assets managing borrowed funds or in generating income on borrowed Times Interest Earned = Operating Income Measure interest expense management: the number of times funds. Before Interest and Taxes / Interest Expense apositive company able from to make interest payments by generating cashisflow operations.

Analytical Procedures in Tests of Balances

An auditor uses analytical procedures in tests of balances (TOB) either: 1. As a TOB procedure to achieve an audit objective related to a particular management assertion, or 2. To provide audit evidence to corroborate evidence obtained from other audit testing procedures. For some assertions, analytical procedures are effective and efficient TOB procedures. For other assertions, however, analytical procedures are not as effective and efficient. Several factors determine the effectiveness and efficiency of an analytic procedure. These are shown in Table 7-9. It should be note that AU 520 states that analytical procedures must be applied (mandatory) at audit plan and completing the audit, but that analytical procedures may be applied (not mandatory) at tests of balances (substantive tests). Table 7-9 Factors Affecting the Effectiveness and Efficiency of an Analytical Procedure

Factors

Comments

(1) Nature of the assertion.

Analytical procedures are effective and efficient for assertions in which misstatements would not be apparent from TOB of individual transaction. For example, comparisons of aggregate salaries paid with the number of personnel may indicate unauthorized payments that may not be apparent from testing individual transactions. (2) Plausibility and predictability Analytical procedures are more effective and efficient for expected relationships that are plausible and of the relationship. predictable. As a rule of thumb: (a) Relationships are more predictable in a stable than a dynamic or unstable environment. (b) Relationships are more predictable for income statement accounts (representing transactions over a period of time) than balance sheet accounts (representing amounts at a point in time). (c) Relationships involving transactions subject to management discretion are less predictable. For example, management may delay advertising expenditures. (3) Availability and reliability of Analytical procedures are more effective and efficient when data is readily available and reliable. As a rule data. of thumb: (a) Audit data (current or prior year) is more reliable than un-audited data. (b) Data is more reliable when obtained from sources outside than from sources within the client. (c) Data is more reliable when the client has adequate separation of duty. (d) Data is more reliable when the client has adequate internal controls. (e) Reliability of expectations increases as sources of data increase. (4) Precision ofthe expectation. Analytical proceduresare more effective andefficient whenthe expected relationshipsare more precise. The precision of the expected relationships depends on: (a) The number of relevant variables that affect the amount being audited, e.g., sales are affected by prices, volume and product mix. The more variables, the more precise is the expectation. (b) The number of relevant variables that are evaluated by the auditor. The more variables evaluated, the more precise the expectation. (c) The level of detail in the data used to develop the expectation. The more detailed the data, the more precise the expectation. For example, monthly amounts are more precise than annual amount; comparison by location or line of business is more precise than company-wide comparisons.

Benford’s Lawin Tests of Balances

A complex analytical procedure that can be used as a TOB procedure is the application of Benford’s Law. Benford’s Law is a numerical probability theory that establishes the probability of the appearance of numerical digits in naturally occurring sets of numbers. The Benford’s Law establishes the following approximate probabilities of

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occurrence as first digits: 1-30%, 2-18%, 3-12%, 4-10%, 5-8%, 6-7%, 7-6%, 8-5%, and 9-4%. A perpetrator, who has no knowledge of the Benford’s Law, would create accounting numbers by assuming that all the fraudulently created numbers have an equal probability of occurrence as the first digit. Thus, by checking the probability of occurrence of the first digit in a sample of accounting numbers under consideration, the auditor is able to detect potential accounting frauds. For example, a purchasing officer in charge of the purchasing department is authorized to approve payments of vouchers to a maximum limit of $5,000. If the auditor finds a higher than expected probability of occurrence (i.e., more than 10%) of 4 as a first digit in a sample of vouchers (i.e., vouchers at $4,001 to $4,999), then it is very likely that the purchasing officer intentionally divided large voucher payments into smaller voucher payments of just under the maximum limit of $5,000 to avoid seeking higher level of approval for the voucher payments. Thus, t he purchasing officer’s spending pattern is likely to be further investigated by the auditor. It should be note that large samples of numbers adhere more closely to the probability of occurrence of the Benford’s Law than small samples. Moreover, the application of the Benford’s Law can result in false positives (i.e., wrong conclusion) in practice. For example, an HMO’s fee schedule can create clustering (i.e., groups of set fees), and hence results in false non-compliant number repetition in a medical office’s billing. Analytical Procedures in Completing the Audit

An auditor uses analytical procedures at the completing the audit phase either as part of the final review of the audited financial statements or to assess whether the client continues as a going concern. Table 7-10 provides some comments on applying the analytical procedures for these two purposes. Table 7-10 Applying Analytical Procedures at Completing the Audit Phase

As Part of the Final Review

Assessment of a Client's Going Concern Status

As part of the final review of the audited financial statements, At the completion of the audit, an auditor uses analytical procedures to analytical procedures are used to determine whether the anticipated assess whether a client will continue as a going concern, e.g., a low opinion on the financial statements is appropriate. For this purpose, thecurrent ratio indicates a potential going concern problem. auditor should consider: Altman (1968) developed a model for predicting bankruptcy as (1) The adequacy of data collected in response to unusual or follows: unexpected balances identified as part of the preliminary analysis. Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5 (2) The existence of unusual or unexpected balances not otherwise Z = discriminant Zscore identified during the examination of the financial statements. X1 = net working capital/total assets When the during final review or unexpected balancesmust not X2 = retained earnings/total assets addressed other identifies phases ofunusual the engagement, the auditor determine whether additional procedures should be performed before X3 = earnings before interest and taxes/total assets expressing an opinion on the financial statements. X4 = market value of equity/total debt (liabilities) X5 = net sales/total assets A client will be a going concern if Z is greater than 2.99 The predictive accuracy of Altman's model is about 95% one year prior to bankruptcy. Since auditors are responsible for assessing a client's going concern status for a reasonable period of time; and a reasonable period of time is defined as one year beyond the date of client's year-end financial date according to AU 570 Going Concern, the model's high predictive accuracy of one year prior to bankruptcy (95%) renders it a very effective analytical procedure for assessing a client's going concern status.

Other Audit Procedures to Assess a Client’s Going Concern Status

In addition to performing analytical procedures, an auditor also performs other audit procedures to identify conditions and events that indicate there could be substantial doubt about a client's ability to continue as a going concern. These other audit procedures include: 1. Review of subsequent events. 2. Review of compliance with the terms of debt and loan agreements. 3. Reading of minutes of meetings of stockbrokers, board of directors, and important committees of the board. In performing these audit procedures, the auditor seeks to identify conditions and events that indicate a substantial doubt about a client's ability to continue as a going concern. Table 7-11 shows some of these conditions and events. After considering these conditions and events in the aggregate; if the auditor believes there is substantial doubt about a client's ability to continue as a going concern, s/he should identify the management's plan, if any, for


mitigating the adverse conditions and events, and consider the effectiveness and feasibility of the management's plan. Table 7-12 describes the auditor’s considerations about the management’s plan. Table 7-11 Conditions and Events that Indicate a Substantial Doubt

Conditions and Events (1) Negative financial trend

(2) Non-financial indicators

(3) Internal factors

(4) External factors

Examples (a) Recurring operation losses (b) Working capital deficiencies (c) Negative cash flows (d) Adverse key financial ratios (a) Arrearages in dividends (b) Denial of trade credit from suppliers (c) Restructuring of debt (d) Noncompliance with statutory capital requirements (e) Need new source/method of financing (f) Need to dispose substantial assets (a) Work stoppages/labor difficulties (b) Over dependence on the success of a particular project (c) Uneconomic long-term commitments (d) Need to significantly revise operation (a) Adverse legal proceedings (b) Loss of a key franchise, license, patents, copyright , trademark (c) Loss of a principal customer or supplier (d) Uninsured or underinsured policies against drought, earthquake, fire or flood.

Table 7-12 Management’s Plan and Auditor’s Consideration

Management’s Plan

Auditor’s Consideration

(1) Plans to dispose of assets

(a) Restrictions on disposal of assets, e.g., covenants on assets (b) Marketability of assets (c) Direct/indirect effects of disposal of assets (2) Plans to borrow money or (a) Availability of debt financing, e.g., new credit line, factoring of receivables, sale -leaseback of assets restructure debt (b) Availability/committed loans to the client (c) Effects of additional borrowings (3) Plans to reduce or delay (a) Feasibility of reducing overheads or administrative expenditures expenditure (b) Lease Postponing orassets research and development projects (c) rathermaintenance than purchase (4) Plans to increase ownership (a) Feasibility of increasing ownership equity equity (b) Arrangements to raise additional capital (c) Arrangements to reduce dividend requirement (d) Arrangements to accelerate cash disbursement from affiliates or other investors.

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Which of the following statements is true with regard to audit evidence? a. Evidence obtained from sources external to the client is less reliable than those from sources internal to the client. b. Evidence obtained from sources internal to the client is more reliable when its internal control is strong than weak. c. Evidence supplied by the client is more reliable than those personally obtained by the auditor. d. Evidence obtained through confirmation is less reliable than those obtained through observation.

7-2

Which of the following audit procedures would produce the least reliable audit evidence? a. Test counts of inventory made by the auditor. b. Notes on inquiry with the warehouse manager. c. Correspondence with the suppliers of the inventory. d. An analysis of the perpetual inventory records.

7-3

The auditor's analytical procedures will not be very effective in determining which of the following assertions? a. Rights and obligations. b. Completeness. c. Valuation and allocation. d. Presentation and disclosure.

7-4

Analytical procedures are best described as a. tests of controls designed to evaluate the strength of internal controls. b. tests of balances designed to substantiate financial information. c. audit tests designed to evaluate the reasonableness of financial and non-financial information. d. audit tests designed to investigate unrecorded accounting transactions.

7-5

Analytical procedure may be performed a. at the planning and completion phases of an audit. b. at the tests of controls and tests of balances phases of an audit. c. at the tests of transactions and tests of balances phases of an audit. d. at the planning, testing, and completion phases of an audit.

7-6

Which of the following ratios is an indicator of a client's ability to pay its long-term debt? a. Debt to equity ratio. b. Gross profit margin ratio. c. Quick ratio. d. Accounts receivable turnover ratio.

7-7

If accounts receivableturnover ratio for a client is 4 times in 20x0 and 2 times in 20x1, it is most likely that a. there were fictitious credit sales in 20x1. b. there was a better management of credit granting procedure in 20x0. c. there were unrecorded credit sales in 20x0. d. there was a poorer management of credit granting procedure in 20x0.

7-8

If inventory turnover ratio for a client is 5 times in 20x0 and 10 times in 20x1 , it is most likely that (Hint: obsolete inventory is deducted from closing inventory) a. there was an increase in the cost of goods sold in 20x0. b. there was an increase in purchases in 20x0. c. there was a decrease in obsolete inventory in 20x1. d. there was an increase in obsolete inventory in 20x1.

7-9

When an auditor compares a set of financial data with a set of expected data computed by the auditor, which of the following characteristics should the auditor pay most attention to? a. The reliability of the srcinal data from which the auditor computed the expected results. b. The availability of the srcinal data from which the auditor computed the expected results. c. The size of the srcinal data from which the auditor computed the expected results. d. The realism of the srcinal data from which the auditor computed the expected results.


7-10

Which of the following ratios is an indicator of a client's effectiveness in its operation? a. Quick ratio. b. Return on total assets. c. Times interest earned. d. Average inventory turnover ratio.

7-11

Which of the following ratiosis least likely to be used in comparing clients in the same industry? a. Average inventory turnover ratio. b. Return on total assets ratio. c. Current ratio. d. Return on common equity ratio.

7-12

Which of the following ratios is least likely to be used in checking the liquidity position ofa client? a. Debt to equity ratio. b. Gross profit margin ratio. c. Current ratio. d. Quick ratio.

7-13

Evidence is generally considered appropriate when a. it has been obtained by a random selection. b. there is enough of it to afford a reasonable basis for an opinion on financial statements. c. it has the qualities of being relevant and reliable. d. it consists of written statements made by managers of the audit client.

7-14

When the auditor examines the client’s documents and records to substantiate the information on the financial statements, it is commonly referred to as

a. inquiry. b. confirmation. c. vouching. d. physical examination. 7-15

Evidence obtained directly by the auditor will not be reliable if a. the auditor lacks the qualifications to evaluate the evidence. b. it is provided by the client’s attorney. c. the client denies its veracity. d. it is impossible for the auditor to obtain additional corroboratory evidence.

7-16

Which of the following factors would least i nfluence an auditor’s consideration of the reliability of data for purposes of analytical procedures?

a. Whether sources within the client were independent of those who are responsible for the amount being audited. b. Whether the data were processed in an EDP system or in a manual accounting system. c. Whether the data were subjected to audit testing in the current or prior year. d. Whether the data were obtained from independent sources outside the entity or from sources within the entity. 7-17

Which of the following procedures would provide the most reliable audit evidence? a. Inquiries of the client’s internal audit staff held in private. b. Inspection of prenumbered client purchase orders filed in the vouchers payable department. c. Analytical procedures performed by the auditor on the entity’s trial balance. d. Examine of bank statements obtained directly from the client’s financialinstitution.

7-18

Which of the following statements concerning audit evidence is correct? a. To be appropriate, audit evidence should be either reliable or relevant, but need not be both. b. The auditor exercises judgment in determining the reliability of audit evidence. c. The difficulty and cost of obtaining audit evidence concerning an account balance is a valid basis for omitting the test. d. A client’s accounting data can be sufficient audit evidence to support the financial statements.

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7-19

Which of the following presumptions is correct about the reliability of evidence? a. Information obtained indirectly from outside sources is the most reliable evidence. b. To be reliable, evidence should be convincing rather than persuasive. c. Reliability of evidence refers to the amount of corroborative evidence obtained. d. A strong internal control provides more assurance about the reliability of evidence.

7-20

In testing the existence or occurrence assertion for an asset, an auditor ordinarily vouches from the a. financial statement s to the potentially unrecorded items. b. potentially unrecorded items to the financial statements. c. accounting records to the supporting documents. d. supporting documents to the accounting records.

7-21

In determining whether transactions have been recorded (completeness objective), the direction (tracing versus vouching) should be from the a. general ledger balance. b. adjusted trial balance. c. srcinal source documents. d. general journal entries.

7-22

A client’s income statements were misstated due to the recording of journal entries that involved debits and credits to an unusual combination of expense and revenue accounts. The auditor would most likely detect these misstatements by

a. tracing a sample of source documents to the related general ledger. b. evaluating the effectiveness of internal control policies and procedures. c. investigating the reconciliations between controlling accounts and subsidiary records. d. performing analytical procedures designed to disclose differences from expectations. 7-23

Which of the following non-financial information would an auditor most likely consider in performing analytical procedures during the planning phase of an audit? a. Work stoppages and labor difficulties. b. Objectivity of audit committee member. c. Square footage of selling space and market share. d. Management plans to repurchase stock.

7-24

Analytical proceduresperformed at the completing theaudit phase as part of the final review of the audited financial statements suggest that several accounts have unexpected relationships. The results of these analytical procedures most likely would indicate that a. additional tests of balances are required. b. fraud exists among the relevant accountbalances. c. internal controls of the relevant account are not effective. d. previous communication with the audit committee should be revised.

7-25

Which of the following would not be considered an analytical procedure? a. Estimating payroll expense by multiplying the number of employee by the average hourly wage rate and the total hours worked. b. Estimating the maximum population misstatement rate of inventory based on the results of a statistical sample. c. Computing accounts receivable turnover by dividing credit sales by the average net receivable. d. Developing the expected current-year sales based on the sales trend of the prior five years.

7-26

Which of the following factors least affects the effectiveness and efficiency of an analytical procedure? a. Segregation of obsolete inventory before the physical inventory count. b. A standard cost system that produces variance reports. c. Collection of data from sources with strong internal controls. d. The level of detail in the data used to develop the expected relationships.

7-27

Analytical procedures used in the planning phase of an audit process should focus on a. reducing the scope of tests of controls and tests of balances. b. providing assurance that potential material misstatements will be identified. c. enhancing the auditor’s understanding of the client’s business. d. assessing the sufficiency of the available evidential matter.


7-28

An auditor’s decision either to apply analytical procedures as tests of balances or to perform tests of balances usually is determined by the

a. availability of the tests of balances procedures. b. auditor’s familiarity with industrytrend. c. timing of performing the tests of balances procedures. d. relative effectiveness and efficiency of the testing procedures. 7-29

Which of the following statements concerning analytical procedures is correct? a. Analytical procedures should be used when there is no plausible relationships among non-financial information. b. Analytical Analytical procedures procedures usually used in are planning the and auditefficient should for not tests use non-financial c. effective of controls. information. d. Analytical procedures alone may provide the appropriate level of assurance for some assertions.

7-30

Which of the following tendsto be most predictable forpurposes ofanalytical proceduresapplied as tests of balances? a. Data subjected to auditing in the prior year. b. Transactions subject to management discretion. c. Relationships involving income statement accounts. d. Relationships involving balance sheet accounts.

7-31

Which of the following comparisons is the most useful analytical proc edure an auditor could make in evaluating a client’s expenses? a. The current year’s accounts receivable with the prior year’s accounts receivable. b. The current year’s payroll expense with the prior year’s payroll expense. c. The current year’s budgeted sales with the prior year’s sales. d. The current year’s budgeted contingent liabilities with prior year’s contingent liabilities.

7-32

Which of the following conditionsor events mostlikely would cause an auditor to have substantial doubtabout aclient’s ability to continue as a going concern? a. Significant related party transactions are pervasive. b. Usual trade credit from suppliers is denied. c. Arrearages in preferred stock dividends are paid. d. Restrictions on the disposal of principal assets are present.

7-33

An auditor believesthere is substantial doubtabout the ability ofa client to continue as a going concernfor a reasonable period of time. In evaluating the client’s plans for dealing with the adverse effects of future conditions and events, the auditor most likely would consider, as a mitigating factor, the client’s plans t o a. discuss with lenders the terms of all debt and loan agreements. b. strengthen internal controls over cash disbursements. c. purchase production facilities currently being leased from a related party. d. postpone expenditures for research and development projects.

7-34

An auditor believesthere is substantial doubtabout the ability ofa client to continue as a going concernfor a reasonable period of time. In evaluating the client’s plans for dealing with the adverse effects of future conditions and events, the auditor most likely would consider, as a mitigating factor, the client’s plans t o a. accelerate research and development projects related to future products. b. accumulate treasury stock at prices favorable to the client’s historic price range. c. purchase equipment and production facilities currently being leased. d. negotiate reductions in required dividends being paid on preferred stock.

7-35

Which of the following auditingprocedures most likely would assist an auditor in identifying conditionsand events that may indicate substantial doubt about a client’s ability to continue as a going concern? a. Inspecting title documents to verify whether any assets are pledged as collateral. b. Confirm with third parties the details of arrangements to maintain financial support. c. Reconciling the cash balance per books with the cutoff bank statement and the bank reconciliation. d. Comparing the client’s depreciation and asset capitalization policies to other entities in the industry.

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7-36

When an auditor concludes there is substantial doubt about a continuing client’s ability to continue as a going concernfor a reasonable period of time, the auditor’s responsibility is to

a. express a qualified or adverse opinion, depending upon materiality, due to the possible effects on the financial statements. b. consider the adequacy of disclosure about the client’s possible inability to continue as a going concern. c. report to the client’s audit committee that management’s accounting estimates may need to be adjusted. d. reissue the prior year’s auditor’s report and add an explanatory paragraph that specially refers to “substantial doubt” and “going concern.” 7-37

The third standard of field work requires the auditor to collect sufficient appropriateevidential matter in support of the opinion. Which procedure for collecting evidential matter is not identified in this standard? a. Inspection. b. Inquiries. c. Observation. d. Rechecks.

7-38

AU 500 Audit Evidential , states that management makes certain assertions that are embodied in financial statement components; for example, two such categories of assertions are completeness and valuation or allocation. Which of the following is not a broad category of management assertions according to the auditing standards? a. Rights and obligations. b. Presentation and disclosure. c. Existence or occurrence. d. Errors or fraud.

7-39

Which of the following is an example of corroborating information (note:versus underlying information)that could be used by an auditor as evidential matter supporting the financial statements? a. Worksheets supporting cost allocations. b. Confirmation of accounts receivable. c. General and subsidiary ledgers. d. Accounting manuals.

7-40

Audit evidencecan come in different formswith different degreesof persuasiveness. Which of the following isthe least persuasive type of evidence? a. Bank statement obtained from the client. b. Test counts of inventory made by the auditor. c. Prenumbered purchase order forms. d. Correspondence from the client’s attorney about litigation.

7-41

Audit evidencecan come in different formswith different degreesof persuasiveness. Which of the following is the most persuasive type of evidence? a. Prenumbered client purchase order forms. b. Client work sheets supporting cost allocations. c. Bank statements obtained from the client. d. Client representation letter.

7-42

Which of the following presumptionsdoes not relate to the appropriateness (note:versus sufficiency) ofaudit evidence? a. The more effective internal control, the more assurance it provides about the accounting data and financial statements. b. An auditor’s opinion, to be economically useful, is formed within reasonable time and based on evidence obtained at a reasonable cost. c. Evidence obtained from independent sources outside the entity is more reliable than evidence secured solely within the client. d. The independent auditor’s direct personal knowledge, obtained through observation and inspection, is more persuasive than information obtained indirectly.

7-43

A basic premise underlying analytical procedures is that a. procedures replace tests of may balances transactions. b. these statistical tests ofcannot financial information lead and to the discovery of material misstatements in the financial statements. c. the study of financial ratios is the only alternative to the investigation of unusual fluctuation. d. plausible relationships among data may reasonably be expected to exist and continue in the absence of known conditions to the contrary.


7-44

An objective of performing analytical procedures in planning an audit is to identify the existence of a. unusual transactions and events. b. illegal acts that went undetected because of internal control weaknesses. c. related party transactions. d. recorded transactions that were not properly authorized.

7-45

For audits of financial statements made in accordance withgenerally accepted auditing standards (GAAS), the use of analytical procedures is required (mandatory) to some extent

a. b. c. d. 7-46

In Planning No Yes Yes No

In Tests of Balances Yes Yes No No

In Completing the Audit Yes No Yes No

A primary objective ofanalytical proceduresused in the final review stage of completing h t e audit is to a. obtain evidence from details testing to corroborate particular assertions. b. identify areas that represent specific risks relevant to the audit. c. assist the auditor in assessing the validity of the conclusions reached. d. satisfy doubtswhen questions arise about a client’s ability to continue in existence.

7-47

Analytical procedures used in the final review stage of completing the audit generally include a. considering unusual or unexpected account balances that were not previously identified. b. performing tests of transactions to corroborate management’s financial statement assertions. c. gathering evidence concerning account balances that have not changed from the prior year. d. retesting controls that appeared to be ineffective during the assessment of control.

7-48

If an auditor were concerned thata client was failing to bill customers for shipments (i.e., completeness objective), the auditor would a. select a sample ofsales transactions from the sales journal and vouched each toshipping documents to determine whether sales are supported by adequate documentations. b. select a sample of shipping documents and traced each to recorded sales transactions in the sales journal to determine whether shipments have been billed. c. select a sample of sales account balances and observed the inventory count for shipments to examine existence. d. select a sample of sales transactions and recomputed the costs of shipments to determine accuracy.

7-49

If an auditor selectsa sample of sales transactions fromthe sales journal and vouches each to shipping documents to determine whether sales are supported by adequate documentations, the auditor is most likely testing for the specific audit objective of a. Completeness b. Rights and Obligations c. Accuracy and Valuation d. Occurrence

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7-1 b. 7-2 b. 7-3 a.

7-4 c. 7-5 d. 7-6 a. 7-7 b. 7-8 d. 7-9 a. 7-10 b. 7-11 d.

7-12 b. 7-13 c. 7-14 c. 7-15 a. 7-16 b. 7-17 d. 7-18 b. 7-19 d. 7-20 c. 7-21 c. 7-22 d. 7-23 c. 7-24 a. 7-25 b. 7-26 a. 7-27 c. 7-28 d. 7-29 d. 7-30 c. 7-31 b. 7-32 b. 7-33 d. 7-34 d. 7-35 b. 7-36 b. 7-37 d. 7-38 d. 7-39 b. 7-40 c. 7-41 c. 7-42 b. 7-43 d. 7-44 a. 7-45 c. 7-46 c. 7-47 a.

7-48 b. 7-49 d.


Simulation Question 7-1 Simulation Question 7-1 is an adaptation with permission from an article by Lanza, R. B. in The the White Paper , a publication of the Association of Certified Fraud Examiners in Austin, Texas. This simulation question is based upon a true set of facts; however, the names and places have been changed. m who was assigned to investigate possible embezzlement at one retail store. Bruce’s Bruce Lee was a member of an audit tea responsibility was to examine the questionable actions of one of the cashiers named Helen Uddin. The regional manager of that retail store informed Bruce that he knew Helen was up to no good. “Maybe she is playing with her refunds or discounts, but something fishy is going on!” he lamented. Helen knew the store cameras and informants were watching her and that management regularly counted the cash. Therefore, Bruce determined that he would not be able to detect any unrecorded cash skimming schemes because, obviously, if there were no recorded sales then there were no sales transaction data. But Bruce knew that he could look for register adjustment schemes such as phony discounts, refunds, and sales voids. For example, Helen might say to a customer that her computer was down, wrote a manual receipt at the full price, and accepted cash for the sale. Then, after the customer left, she would book the sale with a large discount and take the difference in cash. Another scenario was Helen might book the sale with the large discount but never gave the receipt to the customer. Finally, Helen could fake a large number of refunds and sales voids. Bruce obtained a copy of the sales register data file from the MIS department of the retail store. You should access Data File 7-1 in iLearn for the sales register data file, which contains 10,240 sales transactions. After reviewing the sales register data file, Bruce planned to analyze the data to find out if Helen was in fact posting large number of phony discounts, sales voids and refunds. He planned to:

 

Extract sales with discounts over 90% and summarize by employee;

Identify employees that have produced register adjustments (discounts, refunds, and sales voids) over 300 % more than the average employee; and

 List the top 10 employees by register adjustments (discounts, refunds, and sales voids). Bruce was confident that the data analyses would identify Helen as the number one suspect in the retail store. Required Access Data File 7-1 i n iLearn for the sales register data file, which contains 10,240 sales transactions.

1. Analyze the sales register data file to produce the following three reports: i. Report No.1 – Extract sales with discounts over 90% and summarize by employee. ii. Report No.2 – List the top 10 employees by register adjustments (discounts, refunds, and sales voids). iii. Report No.3 – Identify employees that have produced register adjustments over 300% more than the average employee. 2. Review the three reports in 1 above and explain why you think whether Helen should or should not be the number one suspect. Note: State your assumption, if any, about Helen’s employee number.

Simulation Question 7-2 Simulation Question 7-2 is an adaptation with permission from a case by Coulter, J.M. and T.J. Vogel in Issues the in Accounting Education , a publication of the American Accounting Association in Sarasota, Florida. This simulation question is based upon a true set of facts.



Pets.com, Inc.

During the 1990s, the establishment and growth of the Internet created a “dot-com euphoria.” Venture capitalists were eager to invest their funds in Internet start-ups that offered the potential to provide large returns with the growth of the Internet. Among the most popular new dot-com companies were online retailers, or “e-tailers.” Because there was no required investment in “brick and mortar” needed for these etailers, the common perception was that e-tailers could sell their products for less. The lower prices and customer convenience of shopping from a computer made these business very attractive investments. One such company that was established during the period was Pets.com, Inc. (hereafter, P). P incorporated in February 1999 as an online retailer of pet products. The corporate headquarters were located in San Francisco. P’s online store was designed to service the needs of the owners of many pets including dogs, cats, birds, fish, reptiles, and ferrets, among others. Approximately 12,000 products were available. P also integrated this broad product selection with extensive pet-related information and resources designed to help customers make informed purchasing decisions. P’s strategy included the following key components: a. Building enduring brand equity through an advertising strategy that included its P’s sock puppet brand icon, relationshipswith selected online companies, and support for national events and pet-related local market activities. b. Offering the broadest possible pet product selection available to its customers at competitive prices. c. Establishing its private label brands for pet products marketed under the Petsplete and Pets brand names. d. Providing increasingly comprehensive and relevant content in conjunction with a range of consumer and veterinary care partners. e. Delivering superior customer service and promoting repeat purchases through investments in people, technology, and distribution facilities. f. Continuing to maintain and expand its relationships with Amazon.com, which was its largest shareholder, and Go.com. g. Expanding internationally in order to capitalize on the global market.

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Like all business start-ups, the main challenge to achieving these ambitious goals was to gain market share. P set out to establish and grow a customer base with an aggressive marketing campaign and discounted prices. The marketing campaign inclu ded the creation of its “sock puppet” and extensive advertising at national events. With product pricing, company officials decided to offer severe discounts to attract customers. They were successful in gaining market share, but their strategy resulted in a negative gross margin over the first year of operations. . You should access Data File 27-in iLearn for Exhibits 1, 2, and 3 that contain the financial statements for P’s first year of operations. The income statement in Exhibit 2 demonstrates P’s increasing customer base. Sales grew from a mere $39k in its first quarter of operations to

nearly $5.2m in the final quarter of 1999. Unfortunately, P was experiencing the financial hardships encountered by many start-ups. As the MD&A in Exhibit 4 indicates, extensive marketing costs and severe price discounts created a large operating loss for the period. You should access Data File 72 in iLearn for Exhibits 4 that contains P’s Management’s Discussion and Analysis. The balance sheet in Exhibit 2 reports available cash of $30.2 million, but company officials knew that this was not enough to support the growth planned for subsequent periods. The statement of cash flows in Exhibit 3 shows that P used $65.3 million in its 1999 operations. Certainly this use would grow in 2000 as any’s brief time the company extended its customer base. Additional funding would have to be acquired to support this growth. Despite the comp in existence to that point, company officials determined it was time to go forward with its initial public offering (IPO) of common stock.



The Planned IPO

P planned to go public in February 2000. The principal purposes of the offering were to fund operating losses, increase working capital, fund capital expenditures, create a public market for P’s common stock, and facilitate future access to the public capital markets. The net proceeds of the offering would be used primarily for working capital and general corporate purposes, including marketing and brand building efforts, capital expenditures associated with the expansion and building of distribution centers, and technology and system upgrades. Pets’ executives believed that their extensive product offering along with an efficient and convenient web shopping store would enable it to attract an increasing share of the pet product retail industry. The most recent data on this industry showed an annual growth rate of 9 percent between 1993 and 1997. Total industry sales for 1997 exceeded $22 billion. It was believed that if P could establish itself as a market leader for the online purchase of pet products, it could capture an increasing share of the growing market. Unfortunately, because P was such a young company, many business risks existed. Together with the interested underwriters, P executives evaluated the risks that potential investors would encounter with the purchase of P’s common stock.You should access Data File 7-2 in iLearn for Exhibits 5 that contains a summary of the risks disclosed in P’s prospectus. After evaluating the risks and the potential payoffs to investors, four companies agreed to underwrite the issue: Merrill Lynch $ Co., Bear, Stearns & Co. Inc., Thomas Weisel Partners LLC, and Warbury Dillon Read LLC. P’s initial offering of 7.5 million shares at an offering price of $11 per share was scheduled for February 16, 1999. The shares were approved for listing on the NASDAQ national Market under the symbol “IPET.” The offering was expected to provide net proceeds to Pets of $76.725 milli on as follows: Gross Proceeds (7.5 million shares at $11) Less: Underwriting discount ($0.77 per share) Net proceeds to P



$82,500,000 5,775,000 $76,725,000 =========

The Audit

P hired Ernst & Young LLP (hereafter, E&Y) to audit the 1999 financial statements summarized in Exhibits 2 through 4. As part of the opinion formulation process, E&Y needed to consider the company’s poor operating performance. After all, the company’s strategies had thus far led to a substantial loss in its expected first year to of survive existence, includingina negative gross profit. is questionable whether adoubt company type of performance can be reasonably financially the foreseeable future.It If E&Y has substantial about ’swith ability P this to continue as a going concern, they would have to indicate this in an explanatory paragraph accompanying their audit opinion. However, such an opinion would certainly hinder any chance for a successful public offering of stock. E&Y’s auditors would certainly have to examine the situation thoroughly before making this critical decision. In order to guide them in this decision, the auditors would utilize AU 570 Going Concern . This standard requires the auditors to obtain additional information about conditions and events that could create substantial doubt about the entity’s ability to continueas a going concern. You should refer toTable 7-11 Conditions and Events that Indicate a Substantial Doubt in Chapter Certainly, 7. the financial performance of P, along with the information on business risks contained in Exhibit 5, suggests that some of the conditions and events did indeed exist for P. In addition to the information above, auditors often utilize bankruptcy prediction models to assist in the going concern analysis. These models are designed to predict financial distress within one year. Studies suggest that the key factors in determining the likelihood of financial distress are profitability, the volatility of that profitability, and the company’s degree of financial leverage (solvency). Interestingly, liquidity measures turn out to be of less importance.You should access Data File 7-2 in iLearn for Exhibits 6 that contains the most popular of the bankruptcy prediction models – the Altman Z-score model. The auditors also should evaluate their client’s industry for any macro-economic impact from the external environment. P operated in

the e-tailing industry where companies were relatively young and characterized by fast growth and cash shortages. In fact, operating losses and cash shortages are the “norm” for the industry. These are necessary in the short run to gain the market share that ohpefully provides a large payoff in the long run. You should access Data File 7-2 in iLearn for Exhibits 7 that provides selected financial information for three other etailers: Amazon.com Inc., eToys Inc., and priceline.com Inc. These companies were characterized by increasing losses, even as they gained market share, and negative cash flows from operations. Despite this normally poor operating performance, e-tailers had established favor among the investing community. eToys and priceline.com each had a fairly large share price in their first year as a publicly traded company despite the large operating losses. Amazon.com had really become a market favorite. Despite mounting operating losses, its stock price had jumped from a split-adjusted $17.85 at the end of 1998 to $76.13 at the end of 1999. It certainly appeared that the market was confident of the future success of these e-tailers. Thus e-tailers in need of additional funding to support their short-term operating losses had reasonable expectations of being able to obtain the funds through subsequent stock issuances. E&Y’s auditors had a tremendous amount of information to digest regarding the risks facing P. The anticipated date for the IPO was soon approaching. Without a standard unqualified audit opinion, questions would arise regarding the viability of P as a viable investment alternative, and the initial public offering would most likely fail. A decision had to be made regarding the type of opinion that E&Y would provide in the IPO prospectus.


Required To answer the following questions, in addition to the information provided in Exhibits 1 through to 7 in iLearn, you are encourage to use other information available in SEC reports such as P’s prospectus, proxy statements, and the 10-Ks for other e-commerce companies. These reports are available at the SEC’s EDGAR database http://www.sec.gov/cgi_bin/srch-edgar 1. Refer to the four categories of common ratios used for ratio analysis in Table 7-8 of Chapter 7. a. Compute the financial ratios of P that you believe are relevant to evaluate the ability of the company to continue as a going concern. b. In your opinion, will P continue as a going concern based on the results of 1a? Explain your opinion. 2. Refer to the Altman Z-score model in Table 7-10 of Chapter 7 and Exhibit 6 in iLearn. a. Compute Model 1 (1968) of Altman Z-score for P as public a company. Assume P was publicly traded at a stock price of $411 (i.e., the IPO price in February 2000)ofand that all preferred stock outstanding had been converted into common stock. The conversion rate is one share of common for each share preferred. b. Compute Model 2 (1983) of Altman Zscore for P as a private company. c. In your opinion, will P continue as a going concern based on the combined results of 1a, 2a, and 2b? Explain your opinion. 3. Refer to selected financial information from other e-tailers in Exhibit 7 in iLearn. a. Compare your financial analysis in 1a, 2a, and 2b for P with the financial information provided for other e-tailers in Exhibit 7 in iLearn. b. In your opinion, will P continue as a going concern based on the combined results of 1a, 2a, 2b, and 3a? Explain your opinion. 4. Considering all your work done in 1, 2, and 3 above, and assume you are E&Y’s auditor, which of the following opinions would you issue? Provide justification for your chosen opinion. a. A standard unqualified opinion. b. An unqualified opinion with an additional paragraph about P will not continue as a going concern. c. A qualified opinion. d. A qualified opinion with an additional paragraph about P will not continue as a going concern.

Simulation Question 7-3 Simulation Question 7-3 is an adaptation with permission from a case by Coulter, J.M. and T.J. Vogel in Issues the in Accounting Education , a publication of the American Accounting Association in Sarasota, Florida. This simulation question is based upon a true set of facts.



Pets.com, Inc. During the 1990s, the establishment and growth of the Internet created a “dot-com euphoria.” Venture capitalists were eager to invest

theircom funds in Internet start-ups offered potential to provide withinvestment the growthinof“brick the Internet. Among the most popular companies were online that retailers, or the “e-tailers.” Because therelarge was returns no required and mortar” needed for these e- new dottailers, the common perception was that e-tailers could sell their products for less. The lower prices and customer convenience of shopping from a computer made these business very attractive investments. One such company that was established during the period was Pets.com, Inc. (hereafter, P). P incorporated in February 1999 as an P’s online store was designed to service the needs of online retailer of pet products. The corporate headquarters were located in San Francisco. the owners of many pets including dogs, cats, birds, fish, reptiles, and ferrets, among others. Approximately 12,000 products were available. P also integrated this broad product selection with extensive pet-related information and resources designed to help customers make informed purchasing decisions. P’s strategy included the following key components: a. Building enduring brand equity through an advertising strategy that included its P’s sock puppet brand icon, relationshipswith selected online companies, and support for national events and pet-related local market activities. b. Offering the broadest possible pet product selection available to its customers at competitive prices. c. Establishing its private label brands for pet products marketed under the Petsplete and Pets brand names. d. Providing increasingly comprehensive and relevant content in conjunction with a range of consumer and veterinary care partners. e. Delivering superior customer service and promoting repeat purchases through investments in people, technology, and distribution facilities. f. Continuing to maintain and expand its relationships with Amazon.com, which was its largest shareholder, and Go.com. g. Expanding internationally in order to capitalize on the global market. Like all business start-ups, the main challenge to achieving these ambitious goals was to gain market share. P set out to establish and grow a customer base with an aggressive marketing campaign and discounted prices. The marketing paign cam included the creation of its “sock puppet” and extensive advertising at national events. With product pricing, company officials decided to offer severe discounts to attract customers. They were successful in gaining market share, but their strategy resulted innegative a gross margin over the first year of operations. . You should access Data File 7-3 in iLearn for Exhibits 1, 2, and 3 that contain the financial statements for P’s first year of operations. The income statement in Exhibit 2 demonstrates P’s increasing customer base. Sales grew from a mere $39k in its first quarter of operations to

nearly $5.2m in the final quarter of 1999. Unfortunately, P was experiencing the financial hardships encountered by many start-ups. As the You should MD&A in Exhibit 4 indicates, extensive marketing costs and severe price discounts created a large operating loss for the period. access Data File 7-3in iLearn for Exhibits 4 that contains P’s Management’s Discussion d Analysis. an The balance sheet in Exhibit 2 reports cash of of cash $30.2flows million, but company knew that this was enough to support the growth for subsequent periods. available The statement in Exhibit 3 shows officials that P used $65.3 million in itsnot 1999 operations. Certainly this useplanned would grow in 2000 as any’s brief time the company extended its customer base. Additional funding would have to be acquired to support this growth. Despite the comp in existence to that point, company officials determined it was time to go forward with its initial public offering (IPO) of common stock.



The Planned IPO

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188


P planned to go public in February 2000. The principal purposes of the offering were to fund operating losses, increase working capital, fund capital expenditures, create a public market for P’s common stock, and facilitate future access to the public capital markets. The net proceeds of the offering would be used primarily for working capital and general corporate purposes, including marketing and brand building efforts, capital expenditures associated with the expansion and building of distribution centers, and technology and system upgrades. Pets’ executives believed that their extensive product offering along with an efficient and convenient web shopping store would enable it to attract an increasing share of the pet product retail industry. The most recent data on this industry showed an annual growth rate of 9 percent between 1993 and 1997. Total industry sales for 1997 exceeded $22 billion. It was believed that if P could establish itself as a market leader for the online purchase of pet products, it could capture an increasing share of the growing market. Unfortunately, because P was such a young company, many business risks existed. Together with the interested underwriters, P executives evaluated the risks that potential investors would encounter with the purchase of P’s common stock.You should access Data File 7-3 in iLearn for Exhibits 5 that contains a summary of the risks disclosedin P’s prospectus.

After evaluating the risks and the potential payoffs to investors, four companies agreed to underwrite the issue: Merrill Lynch $ Co., Bear, Stearns & Co. Inc., Thomas Weisel Partners LLC, and Warbury Dillon Read LLC. P’s initial offer ing of 7.5 million shares at an offering price of $11 per share was scheduled for February 16, 1999. The shares were approved for listing on the NASDAQ national Market under the symbol “IPET.” The offering was expected to provide net proceeds to Pets of $76.725 million as follows: Gross Proceeds (7.5 million shares at $11) Less: Underwriting discount ($0.77 per share) Net proceeds to P



$82,500,000 5,775,000 $76,725,000 =========

The Audit

P hired Ernst & Young LLP (hereafter, E&Y) to audit the 1999 financial statements summarized in Exhibits 2 through 4. As part of the opinion formulation process, E&Y needed to consider the company’s poor operating performance. After all, the company’s strategies had thus far led to a substantial loss in its first year of existence, including a negative gross profit. It is questionable whether a company with this type of performance can be reasonably expected to survive financially in the foreseeable future. If E&Y has substantial doubt about ’s abili P ty to continue as a going concern, they would have to indicate this in an explanatory paragraph accompanying their audit opinion. However, such an opinion would certainly hinder any chance for a successful public offering of stock. E&Y’s auditors would certainly have to examine the situation thoroughly before making this critical decision. In order to guide them in this decision, the auditors would utilize AU 570 Going Concern . This standard requires the auditors to obtain additional information about conditions and events that could create substantial doubt about the entity’s ability to continueas a going concern. You should refer toTable 7-11 Conditions and Events that Indicate a Substantial Doubt in Chapter Certainly, 7. the financial performance of P, along with the information on business risks contained in Exhibit 5, suggests that some of the conditions and events did indeed exist for P. In addition to the information above, auditors often utilize bankruptcy prediction models to assist in the going concern analysis. These models are designed to predict financial distress within one year. Studies suggest that the key factors in determining the likelihood of financial distress are profitability, the volatility of that profitability, and the company’s degree of financial leverage (solvency). Interestingly, liquidity measures turn out to be of less importance.You should access Data File 7-3 in iLearn for Exhibits 6 that contains the most popular of the bankruptcy prediction models – the Altman Z-score model. The auditors also should evaluate their client’s industry for any macro-economic impact from the external environment. P operated in the e-tailing industry where companies were relatively young and characterized by fast growth and cash shortages. In fact, operating losses and cash shortages are the “norm” for the industry. These are necessary in the short run to gain the market share that hopefullyprovides a large payoff in the long run. You should access Data File 7-3 in iLearn for Exhibits 7 that provides selected financial information for three other etailers: Amazon.com Inc., eToys Inc., and priceline.com Inc. These companies were characterized by increasing losses, even as they gained market share, and negative cash flows from operations. Despite this normally poor operating performance, e-tailers had established favor among the investing community. eToys and priceline.com each had a fairly large share price in their first year as a publicly traded company despite the large operating losses. Amazon.com had really become a market favorite. Despite mounting operating losses, its stock price had jumped from a split-adjusted $17.85 at the end of 1998 to $76.13 at the end of 1999. It certainly appeared that the market was confident of the future success of these e-tailers. Thus e-tailers in need of additional funding to support their short-term operating losses had reasonable expectations of being able to obtain the funds through subsequent stock issuances. E&Y’s auditors had a tremendous amount of information to digest regarding the risks facing P. The anticipated date for the IPO was soon approaching. Without a standard unqualified audit opinion, questions would arise regarding the viability of P as a viable investment alternative, and the initial public offering would most likely fail. A decision had to be made regarding the type of opinion that E&Y would provide in the IPO prospectus.

Required To answer the following questions, in addition to the information provided in Exhibits 1 through to 7 in iLearn, you are encourage to use other information available in SEC reports such as P’s prospectus, proxy statements, and the 10-Ks for other e-commerce companies. These reports are available at the SEC’s EDGAR database http://www.sec.gov/cgi_bin/srch-edgar 1. Refer to the four categories of common ratios used for ratio analysis in Table 7-8 of Chapter 7. a. Compute the financial ratios of P that you believe are relevant to evaluate the ability of the company to continue as a going concern. b. In your opinion, will P continue as a going concern based on the results of 1a? Explain your opinion. 2. Refer to selected financial information from other e-tailers in Exhibit 7 in iLearn. a. Compare your financial analysis in 1a for P with the financial information provided for other e-tailers in Exhibit 7 in iLearn. b. In your opinion, will P continue as a going concern based on the combined results of 1a and 2a? Explain your opinion. 3. Refer to the four categories of conditions and events that indicate a substantial doubt about going concern in Table 7-11 of Chapter 7.


a. Access Exhibit 5 in iLearn and sort the 39 risk factors in Exhibit 5 into the four categories of conditions and events in Table 7-11. List them under four headings: 1. Negative financial trend, 2. Non-financial indicator, 3. Internal factors, and 4. External factors. b. Review the risk factors in each of the four categories in 3a. Identify and state those risk factors in each of the four categories that you believe are relevant for forming an opinion on whether P will continue as a going concern. c. In your opinion, will P continue as a going concern based on the combined results of 1a, 2a, and 3b? Explain your opinion. 4. Considering all your work done in 1, 2, and a3bove, and assume you are E&Y’s auditor, which of the following opinions would you issue? Provide justification for your chosen opinion. a. A standard unqualified opinion. b. An unqualified opinion with an additional paragraph about P will not continue as a going concern. c. A qualified opinion. d. A qualified opinion with an additional paragraph about P will not continue as a going concern.

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Chapter 8 Audit Plan – Internal Control Chapter Learning Outcomes (LOs) Checklist


LO8-1 Understand the 5 components of internal control.



LO8-2 Distinguish among the 3 methods of documenting internal control.



LO8-3 Explain how the auditor assesses control risk (CR).



LO8-4 Understand the definition of a material weakness according to AICPA’s AU 265 and PCAOB’s AS 5.



LO8-5 Describe how the auditor communicates internal control-related matters.



LO8-6 Describe the management’s responsibilities on Internal Control over Financial Reporting (ICFR) under Section 404 of the Sarbanes-Oxley Act of 2002 and guided by the PCAOB’s AS 5.



LO8-7 Describe the auditor’s responsibilities on Internal Control over Financial Reporting (ICFR) under Section 404 of the Sarbanes-Oxley Act of 2002 and guided by the PCAOB’s AS 5.



LO8-8 Describe the Top-Down approach for obtaining an understanding of ICFR and identifying controls to test.



LO8-9 Describe how the auditor form an opinion on the effectiveness of ICFR under Section 404 of the Sarbanes-Oxley Act of 2002 and guided by the PCAOB’s AS 5 and AS 4.



LO8-10 Compare internal control of an integrated audit with internal control of a financial audit.

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Chapter 8 Audit Plan – Internal Control Figure 8-1 shows the sequential steps in which an auditor considers a client’s internal control. Figure 8-1 Steps in Internal Control Consideration

The Audit Process

Audit Plan

Preplan CH 5

Tests of Controls

Tests of Balances

Financial Audit


Audit Report

Integrated Audit

Objectives CH 6 1. Understanding of Internal Control

1. Plan the Audit of ICFR

2. Document the Understanding of Internal Control

2. Obtaining an Understanding of ICFR and Identifying Controls to Test

3. Assess Control Risk (CR)

3. Test and Evaluate Design Effectiveness of Controls

4. Perform Tests of Controls Procedures

4. Test and Evaluate Operating Effectiveness of Controls

5. Communicate Internal ControlRelated Matters

4. Form an Opinion on the Effectiveness of ICFR

Evidence CH 7



Program and Technology CH 10


Financial Audit of Internal Control

AU 315 Understanding the Entity and its Environment and Assessing the Risks of Material Misstatement defines internal control as “The policies and procedures established by management to provide reasonable assurance that specific objectives of the entity will be achieved.” According to the definition, an audit should only expect reasonably assurance, not absolute assurance, that a client's control objectives will be accomplished. This is because there are two inherent limitations of a client’s internal control: 1. Human errors. For example, an effective internal control may be undermined by employee's unintentional errors or management's intentional acts of overriding the control. 2. Changing circumstances. For example, controls over a manual data processing system may not be appropriate for a new computerized data processing system. An auditor should also recognize that the cost of a client's internal control should not exceed the expected benefit derived from its implementation. This adds another limitation to the client's internal control. Finally an auditor should understand a client’s internal control according to the AICPA’s third fundamental “Performance” principle, which states, “[T]he auditor identifies and assesses risks of material misstatement, whether due to due to fraud or error, based on an understanding of the entity and the environment, including the entity’s internal control.” Understanding of Internal Control

The auditor should understand five components of a client’s internal control based on the Committee of Sponsoring Organizations of the Treadway Commission - COSO’s Internal Control-Integrated F ramework. Table 8-1 describes these five components and the auditor’s understanding of them Table 8-1 Understanding the Five Components of Internal Control

Components of Internal Control

Understanding the Components

1. Control Environment The auditor should learn enough about the control environment to This consists of actions, policies, and procedures that reflect the understand the management’s and board of directors’ attitude, overall attitude of the top management, directors, and owners of a awareness, and actions concerning the control environment. In addition, client about internal control and its importance. Seven key factors the auditor should focus on the substance of controls rather than on their that affect the control environment are: form because controls may be established but not acted on. Thus, the most important aspect of any internal control is having competent and  Integrity and ethical values. trustworthy personnel who follow internal control policies and

 

Commitment to competence. procedures. Participation of those charged with governance (e.g., board of directors or audit committee).

   

Management philosophy and operating style. Organizational structure. Assignment of authority and responsibility.

Human resource policies and practices. The auditor should obtain sufficient information about a client’s risk 2. Risk Assessment This consists of managem ent’s identification and analysis of risks assessment process to understand how the management considers risks relevant to the preparation of financial statements in accordance with relevant to financial reporting objectives and decides what to do to GAAP. The management’s risk assessment process should consider address those risks. external and internal events and circumstances that may arise and adversely affect the company’s ability to record, process, summarize, and report financial data consistent with the assertions of the management in the financial statements. Five basic assertions that must be met by the management’s risk assessment are:

    

Existence or occurrence. Completeness. Valuation or allocation. Rights and obligations.

Presentation and disclosure. The auditor’s understanding of control activities is a function of the 3. Control Activities This consists of policies and procedures that the management has audit plan adopted. If the auditor plans to conduct only TOB, then little established to meet its objectives for financial reporting. Five basic or no work is done on understanding control activities. If the auditor control activities that the management must establish are: plans to conduct both TOC and TOB, then s/he needs to understand the control activities relating to specific audit objectives and for the purpose

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Components of Internal Control

Understanding the Components of assessing control risk (CR).

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Adequate Separation of Duties

Proper Authorization of Transactions and Activities (or Information Process Controls)

Adequate Documentations and Records.

Physical Control over Assets and Records (or Physical Controls)

Independent checks on performance (or Performance Reviews)

Separation of duties controls include (1) Separation of the custody of assets from accounting. (2) Separation of the authorization of transactions from the custody of related assets. (3) Separation of operational responsibility from record-keeping responsibility. (4) Separation of IT duties from user departments. Proper authorization controls include (1) General authorization in that management establishes polices and subordinates are instructed to implement these general authorizations by approving all transactions within the limits set by the policy. (2) Specific authorization in that managementsystem, authorizes a specific transaction. In are an performed information processing information processing controls to check accuracy, completeness, and authorization of transactions. They include (1) General controls, which relate to the overall information processing environment such as controls over data center and network operations; system software acquisition, change, and maintenance. (2) Application controls, which apply to the processing of individual applications and help ensure the occurrence, completeness, and accuracy of transaction processing. Adequate documentations and records include (1) Prenumbered documents to facilitate the control of, and accountability for, transactions for the completeness assertion. (2) Prepared documents on a timely basis to minimize timing errors. (3) Designed documents for multiple use, when possible, to minimize the number of different form. (4) Constructed documents in a manner that encourages self-input correction and verification. Physical controls include (1) Physical security of assets, including adequate safeguards, such as secured facilities over access to assets and records. (2) Authorization for access to computer programs and data files. (3) Periodic counting and comparison with amounts shown on control records such as comparing the results of inventory counts with inventory records. Performance reviews controls include (1)Management’s i ndependent checks on the performance of individuals. (2) Management’s active participation in thesupervision of operations. (3) Management’s study of budget variances with follow-up action.

The auditor must obtain sufficient knowledge of a client’s information 4. Information and communication The information system consists of methods used to identify, system: assemble, classify, record, and report a company’s transactions and to I. To understand (1) the classes of significant transactions, (2) the ways maintain accountability for related assets and liabilities. An effective those transactions are initiated, (3) the accounting records and accounting system should: supporting documents for those transactions, (4) the accounting processing involved, and (5) the financial reporting process, including  Identify and record all valid transactions. significant accounting estimates and disclosures.  Describe on a timely basis the transactions in sufficient II. To ensure that the TOC and TOB procedures meet the following detail to permit proper classification of transactions for financialtypes of specific audit objectives (recall Chapter 6): (1) Existence or Occurrence reporting. (2) Completeness.  Measure the value of transactions in a manner that permits (3) Rights and Obligations. recording their proper monetary value in the financial statements. (4) Valuation and Allocation.  Determine the time period in which transactions occurred to (5) Classification. permit recording of transactions in the proper accounting period. (6) Cutoff. (7) Accuracy.  Present properly the transactions and related disclosures in (8) Understandability. the financial statements. In addition, the auditor should obtain sufficient knowledge of how the Communication involves providing an understanding of individual client communicates financial reporting roles and responsibilities and roles and responsibilities so that the personnel understand how their significant matters relating to financial reporting. financial reporting activities are related to the work of others and the means of reporting exceptions to an appropriate higher level within the company. 5. Monitoring The auditor should know how a client monitors the performance of This consists of the management’s ongoing and periodic assessment internal control over time, including how corrective action is initiated. of the performance of internal control. The Management may use

internal auditors to monitor the operating effectiveness and efficiency of internal control.

Documenting the Understanding of Internal Control


AU 230 Audit Documentation requires auditors to document their understanding of a client’s internal control. The form and extent of this documentation are influenced by the size and complexity of the client, as well as the nature of the client's internal control. The three most common methods used by the auditors to document their understanding of the client's internal control are described in Table 8-2. Table 8-2 Three Methods of Documenting Internal Control

Narrative Description A narrative description is a written memorandum of the auditor's understanding of the client's internal control. Narrative descriptions generally are more appropriate for documenting the internal control of a small client. They can be cumbersome to use as the size of the client increases. Figure 8-2 shows an example of using a narrative description to document the auditor’s understanding of a client’s control environment.

Internal Control Questionnaires An internal control questionnaire is a checklist of questions designed to detect internal control deficiencies. The questionnaires typically require a "yes," "no," or "not applicable (n/a)," response. "Yes" responses suggest strong or satisfactory internal controls, and "no" responses suggest weak or no internal controls. The internal control questionnaires may not be efficient in documenting a client's internal control for various reasons:

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They can lack flexibility. For example, they may contain many questions that are "not applicable" to a specific client.

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Compensatory controls are not obvious. The situation where a strong internal control may compensate for a weak internal control elsewhere is not obvious from examining the completed set of questionnaires.

Flow Chart A flow chart is a symbolic, diagrammatic representation of a client's internal control. A flow chart is especially useful in documenting the internal control of a large and complex client. Separate flowcharts are prepared for each major transaction cycle. Typically, the departmental units are shown in columns across the top of the chart, and the flow of documents is from left to right. Figure 8-4 shows an example of using a flowchart to document the auditor’s understanding of a client’s information and communication. Figure 8-5 shows some common symbols used in flowcharting a client’s information and communication.

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Client employees may respond inaccurately to internal control questions asked by the auditor. Figure 8-3 shows an example of using an internal control questionnaire to document the auditor’s understanding of a client’s risk assessment.

The auditors may use a combination of narrative descriptions, flowcharts, and questionnaires to document their understanding of the internal controls, thereby maximizing the advantages of each. After the auditors have documented their understanding of the client's internal control, they generally verify that the client's internal control in actual operation matches with the documented internal control by performing a walk-through test. In this walkthrough test, the auditors trace a few transactions through each step, from beginning to end, of the documented internal control to familiarize the auditors with the audit trail and to identify differences between internal control in operation and internal control as documented in the working papers. Figure 8-2 An Example of Using a Narrative Description to Document the Auditor’s Understanding of a Client’s Control Environment

Audit Memo – Control Environment Client: XYZ Company Completed by __________________ Reviewed by ___________________

Date ________________ Date ________________

The company manufactures sophisticated computer components. There is one location in Silicon Valley, San Jose. Mr. A is the chairman of the board and chief executive officer. His son, Mr. B, is the chief operating officer. The family controls 80 percent of the common stock. The board of directors is composed of family members, but Mr. A and Mr. B monitor the business and make most of the business decisions. Mr. C, the controller, and Mrs. D, the bookkeeper, handle most of the significant accounting functions. Both Mr. C and Mr. D are competent and committed to the company. Mr. B reviews cash receipts and cash disbursements. Both Mr. A and Mr. B have conservative attitudes towards accounting, and they consider lower taxes to be important. Our CPA firm is consulted on the accounting for unusual transactions, and there are rarely any adjustments for errors from routine transaction processing. The company uses a standard accounting software package. Access to the computer files is limited to Mr. B, Mr. C, and Mrs. D. Mr. A and Mr. B monitor revenues and expenses by comparing them to the budget and prior-year results.

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Figure 8-3 An Example of Using an Internal Control Questionnaire to Document the Auditor’s Understanding of a Client’s Risk Assessment

Internal Control Questionnaire – Risk Assessment Client: XYZ Company Completed by __________________ Date ________________ Reviewed by ___________________ Date ________________ Yes, No, N/A Does setand broad that state what the client desiresthe to client achieve, are objectives they supported by strategic plans?

Yes

Does the client have a risk analysis process that includes estimating the significance of the risks, assessing the likelihood of their occurring, and determining the actions needed to respond to the risks? Does the client have mechanisms to identify and react to changes that may dramatically and pervasively affect the client?

Yes

Yes

Comments Management prepared a five-year business plan that includes goalshas for the company’s products, responsibilities, and growth plan. The company’s business plan and budgeting process include analyzing risks that might affect the company. Senior management meets monthly to discuss recent events and how they may affect the company. Management has a number of mechanisms to identify risks that may affect the company. These include review of business and industry publications, participation in industry trade groups, and a strategic analysis group.

Assessing Control Risk (CR)

After obtaining an understanding and documentation of the client's internal control, the auditor assesses the control risk (CR). AU 315 defines control risk as "the risk that a material misstatement that could occur in an assertion will not be prevented or detected on a timely basis by the entity's internal controls.” In practice, an auditor regards a client's CR as the risk of material misstatement of assertions relating to an individual account-balance or class of transactions that is not prevented or detected by a client's internal control. In addition, as noted previously, CR exists independent of the audit of a client's financial statements. Thus, the auditor cannot change the actual level of CR. Finally, there is no authoritative guideline for assessing the level of CR. In practice, a percentage between 0% and 100%, with 0% as the minimum and 100% as the maximum control risk, is commonly used to indicate the level of CR. Based on the auditor's understanding and documentation of a client's internal controls, the auditor assesses the level of CR in two ways as described in Table 8-3. On occasion, an auditor may desire to fine-tune (i.e., to further reduce) the assessed level of CR below the maximum of 100% by conducting some TOC at the audit plan phase. In such a case, the auditor considers (a) whether additional evidential matter is available to support the fine-tuning, and (b) whether the expected effort to perform some TOC is likely to result in less e ffort in TOB. After assessing the level of CR at the audit plan phase, and together with the assessment of inherent risk (IR), the auditor derives the level of detect risk (DR) based on an audit risk model, AR = IR X CR X DR (discussed in Chapter 9) and determines the nature, timing, and extent of TOB that are needed to achieve the derived level of DR, given a pre-specified level of audit risk (AR). Although the inverse relationship between CR and DR permits the auditor to alter the nature, timing, and extent of the TOB, the assessed level of CR cannot be so low (e.g., close to zero) as to eliminate the need to perform any TOB. In addition, the auditor's understanding and documentation of the client's internal control and the assessment of CR provide the basis for communicating internal control-related matters to those charged with governance (e.g., audit committee or board of directors), a requirement of AU 265 Communication of Internal Control Related Matters Identified in an Audit .


Figure 8-4 An Example of Using a Flowchart to Document the Auditor’s Understanding of a Client’s Information and Communication ______________________________________________________________________________________

Flow Chart – Information and Communication Client: XYZ Company Completed by __________________ Reviewed by ___________________

Date ________________ Date ________________

Order Entry Portion of the Revenue Cycle ______________________________________________________________________________________ Order Entry Department

IT Department

Shipping Department

____________________________________________________________________________________________________________ By phone/mail/internet or from sales representative

Customer

Approved shipping order

Price

Inventory

Inventory Open orders

Open orders Ship goods

Customer order

Correct error

D

Data validation program

Input

Filed by date

Error report

Shipping program

Order acknowledgement

Approved shipping order

To customer

To customer

N

Filed in numeric order

Figure 8-5 Some Common Symbols Used in Flowchart

Symbol

Description

Document

Paper documents and reports of all kinds, e.g., customer orders, sales invoices, purchase orders, error report, shipping documents, and paychecks.

Manual Input

Input entered manually at the time of processing, e.g., using keyboard.

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Symbol

Description

Manual Operation or Activity

Any manual operation or activity, e.g., preparation of a sales invoice, bank reconciliation, posting of accounts receivable, and correcting errors.

Computer Process

Computer executed process, e.g., execution of data validation program or checking of customer’s credit limit.

Data Inputted or Outputted

Data inputted from or outputted to another part of the flowchart, e.g., cash received from customer is inputted to cash receipts journal which in turn is outputted to accounts receivable ledger.

Off-page Connector

Off-page connector that indicates source or destination of items entering or exiting the flowchart, e.g., sending a copy of an invoice to an outside customer that exits the flowchart.

Computer off-page Connecting Node

Computer connecting node thatindicates source or destination of items entering or exiting the flowchart, e.g., the connecting node from mail room indicates cash receipt entering the flowchart from the mail room.

Paper Document or Record File

Paper document or record storage, e.g., filing of bank deposit slips. An “A” indicates a file organized in an alphabetic order, a “N” indicates a numeric order file, and a “D” indicates a file organized by date.

N

Filed by Annotation Date

Flow-line

No

Annotation used for explanatory comments, e.g., filing of sales invoices by date, alphabetical, or category of merchandises.

Lines indicating the directional flow of documents. Lines are typically downward or to the right unless otherwise indicated by arrowheads.

Decision indicates alternative course of action resulting from a yes or no decision.

Yes

Computer Card

Computer input medium which is a punched card, e.g., payroll earning cards.

Computer Tape

Computer input medium which is a punched tape, e.g., inventory tapes.

Computer Data Inputted or outputted

Computer data inputted from or outputted to another part of the flowchart, e.g., payroll data is inputted from payroll records which in turn is outputted to store in magnetic tape.

Computer Magnetic Disk or Drum

ers’ names and addresses are Computer storage medium which is a magnetic disk or drum, e.g., custom stored in a magnetic disk.

Computer Magnetic Tape

Computer storage medium which is a magnetic tape, e.g., payroll data are stored in a master payroll magnetic tape.

Computer Display

Computer input or output device in which the information is displayed at the time of process, e.g., display of customer accounts on a computer monitor.


Table 8-3 Two Ways in Assessing CR

(1) CR at the maximum of 100% For assertions relating to some account-balances or classes of transactions, the auditor's initial understanding and documentation of the internal controls may cause him/her to conclude that the internal controls are unlikely to be effective, or effort required to evaluate their effectiveness would be inefficient. For these assertions, the auditor typically assesses CR at the maximum of 100% at the audit plan phase in the past. However, under AU315, it is no longer acceptable to assess CR at the maximum of 100% based on the auditor’s initial understanding and documentation of the internal controls. The auditor must now develop a greater understanding of the internal controls, which includes testing and evaluating the design and operation of the internal controls in order to assess CR at the maximum of 100%. When assessed CR is at the maximum (a) the auditor needs only to document the assessment but not the basis for the assessment, (b) the auditor would not plan to rely on the internal controls, and (c) the auditor would not plan to perform TOC but to only perform TOB.

(2) CR below the maximum of 100% For other assertions relating to some account-balances or classes of transactions, the auditor's understanding and documentation of the internal controls may cause the auditor to assess CR at below the maximum of 100%. When assessed CR is below the maximum (a) the auditor should document the assessment and the basis for the assessment, (b) the auditor would plan to rely on the internal controls, and (c) the audit would plan to perform both the TOC and TOB. When the auditor plan to rely on the internal controls, s/he must:

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Identify the control activities (see Table 8-1) that are relevant to a financial statement assertion. The relevance of a control activity to an assertion is judged in terms of: (a) Its pervasive effect on an assertion. A control activity can be relevant to an assertion either because it has a pervasive effect on many assertions or because it has a specific effect on an individual assertion. A control activity that affects more than one assertion is usually more pervasive than one that affects only a single assertion. For example, a credit manager’s follow-up on customers’ complaints in a monthly statement- a control activity of independent checks that affects both the valuation and allocation, and completeness assertions - is a more pervasive ntrol co activity than the credit manager’s approval of credit for customers– a control activity ofproper authorization that affects only the valuation and allocation assertion. In general, the more pervasive is the effect, the more relevant is the control activity, the stronger is the overall internal controls, and the lower is the assessed CR. (b) Its direct relationship to an assertion. The more directly related a control activity is to an assertion, the more effective it is in preventing or detecting material misstatements in that assertion. For example, a sales manager’s tracing of shipping documents to billing documents - a control activity of adequate documentation that affects the completeness of sales revenue - is more directly related to the completeness assertion than the sales manager’s reviews of sales activities at various stores– a control activity of independent checks that is less directly related to the completeness of sales revenue. In general, the more direct is the relationship, the more relevant is the control activity, the stronger is the overall internal controls, and the lower is the assessed CR.

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Evaluate the effectiveness of the control activities in preventing and detecting material misstatements in an assertion.

After a control activity that is relevant to an assertion has been identified, the auditor evaluates its effectiveness in preventing and detecting material misstatements in the assertion. To evaluate its effectiveness, the auditor obtains evidence (recall Chapter 7) about the design and operation of the control activity by performing TOC. TOC directed at the effectiveness of the design of the control activity are concerned with whether it is suitably designed to prevent or detect material misstatements. On the other hand, TOC directed at the operation effectiveness of the control activity are concerned with how it is suitably applied to prevent or detect material misstatements. Recall some of the common TOC procedures used by the auditor in Chapter 7. No one specific procedure is always necessary, applicable, or equally effective in every circumstance. The auditor selects a variety of TOC procedures, for example, inquiry, observation, and inspection to evaluate the effectiveness of the design and operation of a control activity.

Communicating Internal Control-Related Matters

Consistent with the PCAOB’s AS 5 definition, the AICPA’s AU 265 defines “a material weakness” as “a material weakness is a control deficiency , or a combination of significant deficiencies, in internal control over financial reporting (ICFR), such that there is a reasonable possibility that a material misstatement of the company’s annual or interim financial statements will not be prevented or detected on a timely basis”(emphasis added). AU 265 further defines: 1. Control deficiency. A control deficiency exists if the design or operation of controls does not permit company personnel to prevent or detect misstatements on a timely basis in the normal course of performing their assigned functions. A design deficiency exists if a necessary control is missing or not properly designed. An operation deficiency exists if a well-designed control does not operate as designed or if the person performing the control is insufficiently qualified or authorized. Table 8-4 shows some examples of control deficiency in the design or operation of controls in AU 265. 2. Significant deficiency. A significant deficiency exists if one or more control deficiencies exist that is less severe than a material weakness (defined below), but important enough to merit attention by those responsible for oversight of the company’s financial reporting.

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3. Material weakness . A material weakness exists if a significant deficiency, by itself or in combination with other significant deficiencies, results in a reasonable possibility that internal control will not prevent or detect material financial statement misstatements on a timely basis. 4. Reasonable possibility and Materiality . To determine a material weakness, the auditor must consider two dimensions: Reasonable possibility and Materiality. Reasonable possibility refers to reasonably possib le or probable that a misstatement resulting from a significant deficiency or a combination of significant deficiencies. Materiality refers to the same concept of materiality that is used in determining financial statement materiality (discussed in Chapter 9). Table 8-5 shows the auditor’s consideration of reasonable possibility and materiality, and communication of material weakness, significant deficiency, and insignificant deficiency. Note that if reasonable possibility is remote, an identified control issue will not be reported. However, if reasonable possibility is reasonably possible or probable, an identified control issue will be reported as a material weakness, a significant deficiency, or an insignificant deficiency depending on the materiality of misstatement in the financial statements. The auditor must communicate material weaknesses and significant deficiencies in writing (refer to as a material weakness report) and such communication must be documented in the auditor's working papers. There is no specific guideline for the format of the written report, for example, a memo is acceptable, but the content of the written report should at least include: 1. An indication that the purpose of the audit is to report on the financial statements and not to provide assurance on the internal controls. 2. A definition of material weakness. 3. A statement that the report is intended solely for the information of the audit committee, management, and others within the organization, and when applicable, specific regulatory agencies that have requested a copies of the report. 4. A description of the material weakness and significant deficiency noted. The material weakness and significant deficiency report should be addressed to those charged with governance (e.g., audit committee or its board of directors) and the management. Figure 8-6 shows an example of a material weakness report. AU 265 requires the auditor to communicate material weaknesses or significant deficiencies to those charged with governance even if the management has addressed the material weaknesses or significant deficiencies and has implemented new controls that improve the effectiveness of internal control. However, AU 265 does not require the auditor to communicate material weaknesses and significant deficiencies if (1) the management has already made them known to those charged with governance, an d (2) those charged with governance has accepted the management's conscious effort to trade off the cost against the risk associated with the material weaknesses and significant deficiencies. Ordinarily, a previously communicated material weakness or significant deficiency that has not been corrected would not need to be communicated again by the auditor. However, the auditor should periodically consider whether the passage of time or changes in the management, the board of directors, or the audit committee would require the material weakness or deficiency to be communicated again. Finally, the auditor may choose to communicate all material weaknesses and significant deficiencies either during the course of the audit or after the audit is concluded. In addition to communicating material weaknesses and significant deficiencies that is required under AU 265, the auditor may also send an optional client’s advisory comments letter (also known as a management letter) that: 1. Communicates insignificant control deficiencies. 2. Makes recommendations for improving the client's business. 3. Promotes a better relationship between the CPA firm and the client. 4. Suggests additional tax and management services available to the client. This client ’s advisory comments letter should be addressed to the client's management (AU 265). However, many auditors combine the client’s advisory comments letter and the material weakness report into one report and report it to the audit committee. Figure 8-7 shows an example of a client’s advisory comment letter (management letter). Note that an auditor should never issue a written report stating that no-material-weaknesses were noted in the course of the audit because of the potential for a reader misinterpreting the limited assurance associated with the auditor issuing such a no-material-weakness report. Lastly, sometime an auditor may be specially engaged to express an opinion on a client's internal control as a special attestation service under the AICPA’s SSAE No.10 AT 501 Reporting on an Entity’s Internal Control Over Financial Reporting, that is separate from the normal audit engagement. In this special type of service, the auditor issues a special internal control report that also reports material weaknesses ad significant deficiencies to the audit committee. This of control specialover service is similar to (ICFR) PCAOB’s to financial reporting underrequirement Section 404 that of theauditors Sarbanesattest management’s report on type internal –Oxley Act of 2002. Chapter 22 provides more discussion on this special attestation service.


Table 8-4 Some Examples of Control Deficiency in the Design or Operation of Controls in AU 265

Examples of Control Deficiency in the Design or Operation of Controls Deficiencies in the Design of Controls

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Inadequate design of internal control over the preparation of the financial statements being audited. Inadequate design of internal control over a significant account or process. Inadequate documentation of the components of internal control. Insufficient control consciousness within the organization, for example, the tone at the tip and the control environment. Absence or inadequate segregation of duties within a significant account or process. Absence or inadequate controls over the safeguarding of assets. Inadequate design of information technology (IT) general and application controls. Employees or management who lack the qualifications and training to fulfill their assigned functions. Inadequate design of monitoring controls. The absence of an internal process to report deficiencies in internal control to management on a timely basis.

Failures in the Operation of Internal Control

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Failure in the operation of effectively designed controls over a significant account or process. Failure of the information and communication component of internal control to provide complete and accurate output because of deficiencies in timeliness, completeness, or accuracy. Failure of controls designed to safeguard assets from loss, damage, or misappropriation. Failure to perform reconciliations of significant accounts. Undue bias or lack of objectivity by those responsible for accounting decisions. Misrepresentation by client personnel to the auditor (an indicator of fraud). Management override of controls. Failure of an application control caused by a deficiency in the design or operation of an IT general control. An observed deviation rate that exceeds the number of deviations expected by the auditor in a test of operating effectiveness of a control.

Table 8-5 Auditor’s Consideration of Reasonable Possibility and Materiality, and Communication of Material Weakness, Significant Deficiency, and Insignificant Deficiency Reasonable Possibility Materiality Material and Significant deficiency

Not Material but Significant deficiency

Not Material and Insignificant Deficiency

Remote

Reasonably Possible or Probable Communicate Material weakness

No Report Report material weakness to audit committee and to management

Communicate Significant Deficiency

No Report Report significant deficiency to audit committee and to management

Communicate Insignificant Deficiency

No Report Send client’s advisory comment letter to management

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Figure 8-6 An Example of a Material Weakness Report

XYZ CPA, LLP P.O.Box 888 San Francisco

February 8, 20xx

Board of Directors and Those Charged with Governance ABC Company 1st Street, San Francisco In planning and performing our audit of the financial statements of ABC Company for the year ended December 31, 20xx, we considered its internal controls in order to determine our auditing procedures for the purpose of expressing our opinion on the financial statements and not to provide assurance on internal controls. However, we noted certain matters involving internal controls and its operation that we considered to be a material weakness in accordance with the standards of the Public Company Accounting Oversight Board (United States). A material weakness is a control deficiency, or a combination of significant deficiencies, in internal control over financial reporting (ICFR), such that there is a reasonable possibility that a material misstatement of the company’s annual or interim financial statements will not be prevented or detected on a timely basis. The matter noted is that there is a lack of independent verification of the key entry of the customer’s name, product number, quantity shipped, prices used, and the related mathematical extensions on sales invoices and credit memos. As a consequence, errors in these activities could occur and remain uncorrected, adversely affecting both recorded net sales and accounts receivable. This deficiency is significant because of the large size of the average sales of ABC Company. This report is intended solely for the information and use of the board of directors and those charged with governance in ABC Company.

Sincerely, _________________________________ XYZ CPA, LLP

Figure 8-7 An Example of alient’s C Advisory Comment Letter Management ( Letter) XYZ CPA, LLP P.O.Box 888 San Francisco

April 28, 20xx

Mr. A Chief Executive Officer ABC Company 1st Street, San Francisco Dear Mr. A: We have audited the financial statements of ABC Company for the year ended December 31, 20xx, and have issued our report thereon dated March 31, 200x. As part of our audit, we studied internal controls only to the extent that we considered necessary to determine the nature, timing, and extent of auditing procedures. Summarized below are suggestions of importance that we believe warrant your attention. Our recommendations were discussed with personnel responsible for the various areas, and many of these recommendations are currently being implemented. Equipment Returned to Vendor for Repair

The company does not maintain shipping and receiving logs for all equipments sent to and received from vendor for repair. The shipping/receiving log, listing the serial numbers of equipments sent and the dates the equipments were sent and received back, should be used to track and monitor the status of repairs and to ensure that the equipments are returned from vendor promptly. We appreciate the opportunity to present these comments for your consideration, and we are prepared to discuss them at your convenience. Sincerely, ______________________ XYZ CPA, LLP


Integrated Audit of Internal Control Management’s Responsibilities on ICFR

The Sarbanes-Oxley Act of 2002 establishes the Public Company Accounting Oversight Board (PCAOB), whose responsibilities are to oversee the audits of public companies that are subjected to the securities laws. These responsibilities include overseeing the corporate responsibilities rules on internal controls under the Act. If the PCAOB determines that any public company has engaged in practices in violation of the rules, the Board may impose sanctions, including fine of not more than $5 million and/or imprisonment of up to 20 years. A section of the corporate responsibilities rules on internal controls is as follows:

Section 404 – Management Assessment of Internal Controls Requires the annual report of each public company to include an internal control report which shall: (1) state the responsibility of management for establishing and maintaining an adequate internal controls and procedures for financial reporting; and (2) contain an assessment, as of the end of the public company’s fiscal year, of the effectiveness of the internal controls and procedures of the company for financial reporting.

The management must develop a control framework, based on a recognized control framework such as the Internal control –Integrated Fra mework developed by the Committee of Sponsoring Organizations (COSO) of the Treadway Commission, to identify important controls, document their existence, and test their operation as a basis for developing its report on internal controls. The management is required to include its assessment of the effectiveness of the company’s internal control over financial reporting as an addition to the annual financial statements. The management’s report on internal control over financial reporting is required to include the following: 1. A statement of management’s responsibility for establishing and maintaining effective internal controls over financial reporting. 2. A statement identifying the framework used by management to evaluate internal control such as the COSO framework. 3. An assessment of the effectiveness of the company’s internal control as of the end of the period reported on, including an explicit statement as to whether internal control over financial reporting (ICFR) is effective. 4. A statement that the management’s report has been audited and that the audit report is contained in the annual financial report. Figure 8-8 provides an example of the management’s integrated report on a company’s internal control and financial information. Figure 8-8 Management’s Integrat ed Report on Internal Control and Financial Information XYZ COMPANY STATEMENT ON FINANCIAL INFORMATION XYZ company is responsible for the information presented in this Annual Report. The consolidated financial statements have been prepared in accordance with generally accepted accounting principles and present fairly, in all material respects, the company’s results of operations, financial position, and cash flows. Certain amounts included in the consolidated financial statements are estimated based on currently available information and judgment as to the outcome of future conditions and circumstances. Financial information elsewhere in this Annual Report is consistent with that in the consolidated financial statements. XYZ company’s management is responsible for the design and operation of an effective system using the framework developed byCOSO in the Internal Control-Integrated Framework . This system is designed to provide reasonable assurance, at suitable costs, that assets are safeguarded and that transactions are executed in accordance with appropriate authorization and are recorded and reported properly. The XYZ company’s system of internal controls is supported by written policies and procedures and is supplemented by a staff of internal auditors. During the past year, the XYZ company evaluated both the design and the operation of the internal control system, including tests of the controls, where applicable.Our assessment is that the internal controls over financial reporting as of December 31, 20xx are effective in preventing or detecting material misstatements in our financial reports . The system is continually reviewed, evaluated and where appropriate, modified to accommodate current conditions. Emphasis is placed on the careful selection, training and development of professional managers. An organizational alignment that is premised upon appropriate delegation of authority and division of responsibility is fundamental to this system. Communication programs are aimed at assuring that established policies and procedures are disseminated and understood throughout the XYZ company. The consolidated financial statements and our report on internal control over financial reporting have been audited by independent auditors whose report appears below. Their audit was conducted in accordance with generally accepted auditing standards established by the Public Company Accounting Oversight Board, which include testing and evaluation of the XYZ company’s internal controls and gatheringof independent evidence to form an opinion on the fairness of the XYZ company’s financial and control reports. The Audit Committee of the Board of Directors is composed solely of directors who are not officers or employees of the XYZ company and who have financial expertise. The Audit Committee’s responsibilities include recommending to the Board for stockholder approval the independent auditors for the annual audit of the XYZ company’s consolidated financial statements. The Committee also reviews the

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independent auditors’ audit strategy and plan, scope, fees, audit results, and non-audit services and related fees; internal audit reports on the adequacy of internal controls; the XYZ company’s ethic program; status of significant legal matters; the scope of the internal auditors’ plans and budget and results of their audits; and the effectiveness of the XYZ com pany’s program for correcting audit findings. The independent auditors and XYZ company personnel, including internal auditors, meet periodically with the Audit Committee to discuss auditing and financial reporting matters.

_____________________ Mr. A MBA, CPA Chief Executive Officer

Auditor’s Responsibilities on ICFR

To provide guidance for audits in accordance to Section 404, the PCAOB issued Auditing Standard No.5 (AS 5) An Statements. AS 5 Audit of Internal Control over Financial Reporting that is Integrated with an Audit of Financial states that the auditor must conduct an integrated audit of the client’s internal control over financial reporting (ICFR) and its financial statements. The auditor must conduct the audits ICFR and financial statements in an integrated way because each provides the auditor with information relevant to the evaluation of the results of the other. In addition, AS 5 makes it clear that while the two audits are to be integrated, they have different objectives. The auditor’s objective in an audit of ICFR is to express an opinion on the effectiveness of the client’s internal control over financial reporting, while the objective in a financial statement audit is to express an opinion on whether the financial statements are fairly stated in accordance with generally accepted accounting principles. Plan the Audit of ICFR

Planning in an audit of ICFR is coordinated with the planning in a financial audit. For both audits, the auditor considers matters related to the client’s industry, business, and regulatory environment and so on. Planning matters specific to an audit of ICFR include: 1. Knowledge of the entity’s internal control over financial reporting (ICFR) obtained during other engagements. 2. Matters affecting the industry in which the client operates, such as financial reporting practices, economic conditions, laws and regulations, and technological changes. 3. Matters relating to the client’s business, including its organization, operating characteristics, and capital structure. 4. The extent of recent changes in the client, its operations, or its ICFR. 5. Preliminary judgments about materiality, risk, and other factors relating the determination of material weaknesses. 6. Control deficiencies previously communicated to the audit committee or management. 7. Legal or regulatory matters of which the client is aware. 8. The type and extent of available evidence related to the effectiveness of the client’s ICFR. 9. Preliminary judgments about the effectiveness of ICFR. 10. Public information about the client relevant to the evaluation of other likelihood of material financial statement misstatements and the effectiveness of the client’s ICFR. 11. K nowledge about risks related to the client’s evaluated as part of the audit’s client acceptance and retention evaluation. 12. The relative complex ity of the client’s operations. In addition, planning matters specific to the risk of fraud and the risk of management override of controls in an audit of ICFR include: 1. Controls over significant, unusual transactions, particularly those that result in late or unusual journal entries. 2. Controls over journal entries and adjustments made in the period-end financial reporting process. 3. Controls over related-party transactions. 4. Controls related to significant management estimates. 5. Controls that mitigate incentives for, and pressures on, management to falsify or inappropriately manage financial results. Lastly, to effectively plan an audit of ICFR, PCAOB’s AS 5 recommends 1. “Scaling the audit” which means the auditor takes into consideration the size and complexity of the client, its business processes, and business units that affect the way in which the client achieves effective internal control objectives. 2. “Using the work of others” which means the auditor uses the work performed by, or receives direct assistance from, internal auditors (consistent with AU 610), company personnel, and third parties working for management (e.g. valuation specialist discussed in Chapter 19) or the audit committee. Obtaining an Understanding of ICFR and Identifying Controls to Test

In the U.S., most management based on a control framework, Internal control –Integrated Framework, developed by the Committee of Sponsoring Organizations (COSO) of the Treadway Commission to identify important controls, document their existence, and test their operation as a basis for developing its report on internal controls. Likewise,


most auditors use a “Top -Down Approach” for obtaining an understanding of ICFR and identifying controls to test based on the same control framework developed by the COSO. As shown in Figure 8-9, a Top-Down approach starts at the top, the financial statements elements and entity-level controls, and links the financial statement elements and entity-level controls to significant accounts, relevant assertions, and to the major classes of transactions. Table 8-6 provides brief comments on the top-down approach for obtaining an understanding of ICFR and identifying controls to test. Figure 8-9 A Top-Down Approach for Obtaining an Understanding of ICFR and Identifying Controls to Test

Identify Entity-Level Control

\ Identify Significant Accounts and Disclosures and their Relevant Assertions

Understand Likely Sources of Misstatement

\ Select Controls to Test

Table 8-6 Brief Comments Identifying Controls to Test on the Top-Down approach for Obtaining an Understanding of ICFR and

A Top-Down Approach





Identify Entity-Level Controls

Identify Significant Accounts and Disclosures and their Relevant Assertions

Brief Comments To identify entity-level controls, AS 5 emphasizes identifying two categories of entity-level controls: (1) The control environment– in addition to understand the “control environment” component in the financial audit (audit of financial statements), the auditor should also understand whether (a) Management’s philosophy and operating style promote effective ICFR. (b) Sound integrity and ethical values, particularly of top management, are developed and understood. (c) The Board or audit committee understands and exercises oversight responsibility over financial reporting and internal control. (2) The period-end financial reporting process– in addition to understand the “information and communication” component in the audit of financial statements, theauditor should also understand (a) the procedures used to enter transaction totals into the general ledger; select and apply accounting policies; initiate, authorize, record, and process period-end journal entries in the general ledger; record recurring and nonrecurring adjustments to the annual and quarterly financial statements, and prepare annual and quarterly financial statements and related disclosures, and (b) The extent of IT (information technology) involvement in each period-end financial reporting process; who participated from management; the number of locations involved; types of adjusting and consolidating entries, and the nature and extent of the oversight of the process by management, the board of directors, and the audit committee. In an integrated audit, the auditor should identify significant accounts and disclosures that have a reasonable possibility of containing a misstatement that would cause the financial statement to be materially misstated. Factors that the auditor should consider for identifying significant accounts and disclosures include (1) Size and composition. (2) Susceptibility of loss due to errors or fraud. (3) Volume of activity, complexity, and homogeneity of individual transactions. (4) Nature of the account. (5) Accounting and reporting complexity. (6) Exposure to losses. (7) Possibility of significant contingent liabilities. (8) Existence of and related party transactions. (9) Changes fromidentifies the priorwhich period.financial statement Once significant accounts disclosures are identified, the auditor assertions are relevant to the significant accounts and disclosures. The relevant assertions are then translates into specific audit objectives. For example, a relevant existence or occurrence assertion to a significant accounts receivable transaction during the period under audit is translated into the specific audit objective of occurrence that is to be accomplished by performing certain tests of controls (Recall

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A Top-Down Approach





Brief Comments

Table 6-7 in Chapter 6). In an integrated audit, in order to understand likely sources of misstatements, and to assist in selecting Understand Likely Sources of controls to test, the auditor should (1) Understand the flow of transactions. (2) Verify points within the Misstatements client’s processes at which a misstatement could arise that could be material. (3) Identify the controls management has implemented to address these potential misstatements. (4) Identify the controls management has implemented to prevent or detect on a timely basis unauthorized acquisition, use, or disposition of the client’s assets that could result in a material misstatement. Ordinarily, the auditor accomplishes the above four objectives by performing a walk-through . In a walkthrough, the auditor traces a transaction from srcination through ethclient’s processes and information system until it is reflected in the client’s financial reports. It should encompass the entire information flow through the sub-processes of initiating, authorizing, recording, processing, and reporting individual

Select Controls to Test

transactions for each of the significant processes identified. A walk-through the auditorwhether in (a) confirming his/her understanding of control design and transaction process flow, helps (b) determining all points at which misstatements could occur have been identified, (c) evaluating the effectiveness of the design of controls, and (d) confirming whether controls have been placed in operation. In an integrated audit, it is not necessary to design test of all controls. The auditor only tests those controls that are important to his/her conclusion about whether the client’s controls sufficiently address the risk of misstatement for each relevant assertion identified. Factors that the auditor should consider in selecting controls to test include (1) Points at which errors or fraud could occur. (2) The nature of the controls implemented by management. (3) The design of the controls in relation to management assertions and specific audit objectives. (4) The risk that the controls might not be operating effectively.

Test and Evaluate Design Effectiveness of Controls

Controls are effectively designed when they prevent or detect errors or fraud that could result in material misstatements in the financial statements. As mentioned above, in the U.S., most management based on a control framework, Internal control –Integrated Framework, developed by the COSO to identify important controls, document their existence, and test their operation as a basis for developing its report on internal controls. Thus, the auditor first identifies the management’s relevant controls that are set up according to the COSO framework, then the auditor tests and evaluates design effectiveness of the relevant controls through inquiry, observation, walkthroughs , inspection of relevant documentation, and subjective evaluation of whether they are likely to prevent or detect misstatements. Similar to Table 8-4, AS 5 also provides some examples of control deficiency in the design or operation of controls in Table 8-7. Table 8-7 Some Examples of Control Deficiency in the Design or Operation of Controls in AS 5

Examples of Control Deficiency in the Design or Operation of Controls Deficiencies in the Design of Controls

      

Inadequate overall internal control design. Absence of appropriate segregation of duties. Absence of appropriate reviews and approvals of accounting transactions and entries. Inadequate procedures for applying accounting principles. Inadequate procedures for safeguarding assets. Absence of other appropriate control techniques. Evidence of other accounting (computer) system design flaws.

Failures in the Operation of Internal Control

        

Evidence of failure of internal controls to prevent or detect misstatement. Misapplication of control procedures. Failure to safeguard assets from loss, damage or misappropriation. Evidence of intentional override of internal controls. Failure to perform part of the internal controls. Evidence of willful wrong doing by employees or management. Evidence of manipulation, falsification, or alteration of accounting records. Evidence of intentional misapplication of accounting principles. Evidence of misrepresentation by client personnel to the auditor.


Examples of Control Deficiency in the Design or Operation of Controls



Evidence of employees or management lack the qualifications and training to fulfill their assigned functions.

Others

   

Absence of a sufficient level of control consciousness within the organization. Failure to follow up and correct previously identified internal control weaknesses. Evidence of significant or extensive undisclosed related party transactions. Evidence of undue bias or lack of objectivity by those responsible for accounting decisions.

Test and Evaluate Operating Effectiveness of Controls

The auditor tests and evaluates the operating effectiveness of a control by determining whether the control is operating as designed and whether the person performing the control possesses the necessary authority and competence to perform the control effectively. The PCAOB’s AS 5 provides the following guidelines for auditor to consider the nature, timing , and extent of testing and evaluating the operating effectiveness of controls: 1. Nature - Tests of operating effectiveness usually include such type (nature) of procedures as inquiry of management, inspection of relevant documentation, observation of the client’s operations, and re-performance of the application of the control. When the procedure of inquiry is used to test and evaluate operating effectiveness of a control, the auditor should perform additional procedures because inquire alone does not provide sufficient evidence to support operating effectiveness of a control. 2. Timing - The auditor should perform tests of operating effectiveness of controls over a period of time that is adequate to determine whether the controls are operating “as of” the date indicated in management’s internal control report. The period of time over which the auditor performs tests of controls will vary with the frequency with which they are applied. For example, some controls operate continuously such as controls over the processing of routine sales transactions, while other controls operate only periodically such as monthly bank reconciliation. AS 5 provides the following guidelines regarding the timing of testing and evaluating the operating effectiveness of controls: (a) Controls that operate periodically - For example, payroll controls that operate once a month. The auditor can examine the effectiveness of the control near year-end. (b) Computerized controls: The auditor must test the effectiveness of the computer process. If there are strong controls over program changes and access to data, the auditor may test the controls by running a series of transactions application. through the system and determining that there have not been significant changes to the computer (c) Continuous manual-based controls - For example, credit approvals, order entry, and preparation of shipping documents. The auditor must test a sample that is representative of the manual-based processing throughout the period. (d) Controls that operate after the “as of” date specified in management’s report - For example, controls over a December 31 period-end financial reporting process usually operate in January of the following year. In this case, the auditor can only perform tests at the time the controls are operating, that is, after the “as of” date. (e) Management has implemented new controls during the year - The auditor must evaluate whether there has been sufficient time to determine whether the new controls have been effectively implemented. If there has not been sufficient time to evaluate the operating effectiveness of a new control (e.g., the new control was just implemented on December 30 for a December 31 year-end), the auditor should indicate that the control has not been implemented for a period of time that would be sufficient to evaluate its effectiveness. 3. Extent - AS 5 does not provide any detailed guidance on what constitutes a sufficient sample for testing the operating effectiveness of the control. This is left to the auditor as a matter of professional judgment. As a rule of thumb, the auditor should consider the following factors when judging the extent of testing the operating effectives the control (a) Nature of control - Manual controls should be subjected to more extensive testing than automated controls involving people. (b) Frequency of operation - The more frequently a manual control operates; the greater the number of operations of the control the auditor should test. (c) Importance of the control - The more important the control, the more extensively it should be tested. In contrast to the PCAOB, most CPA firms have developed detailed guidance on what constitutes a sufficient sample for testing and evaluating the operating effectiveness of controls (Discussed in Chapter 11 and Chapter 12). Lastly, AS 5 recommends incorporating knowledge obtained from prior years’ audits into the judgment process for determining the nature, timing , and extent of testing for the current year audit. This knowledge includes: 1. The nature, timing, and extent of procedures performed in previous audits, 2. T he results of the previous years’

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testing of the control, and 3. Whether there have been changes in the control or the process in which it operates since the previous audit. Form an Opinion on the Effectiveness of ICFR

The auditor should evaluate all evidence obtained before forming an opinion on the effectiveness of ICFR, including: 1. Items that the management is required to present in its report under AS 5. 2. The results of the auditor’s tests and evaluations of the design and operating effectiveness of controls. 3. Any negative results of substantive procedures (tests of balances) performed during the financial statement audit. 4. Any identified control deficiencies. 5. Review all reports issued during the year by the internal audit function that address controls and evaluate any control deficiencies identified in those reports. The auditor communicates in writing to management all control deficiencies, regardless of severity – this includes material weaknesses, significant deficiencies, and insignificant deficiencies. The auditor also communicates in writing to the audit committee all material weaknesses and significant deficiencies, and an indication that all deficiencies have been communicated to management. The written communication on weaknesses to both management and the audit committee should be made prior to issuance of the audit opinion on the effectiveness of ICFR. In addition, AS 5 requires the auditor to communicate material weaknesses or significant deficiencies to the audit committee even if the management has addressed the material weaknesses or significant deficiencies and has implemented new controls that improve the effectiveness of internal control. Consistent with the AICPA’s AU 265 definition, the PCAOB’s AS 5 defines “a material weakness” as “a material weakness is a control deficiency , or a combination of significant deficiencies, in internal control over financial reporting (ICFR), such that there is a reasonable possibility that a material misstatement of the company’s annual or interim financial statements will not be prevented or detected on a timely ba sis” (emphasis added). Table 8-8 shows the auditor’s consideration of reasonable possibility and materiality, communication of material weakness, significant deficiency and insignificant deficiency, and forming an opinion on the effectiveness of ICFR. Note that if reasonable possibility is remote, an unqualified opinion will be issued irrespective of materiality of misstatement in the financial statements. However, if reasonable possibility is reasonably possible or probable: 1. An adverse opinion will be issued for a material weakness. 2. (a) An unqualified opinion will be issued for a significant deficiency in minor scope limitation. (b) A qualified opinion will be issued for a significant deficiency in more than minor scope limitation. (c) A disclaim opinion or withdraw will be issued for a significant deficiency in serious scope limitation. 3. An unqualified opinion will be issued for an insignificant deficiency. In a financial audit, AU 265 allows the auditor to report material weaknesses and significant deficiencies in a material weakness report that separates from the audit report of financial statements. Likewise, in an integrated audit, AS 5 allows the auditor to report material weaknesses and significant deficiencies in an ICFR report that separates from the audit report of financial statements. Figure 8-10 shows an example of a separate report giving an unqualified opinion on the effectiveness of ICFR. Figure 8-11 shows an example of a combined report expressing an unqualified opinion on financial statements and an unqualified opinion on the effectiveness of ICFR. Chapter 21 discusses more on the various types of opinion on the effectiveness of ICFR. If the auditor identified a material weakness or significant deficiency in internal control prior to the yearend “as of” date specified in management’s internal control report, and if management implements changes to the internal control that eliminated the material weakness or significant deficiency prior to the year- end “as of” date specified, the auditor would normally issue an unqualified report with an additional paragraph in the report to explain that the auditor concluded that management has eliminated an identified material weakness or significant deficiency prior to the year- end “as of” date. In addition, t he PCAOB’s AS 4, Reporting on Whether a Previously Reported Material Weakness Continue to Exist , provides guidance for the auditor in reporting on whether a material weakness or significant deficiency continues to exist at an interim date. According to AS 4, rather than making a client wait twelve months to receive an unqualified opinion regarding its ICFR in the next year-end ICFR report, the auditor can provide an interim opinion once management has remediated the material weakness or significant deficiency. Thus, AS 4 allows the auditor to attest on a timely basis as to whether a client has eliminated the cause of a previously issued adverse opinion regarding its ICFR. However, the auditor’s engagement to report on whether a previously reported material weakness to exist ainwritten conformity with AS 4representation is voluntary. from management related to the audit of Lastly, thecontinues auditor obtains management ICFR. It includes statements such as management did not rely on work performed by the auditor in forming its assessment of the effectiveness of ICFR, management has disclosed to the auditor all deficiencies in the design or operation of ICFR, control deficiencies identified and communicated to the audit committee during previous


engagements have (or have not ) been resolved, and so on. While the required management representations are typically drafted (worded as if written) by the auditor, they are addressed to the auditor and are signed by the CEO and CFO. A failure to obtain written representations from management, including management’s refusal to furnish them, constitutes a limitation on the scope of the audit sufficient to preclude an unqualified opinion of the ICFR. Table 8-8 A uditor’s Consideration of Reasonable Possibility and Materiality, Communication of Material Weakness, Significant Deficiency and Insignificant Deficiency, and Forming an Opinion on the Effectiveness of ICFR Reasonable Possibility Materiality

Remote

Material and Significant deficiency

Issue unqualified opinion

Reasonably Possible or Probable Communicate Material weakness

Report material weakness to audit committee and to management Issue adverse opinion

Not Material but Significant deficiency


Communicate Significant Deficiency

Report significant deficiency to audit committee and to management Issue unqualified opinion (in minor scope limitation) Issue qualified opinion (in more than minor scope limitation) Issue disclaim opinion/withdraw (in serious scope limitation)

Not Material and Insignificant deficiency


Communicate Insignificant Deficiency

Send client’s advisory comment letter to audit committee and to management

Issue unqualified Opinion

Figure 8-10 An Example of a Separate Report Giving an Unqualified Opinion on the Effectiveness of ICFR [TITLE] Report of Independent Registered Public Accounting Firm ABC CPA, LLP San Francisco, California [ADDRESSEE] The Board of Directors and Stockholders XYZ Corporation [INTRODUCTORY PARAGRAPH] We have audited XYZ C orporation’s internal control over financial reporting as of December 31, 20xx, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). XYZ Corporation’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsib ility is to express an opinion on the effectives of the company’s internal control over financial reporting based on our audits. [SCOPE PARAGRAPH] We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit of internal control over financial reporting includes obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness o f internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinion.

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[DEFINITION PARAGRAPH] A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company, and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. [INHERENT LIMITATIONS PARAGRAPH] Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. [OPINION PARAGRAPH] In our opinion, XYZ Corporation maintained, in all material respects, effective internal control over financial reporting as of December 31, 20xx, based on criteria established inInternal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). [EXPLANATORY PARAGRAPH] We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements of XYZ Corporation, and our report dated March 31, 20xx, expressed an unqualified opinion. [SIGNATURE OF THE AUDITOR] _____________________________ ABC CPA, LLP

[DATE OF THE AUDIT REPORT] March 31, 20xx

Figure 8-11 An Example of a Combined Report Expressing an Unqualified Opinion on Financial Statements and an Unqualified Opinion on the Effectiveness of ICFR. [TITLE] Report of Independent Registered Public Accounting Firm ABC CPA, LLP San Francisco, California [ADDRESSEE] The Board of Directors and Stockholders XYZ Corporation [INTRODUCTORY PARAGRAPH] We have audited the accompanying balance sheets of XYZ Corporation as of December 31, 20xx, and the related statements of income, retained ’s internal control over financial reporting as of earnings, and cash flows for the year then ended. We also have audited XYZ Corporation December 31, 20xx, based on criteria established inInternal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). XYZ Corporation’s management is responsible for these financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management Report on the financial statements and Internal Control. Our responsibility is to express an opinion on these financial statements and an op inion on the effectives of the company’s internal control over financial reporting based on our audits. [SCOPE PARAGRAPH] We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audit of financial statements includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting includes obtaining an understanding of internal control over financial reporting, evaluating management’sassessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinion. [DEFINITION PARAGRAPH]


A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company, and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect onthe financial statements.

[INHERENT LIMITATIONS PARAGRAPH] Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. [OPINION PARAGRAPH] In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of XYZ Corporation as of December 31, 20xx, and the results of its operations and its cash flows for the year then ended in conformity with generally accepted accounting principles in the United States of America. Also, in our opinion, XYZ Corporation maintained, in all material respects, effective internal control over financial reporting as of December 31, 20xx, based on criteria established Internal in Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).

[SIGNATURE OF THE AUDITOR] _____________________________ ABC CPA, LLP


A Summary that Compares Internal Control of an Integrated Audit with Internal Control of a Financial Audit

Table 8-9 provides a summary that compares internal control of an integrated audit with internal control of a financial audit. Internal Control of an Integrated Audit

Internal control of a Financial Audit

Objective:



In an integrated audit, the objective is to obtain evidence about  the effectiveness of controls to support the auditor’s opinion on the effectiveness of aclient’s ICFR.

In a financial audit, the objective is to obtain evidence when control risk is assessed at less than the maximum of 100% to support the auditor’s opinion on the fairness of the financial statements presentation.

Framework:







The auditor obtains evidence about the effectiveness of  controls for all relevant assertions of all significant account and disclosures in the financial statements.

The auditor uses a “Top-Down Approach” to understand a client’s ICFR based on the COSO’s Internal ControlIntegrated Framework . Evidence:

The auditor understands five components of a client’s internal control based on the COSO’s Internal Control-Integrated Framework .

The auditor obtains evidence only for all relevant assertions of all significant accounts and disclosures that have their control risk assessed at less than the maximum of 100%.

Type (Nature):



An integrated audit and a financial audit use the same type of audit procedures to test controls.



An integrated audit and a financial audit use the same type of audit procedures to test controls.

Timing:



The auditor performs tests of operating effectiveness of controls over a period of time that is adequate to determine whether the controls are operating effectively“as of” the date indicated inmanagement’s internal control report.

Extent (Sample Size):



The audit performs tests of operating effectiveness of controls over the entire financial year to determine whether the controls are operating effectively according to aclient’s internal control policies and procedures.

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Internal Control of an Integrated Audit

 

The auditor uses professional judgment to determine the sample size to test controls.

Internal control of a Financial Audit



Extensive tests of controls performed in the integrated audit of  ICFR may reduce the extent of tests of balances (substantive tests) for the financial audit of financial statements.

The auditor uses aCPA firm’s detailed guidance to determining the sample size to test controls. Extensive tests of balance in the financial audit of financial statements may reveal deficiency in internal controls that are not detected by the integrated audit of ICFR.

Report:







 

The auditor communicates in writing to management all  control deficiencies, regardless of severity– this includes material weaknesses, significant deficiencies, and insignificant deficiencies. The auditor communicates in writing to the audit committee all material weaknesses and significant deficiencies, and an indication that all deficiencies have been communicated to management. The auditor communicates material weaknesses or significant deficiencies to the audit committee even if the management has addressed the material weaknesses or significant deficiencies and has implemented new controls that improve the effectiveness of internal control.

The written communication on weaknesses to both management and the audit committee should be made prior to issuance of the audit opinion on the effectiveness of ICFR.







The PCAOB’s AS 4, Reporting on Whether a Previously  Reported Material Weakness Continue to Exist, provides guidance for the auditor in reporting on whether a material weakness or significant deficiency continues to exist at an interim date. According to AS 4, rather than making a client wait twelve months to receive an unqualified opinion

regarding its ICFR in the next year-end ICFR report, the auditor can provide an interim opinion once management has remediated the material weakness or significant deficiency. Thus, AS 4 allows the auditor to attest on a timely basis as to whether a client has eliminated the cause of a previously issued adverse opinion regarding its ICFR. However, the auditor’s engagement to report on whether a previously reported material weakness continues to exist in conformity with AS 4 isvoluntary.

The auditor communicates insignificant deficiencies to management in writing in a client’s advisory comments letter (management letter). The auditor communicates in writing to the audit committee all material weaknesses and significant deficiencies.

The auditor communicates material weaknesses or significant deficiencies to the audit committee even if the management has addressed the material weaknesses or significant deficiencies and has implemented new controls that improve the effectiveness of internal control. However, the auditor is not required to communicate material weaknesses and significant deficiencies if (a) the management has already made them known to the audit committee, and (b) the audit committee has accepted the management's conscious effort to trade off the cost against the risk associated with the deficiencies. The auditor may choose to communicate all material weaknesses and significant deficiencies either during the course of the audit or after the audit of financial statements is concluded. Ordinarily, a previously communicated material weakness or significant deficiency that has not been corrected would not need to be communicated again by the auditor. However, the auditor should periodically consider whether the passage of time or changes in the management, the board of directors, or the audit committee would require the material weakness or significant deficiency to be communicated again.

Management Representation:



 

The auditor obtains a written management representation from management related to the audit of ICFR. It includes statements such as management did not rely on work performed by the auditor in forming its assessment of the effectiveness of ICFR, management has disclosed to the auditor all deficiencies in the design or operation of ICFR, control deficiencies identified and communicated to the audit committee during previous engagements have (or have not ) been resolved, and so on. While the required management representations are typically drafted (worded as if written) by the auditor, they are addressed to the auditor and are signed by the CEO and CFO. In an integrated audit, a failure to obtain written representations from management, including management’s refusal to sufficient furnish them, constitutes limitation on the scope of the audit to preclude an aunqualified opinion of the ICFR.



 

The auditor obtains a written management representation (also known as a management representation letter) from management related to the audit of financial statements (discussed in Chapter 20).

While the required management representations are typically drafted (worded as if written) by the auditor, they are addressed to the auditor and are signed by the CEO and CFO. In a financial audit, it does not address a failure to obtain written representations from management. However, it does address a failure to obtain written representations from a client’s lawyer, to which constitutes a limitation on the scope of the audit sufficient preclude an unqualified opinion of the financial statements (discussed in Chapter 20).



Which of the following factors is not related to a client's control environment? a. Personnel policies and practices. b. Audit committee. c. Segregation of duties. d. Management philosophy.

8-2

Which of the following procedures is not used by the auditor for documenting a client's internal controls? a. Fill out an internal control questionnaires. b. Perform a walkthrough test. c. Prepare a flow chart about internal controls. d. Write a report of the characteristics of internal controls.

8-3

If a control activity affects several management assertions, then it is generally considered to be a. a more relevant controlactivity and it contributes to morecontrol risk. b. a less relevant control activity and it contributes to less control risk. c. a more relevant control activity and itcontributes to less effective overall internal control. d. a more relevant control activity and it contributes to less control risk.

8-4

In relation to material weaknesses, whichof the following procedures isnot a deficiency in the design of internal controls? a. Inadequate procedures for applying accounting principle. b. Absence of reviews and approvals of accounting transactions. c. Intentional misapplication of accounting principle. d. Inadequate procedures for safeguarding assets.

8-5

The auditor does not need to communicate material weaknesses if a. a client's management has already communicated the substance of the material weaknesses to the audit committee and the committee has accepted the management's explanation of the matter. b. a client's management has discussed the substance of the material weaknesses with the auditors. c. the auditor is aware of the material weaknesses near the very end of the audit. d. the auditor has obtained satisfactory explanations about the material weaknesses from the client's management.

8-6

The auditor should not issue a no-material-weakness report if a. s/he has issued a management letter. b. s/he has accepted the management's explanations about the material weaknesses. c. s/he has previously issued a no-material-weakness report. d. s/he was not aware of material weaknesses.

8-7

The auditor may communicate material weaknesses to those charged with governance a. orally. b. orally and document the communication in the auditor's working papers. c. in writing and document thecommunication in the auditor’s working papers. d. on internet and make it available to any interested party.

8-8

Proper segregation of duties in an effective internal control calls for segregation of the functions of a. recording cash sales and also recording credit sales. b. preparing bank reconciliation and also approving purchase orders. c. receiving cash and also recording cash transactions. d. recording daily cash summary and also recording incoming mail.

8-9

When considering internal controls, an auditor should be aware of the concept of reasonable assurance, which recognizes that the a. cost of internal control should not exceed the benefits expected to be derived from internal control. b. separation of duties is necessary toascertain that internal control is effective. c. employment of competent personnel provides assurance that the objectives of internal control will be achieved. d. establishment and maintenance of internal control is an important responsibility of the management.

213

214


8-10

When planning an audit, the auditor’s assessed level of control risk is

a. determined by using an actuarial table. b. calculated by using an audit risk model. c. an economic issue, trading off the costs of testing controls against the costs of testing balances. d. calculated by using the formulas provided in the AUs. 8-11

After considering a client’s internal controls, an auditor has concluded that it is well designed and is functioning as intended. Under these circumstances the auditor would most likely

a. perform tests of controls to the extent outlined in the audit program. b. not increase the extent of predetermined tests of balances. c. determine the control procedures that should prevent or detect errors and frauds. d. determine whether transactions are recorded to permit preparation of financial statements. 8-12

Which of the following best describes the inherent limitations that should be recognized by an auditor when considering the potential effectiveness of a client’s internal controls? a. Procedures whose effectiveness depends on separation of duties can be circumvented by collusion. b. The competence and integrity of client personnel provides an environment conducive to effective internal controls. c. Procedures designed to assure proper authorizations are effective against fraud perpetrated by the management. d. The benefits expected to be derived from an effective internal control usually do not exceed the costs of such control.

8-13

Which of the following statements is not correct? a. It would be unusual to use both a narrative description and a flowchart to describe the same internal controls. b. The use of both internal control questionnaires and flowchart on the same audit engagement is desirable for understanding the client’s internal controls. c. The advantage of the narrative description is the ease of describing the details of complex internal controls. d. When reliable flowcharts on internal controls are available from client, it is desirable to use them rather than have the auditor prepare his/her own flowcharts.

8-14

The most important aspect of any internal control is a. proper authorization procedures. b. separation of duties. c. independent review by top management. d. competent and trustworthy personnel.

8-15

Which of the following most likely would not be considered an inherent limitation of the potential effectiveness of a client’s internal controls? a. Management override. b. Mistake in judgment. c. Collusion among employees. d. Incompatible duties.

8-16

When considering internal controls, the auditor should be aware of the concept of reasonable assurance, which recognizes that a. a client’s internal control risk cannot be assessed completely. b. the costs of a client’s internal controlsshould not exceed the benefits expected to be derived. c. adequate safeguards over access to assets and records should permit a client to maintain proper accountability. d. establishing and maintaining internal controls is the responsibility of management.

8-17

Which of the following most likely has a significant negative influence on a cli ent’s control environment?

a. The client has a formal written code of ethical conduct. b. Management is dominated by one individual who is also a major shareholder. c. Internal auditors have direct access to the board of directors. d. The audit committee i s active in overseeing the client’s financial reporting practice. 8-18

The primary objective ofprocedures performedto obtain an understanding ofinternal controlis to provide anaudit with a. necessary for audit planning. b. knowledge an evaluation of the consistency of application of management’s policies. c. a basis to modify the timing, nature, and extent of tests of controls. d. evidential matter to use in assessing detection risk.


8-19

In obtaining an understanding of a client’s internal controls in a financial statement audit, an auditor is not obligated to

a. determine whether the management monitors the performance of internal controls over time. b. perform procedures to understand the system of information and communication. c. search for significant deficiencies in the design of control activities. d. document the understanding of the internal controls. 8-20

Which of the following statements is correct concerning material weaknesses in an audit? a. An auditor is required to search for material weaknesses during an audit. b. An auditor may report all material weaknesses in internal controls. c. An auditor may communicate material weaknesses during an audit or after the audit is completed. d. An auditor may report that no material weaknesses were noted during the audit.

8-21

Which of the following statements is correct concerning an auditor’s required communication of material weaknesses? a. A material weakness previously communicated during the prior year’s audit that remains uncorrected causes a scope limitation. b. An auditor should perform tests of controls on material weaknesses before communicating them to the client. c. An auditor’s report on material weaknesses should include a restriction on the use of the report. d. An auditor should communicate material weaknesses after tests of controls, but before commencing tests of balances.

8-22

Material weaknesses are matters that come to an auditor’s attention that should be communicated to a client’s audit committee because they represent a. disclosures of information that significantly contradict the auditor’s going concern assumption. b. material fraud or illegal acts perpetrated by high-level management. c. manipulation or falsification of accounting records or documents from which financial statements are prepared. d. significant control deficiencies in the design or operation of internal controls.

8-23

An auditor’s communication of internal control related matters noted in an audit usually should be addressed to

a. those charged with governance. b. director of internal auditing. c. chief financial officer. d. chief accounting officer. 8-24

A previously communicated material weakness that has not been corrected ordinarily should be communicated again if a. the deficiency has a material effect on the auditor’s assessment of control risk. b. the entity accepts that degree of risk because of cost-benefit considerations. c. the weakness could adversely affect the client’s ability to report financial data. d. there has been major turnover in upper-level management and the board of directors.

8-25

An auditor’s material weaknesses report relating to a client’s internal controls observed during a financial statements audit should

a. include a brief description of the tests of controls performed in searching for material weaknesses and material weaknesses. b. indicate that the material weaknesses should be disclosed in the annual report to the client’s shareholders. c. include a paragraph describing management’s assertion concerning the effectiveness of internal controls. d. indicate that the audit’s purpose was to report on the financial statements and not to provide assurance on internal control. 8-26

Which of the following statements concerning material weaknesses and control deficiencies is correct? a. An auditor should identify and communicate material weaknesses separately from control deficiencies. b. All material weaknesses are control deficiencies. c. An auditor should immediately report material weaknesses and control deficiencies discovered during an audit. d. All control deficiencies are material weaknesses.

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8-27

Which of the following statements is true concerning insignificant control deficiencies noted in an audit? a. Insignificant control deficiencies are material weaknesses in the design or operation of specific internal control components. b. The auditor is obligated to search for insignificant control deficiencies that could adversely affect the client’s ability t o record and report financial data. c. Insignificant deficiencies should be re-communicated each year, even if management has acknowledged its understanding of such deficiencies. d. The auditor may separately communicate those insignificant control deficiencies in a client advisory comment letter.

8-28

Which of the following statements is true concerning the auditor’s required communication of a material weakness in internal controls? a. A material weakness that management refuses to correct should be included in a separate paragraph of the auditor’s report. b. A material weakness previously communicated during the prior year’saudit that has not been corrected should be communicated again in writing. c. Suggested corrective actions for management’s consideration concerning a material weakness need not be communicated to the client. d. The auditor should test the controls that constitute a material weakness before communicating it to the client.

8-29

Which of the following representationsshould not be included in a report on internal controlrelated matters noted in an audit? a. Control deficiencies related to internal control design exist, but none is deemed to be a material weakness. b. There are no significant deficiencies in the design or operation of internal controls. c. Corrective follow-up action is recommended due to the relative significance of material weaknesses discovered during the audit. d. The auditor’s consideration of internal controls could not necessarily disclose all material weaknesses that existed.

8-30

Which of the following statements is true concerning an auditor’s communicationof internal control related matters noted in an audit?

a. The auditor may issue a written report to those charged with governance representing that no material weaknesses were note during the audit. b. Material weaknesses should be re-communicated each year even if those charged with governance has acknowledged its understanding of such deficiencies. c. Insignificant control deficiencies may not be communicated in a memo that contains suggestions regarding activities that concern other topics such as business strategies or administrative efficiencies. d. The auditor may choose to communicate significant internal control related matters either during the course of the audit or after the audit is concluded. 8-31

Samples to test internal controls are intended toprovide a basis for an auditor to conclude whether a. the control activities are operating effectively. b. the financial statements are materially misstated. c. the risk of incorrect acceptance is too high. d. preliminary judgment about materiality (PJAM) for planning purposes is at a sufficiently low level.

8-32

Which of the following testsof controls most likely would help assure an auditor thatgoods shipped areproperly billed? (Hint: Think of the audit procedure that tests the completeness assertion) a. Scan the sales journal for sequential and unusual entries. b. traces shipping documents for matching sales invoices. c. compare the accounts receivable ledger to daily sales summaries. d. inspect unused sales invoices for consecutive pre-numbering.

8-33

An auditor is least likely to test controls that provide for a. approval of the purchase and sale of trading securities. b. classification of revenue and expense transactions by product line. c. segregation of the functions of recording disbursements and reconciling the bank account. d. comparison of receiving reports and vendors’ invoices with purchase orders for proper authorization.


8-34

After obtaining an understanding of a client’s internal controls and assessing control risk, an auditor may next a. perform tests of controls to verify management’s assertions that are embodied in the financial statements. b. consider whether evidential matter is available to support a further reduction in the assessed level of control risk. c. apply analytical procedures as tests of balances to validate the assessed level of control risk. d. evaluate whether the internal controls detected material misstatements in the financial statements.

8-35

An auditor usesthe knowledge provided by the understanding ofinternal controls andthe final assessed levelof control risk primarily to determine the nature, timing, and extent of the a. attribute sampling tests. b. compliance tests of transactions. c. tests of controls. d. tests of balances.

8-36

An auditor uses the knowledge provided bythe understanding ofinternal controlsand the assessed levelof control risk primarily to a. determine whether procedures and records concerning the safeguarding of assets are reliable. b. ascertain whether the opportunities to allow any person to both perpetrate and conceal fraud are minimized. c. modify the initial assessments of inherent risk and preliminary judgments about materiality. d. determine the nature, timing, and extent of tests for financial statement assertions.

8-37

Which of the following are considered control environment factors?

a. b. c. d. 8-38

Detection Risk Yes Yes No No

Commitment to Competence Yes No Yes No

Which of the following is not a component of internal controls? a. Control risk. b. Monitoring. c. Information and communication. d. Control environment.

8-39

Which of the following factors are included in a client’s control environment?

a. b. c. d. 8-40

Audit Committee Participation Yes Yes No Yes

Integrity and Ethical Values Yes No Yes Yes

Organizational Structure No Yes Yes Yes

Which of the following components of internal controls includes assignment of authority and responsibility to employees? a. Monitoring. b. Control environment. c. Risk assessment. d. Control activities.

8-41

The control activity of adequate separation of duties calls for separation ofthe functions of a. authorization, execution, and payment. b. authorization, recording, and custody. c. Custody, execution, and reporting. d. authorization, payment, and recording.

8-42

Internal controls cannot be designed to provide reasonable assurance that a. executed in accordance with management’s authorization. b. transactions fraud will beare eliminated. gement’s authorization. c. access to assets is permitted only in accordance with mana d. the recorded accountability for assets is compared with the existing assets at reasonable intervals.

217

218


8-43

When obtaining an understanding of a client’s internal controls, an auditor should concentrate on their substance rather than their form because

a. the controls may be operating effectively but may not be documented. b. management may establish appropriate controls but not enforce compliance with them. c. the controls may be so inappropriate that the auditor assesses control risk at the maximum. d. management may implement controls whose costs exceed their benefits. 8-44

An auditor should obtain sufficient knowledge of a client’s i nformation system relevant to financial reporting to understand the

a. safeguards used to limit access to computer facilities. b. process used to prepare significant accounting estimates. c. procedures used to assure proper authorization of transactions. d. policies used to detect the concealment of fraud. 8-45

An auditor’s flowchart of a client’s accounting system is a diagrammatic representation that depicts the auditor’s

a. assessment of control risk. b. identification of weaknesses in the system. c. assessment of the control environment’s effectiveness. d. understanding of the system. 8-46

An advantage of using flowcharts instead of internal control questionnaires to document a client’s accounting information and communication is that the flowcharts

a. identify internal control weaknesses more prominently. b. provide a visual depiction of client’s activities. c. indicate whether controls are operating effectively. d. reduce the need to observe client’s employees performing routine tasks. 8-47

The Sarbanes-Oxley Act of 2002 requires the auditor to issue an opinion in the audit reporton the management’s report of its internal control assessment. When issuing this opinion, the auditor a. uses the understanding and testing of internal controls performed in the audit of the financial statements. b. must only test controls when control risk is assessed below the maximum (i.e., material weaknesses). c. performs a combination of tests of controls and tests of balances. d. performs tests of additional internal controls specified by the management.

8-48

Which of the following is an incorrect statement regarding the requirement of Sarbanes-Oxley Act of 2002 on management’s internal control assessment? a. The auditor is to issue an opinion in the audit report on the management’s internal control assessment. b. The management is to issue a report on its internal control assessment in the company’s annual report. c. The auditor is to attest the management’s internal control assessment as part of the financial statement audit. d. The management is required to disclose fraud in its internal control assessment.

8-49

Which of the following isnot addressed bythe reports of the auditor and the management oninternal controlassessment under the Sarbanes-Oxley Act of 2002? a. State management’s responsibilities for establishing and maintaining an adequate internal controls and procedures for financial reporting. b. Assure maintenance of records that reasonably reflect the transactions and dispositions of the assets of the company. c. Provide reasonable assurance that transactions are recorded in accordance with GAAP, and that receipts and expenditures are authorized by management and directors of the company. d. Contain an assessment of the efficiency of the internal controls and procedures for financial reporting.

8-50

In AS 5, the PCAOB defines a “material weakness” as a. a control deficiency, or a combination of significant deficiencies, in internal control over financial reporting such that there is a reasonable possibility that a material misstatement of the company’s annual or interim financial statements will not be prevented or detected timelyorbasis. b. a significant deficiency in on theadesign operation of the internal controls. c. a more significant deficiency in the design or operation of the internal controls. d. an insignificant deficiency that would reduce the control risk to an acceptable low level.


8-51

In AS 5, the PCAOB defines “a significant deficiency in internal control” to mean a. the absence of significant misstatements in the financial statements provides evidence that there are no significant deficiencies in internal control. b. the control failure leads to significant or material misstatements in the financial statements. c. the presence of a material weakness that results in material misstatements in the financial statements. d. a control deficiency, or a combination of control deficiencies, in internal control over financial reporting that is less severe than a material weakness, yet important enough to merit attention by those responsible for oversight of the company’s financial reporting. .

8-52

Which of the following opinionsis not required by the PCAOB in the integrated auditreport on internal controland financial statements? a. An opinion on the fairness of the financial statements. b. An opinion on the reasonableness of prospective financial statements. c. An opinion on the management’s assessment of internal control over financial reporting. d. An opinion on the effectiveness of the company’s internal control over financial reporting.

8-53

With regard to an auditor communicating insignificant control deficiencies to a client, which of the following communication procedures is not appropriate? a. The auditor issues a management letter that addressed to the client’s management according to the auditing standard AU 265 Communication of Internal Control Related Matters Identified in an Audit. b. The auditor issues a management letter that addressed to the client’s audit committee according to Section 301 of the Sarbanes-Oxley Act of 2002. c. The auditor combines a management letter and a material weakness report into a special internal control engagement report that addressed to the audit committee. d. The auditor combines a management letter and a material weakness report into one report and report it to the audit committee.

8-54

The Sarbanes-Oley Act of 2002 requires management to include a report on i nternal control in the company’s annual report. It also requires auditors to report on the effectiveness of ICFR. Which of the following statements concerning these requirements is false? a. The auditor should evaluate whether internal controls are effective. b. Management’s report should state its responsibility for establishing and maintaining adequate internal controls. c. Management should identify material weaknesses in its report. d. The auditor should provide recommendations for improving internal control in the audit report on financial statements.

8-55

PCAOB’s Auditing Standard 5 (AS 5) requires an auditor to perform a alkthrough w as part of the internal control audit.A walkthrough requires an auditor to

a. Tour the organization’s facilities and locations before beginning any audit work. b. Trace a transaction from every class of transaction from srcination through the client’s information system. c. Trace a transaction from each major class of transaction from gination ori through the client’s information system. d. Trace a transaction from each major class of transaction from srcination through the client’s information system until it is reflected in the client’s financial reports. 8-56

If management makesan adverse assessment ofinternal control because ofa material weakness (i.e.,ICFR is not effective) and the auditor agrees with the assessment, the auditor would issue a. An adverse opinion. b. An unqualified opinion. c. A disclaimer. d. A qualified opinion.

8-57

Material weaknesses must be communicated to a client’s audit committee because they represent

a. Fraud or illegal acts perpetrated by high-level management. b. Disclosures of information that contradict the auditor’s goingconcern assumption. c. Material weaknesses in the design or operation of internal control. d. Manipulation or falsification of accounting records.

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8-58

In an integrated audit, which of the following must the auditor communicate to the audit committee? Known Material Weaknesses Yes Yes No No

a. b. c. d. 8-59

In Auditing Standard5 (AS 5), which of the followingis defined as a weakness ininternal controlthat allowsa reasonable possibility of a misstatement that is material? a. b. c. d.

8-60

Known Significant Deficiency Yes No Yes No

Control deficiency. Material weakness. Insignificant deficiency. Significant deficiency.

The auditor identified amaterial weakness in internal control in August. The management and audit committee were informed about the material weakness. The management implemented internal control that eliminated the material weakness prior to the year-end December “as of” date specified in management’s report on internal control. The appropriate audit report on internal control is a. an adverse report. b. a qualified report with an additional paragraph in the report to explain that the auditor concluded that management has d “as of” date specified in management’s report on eliminated an identified material weakness prior to the year-en internal control. c. an unqualified report. d. an unqualified report with an additional paragraph in the report to explain that the auditor concluded that management end “as of” date specified in management’s report on has eliminated an identified material weakness prior to the yearinternal control.

8-61

In an audit of ICFR, the auditor encountereda minor scope limitation in identifying areasonably possible andsignificant deficiency that has no material magnitude, the auditor would normallyissue a. an adverse opinion. b. a disclaimer. c. an unqualified opinion. d. a qualified opinion.

8-62

Which of the following is not a correct statementwith regardto tests of controls preformedin the audit of ICFR or in the audit of financial statements? a. In the audit of ICFR, the auditor performs tests of operating effectiveness of controls over a period of time that is “as of” the date indicated i n management’s internal control adequate to determine whether the controls are operating report. b. In the audit of financial statements, the auditor obtains evidence about the effectiveness of controls for all relevant assertions of all significant account and disclosures in the financial statements. c. Extensive tests of controls performed in the audit of ICFR may reduce the scope of tests of balances (substantive tests) for the audit of financial statements. d. Any written communication to both management and the audit committee on weaknesses found in the audit of ICFR should be made prior to issuance of the audit opinion on ICFR.


8-1 c. 8-2 b. 8-3 d. 8-4 c. 8-5 a. 8-6 d. 8-7 c. 8-8 c. 8-9 a. 8-10 c. 8-11 b. 8-12 a. 8-13 c.

8-14 d. 8-15 d. 8-16 b. 8-17 b. 8-18 a. 8-19 c. 8-20 c. 8-21 c.

8-22 d. 8-23 a. 8-24 d. 8-25 d. 8-26 b. 8-27 d. 8-28 c. 8-29 b. 8-30 d. 8-31 a. 8-32 b. 8-33 b. 8-34 b. 8-35 d. 8-36 c. 8-37 c. 8-38 a. 8-39 d. 8-40 b. 8-41 b. 8-42 b. 8-43 b. 8-44 b. 8-45 d. 8-46 b. 8-47 a. 8-48 d. 8-49 d. 8-50 a. 8-51 d. 8-52 b. 8-53 c. 8-54 d. 8-55 d. 8-56 a. 8-57 c. 8-58 a. 8-59 b. 8-60 d. 8-61 c. 8-62 b.


Simulation Question 8-1 Simulation Question 8-1 is an adaptation with permission from a case by Agoglia, C.P., K.F. Brown, and D.M. Hanno in theIssues in Accounting Education , a publication of the American Accounting Association in Sarasota, Florida. This simulation question is based upon a true set of facts; however, the names and places have been changed. For the past two years, Paul Russell has been working as a staff auditor for a “Big Four” CPA firm. One day, Jean Schmidt, the audit manager, called Russell into her office to give him the good news of his promotion to senior auditor. Schmidt also informed him that the current auditor-in-charge of Dickinson Technologies, Inc. engagement was being reassigned and that Russell would be taking over as her in-charge on the audit. Russell’s responsibilities on the engagement would include supervising the audit staff in their completion of planning and fieldwork. Russell was excited about the challenge of his first engagement as an auditor-in-charge. However, he also knew that Schmidt was an extremely demanding audit manager. The thought of reporting directly to Schmidt made him nervous. True to her reputation as a demanding manager, Schmidt expected Russell to hit the ground running. She directedim h to evaluate Dickinson’s control environment right away and provided him with the following background information: 1. Their CPA firm has audited Dickinson Technologies, Inc. for the past three years and has again been engaged to audit their financial statements for the fiscal year ending December 31, 20X4. The audit was currently in the early stages of the planning process. Their CPA firm maintained a good working relationship with Dickinson and has found both management and the employees to be generally cooperative. 2. So far, an audit staff has collected information Dickinson’s control environment, and he has documented his observations and comments in the right-hand column of the Control Environment Questionnaire. You should access Data File 8-1 in iLearn, which contains the Control Environment Questionnaire.

3.a. The audit client, Dickinson Technologies, Inc., is an international manufacturer of instruments used to measure electricity and electrical signals, and has manufacturing operations both in and outside of the United States. Its stock is publicly traded on the New York Stock Exchange. b. Dickinson’s net income has increased each year, from $3.8 milli on seven years ago, to a projected $15.6 million in t he current fiscal year. For fiscal year 20X4, Dickinson Technologies, Inc. expects sales of $247 million. Sales have steadily increased an average of 26 percent per year over the last seven years. The company’s market niche is in a rapidly growing area; new markets and new products should conti nue to provide significant sales growth. However, Dickinson’s markets are becoming increasingly competitive. c. Dickinson’s management believes its technical staff is highly skilled, but several of its competitors have substantially greater financial resources and larger technical staffs at their disposal. However, management believes that it is able to maintain its competitive advantage by relying on a combination of market leadership, highly skilled technical staff, reputation, patents, proprietary knowledge and experience, and the quality, safety, and cost effectiveness of its products. d. Dickinson operates research and development centers in the United States, Europe, and Asia. Total research and development costs for 20X4 are projected to be $23.8 million, up from $17.9 million in 20X3 and $11.7 million in 20X2. Management believes customer collaboration is an important part of their technical strength and competitive advantage, and has built close working relationships with a significant number of professionals who use the company’s instruments. e. Dickinson has several related and wholly owned subsidiaries and has over 1,100 U.S. employees on its payroll. Approximate breakdown of employee assignment by function are: 48 percent manufacturing, 17 percent sales and marketing, 15 percent general and administrative, 11 percent quality control and field service, and 9 percent research and development. Dickinson considers its employee relations to be satisfactory. 4. In order to obtain an un derstanding of the Dickinson’s business before consideration of its control environment, financial results for the first six months of the current year have been obtained from its management as follows: Dickinson Technologies, Inc. Unaudited Balance Sheet as of June 30, 20X4

ASSETS Current assets Cash Short-term investments Accounts receivable, net Inventories Prepaid expenses and other current assets Total current assets Property, plant, and equipment Land Building and building improvements Machinery and equipment Furniture and fixtures Total property, plant, and equipment Less: Accumulated depreciation Net property, plant, and equipment Other assets Investments in affiliates Patents Other assets, net Total other assets

June 30, 20X4 $ ‘000

Dec 31, 20X3 $’000

Dec 31, 20X2 $’000

1,161 1,683 26,189 11,363 1,679 42,075

1,072 1,557 21,906 10,125 1,743 36,403

797 1,654 18,742 7,442 1,083 29,718

1,644 11,171 27,772 2,613 43,200 11,599 31,601

1,515 10,214 25,296 2,584 39,609 10,284 29,325

1,090 7,757 15,733 2,098 26,678 8,784 17,894

7,719 4,419 948 13,086

7,021 3,819 851 11,691

2,397 2,479 759 5,635

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222


TOTAL ASSETS LIABILITIES AND STOCKHOLDERS’EQUITY

86,762

Current liabilities Notes payable and current maturities of long-term debt Accounts payable Accrued payroll and related costs Deferred revenue Accrued income taxes Other accrued expenses Total current liabilities Deferred income taxes Long-term debt, net of current maturities Common stock Additional paid-in capital Retained earnings Cumulative translation adjustments Stockholders’ equity before treasury stock Less: Treasury stock at cost Total stockholders’ equity

67,188 65,909

TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY

86,762

77,419

53,247

1,837 3,618 1,308 855 1,635 832 10,085 2,247 8,521

1,568 3,332 1,179 644 1,039 691 8,453 1,713 8,839

2,160 3,296 906 566 749 523 8,200 1,353 12,629

87 29,309 37,890 (98) 59,693 1,279 58,414

87 29,309 30,375 (78) 31,065 1,279 31,065

44 10,774 20,079 168

77,419

--

53,247

Dickinson Technologies, Inc. Unaudited Income Statement for the Six-Month Period Ended June 30, 20X4

Net revenues Cost of goods sold Gross profit Operating Expenses: Research and development Selling, general, and administrative Total operating expenses Operating Income

Interest expense Interest income Other expense, net Income before provision for income tax Provision for income taxes NET INCOME

For Six Months Ended June 30, 20X4 ($’000) 124,924 61,983 62,941

For Year Ended Dec 31, 20X3 ($’000) 200,398 99,876 100,522



11,821 38,441 50,262 12,679 (376) 139 (237) 12,442 4,355

17,931 62,376 80,307 20,215 (787) 240 (547) 19,668 6,884

11,674 51,395 63,069 15,387 (880) 304 (576) 14,811 5,184

8,503 42,112 50,615 12,763 (950) 314 (636) 12,127 4,366

8,087

12,784

9,627

7,761

Required 1. Schmidt asked Russell to review the Control Environment QuestionnaireAccess ( Data File 8-1 in iLearn, which contains the Control Environment Questionnaire ) and submit to her a detailed memo on his assessment of Dick inson’s control environment regarding: a. b. c.

How likely is it that its control environment will prevent misstatements arising from fraudulent financial reporting? How likely is it that its control environment will prevent misstatements arising from the misappropriation of assets? Which one, a. or b. above, should be of greatest concern in the audit of Dickinson Technologies, Inc.?

Assuming the role of Russell, you are to do what Schmidt has asked. You should find the discussion on “Overall Audit Objective” in Chapter 6 to be helpful in drafting your memo. Your memo should conclude with an assessment of the overall likelihood that the control environment will prevent fraud in Dickinson Technologies, Inc. Explain your overall conclusion.

Simulation Question 8-2 Simulation Question 8-1 is based on publicly available information on the Internet and is based upon a true set of facts. The simulation question is developed by F. Choo inFinancial a nd Integrated Au dits , a publication of AcademicPub of California State Universities.



Enron’s Internal Control

Enron’s 2000 annual report stated that it has metamorphosed from an asset-based pipeline and power generating company to a established business approach and its innovative people. Enron’s marketing and logistics company whose biggest assets are its wellmetamorphosis seemed to pay off: In 2000 it was the seventh largest company on the Fortune 500, with assets of $65 billion and sales revenues


of $100 billion. From 1996 t o 2000 Enron’s revenues had increased by more than 750 percent and 65 percent per year, which was unprecedented in any industry. Yet just a year later, Enron filed for bankruptcy, and billions of shareholder and retirement savings dollars were lost. At Enron, executives had incentives to achieve high-revenue growth because their salary increases and cash bonus amounts were linked to reported revenues. In the proxy statement filed in 1997, Enron wrote the “based salaries are targeted at the medianof a competitor group that includes peer group companies … and general industry companies similar in size to Enron.” In the proxy statement filed in 2001, Enron wrote, “The [compensation] committee determined the amount of the annual incentive award taking into consideration the compet itive pay level competitive bonus levels for C EO’s in specific high performing companies.” for a CEO of a company with comparable revenue size and Employees also had incentives to achieve high revenues and earnings targets because of the shares of stock they held. Enron made significant use of stock options as a further means of providing incentives for its executives to achieve growth. For example, Enron noted in its 2001 proxy statement that the following stock option awards would become exercisable as of February 15, 2001: 5,285,542 shares for Chairman Ken Lay; 824,038 shares for President Jeffrey Skilling, and 12,611, 385 shares for all officers and directors combined. In fact, as of December 31, 2000, Enron had dedicated 96 million of its outstanding shares (almost 13 percent of its common shares outstanding) to stock option plans. Enron’s performance review committee (hereafter, PRC) determined the salaries and bonuses of employees on a semiannual basis. The PRC was initially instituted in the gas services business during the early 1990s after the merger between Houston Natural Gas and InterNorth. One Enron employee said, “At the time, it was a great tool … When we started the ranking process, we were tryingto weed out the lower 5 or 6 percent of the company. We had some old dinosaurs, and we had some younger people who ded nee incentives.” The PRC was gradually instituted companywide when Jeffrey Skilling, a former McKinsey & Co. consultant who joined Enron in 1990 as the chief executive of the Enron finance division, was promoted to president and COO. The PRC made its determinations based on feedback reports that assessed the performance of employees on a scale from 1 to 5. Those who received ratings of 1 received large bonuses, and a rating of 2 or 3 could cost a vice president a six-figure sum. Those who ranked in the bottom 10 percent of the review had until the next semiannual review to improve or they would be fired. Those in categories 2 and 3 were also given notice that they could be fired within the next year. During the 1990s Enron made significant changes to several of its accounting procedures designed to improve reported earnings and financial position. For example, Enron began using mark-to-market (MTM) accounting for its trading business, which allowed the present value of a stream offuture inflows and outflows under a contract to be recognized as revenues and expenses, respectively, once the contract was signed. Enron was the first company outside the financial services industry to use MTM accounting. Enron also began establishing several specialpurpose entities (SPE), which were formed to accomplish specific tasks such as building gas pipelines. If an SPE satisfied certain conditions, satisfied certain conditions, it did not have to be consolidated with the financial statements of the sponsoring company. This SPE could be utilized by a company hoping to achieve certain accounting purposes, such as hiding debt.

Required You should access the PCAOB’s Auditing Standard No.5 (AS 5) in http://www.pcaobus.org/Standards/index.aspxto answer the following questions: 1. Read Paragraphs 21 to 25 of AS 5, then a. Define what is meant by “control environment” in AS5. b. Comment on your understandingof Enron’s “control environment.” c. Explain how Enron’s “control environment” would affect your implementation of the Top-Down approach for Obtaining an Understanding of ICFR and Identifying Controls to Test. 2. Read Paragraphs 62 to 70, then a. Explain whether Enron’s executive incentive scheme might be a material weakness, significant deficiency, or insignificant deficiency in internal control. State all your assumptions and support your arguments. b. Explain whether Enron’s performance review scheme might be a material weakness, significant deficiency, or insignificant deficiency in internal control. State all your assumptions and support your arguments. c. Explain whether Enron’s accounting procedures relating to MTM and SPE might be material weaknesses, significant deficiencies, or insignificant deficiencies in internal control. State all your assumptions and support your arguments.

Simulation Question 8-3 Simulation Question 8-3 is an adaptation with permission from a case by H. N. Higgins in Issues the in Accounting Education , a publication of the American Accounting Association in Sarasota, Florida. This simulation question is based upon a true set of facts.

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Bank of China and China’s Banking Sector

Established in February 1912, Bank of China (BOC) functioned as the country's central bank, its international settlement bank, and its international trade bank until 1949. After the founding of the People's Republic of China, BOC became a state-owned specialist bank engaged in foreign exchange and foreign trade. In 1994, BOC was restructured into a wholly state-owned commercial bank. In August 2004, BOC was incorporated into Bank of China Limited, and it went public on the Hong Kong Stock Exchange in June 2006 and on the Shanghai Stock Exchange in July 2006, becoming the first Chinese commercial bank listed in the Chinese Mainland and in Hong Kong. The major stockholder (owning 67 percent of BOC) is Central Huijin Investment Limited, owned by the People's Republic of China. Shareholder rights exercisedofbythethe State Council. Central Huijin provides a structure by which the government can operate under China's Company Law as aare shareholder large Chinese banks. Besides its large share of the domestic market, BOC has substantial overseas operations, including operations in highly regulated banking environments such as Hong Kong, New York, and London. For this reason, BOC has had perhaps greater exposure to international business and You should access Data File 8-3 in iLearn for Figure 1, which shows the regulatory standards than any other Chinese state enterprise. ownership and operational structures of BOC.

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The governance structure of BOC is that of a joint-stock company, composed of the General Meeting of Shareholders, the Board of Directors, and the Board of Supervisors. The Board of Directors is BOC's decision-making body composed of 15 members, namely its chairperson, three executive directors, seven non-executive directors, and four independent directors. Its committees include the Strategic Development Committee, Audit Committee, Risk Policy Committee, Personnel and Remuneration Committee, and Connected Transaction Control Committee. The Senior Management, BOC's executive body, reports to the Board of Directors. It consists of a president, vice-president, and other senior management members. It includes numerous committees responsible for corporate banking, personal banking, global markets business, operational service, risk management and internal control, securities investment management, purchase review, asset disposal, and anti-money laundering. The Board of Supervisors is BOC's supervisory body, consisting of five supervisors, three of whom are shareholders and two of whom are employees. The Board of Supervisors is responsible to the General Meeting of Shareholders, and it oversees the bank's financial affairs and the legal compliance of the Board of Directors and the Senior Management. The governance structure of BOC, depicted in Figure 2, is consistent with a dual board structure often found in countries with a civil law tradition such as Germany and France. You should access Data File 8-3 in iLearn for Figure 2, which shows the governance structure of BOC. BOC is one of the “Big Four” state-owned commercial banks (Industrial and Commercial Bank of China, Bank of China, Agricultural Bank

of China, and China Construction Bank), which together account for the majority of the country's market. The remainder of the country's sector is made up of policy banks, joint-stock banks partially owned by the government and partially by other interests, foreign banks, and rural credit cooperatives. The Big Four face little competitive threat and are better known for their poor risk controls than their contribution to the economy. The Big Four are less profitable, are less efficient, and have worse asset quality than most other banks in China. Lending by the Big Four is less prudent, although improvements over time are expected as reform initiatives are implemented. Economic growth leads financial development in China (not the other way around), and until 2005, bank loans had little effect on local growth. China's banking system is notably different than private, market-based banking systems in the West, in that it is state owned and it plays a significant role in commercial enterprise financing. The most salient aspect of the system is the dominant role of the state. The Chinese government holds, on average, 53 percent of a listed company's total shares, while the second-largest shareholder holds roughly 10 percent. State ownership is exercised by the Chinese Communist Party and government ministries. The state participates actively in managing the banks. Government officials are routinely appointed as bank managers and directors, and the state sets management compensation at most banks. The party appoints the boards with the approval of the State Council. Chinese financial regulators tend to pursue macroeconomic policy goals through regulated institutions, particularly through banks and securities firms. Because China is an extremely populous country and because Chinese communism emphasizes social and economic equality over the profit motive, social and economic stability are deemed essential and generally constitute the overarching goals of government policies. Government officials in manager or director positions tend to pursue government policies without emphasizing profit-seeking goals. The second most salient aspect of the system is the banks' significant role in commercial financing. Despite significant recent growth in China's capital markets, close to 90 percent of Chinese enterprise financing comes from the banks. In stark contrast, in the U.S., capital markets account for about half of total business financing. Even in Japan, a bank-centered economy, bank financing accounts for only about two-thirds of total business financing. Thus, banks are even more important for commercial financing in China than in Japan.

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Bank Governance Problems and Reforms

China opened its economy and launched economic reform in the late 1970s. In the 30 years prior to this, the Chinese economy had functioned as a socialist economy, based upon state ownership and centralized decision making. Chinese banks executed government directives to support regional and industrial policies. Owned by the state and not beholden to interested shareholders, they were not profit oriented. Rather, they allocated resources in accordance with central planning. Since the launch of economic reform in the late 1970s, Chinese banks have been moving away from being mere extensions of the government; however, many Chinese banks still have a governance regime that is not well adapted to a more independent, active role in resource allocation. The four largest commercial banks, including BOC, are owned primarily by the state. The second-largest category of banks consists of 11 joint-stock banks that emerged after the reforms. These banks are co-owned by the government and by other interests. Less constrained by government directives, these banks have developed a stronger commitment to profitability. In tremendous growth, China's banking sector is deemed more vulnerable to fraud than the banking sectors of developed countries. Due to the very recent development of the country's corporate culture, the distinction between government and commercial functions is still blurred in Chinese enterprises. Because state officials still often act as bank owners, managers, and directors, they often interfere with banking operations for policy purposes and do not base decisions on commercial principles. Many state-owned commercial banks continue lending to favored borrowers, many of whom are unprofitable state-owned enterprises. Furthermore, the government has an implicit policy of not letting major banks fail. Lack of adherence to commercial principles and a bailout mentality open doors to adverse credit selection and to conflicts of interest. Decades of reform have achieved only limited success in instilling discipline in the state-owned banks. While cumulating huge assets due to a high savings rate from the thrifty Chinese public (40 percent of national income is in the form of bank deposits from the public), Chinese banks manage these assets poorly. Particularly, state-owned banks often extend credit to weak but privileged borrowers and then continue approving further loans to these borrowers in order to avoid reporting non-performing loans. Many such borrowers are loss-making, state-owned enterprises. Many others are individuals and businesses perpetrating fraud. Unprincipled lending has led to an increase in non-performing loans. By the end of 1997, non-performing loans generated by China's stateowned commercial banks were equivalent to $400 billion. Estimates of China's non-performing loan ratio varied between 20 percent as officially reported, to 40–50 percent as estimated by some in the West. At the same time, the average capital adequacy rate of Chinese banks was 3.5 percent, much lower than the 8 percent required by the Basel Accords. Important restructuring began in 1998, when capital of RMB 270 million (3 percent of China's GDP, equivalent to $33 billion) was injected into the four state-owned banks. In 1999, the Chinese government established Asset Management Companies to purchase RMB 1.4 trillion (equivalent to $170 billion) of non-performing loans. In these transactions, the Chinese government transferred a substantial number of nonperforming loans to state-owned asset management companies at book value, essentially injecting capital into banks to rid them of their toxic assets. Further capital injections followed in 2003 and 2004. The estimated cost to the government for non-performing loans was at least 20 percent and as much as 50 percent of one year's GDP, equivalent to 1 to 2.5 percent of GDP annually over 20 years. Capital injection has indeed played a role in reducing non-performing loans at BOC and at other Chinese banks. In 1997 at BOC, a whopping 60 percent of total loans were estimated as non-performing. By 2002, this rate was reduced to roughly 26 percent. By 2004, BOC's non-performing loan rate was only around 5 percent. By 2009, the rate was under 2 percent, helping BOC rank 11th among the world's top 1,000


banks by Tier 1 capital. This bailout demonstrated the Chinese government's resolution to resurrect Chinese banks. Nonetheless, the provision of funds was insufficient to address banks' balance-sheet problems and provided little incentive to prevent the banks from reverting to earlier patterns of lending.You should access Data File 8-3 in iLearn for Figure 3, which showsnon-performing the loans of BOC over the years. Another phase of governance reform was undertaken in 2003 as a condition for China's accession to the World Trade Organization (WTO). WTO membership required China to open the country's finance sectors to more foreign competition. Key reform elements that grew out of WTO requirements were ownership diversification, public listing, and expanded foreign presence, all designed to subject banks to higher standards of transparency and to enable external scrutiny. Governance reform and international exposure are intertwined because they are both linked to banks' attempts to strengthen their balance sheets via additional financial support. At the same time, a specialized independent agency for bank supervision, the China Banking Regulatory Commission (CBRC), was formed to accelerate new measures of bank supervision. The reform initiatives aimed to incorporate internationally accepted best practices and to foster banks' transition from their traditional role as government agencies toward a commercial orientation. After China's accession to the WTO in 2001, initiatives to strengthen corporate governance and risk management helped uncover a myriad of fraud instances at Chinese banks. In 2005, China's Ministry of Commerce revealed that over 4,000 corrupt officials had fled the country, taking with them nearly $50 billion. Corrupt officials had reason to flee: corruption is a crime that can draw capital punishment in China, although the death penalty often may be reduced to life imprisonment in non-political cases. The following incident relates one such example of fraud.

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Fraud Incident

BOC has experienced no shortage of fraud orchestrated by management at all levels. One of the most spectacular schemes came to light in 2001, coinciding with China's entrance in the WTO. In the process of improving their systems to comply with WTO requirements, BOC auditors discovered that amounts equivalent to half a billion U.S. dollars were missing from the bank's accounts. Investigations led to a branch in Kaiping, a manufacturing town in the Guangdong province.

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The Gang

According to Hong Kong authorities, Xu Chaofan, mastermind of the scheme and a former general manager at the Kaiping branch, began illegal transfer and use of BOC funds in the early 1990s. While at the branch, he stole an estimated $400+ million. Promoted to manager of the regional headquarters at Guangzhou in 1999, Xu Chaofan netted an additional $80 million in stolen funds by conspiring with two succeeding Kaiping general managers, Yu Zhendong and Xu Guojun.

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The Operation

called “window” companies to speculate in stocks and real estate in Hong Kong, China's In the 1990s, many mainland Chinese set up sowindow to the world. The gang helped create two window companies in 1992; they then used the companies as vehicles to invest BOC funds and to pull in profits for themselves, as well as to divert stolen funds. Relatives of Xu Chaofan set up both companies, Ever Joint Properties and Yau Hip Trading Limited. On the surface, the window companies acted as investing arms of BOC Kaiping. However, no permission to remit these funds abroad was granted by a BOC senior branch manager. Some funds from Ever Joint were funneled to a third organization the gang had created, Land Galaxy Limited, which paid salaries and expenses incurred by the gang, whose members had created false Hong Kong identities for this purpose. Ever Joint funds also were moved to other accounts controlled by the gang at casinos and elite financial institutions in Hong Kong and in other countries. The gang's typical fraudulent transaction was a bank loan. BOC funds were remitted to Ever Joint in Hong Kong mostly by means of false information purporting to show loans made to intermediary companies in Hong Kong, although there was no genuine business between Ever Joint and these intermediaries.

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Co-Conspirators

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The Stolen Funds

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The Cover

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Discovery

The gang's most important co-conspirators were Hui Yat-sing, Xu Chaofan's first cousin, and Wong Suet-mui, Hui Yat-sing's wife. Both were directors and managers of Ever Joint Properties and signatories of the company's bank account. Wong also ran Yau Hip Trading and was the signatory of its bank account. The gang also had accomplices managing mainland companies that received loans from BOC Kaiping and remitted the funds to Ever Joint. Additional accomplices in Hong Kong received funds from Ever Joint and then disbursed them to the gang under members' false Hong Kong identities. Ever Joint funded the purchase of three expensive Hong Kong apartments for the gang. Monies from the window company were invested in real properties, stocks, index futures, and foreign exchange. Some investments apparently met with disastrous results in the wake of the real estate and stock market crashes of 1997. Ever Joint's biggest stock position was in Leading Spirit High-Tech Holdings Company Limited, a Chinese stock that plunged 99 percent from its 1997 high. The gang also bought and suffered great loss from a stake in tycoon Richard T. K. Li's Pacific Century CyberWorks Limited. They also deposited large sums into accounts controlled by themselves, their wives, and their relatives at casinos in Macau, Australia, and the United States.You should access Data File 8-3 in iLearn for Figure 4, which shows the flow of stolen funds. Since the bank managers had insider authority to make loans and transfer funds without controls, the stolen funds went unnoticed by BOC's information system and auditing processes for some time. Lax supervision and the proliferation of non-performing loans also provided a mask, hiding the theft. The managers could further resort to accounting gimmicks to cover their tracks. A major auditing weakness at the time was the system's inability to clear and verify a large number of accounts simultaneously, leaving a window of a couple of days for bank managers to transfer funds from account to account to camouflage shortages. In October 2001, coinciding with China's entrance to the WTO, a change at BOC in the structure providing for the transfer of funds and centralization of information helped auditors discover discrepancies in the accounting books of BOC Kaiping. On October 13, 2001, BOC's auditors examined the accounting records for that branch and found that a huge sum of money was missing. On the same day, the three managers failed to attend work, fleeing to Hong Kong and using their Hong Kong identity cards to gain entry. On October 15, 2001, they left Hong Kong for Canada. Their final destination was the U.S., where they and their wives obtained citizenship by unlawfully using loopholes in the system and by using forged documentation. Via the arrangement of his true wife, Yu Zhendong entered a sham marriage with a naturalized U.S. woman named Shanna Yu Ma in order to procure his own U.S. citizenship. Police in China, Hong Kong, Canada, and the U.S. cooperated in the investigation. Yu Zhendong was arrested in Los Angeles in December 2002. He pleaded guilty to racketeering in February 2004, was sentenced to 144 months in prison by a federal court in Las Vegas, and voluntarily returned to China on China's promise to exempt him from the death penalty. In China, a court in Jiangmen City sentenced him to 12 years in

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prison, comparable to the U.S. sentence. Yu was the first corrupt Chinese official to be repatriated as a result of China's ratifying the United Nations Convention against Corruption in October 2005. Prior to this convention and before Yu's case, suspects of severe economic crimes in China had rarely been sent back, because many countries objected to the death penalty for this type of crime. Xu Guojun was arrested in Kansas in September 2004, and Xu Chaofan was arrested in Oklahoma in October 2004. In 2008, the two were convicted of racketeering, money laundering, and passport fraud by a Las Vegas court. In 2009, a U.S. district judge sentenced Xu Chaofan to 25 years in prison and Xu Guojun to 22 years in prison.

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The Need for More Bank Audits and Reforms in China

In light of the fraud triangle theory, the Kaiping scheme suggested high fraud risk at BOC and other Chinese banks. The concept of a fraud triangle denotes three factors, namely opportunity, pressure/incentive, and rationalization/attitude that signal high likelihood of fraud. The Kaiping managers' ability to abuse their positions of trust was consistent with a lack of supervision in many Chinese enterprises, which created ample opportunities for managers to commit fraud. These opportunities suggested high fraud risk at the bank, and to the extent that other Chinese banks shared the same governance and control structure, they also had high fraud risk. Indeed, not just BOC but other Chinese banks and enterprises have similar challenges in applying control activities. The following notes highlight some common challenges beyond the facts of the described fraud incident. These notes should be important to managers and auditors of Chinese banks and enterprises. First, managers often have undivided authority in China. According to Shen Xiaoming, deputy director of the China Banking Regulatory Commission (CBRC), regulations as of 2005 allowed bank managers to give loans with undivided authority. Banks often accepted forged commercial papers and illegal deposit pledges in exchange for loan disbursements. Banks typically did not have procedures to limit managers' authority, such as loan approval committees to assess lenders' merit based on credit and business purposes. Second, it is common in China for the authorized signatory of bank accounts to use seals in place of handwritten signatures. Usually, the minimum two seals required are the Legal Representative Seal and the Finance Seal, although some companies may use more seals for better segregation of duties. However, the intended control is overridden if both seals are accessible to one single individual. Third, many Chinese banks lack a process for controlling bank confirmations at the branch level; as a result, fraudulent employees at local branches may give fake bank confirmations without being detected. An essential audit procedure by auditors is to seek bank confirmations of a firm's cash balance. However, firms with friends at the local bank may deceive their auditors if their friends issue a fake confirmation. To mitigate this problem, auditors may seek confirmations at both the bank branch and headquarters. The fraud incident prompted BOC, other Chinese banks, and Chinese bank regulators to strengthen supervisory standards. Today, Chinese regulators have published standards that are comparable to those of other major financial systems in the world. China's Basic Standard for Enterprise Internal Control (Basic Standard ) was issued in June 2008, followed byImplementation Guidelines (Guidelines ), issued in April 2010. The Guidelines were based on the 1992Document on Internal Control , published by the Committee of Sponsoring Organizations (COSO 1992). The COSO framework has been adopted by many organizations and government entities in the U.S. and throughout the world to design and assess internal control systems. COSO identifies three objectives: effectiveness and efficiency of operations, reliability of financial reporting, and compliance with applicable laws and regulations. To achieve these objectives, COSO identifies five interrelated components of internal control: control environment, risk assessment, control activities, information and communication, and monitoring. Thus, the COSO framework may be visualized as a matrix of three objectives and five components that can assist high-level managers in designing internal control systems and auditors in conducting COSO-based audits.Y ou should access Data File 8-3 in iLearn for Figure 5, which shows the COSO Internal Control – Integrated Framework.

Although all five components of an internal control system are important, control activities form the first line of defense against fraud. These activities include establishment of responsibility; segregation of duties; documentation of procedures; establishment of physical, mechanical, and electronic controls; development of a system for independent internal verification; and creation of human resource controls. The Guidelines have been dubbed “C-SOX” since they are similar to the U.S. Sarbanes-Oxley Act Section 404. They outline the regulatory requirements for Chinese enterprises to establish, evaluate, and assess the effectiveness of their internal controls. C-SOX also requires accounting firms to audit the effectiveness of the enterprise's internal controls. Enterprises are required to issue assessment reports of internal controls every year. The CEO and Board of Directors are ultimately responsible for risk management and compliance. In addition, auditors are required to disclose in their audit reports any noted material deficiencies in internal controls that are both related and unrelated to financial reporting. Note that China's Guidelines are referred to as C-SOX, it should not be confused with Canada's CSOX. While these standards should help, some remain fundamentally concerned about the inherent conflicts of interest that emerge in statecontrolled banks, arguing that independence in individuals' judgment is a necessary foundation for implementing governance and reform standards. State control calls into question the independence of the supervisory process, objectivity of the board, independence of management, and integrity of the audit and risk management processes. Other concerns are about the aspects of Chinese culture that may impede systems of internal controls. For example, the most prominent Chinese cultural characteristics that have strong implications for interpersonal and inter-organizational dynamicsguanxi are and mianzi. Guanxi, which means personal connections, is embedded in a tradition of mutual trust, warmth, loyalty, and respect. Guanxi is consistent with other characteristics of Chinese culture, such as family orientation, favor, and harmony. Mianzi, which means face, is the recognition by others of an individual's social standing.Mianzi is consistent with typical Confucian values, such as respect for age and hierarchy, and avoidance of conflict and overt disagreement.Mianzi is a key component in the dynamics ofguanxi, whereby parties of a business relationship must save mianzi for each other. In the Chinese business context, building guanxi and saving mianzi creates trust and a bond between partners. Whileguanxi and mianzi contribute to the success of many Chinese societies, these cultural aspects can become fertile soil for corruption and fraud, especially when combined with state paternalism and collectivism. Although guanxi is not necessarily a source of corrupt behavior, it is a critical facilitator of corruption, which some say is ubiquitous in China. Saved faces and special relations with powerful people may turn into power exchange and gain sharing without obligating formal laws and informal norms. In addition, Chinese fraud often involves more than individual wrongdoing but also institutionalized corruption that involves guanxi networks between high-ranking government officials and private businessmen. It should be noted that the intertwinement of connections and corruption may exist in any country, not just in China. Ultimately, reform success depends largely on the commitment of the government and people. In a country with centuries-old traditions and a corporate culture that is still quite young, it will be interesting to see whether new standards affect the banks' control environment significantly.

Required


1. Based on your understanding of “control activities” described in this Chapter, identify the internal control weaknesses that contributed to the BOC fraud incident. 2. As you reflect on the“Fraud Triangle” (discussed in Chapter 6), what economic, organizational, institutional, or cultural factors of the fraud triangle helped foster the described fraud incident? 3. Review Figure 5 in iLearn and do additional research on COSO's Internal Control —Integrated Framework . Focusing on “Effectiveness and Efficiency of Operations,” discuss which control features a bank auditor should look for in assessing the effectiveness of the BOC in mitigating the risk of lending to risky borrowers.

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Chapter 9 Audit Plan – Materiality and Risk Chapter Learning Outcomes (LOs) Checklist


LO9-1 Set qualitative Preliminary Judgment about Materiality (PJAM) and quantitative Material Threshold (MT) at the overall financial statements level.

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LO9-2 Allocate PJAM to Tolerable Misstatements (TM) at an individual account -balance or a class of transactions level.

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LO9-3 Assess Audit Risk (AR) at the overall financial statement level.

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LO9-4 Assess Audit Risk (AR) at an individual account-balance or a class of transactions level.

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LO9-5 Distinguish among Inherent Risk (IR), Control Risk (CR), and Detection Risk (DR).

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LO9-6 Apply the audit risk model AR = IR X CR X DR.

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LO9-7 Explain the relationship among audit risk (AR), materiality, and audit evidence.

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Chapter 9 Audit Plan – Materiality and Risk Figure 9-1 provides an overview of the materiality concept as it applies to the audit plan. Figure 9-1 Materiality Concept in the Audit Plan

The Audit Process

Audit Plan


Tests of Controls

Tests of Balances

Financial Audit


Integrated Audit

Objectives CH 6

Evidence CH 7



Program and Technolo CH 10

Audit Report

1. Set preliminary judgment about materiality (PJAM). Quantify PJAM as materiality threshold (MT) by considering the appropriate base, the materiality guideline, and the qualitative factors at the overall financial statements level.

2. Allocate PJAM to tolerable misstatements (TM) by considering the relative propensity for misstatements, the over- and under-statements, and the cost of audit at an individual accountbalance or a class of transactions level.

3. Document all misstatements found for an account-balance at tests of controls and tests of balances. Compare the total misstatements with the PJAM. Revise PJAM (RJAM) if necessary. Perform additional audit work or request the management to make adjustment for the misstatements.

4. Combine all misstatements found for all account-balances at completing the audit. Compare the combined misstatements with the PJAM and determine whether the financial statements taken as a whole is materially misstated.


Materiality Concept

The Financial Accounting Standards Board defines materiality as "the magnitude of an omission or misstatement of accounting information that, in the light of surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information would have been changed or influenced by the omission or misstatement" in its Statement of Financial Accounting Standards No.2 Qualitative Characteristics of Accounting Information (FASB 1980). This conceptual definition does not provide practical guidance on how to make materiality decisions in a real-world audit situation. On the other hand, AU 320 Materiality in Planning and Performing the Audit does not define materiality but offers practical guidance on how an auditor should make materiality decisions. According to AU 320, the auditor should consider materiality both in:

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Planning the audit and designing the audit procedures. In the planning phase of an audit engagement, the auditor should consider a preliminary judgment about materiality (PJAM) for the financial statements taken as whole to plan for the nature, timing, and extent of audit procedures. This PJAM may be based on a client’s annualized interim financial statements or financial statements of one or more prior periods, as long a s recognition is given to the effect of major changes in the client’s circumstances (e.g., a significant merger) and relevant changes in the economy as a whole or the industry in which the client operates.

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Evaluating whether the financial statements taken as a whole is presented fairly in conformity with generally accepted accounting principles. At the completing the audit, after all audit evidence has been gathered and evaluated, an auditor evaluates whether the combined amount of misstatements for all accounts will materially misstate the financial statements taken as a whole. In theory, an auditor's judgment about materiality at the audit plan is based on the same information available to him/her at the completion the audit. Therefore, the materiality level for the planning and at the completing the audit should be the same. However, it is ordinarily not feasible for the auditor, when planning an audit, to anticipate all of the circumstances that may influence his/her judgment about materiality during an engagement. Thus, during the engagement, the auditor may adjust the level of his/her preliminary judgment about materiality (PJAM) in light of the misstatements discovered. The adjusted level of preliminary judgment is referred to as the revised judgment about materiality (RJAM). At the completing the audit, the auditor again considers materiality by comparing the combined amount of misstatement for all accounts with the level of preliminary (or revised) judgment about materiality for the financial statements taken as a whole. If the combined amount of misstatement exceeds the preliminary (or revised) judgment about materiality, then the financial statements will be materially misstated, and the auditor will either perform additional audit procedures or request the management to adjust the misstated accounts. If additional procedures are not performed and the management refuses to adjust the misstated accounts, then the auditor may issue a qualified or an adverse opinion. Example 9-1 illustrates how the materiality concept is applied to the audit plan, testing, and completing the audit. Example 9-1 Application of the Materiality Concept at the Audit Plan, Testing, and Completing the Audit _____________________________________________________________________________________________ At the audit plan, auditor A determines the level of preliminary judgment about materiality (PJAM) for XYZ Company's financial statements taken as a whole to be $50,000. During the engagement, auditor A considers a significantly higher materiality levelis appropriate. His revised level of judgment about materiality (RJAM) is $25,000. At the completing the audit, auditor A finds the combined amount of misstatement for all accounts to be $30,000. How would you explain auditor A’s application of the materiality concept?

At the audit plan, the level of auditor A's PJAM represents the maximum amount, in this case $50,000, by which XYZ Company's entire set of financial statements could be misstated and still would not cause him to believe that the decision of reasonable users of the financial statements would be affected. The purpose of this PJAM is to helpthe auditor determines the timing, extent and nature of audit procedures to perform during the engagement. level During the engagement, A revises the than materiality RJAM, tohigher ainstead as a result,This the is maximum that could affect the decisionauditor of users issmaller before, level, that is, $25,000 of,$50,000. done in amount light ofof themisstatement circumstances surrounding the audit evidence gathered and any additional information about the client. The purpose of the auditor A'sRJAM is to help him to re-evaluate the sufficiency of the audit procedures he has performed.In this case, the extent andnature of the audit procedures would increase, since the auditor would need to examine more audit evidence in order to meet the higher level of materiality.

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At the completing the audit, auditor A compares the actual amount of combined misstatement for all accounts of $30,000 with his RJAM of $25,000. Since the combined amount of misstatement exceeds the materiality level for the financial statements taken as a whole, XYZ Company's financial statements would be materially misstated.As a result of this comparison, the auditor wouldconsider whether to apply additional audit procedures, request the management to adjust the misstated accounts, or to issue a qualified or adverse opinion. ___________________________________________________________________________________________________________

Setting PJAM at Audit Plan

In setting PJAM at audit plan, an auditor considers materiality at two levels:

 

The overall financial statements level, which involves materiality threshold (MT).

individual account-balance of transactions which level involves tolerable Table The 9-1 comments on setting PJAMoratclass the overall financiallevel, statements (MT) and at misstatement the individual(TM). accountbalance or class of transactions level (TM). Table 9-1 Setting PJAM at the Overall Financial Statements Level (MT) and Individual AccountBalance or Class of Transactions Level (TM)

Setting Preliminary Judgment About Materiality (PJAM) at Audit Plan Overall Financial Statements Level Individual Account-Balance or Class of Transactions Materiality Threshold (MT) Level - Tolerable Misstatement (TM)  The auditor ordinarily considers materiality for planning  Although an auditor's judgment about materiality level purpose before the financial statements to be audited are prepared by relates to the entire set of financial statements taken as a whole, audit the client. Thus, the auditor's PJAMis often based on the client's evidence is accumulated from individual account-balance or class of interim financial statements or prior year's financial statements transactions. Accordingly, after an auditor's PJAM is quantified by adjusted for current changes, such as the general condition of the determining MT, the auditor allocates this overall financial statements economy and industry trends. materiality to individual account-balance in the balance sheet or class of  The auditor's PJAM may or may not be quantified. If transactions in the income statement. PJAM is quantified, AU 320 Materiality in Planning and P erforming  Although allocation may be made to both the balance sheet the Audit states that "the auditor ordinarily considered materiality for and income statement accounts, most practicing auditors allocate planning purpose in terms of the smallest aggregate level of materiality to balance sheet rather than income statement accounts. misstatements that could be considered material toany one of the This is because there are usually fewer balance sheet accounts than financial statements." This smallest aggregate level of misstatement income statement accounts, and most income statement misstatements is referred to as the materiality threshold (MT). Thus, it is important also affect the balance sheet.  When an auditor allocates the PJAM to individual accountto note that the PJAM at the overall financial statements level is derived quantitatively by considering the MT among the individual balance, the materiality allocated to any given account-balance is financial statements. This decision rule, the smallest aggregate level referred to as tolerable misstatement (TM). It is also referred to as of misstatement (MT) to any one of the financial statements, is an tolerable error in AU 530 Audit Sampling. For example, when an appropriate one because (1) the financial statements are interrelated auditor decides to allocate $50,000 from a PJAM of $100,000 to and (2) many auditing procedures pertain to more than one statement. accounts receivable, theTM for accounts receivable is$50,000. This For example, the auditing procedure to determine whether year-end means that the auditor is willing to consider accounts receivable fairly credit sales are recorded in the proper accounting period provides stated if it is misstated by $50,000 or less.  In making the allocation from PJAM to TM for an accountevidence for both accounts receivable (balance sheet) and sales (income statement). Example 9-2 illustrates the application of MT. balance, the auditor should ordinarily consider:  In practice, MT is quantified by considering the following (1) Both overstatement and understatement in the account. three factors: (2) The likelihood of misstatement in the account relative to other (1) Relativity. accounts, and MT is considered in relativeterm. For example, $50,000 is a suitable (3) The cost of collecting audit evidence for the account relative to other MT for a small company but is not a suitable MT for a very large accounts. company. Although the above considerations implies a certain degree of precision (2) Appropriate base for quantification. in allocating the overall PJAM to individual TMs, in the final analysis, The most common bases for quantifying MT are: the allocation process is heavily dependent on the auditor’s subjective (a) Income before taxes, judgment. Example 9-5 illustrates the setting of PJAM (by MT) and the (b) Total revenues, allocation of PJAM (to TM). (c) Total assets, or (d) Total stockholders' equity. The auditor should select a stable and predictable base for quantifying MT. For example, if income before tax fluctuates greatly from year to year, total revenues, or total assets is a more stable base to use. Example 9-3 illustrates the selection of an appropriate base. (3) Guideline for judging material effect on financial statements. There is no official percentage guideline for judging material effect on financial statements. Practicing auditors have developed a variety of guidelines. For example, arule of thumbis: (a) No material effect if MT is between 0% to 5% of a base, (b) A matter of judgment, if MT is between 5% to 10% of a base, and


Setting Preliminary Judgment About Materiality (PJAM) at Audit Plan Overall Financial Statements Level Individual Account-Balance or Class of Transactions Materiality Threshold (MT) Level - Tolerable Misstatement (TM) (c) Material effect if MT is above 10% of a base.  The auditor also considers qualitative factors affecting MT, such as: (1) Misstatement attributable to illegal act. For example, a quantitatively immaterial illegal payment that violates the Foreign Corrupt Practice Act 1976 may be qualitatively material because users of financial statements may be significantly influenced by the management's involvement in the illegal act. (2) Misstatement attributable to fraud. For example, a quantitatively immaterial adjustment to working capital (current ratio) that would result in the violation of a debt covenant. Assuming a client held a long-term bank loan that carried a debt covenant requiring the client to maintain a current ratio of 2 to 1. A quantitatively immaterial adjustment to its working capital may be qualitatively material because it violates the covenant. (3) Atypical trend. For example, a small 2% decline in a growing sales trend may not be material quantitatively but such atypical interruption of 2% may be qualitatively material. Example 9-4 illustrates this qualitative factor consideration. (4) Ethical implication of a management policy. For example, a client sells assets to a member of its top management and then buys the assets back at a higher price; this related party transaction warrants disclosure even though the dollar amounts are not large in relation to the financial statements taken as a whole.

Example 9-2 Application of MT at the Audit Plan _____________________________________________________________________________________________________________________ At the audit plan, auditor A considers the following for XYZ Company: a. Income statement - misstatements totaling $500,000 would have a material effect on XYZ Company's income. b. Balance sheet - misstatements totaling $1,000,000 would have a material effect on XYZ Company's financial position. c. Statement of retained earnings - misstatements totaling $800,000 would have a material effect on XYZ Company's retained earnings. b. Statement of cash flows - misstatements totaling $1,200,000 would have a material effect on XYZ Company's cash flows. What should auditor A’s materiality threshold (MT) be at t he overall financial statements levelfor planning purpose?

The auditor should use thesmallest aggregate amount of misstatements considered to be material to anyone of the financial statements. In this case, auditor A’s materiality threshold for planning purpose would be $500,000. In other words, the auditor should plan and design audit procedures that would be expected to detect misstatements to a total of $500,000 at the overall financial statements level. _____________________________________________________________________________________________________________________

Example 9-3 Selection of an Appropriate Base for Quantifying MT _____________________________________________________________________________________________________________________ At the audit plan of XYZ Company, auditor A expects a significant number of audit adjustments based on past audit experience with this client. A fact supported by auditor A’s inspection of prior years' audit working papers. What would be the most appropriate base for quantifying MT? Since past experience indicates a reasonable expectation of significant adjustments, a preliminary amount that is based on net income before taxes would not be stable. A more stable base such as total revenues or total assets is preferred. Note, however, if significant misclassifications are expected instead of significant adjustments, then net income before taxes is a more stable base than total revenues or total assets. _____________________________________________________________________________________________________________________

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Example 9-4 Qualitative Factor Consideration in MT _____________________________________________________________________________________________________________________ In quantifying MT, auditor A noticed that XYZ Company's earnings per share had been $10.00, $11.00, $12.1, and $13.31 for the past four consecutive years. The client's earning per share for the current financial year is $14.37. What qualitative factor relating to XYZ Company's earnings trend should the auditor consider? In the prior four years, XYZ Company's earnings per share had been increasing at a pace of about 10% peryear. However, for the current financial year, this consistent growing trend has been interrupted in that the earning per share figure of $14.37 represents an increase of 8%.In this case, a quantitative immaterial decrease in earnings trend of 2% from previous year may be considered material qualitatively because of its potential effect on financial statement users' investment decision. For example, a bank loan officer may consider this reversal marks the beginning of a long-term downward trend and may request XYZ Company for a higher interest rate to compensate the bank_________ for increased risk. ______________________________________________________________________________________________ ______________

Example 9-5 Setting of PJAM (by MT) and Allocation of PJAM (to TM) _____________________________________________________________________________________________________________________ Mr. A, the auditor of XYZ Company, documented in his working papers the setting of PJAM (by MT) and allocation of PJAM (to TM) for the account-balances of cash, accounts receivable, and inventory as follows: Reference _________ Date _____________ Prepared by _______ Approved by ______ Setting of PJAM (by MT) and allocation of PJAM (to TM) for XYZ Company 1. The PJAM is set by quantifying MT at the overall financial statements level as follows: a. Use net income before taxes of $200,000 as the base. b. Use the rule of thumb that MT of 10% or more of the base would have a material effect. c. (i) The aggregate level of misstatements for the income statement is expected to be $100,000, therefore, its MT is 50% which would have a material effect on XYZ’s income ($100,000/200,000 = 50% > 10% ). (ii) The aggregate level of misstatements for the balance sheet is expected to be $200,000, therefore, its MT is 100% which would have a material effect on XYZ’s financial position ($200,000/200,000 = 100% > 10%). (iii) The aggregate level of misstatements for the statement of retained earnings is expected to be $10,000, therefore, its MT is 5% which would have no material effect on XYZ’s retained earnings ($10,000/200,000 = 5% < 10%). (iv) The aggregate level of misstatements for the statement of cash flows is expected to be $1,000, therefore, its MT is 0.5% which would have no material effect on XYZ’s cash flows ($1,000/200,000 =0.5% < 10%). d. Consider only the MT that would have material effect, which are the income statement and balance sheet. Applying AU 320, the smallest MT is selected to set the PJAM. In this case, the income statement’s MT of 50% is the smallest. Therefore, PJAM is set at the aggregate level of misstatement expected for the income statement of $100,000. 2. The PJAM of $100,000, of which $50,000 is allocated to TM for cash, accounts receivable, and inventory as follows:

Account-Balance Cash Accounts Receivable Notes Receivable Inventory Total current assets

$100,000 200,000 8,000 200,000 $508,000

From the $100,000 PJAM allocate $50,000 to TM Overstatement (5%) $5,000 (7.5%) 15,000 (0%) --(15%) 30,000 $50,000

Understatement (0%) --(0%) --(0%) --(0%) -----

Mr. A's allocation of the PJAM to the account-balances can be explained as follows: 1. Mr. A decided to allocate $50,000 from the PJAM of $100,000 to MT for cash, accounts receivable, and inventory. This means that he was willing to consider these threeaccount-balances fairly stated iftheir aggregated level of misstatements were$50,000 or less. Also, he decided that it was unnecessary to assign any TM to notes receivable. 2. Mr. A decided that he t accounts in the current assets weremore likely to be overstated than understated.As a result, he concluded that it was unnecessary to assign tolerable misstatement to understatement. 3. Based on prior experience with the client, Mr. A predicted that the likelihood of misstating cash (5%) was less than accounts receivable (7.5%), also, both the cash and accounts receivable were less likely to be misstated than inventory (15%). 4. Mr. A also considered therelative cost of gathering evidence for the three accounts. As a rule of thumb, the cost of auditing an account is directly related to the amount of evidence needed for that account.The amount of evidence needed for the account, on the other hand, is inversely related to its TM. In this case, since Mr. Aanticipated more misstatements in inventory account (15%) than in cash (5%) and accounts receivable (7.5%), it would be morecostly (more evidence is needed) toaudit the inventory account than thecash and accounts receivable. But the amount evidence is inversely related to TM, consequently, the inventory account which has the largest TM ($30,000) would require relatively less amount of evidence, orrelatively lower cost to audit than the cash and accounts receivable. 5. Note that the likelihood of misstatement rather than the size of a recorded account-balance (i.e., cash $100,000, accounts receivable $200,000, and inventory $200,000) was considered in the allocation of MT. ____________________________________________________________________________________________________________________


Materiality Concept in Testing and Completing the Audit

The next stage of applying the materiality concept is in the testing and completing the audit, which is discussed in later chapters. Only a brief discussion of its application in those areas is given here. The auditor documents all the misstatements found in the tests of controls and tests of balances. If audit-sampling techniques are used in the tests, then the total misstatements for an account-balance is estimated from the sample results. All misstatements found in an account-balance is combined and compared to the allocated TM. For example, assuming the total misstatements for accounts receivable in example 9-5 is estimated to be $30,000 of overstatement from testing a sample of sales invoices. Since the estimated total misstatements $30,000 > the TM $15,000, the auditor would either revise the PJAM (the RJAM) in light of the evidence found; make new allocation to TM, perform additional audit work to confirm/reject the estimated total misstatements, or request the management to make accounting adjustment for the estimated total misstatements. At the completing the audit, the auditor compares the total misstatements of all account-balances to the PJAM to determine when the financial statements taken as a whole is materially misstated. If the total misstatements exceed the PJAM, the auditor would consider whether to perform additional audit work, request the management to adjust the misstated accounts, or to issue a qualified or adverse opinion. See Figure 20-7 in Chapter 20 for an example of the total misstatements documented in a working paper. PCAOB Guidance on Immaterial Misstatements

Recently, PCAOB has drawn attention to immaterial misstatements. In particular, auditors are to pay attention to the following three situations: 1. “Netting” (offsetting) material misstatements. For example, a material overstatement inone account is offset with a material understatement in another account, thereby making the net misstatement immaterial. The auditor should consider whether each individual account has been affected by a material amount. 2. Material “swings” in accounting estimates. For example, an accounting estimate could be misstated by just under a material amount in one direction one year and just under a material amount in the opposite direction the next year, thereby making the total swing in accounting estimates immaterial over a two year period. The auditor should consider the total “swing” in estimates over the two-year period rather than by using the “best estimate” each year. 3. “Passing” on immaterial misstatement. For example, management consistently objects to making adjustment for misstatements that are not material individually, but are material in aggregate. The auditor should consider the aggregate effect of the individually immaterial misstatements.

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Figure 9-2 provides an overview of the audit risk concept as it applies to the audit plan. Figure 9-2 Audit Risk Concept in the Audit Plan

The Audit Process

Audit Plan


Tests of Controls

Tests of Balances


Financial Audit

Integrated Audit

Objectives CH 6 1. Pre-specify Audit Risk (AR) at overall financial statements level Evidence CH 7


Audit Report

2. Assume the same AR at individual account-balance and class of transactions level


3. Assess Inherent Risk (IR)

Program and Technolo CH 10 4. Assess Control Risk (CR)

5. Derive Detection Risk (DR) using an audit risk model: AR = IR X CR X DR

6. Consider the nature, extent, and timing of Tests of Balances (TOB) procedures for achieving the derived DR.


Audit Risk Concept

AU 320 Materiality in Planning and Performing the Audit defines audit risk as "the risk that the auditor may unknowingly fail to appropriately modify his opinion on financial statements that are materially misstated". This definition suggests that audit risk is for the entire set of financial statements taken as a whole, and is the risk associated with issuing an audit opinion at the completion of an audit. Like the concept of materiality, AU 320 states that an auditor should consider audit risk both in:

 

Planning the audit and designing the audit procedures. Evaluating whether the financial statements taken as a whole is presented fairly in conformity with generally

accepted accounting principles.an auditor considers audit risk at the planning and designing of an audit to obtain According to this requirement, sufficient appropriate evidence on which to properly evaluate the financial statements taken as a whole at the completion of the audit. In addition, like the materiality concept, AU 320 states that an auditor should consider audit risk at two levels: 1. The overall financial statements level. 2. The individual account-balance or class of transactions level. Assessing Audit Risk (AR) at the Overall Financial Sta tements Level

Table 9-2 provides comments on assessing audit risk (AR) at the overall financial statements level. Table 9-2 Assessing Audit Risk (AR) at the Overall Financial Statements Level

Assessing Audit Risk (AR) at the Overall Financial Statements Level



AU 320 defines audit risk (AR) at the overall financial statements level as "the risk that the auditor may unknowingly fail to appropriately modify his opinion on financial statements that are materially misstated." In practice, this is the risk acceptable to the auditor that the client's financial statements may still contain undetected material misstatements after the audit is completed and an unqualified opinion has been issued. Also, in practice, this audit risk is pre-specified by the auditor (typically the auditor-in-charge of the audit) at the planning phase of the audit. Therefore, AR is also referred to as the pre-specified (or acceptable) audit risk (PAR or AAR). The auditor may pre-specify the AR in quantitative (e.g., 1% or 0.5%) or qualitative term (e.g., low or high). For example, if the auditor's pre-specified AR is 1%, this means that the auditor is willing to accept a 1% risk that s/he willincorrectly give an unqualified opinion on financial statements that may still contain undetected material misstatements. Some auditor expresses the pre-specified AR in terms its of complement - auditassurance. For example, if the pre-specified AR of 1% is expressed in terms of audit assurance, the auditor is 99% confident that s/he will correctly give an unqualified opinion on financial statements that may still contain undetected material misstatements.



There is no authoritative guideline on percentages for pre-specified AR, except that it should be "acceptably low." One commonly used percentage is 1% or less. Zero percent for pre-specified AR means complete assurance, which is not possible in practice. Also, 100% for prespecified AR means complete uncertainty, which in effect amounts to issuing an audit opinion without conducting an audit. Such a practice is prohibited under the generally accepted auditing standards.



According to AU 320, it should be noted that the definition of pre-specified AR excludes the following types of risk: (1) The risk that the auditor incorrectly concluded that the client's financial statements are materially misstated and incorrectly issued a qualified opinion (the definition of AR refers to the risk of incorrectly issuing an unqualified opinion). (2) The risk of issuing an inappropriate form of audit report. For example, a 'disclaimer' form of audit report versus an 'except for' form of audit report. (3) The risk of loss or injury to the auditor's professional practice from litigation, adverse publicity, or other events arising in connection with financial statements that the auditor has audited, even though the audit report issued for the client was correct. This type of risk is often referred to as business risk (BR). For example, if a client declares bankruptcy after an audit is completed, the business risk of a lawsuit against the CPA firm is high even if the audit report is a correct one.



In general, an auditor should consider the following factors in pre-specifying the AR: (1) The degree to which a client's financial statements are relied upon by external users. Indicators of the degree of such reliance include the size of the client, SEC versus non-SEC clients, and clients with a large number of creditors. (2) The characteristics of the client's management. These characteristics include: (a) Whether the client's management decisions are dominated by one individual. (b) Whether the management's attitude toward financial reporting is unduly aggressive. (c) Whether the management turnover is unusually high. (d) Whether the management overemphasizes meeting earning projections. (e) Whether management's reputation in the business community is poor. (3) The characteristics of a client's operation. These characteristics include: (a) Whether the client's profitability relative to the industry is adequate. (b)client Whether is sensitivity to economic Whether the is inthe an client's industryoperation that is dominated by many businessfactors. failures.(c) Whether the rate of change of the client's industry is rapid. (d) (4) The characteristics of the audit engagement. Such characteristics include: (a) Whether there will be many contentious or difficult accounting issues. (b) Whether there will be significant number of difficult to audit transactions or balances. (c) Whether there will be many unusual related party transactions. (d) Whether there is a significant number of misstatements detected in the prior period audit. (5) The likelihood of the client having financial difficulties. Indicators of the client's financial position include: (a) Whether the client is in a

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Assessing Audit Risk (AR) at the Overall Financial Statements Level strong or weak liquidity position. (b) Whether the client engages in high versus low financial gearing strategies. (c) Whether the client operates in a high or low risk industry. (d) Whether the client is managed by a competence or incompetence team of management. (e) Whether the client suffers from a succession of losses in previous years.

Assessing Audit Risk (AR) at the Individual Account-B alance or Class of Transactions Level

The auditor assesses AR at the individual account-balance or class of transactions level in order to determine the timing, nature and extent of audit procedures that are used to verify the management's assertions relating to the account-balance or class of transaction. In addition to the factors considered for pre-specifying the audit risk, AR, at the overall financial statements level, the auditor also considers the following factors for the AR at the individual account-balance or class of transactions level: 1. The effect of the risk factors identified at the overall financial statements level on a particular account-balance or class of transactions. 2. The complexity of accounting issues affecting a particular account -balance or class of transactions. 3. The frequency of difficulty-to-audit transactions affecting a particular account-balance or class of transactions. 4. The significance of misstatements of a particular account-balance or class of transactions detected in the prior audit. 5. The quality of a client's personnel assigned to processing accounting data affecting a particular account-balance or class of transactions. 6 The extent of judgment involved in processing accounting data affecting a particular account-balance or class of transactions. 7. The size and volume of items in a particular account-balance or class of transactions. 8. The complexity of calculation affecting a particular account -balance or class of transactions. In theory, the auditor seeks to restrict AR at the individual-balance or class of transactions level in such a way that will enable him/her, at the completion of the audit, to express an opinion at an "acceptable low" level of AR for the financial statements taken as a whole. In practice, the auditor uses various approaches to accomplish this objective. The AICPA recommends the application of an audit risk model at the individual account-balance and class of transactions level. This audit risk model is expressed as: AR = IR X CR X DR AR = audit risk for an account-balance or class of transactions. IR = inherent risk. CR = control risk that the account-balance or class of transactions contain misstatements. DR= detection risk that the auditor will not detect such misstatements. In using this model, the auditor sets the AR (e.g. 1%) for an individual account-balance or class of transactions the same level as the pre-specified AR (i.e., 1%) for the financial statements taken as a whole. The auditor assumes that the aggregated audit risks (i.e., the ARs of 1% + 1% + 1% and so on) for all the account-balances or classes of transactions will accomplish the pre-specified AR (i.e., AR of 1%) at the completion of the audit. Each components of the audit risk model are commented below. Table 9-3 provides comments on inherent risk (IR) of the audit risk model. Table 9-4 provides comments on control risk (CR) of the audit risk model. Table 95 provides comments on detection risk (DR) of the audit risk model. Table 9-3 Inherent Risk (IR) of the Audit Risk Model

Inherent Risk (IR) of the Audit Risk Model



AU 320 defines inherent risk (IR) as "the susceptibility of an assertion to a material misstatement, assuming that there are no related internal controls." In practice, an auditor would regard a client's IR as the risk of material misstatements of individual account-balance or class of transactions before considering the client's internal controls.



There is no authoritative guideline on percentages for IR. One commonly used percentage is between 50% and 100%, with 50% as the minimum and 100% as the maximum IR. Accordingly, high a (for example, 80%) inherent risk implies haigh risk of misstatements.



A client's IR at an account-balance or classes of transactions level exists independently of the audit of a client's financial statements. This is referred to as the client'sactual level of IR. The auditor cannot change this actual level of IR. However, the auditorcan assess the client's actual level of IR by carefully evaluating and considering the relevant inherent risk factors. The auditor's assessment of a client's actual IR is referred to as the assessed level of inherent risk. Ordinarily, the auditor’s assessed level of IR should closely reflect the client's actual level of IR. In o ther words, the actual and assessed levels of IR should be the same.


Inherent Risk (IR) of the Audit Risk Model



On occasion, the auditor may modify the assessed level of IR if it is necessary to do so in the audit plan phase. In doing so, the auditor is said to have changed the assessed level of IR so that it differs from the client's actual level of IR. For example, if the auditor concludes that the effort required to evaluate and consider the actual level of IR for an account-balance or class of transactions would exceed the benefit of a reduction in the extent of tests of balances (TOB) procedures, he/she might simply set the assessed level of IR as being at the maximum when designing TOB procedures at the audit plan phase of the audit process.Example 9-6 illustrates the trade-off between cost and benefit in assessing IR.



Since some account-balances or classes of transactions are inherently more risky than others, an auditor should consider the following factors in assessing IR: (1) Sensitivity of a client's business to technology or economic factors. For example, the impact of technology developments on a client in the electronic industry might render some inventory obsolete; thereby increasing the inherent risk that inventory might be overstated. (2) Susceptibility of a client's business to fraud. For example, liquid assets such as cash or marketable securities of a client in the banking industry are more susceptible to theft, and therefore inherently more risky than non-liquid assets such as coal in the oil and gas industry. (3) Integrity of a client's management. For example, managerial decision is dominated by one individual; high management turnover, or management lacks leadership quality. All these might increase a client's inherent risk of intentional misstatements by the management. (4) Motivation of a going concern problem client to misstate. For example, a client lacks sufficient working capital to continue operations or in a declining industry characterized by a large number of business failure is prone to window-dressing its current ratio, thereby is inherently more risky than a non-going concern client. (5) Results from previous audits. For example, previous audits that have consistently documented a high error rates in recording of accountbalances or classes of transactions would indicate a high inherent risk of misstatements for the subsequent audits. (6) Initial versus repeat audits. For example, an auditor's increased efficiency and familiarity with a client's operation in a repeat engagement may deter the client from misstatements, thereby decreasing the inherent risk of misstatements. (7) Specific nature of the client's accounts. This include: (a) Contentious accounting transactions. For example, a large number of intra-companies loans increase the inherent risk due to deliberate design to obscure such related-parties transactions or to inadequately disclose them in conformity with AU Related 550 Parties . (b) Non-routine versus routine transactions. For example, in classifying a non-routine transaction such as a fire loss, a client may erroneously determine that the loss is extraordinary when the loss does not meet the two criteria of being both unusual and infrequent in APB Opinion No.30 Reporting the Results of Operations. (c) Extent of judgment involved in recording transactions. For example, a client may incorrectly estimate the amount of allowance for uncollectible accounts. Such judgmental error increases the inherent risk of material misstatements. (d) Complexity of accounting transactions. For example, lease assets, franchising, and oil and gas transactions are more susceptible to misstatement due to the complex nature of accounting calculations. (e) Susceptibility of accounts to defalcation. For example, cash and inventory are more susceptible to embezzlement, theft, or other loss than land or prepaid expenses.

Example 9-6 Trade-off between Cost and Benefit in Assessing IR _____________________________________________________________________________________________________________________ In planning her audit of XYZ Company's inventory account, Mrs. A judges that the actual level of IR for the inventory account is about 90%. She decides to carefully evaluate and consider all IR factors relevant to her client's inventory account so that her assessed level of IR for the inventory account closely reflects her initial judgment about its actual level of IR. Two of these factors are particularly important. First, XYZ Company lacks sufficient working capital to continue operations, and second, XYZ Company is in a declining industry characterized by a large number of business failure. Mrs. A knows that clients in this situation are prone to window-dressing their current ratio, therefore they are inherently more risky. She also knows that it will take considerable amount of audit effort and resources to evaluate the above IR factors in order to closely match her assessed level of IR with the actual level of IR for the inventory account. Do you think Mrs. A should try to match the actual and assessed level of IR in planning her audit? It depends. In the audit plan phase, Mrs. A should balance the higher effort (cost) required to precisely match her assessed and actual levels of IR with the benefit of lowering the extent and nature of the ensuing TOB. If the effort requires to evaluate and consider the IR factors exceeds the benefit of lowering the extent and nature of TOB, she should simply set her assessed level of IR at the maximum of 100%. _____________________________________________________________________________________________________________________

Table 9-4 Control Risk (CR) of the Audit Risk Model

Control Risk (CR) of the Audit Risk Model



AU 320 defines control risk (CR) as "the risk that a material misstatement that could occur in an assertion will not be prevented or detected on a timely basis by the entity's internal controls." In practice, an auditor regards aclient's CR as the risk ofmaterial misstatements to an individual account-balance or class of transactions that is not prevented or detected by a client's internal controls. In general, an auditor considers the effectiveness of the design and operation of a client's internal controls in assessing its CR.



Like IR, there is no authoritative guideline on percentages for CR. One commonly used percentage is between 0% and 100%, with 0% as the

minimum and 100% as the maximum CR. Accordingly, high a (for example, 80%) CR implies ahigh riskof misstatements. Furthermore, some CR will always exist, that is, CR can never be zero (0%) because of the inherent limitations of any internal control. For example, a control may be ineffective because of human failures due to carelessness or fatigue.



Like IR, CR existsindependently of a client's financial statements. Thus, the auditorcannot change the actual level of CR. However, the auditor can change the assessed level of control risk ifit is necessary to doso. For example, for assertions relating to some account-balances or

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Control Risk (CR) of the Audit Risk Model classes of transactions, the auditor's initial understanding and documentation of the internal controls may cause him/her to conclude that the internal controls are unlikely to be effective, or effort required to evaluate their effectiveness would be inefficient. For these assertions, the auditor typically assesses CR at the maximum of 100% at the audit plan in the past. However, note that under AU 320, it is no longer acceptable to assess CR at the maximum of 100% based on the auditor’s initial understanding and documentation of the internal controls.The auditor must develop a greater understanding of the internal controls, which includes testing and evaluating the design and operation of the internal controls, in order to assess CR at the maximum of 100%. When assessed CR is at the maximum (1) the auditor needs only to document the assessment but not the basis for the assessment, (2) the auditor would not plan to rely on the internal controls, and (3) the auditor would not plan to perform TOC but to only perform TOB.

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Although the auditor cannot change the actual level of CR, he/she is capable indirectly of changing it. For example, aftertesting a client's internal controls, the auditor makes a recommendation to the client's management on how to improve certain internal control weaknesses.If the client takes up the auditor's recommendation and acts on it, then the srcinal actual level of CR will be changed to a lower level. Of course, if the client's management does not accept the auditor's recommendation, or accepts the recommendation but does not act on it, then the srcinal actual level of CR will not change.



If the auditor indirectly changes the actual level of CR, the auditor may or may not need to modify his/her srcinal assessed level of CR depending on whether the management's action based on the auditor's recommendation is completed before or after the current audit engagement. If the management's action results in lowering the actual level of CR before the completion of the audit, the auditor may need to modify his/her srcinal assessed level of control risk in performing the tests of controls (TOC). If the action takes place after the completion of the audit, the auditor may take this into consideration in assessing the CR for the following year's audit.



An auditor should consider the following two factors in assessing CR: (1) The auditor’s understanding of a client’s internal controls. The auditor's understanding of a client's internal controls (discussed in Chapter 8) provides information the auditor can use to assess the level of CR in two ways: (a) For some account-balances or classes of transactions, the auditor's understanding of the internal controls may cause him/her to conclude that these internal controls are unlikely to be effective, or effort required to evaluate their effectiveness would be inefficient. For these account-balances or classes oftransactions, the auditor would assess CR at the maximum(100%). When CR is assessed at the maximum, the auditor needs only to document the assessment (for example, "CR relating to the rights and obligations assertion for accounts receivable is assessed at the maximum.") but not the basis for the assessment. (b) For other account-balances or class of transactions, the auditor's understanding of the internal controls may cause the auditor to assess CR at below the maximum. When CR is assessed at below the maximum level, the auditor should document the assessment (for example, "CR relating to the rights and obligations assertion for accounts receivable is 60% and the basis for this assessment is …”). (2) The auditor’s testing of internal controls (TOC). On occasion, an auditor may desire to fine-tune the assessed level of CR by conducting some TOC at the audit plan. In such a case, the auditor should consider: (a) whether evidential matter is available to support the fine-tuning, and (b) whether the expected effort to perform some TOC for the purpose of the fine-tuning is likely to result in less audit effort in the tests of balances (TOB). Example 9-7 illustrates the assessment and fine-tuning of CR.

Example 9-7 Auditor’s Assessment and Fine -Tuning of CR

_____________________________________________________________________________________________________________________ Under audit-budget time pressure, auditor A sets his assessed level of CR for accounts receivable of XYZ Company to be 100% although he knows that the actual level of CR is about 40%, based on his understanding of the internal controls. The auditor reasons that, under time pressure, he will be able to bypass the need to perform TOC for the accounts receivable by setting the control at the maximum. How should auditor A assess the CR for XYZ Company's accounts receivable? First, auditor A should assess level of CR to be 100% only if XYZ Company's internal controls for account receivable are unlikely to be effective, or effort required to evaluate their effectiveness would be inefficient. This is not the case here based on auditor A’s understanding of XYZ company’s internal controls. Second, auditor A should assess level of CR to closely reflect t he actual level of control riskof about 40%. Here, he should document the assessment as well as the basis for the assessment. Finally, auditor A may consider fine-tuning the assessed level of control risk of 40% forthe accounts receivable. For example, a fine-tuning of the control risk to 35% may be necessary if evidential matter is available to support the fine-tuning and the expected effort to perform some TOC for the purpose of the fine-tuning is likely to result in less audit effort for the ensuing TOB on the accounts receivable. _____________________________________________________________________________________________________________________

Table 9-5 Detection Risk (DR) of the Audit Risk M odel

Detection Risk (DR) of the Audit Risk Model



AU 320 defines detection risk (DR) as "the risk that the auditor will not detect a material misstatement that exists in an assertion." In practice, an auditor considers DR as the risk of material misstatements of an account balance or class of transactions not detected by the auditor as a result of using ineffective, inappropriate, or misapplying auditing procedures. Accordingly, the auditor considers the effectiveness of an auditing procedure and its application in assessing DR.  Like IR and CR, there is no authoritative standard for percentage guidelines on detection risk. One common guideline is to use the audit risk model to derive the detection risk, known asderived level of detection risk, for a given level of AR, IR, and CR.



Since by definition, DR is a function of the effectiveness of audit procedures and their application by the auditor, the auditor can change the DR by varying the nature, timing, and extent of TOB procedures.For example, the use of a largesample in a TOB will result in a lower DR than


the use of a small sample.



An auditor should consider the following two factors in deriving DR: (1) The auditor’s assessment of IR and CR. (2) The amount audit evidence gathered from TOB that will meet the derived level of DR, or, in terms of the audit risk model, it is the same as saying the amount of audit evidence that will meet the pre-specified level of AR.



In practice, the amount of audit evidence is typically associated with the extent (or the sample size) of the TOB procedures (discuss in Chapter 10). It is important to note that although by definition, the auditor can change (i.e., either increase or decrease) the derived level of DR by varying the extent of the TOB procedures; in practice, the auditor does not change the derived level of DR. Rather, the auditor varies the extent of the TOB procedureto achieve (i.e., neither increase nor decrease) the derived level of DR. Example 9-8 illustrates how the DR is derived and its relationship to the amount of evidence. Table 9-6 summarizes the relationships among the components of the audit risk model.

Example 9-8 Derive DR from the Audit Risk M odel

_____________________________________________________________________________________________________________________ Mrs. A, the auditor of XYZ Company, pre-specified AR to be 1% at the overall financial statements level. Also, Mrs. A assessed IR and CR to be 75% and 30%, respectively for the company's accounts payable. What should Mrs. A’s DR be for accounts payable?

Assuming Mrs. A sets AR for the accounts payable at the same level as the pre-specified AR for XYZ company's financial statements taken as a whole. Solving the audit risk model as follows can derive DR for the accounts payable: Assume AR at overall financial statements level = AR at account balance level = 1%. Using the audit risk model, AR = IR X CR X DR and given AR = 1%, IR = 75%, andCR = 30%, AR 0.01 DR = __________ = _____________ = 0.04 or 4% IR X CR 0.75 X 0.30 The derived level of DR may be any percentage between a minimum of 0% and a maximum 100%. of In this case, 4% may be regarded as a low detection risk, that is, low risk of the auditor’s procedures not detecting material misstatements. In general, alower detect risk means alower risk of not detecting material misstatements, which implies gathering larger a amount of audit evidence in order to achieve the lower detection risk. On the other hand, ahigher detection risk means ahigher risk of not detecting material misstatements, which implies gatheringsmaller a amount of audit evidence in order to achieve the higher detection risk. _____________________________________________________________________________________________________________________

Table 9-6 Relationships among the Components of the Audit Risk Model

Components of the Audit Risk Model 1. Between AR and DR 2. Between DR and IR 3. Between DR and CR 4. Between AR and Amount of Evidence 5. Between DR and Amount of Evidence

Relationship Direct Inverse Inverse Inverse Inverse

Relationship among Audit Risk, Materiality, and Audit Evidence

Conceptually, AU 320 states there is an inverse relationship between audit risk and materiality. For example, the risk that a financial statement account (e.g., accounts receivable) could be misstated by a very large amount (e.g., $1 million), might be quite low, but the risk that the account could be misstated by a very small amount (e.g., $100) might be quite high. In addition, there is an inverse relationship between audit risk or materiality and amount of evidence. For example, everything else stays constant, either a decrease in the level audit risk or a decrease in the level of materiality would cause the auditor to vary one or more of the following: select more effective audit procedures (i.e., vary nature), perform audit procedures closer to the balance sheet date (i.e., vary timing), or increase the amount of evidence to be gathered (i.e., vary extent). As pointed out earlier (recall Example 9-5 and Example 9-8), the auditor typically varies the amount of evidence to achieve the decreased level of audit risk or materiality. In practice, the auditor first uses a decision aid published by the AICPA to estimate the materiality threshold (MT) based on the greater of total revenues or total assets as the appropriate base (recall Example 9-3). Table 9-7 describes the AICPA’s decision aid for determin ing MT. The auditor then revises this estimated MT according to the derived detection risk (DR) using the audit risk model. Finally, the auditor determines the amount of evidence according to the derived DR and the revised MT. In going through these steps, the auditor closely follows the conceptual relationship among audit risk, materiality, and amount of evidence stated in AU 320 above.

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Specifically, there is an inverse relationship between DR and MT, and an inverse relationship between DR or MT and the amount of evidence, which is typically measured in terms of either the budgeted audit hours or sample size. For example, if the derived level of DR using the audit risk model were relatively high, then the estimated MT using the decision aid would be lower, and the sample size would be larger. Example 9-9 illustrates how the relationship among DR, MT, and budgeted audit hours are determined in practice. Figure 9-3 summarizes the relationships in a diagram. Table 9-7 AICPA’s Decision Aid for Material ity

If the Greater of Total Revenues or Total Assets Is: Over $

0 30,000 100,000 300,000 1,000,000 3,000,000 10,000,000 30,000,000 100,000,000 300,000,000 1,000,000,000 3,000,000,000 10,000,000,000 30,000,000,000 100,000,000,000 300,000,000,000

But Not Over $

30,000 100,000 300,000 1,000,000 3,000,000 10,000,000 30,000,000 100,000,000 300,000,000 1,000,000,000 3,000,000,000 10,000,000,000 30,000,000,000 100,000,000,000 300,000,000,000 -

Materiality (MT) Is: $ + Factor

0 + .059300 1,780 + .031200 3,960 + .021500 8,260 +.014500 18,400 + .009950 38,300 + .006740 85,500 + .004610 178,000 + .003120 396,000 + .002150 826,000 + .001450 1,840,000 +.000995 3,830,000 + .000674 8,550,000 + .000461 17,800,000 + .000312 39,600,000 + .000215 82,600,000 + .000148

X the Excess Over $

0 30,000 100,000 300,000 1,000,000 3,000,000 10,000,000 30,000,000 100,000,000 300,000,000 1,000,000,000 3,000,000,000 10,000,000,000 30,000,000,000 100,000,000,000 300,000,000,000

To illustrate application of the decision aid, assume a client has $12,000,000 of total assets and $20,000,000 of total revenue. MT would be calculated as follows: $85,500 + .004610 ($20,000,000– 10,000,000) = 131,600 Note: This decision aid applies to audits of public companies but may need to be adjusted for audits of government agencies or of companies in specialized industries.

Source: AICPA,Audit Sampling, New York: AICPA, 1999, Table C.1.

Example 9-9 Relationship among DR, MT, and Budgeted Audit Hours _____________________________________________________________________________________________ Auditor A uses the AICPA’s decision aid in Table 9-7 to estimate MT which is $131,600. Auditor A then uses the audit risk model to derive DR which is 1%, and he judged that the derived DR for this particular audit is relatively low. Consequently, the auditor revised the estimated MT to a higher level of, say, $190,000.

Assume the auditor has budgeted to perform the audit for 20,000 audit hours. What is thepact im of the revised MT on the auditor’s amount of evidence to be gathered for this audit? In this case, the amount of evidence is determined by the budgeted audit hours. Since the revised MT is higher, the auditor will need to spend less audit time in detecting aggregate misstatements equal or below $190,000 in comparison to that of $131,600. Therefore, the auditor can lower the budgeted audit hours from 20,000 to, say, 10,000 hours. Effectively, this means that the auditor will gather less amount of evidence than that is srcinally budgeted for this particular audit.

_____________________________________________________________________________________________


Figure 9-3 Relationship among Audit Risk, Materiality, and Amount of Evidence

Higher (e.g., 3%)

Audit Risk DR (e.g., 2%)

Lower (e.g., 1%)

Higher (e.g.,$200,000)

Inverse

Materiality MT (e.g., $100,000)

Larger (e.g., 60,000 hours/400 samples)

Inverse

Lower (e.g., $50,000)

The relationships: 1. Audit Risk is inversely related to Materiality. 2. Holding Materiality constant, Audit Risk is inversely related to Amount of Evidence. 3. Holding Audit Risk constant, Materiality is inversely related to Amount of Evidence.

Amount of Evidence Audit Hours/Sample Size (e.g., 50,000 hours/350 samples)

Smaller (e.g., 40,000 hours/300 samples)

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In the audit process, which of the following objectives is least served by an assessment of the materiality of a client's financial information? a. The objective of evaluating whether a client's financial statements taken as a whole are presented fairly. b. The objective of planning an audit. c. The objective of designing an audit procedure. d. The objective of reviewing an audit working paper.

9-2

If an auditor's preliminary judgment about materiality is quantified, which of the following materiality thresholds is most applicable? a. The aggregate amount of misstatements in the income statement. b. The aggregate amount of misstatements in the balance sheet. c. The largest aggregate amount of misstatements in any one of the financial statements. d. The smallest aggregate amount of misstatements in any one of the financial statements.

9-3

Auditor X sets the preliminary judgment aboutmateriality for ABC Inc. to be 10% of its total assets of $300,000. ABC Inc.'s current assets consists of cash$5,000, accounts receivables $10,000 and inventory $15,000.Auditor X allocates $500 ofthe preliminary judgment about materiality to inventory for overstatement. What is the amount of unallocated preliminary judgment about materiality? a. $30,000. b. $15,000. c. $10,000. d. $29,500.

9-4

Auditor B allocates $60,000 of the $100,000 preliminary judgment about materiality to tolerable misstatement for current assets. $10,000 of the tolerable misstatement is allocated to accounts receivable while $30,000 of the tolerable misstatement is allocated to inventory. Both the accounts receivable and inventory accounts have the same balance of $700,000. What is the most likely reason for the auditor's decision to allocate different amount of tolerable misstatements to the two accounts with the same balance of $700,000? a. The cost of collecting evidence for inventory account is greater than accounts receivable. b. Inventory account is more likely to be overstated than accounts receivable. c. The cost of collecting evidence for accounts receivable is greater than inventory. d. Accounts receivable is more likely to be overstated than inventory.

9-5

Which of the following is not an appropriate definition of audit risk? a. The risk that the auditor may unknowingly fail to appropriately modify his/her opinion on materially misstated financial statements. b. The risk that the auditor is willing to accept when s/he gives an unqualified opinion for materially misstated financial statements after the completion of the audit. c. The risk that the auditor derived from an assessment of a client's control risk and inherent risk. d. The confidence level that the auditor wants to achieve when s/he give an unqualified opinion for fairly stated financial statements after the completion of the audit.

9-6

Which of the following factors is generally not considered in assessing inherent risk? a. Integrity of management. b. The auditor's ability to detect fraud. c. Related-parties transactions. d. Nature of inventory.

9-7

Which of the following is not a true statement? a. Auditor can derive detection risk but cannot directly change it. b. Auditor can assess inherent risk but cannot change it. c. Auditor can assess control risk but cannot directly change it. d. Auditor can derive detection risk and directly change it.


9-8

High detection risk implies a. a high chance of misstatements that are not detected by the auditor's procedures and a high amount of audit evidence to be gathered by the auditor. b. a low chance of misstatements that are not detected by the auditor's procedures and a high amount of audit evidence to be gathered by the auditor. c. a low chance of misstatements that are not detected by the auditor's procedures and a low amount of audit evidence to be gathered by the auditor. d. a high chance of misstatements that are not detected by the auditor's procedures and a low amount of audit evidence to be gathered by the auditor.

9-9

Which of the following is not a true statement? a. The auditor cannot change the actual level of control risk. b. The auditor cannot change the actual level of inherent risk. c. The auditor can change the assessed level of control risk. d. The auditor cannot change the level of derived detection risk.

9-10

When the auditor assesses the control risk for an account balance at the maximum of 100%, which of the following is not a true statement? a. The auditor has no duty to document the basis for the assessment. b. The auditor has a duty to document the assessment. c. The auditor has a duty to document the basis for the assessment. d. The auditor has a duty to document the assessment but not the basis for the assessment.

9-11

Tolerable misstatement (TM) as set by the auditor a. decreases acceptable audit risk (AR). b. increases inherent risk (IR) and control risk (CR). c. affects planned detection risk (DR). d. does not affect any of the four risks.

9-12

When allocating materiality (from PJAM to TM), most practitioners choose to allocate to a. the income statement accounts because they are more important. b. the balance sheet accounts because they are fewer. c. both balance sheet and income statement accounts because there could be errors on either one. d. all of the financial statements because there could be errors on all of them.

9-13

Because control risk and inherent risk vary from cycle to cycle and account to account, a. detection risk will vary but audit evidence will remain constant. b. detection risk will remain constant but audit evidence will vary. c. detection risk and audit evidence will vary. d. detection risk and audit evidence will remain constant.

9-14

Audit risk (AR) is ordinarily set by the auditor during planning and a. held constant for each major cycle and account. b. held constant for each major cycle but varies by account. c. varies by each major cycle and by each account. d. varies by each major cycle but is constant by account.

9-15

Regardless of how the allocation of the preliminary judgment about materiality (PJAM) was done, when the audit is complete the auditor must be confident that the combined errors in all accounts are a. less than the preliminary judgment. b. equal to the preliminary judgment. c. less than or equal to the preliminary judgment. d. more than the preliminary judgment.

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9-16

Which of the following would an auditor most likely use in determining the auditor’spreliminary judgment about materiality (PJAM)?

a. The anticipated sample size of the planned tests of balances. b. The client’s annualized interim financial statements. c. The results of the internal control questionnaire. d. The contents of the management representation letter. 9-17

The risk that an auditor will conclude , based on substantive tests of balances, that a material misstatement does not exist in an account balance when, in fact, such misstatement does exist is referred to as a. inherent risk. b. sampling risk. c. non-sampling risk. d. detection risk.

9-18

Regardless of the assessed level of control risk, an auditor would perform some a. analytical procedures to verify the design of internal controls. b. substantive tests of transactions to restrict detection risk for significant transaction classes. c. tests of controls to determine the effectiveness of internal controls. d. dual-purpose tests to evaluate both the risk of monetary misstatement and preliminary control risk.

9-19

Which of the following statements is correct concerning an auditor’s assessment of control risk? a. Assessing control risk may be performed concurrently during an audit with obtaining an understanding of the client’s internal control. b. Evidence about the operation of control procedures in prior audits may not be considered during the current year’s assessment of control risk. c. The basis for an auditor’s conclusions about the assessed level of control risk need not be documented unlesscontrol risk is assessed at the maximum level. d. The assessed level of control risk is inversely related to the amount of audit evidence.

9-20

Assessing control risk below the maximum level most likely would involve a. performing more extensive TOB with larger sample sizes than srcinally planned. b. reducing inherent risk for most of the assertions relevant to significant account balances. c. changing the timing of TOB by omitting interim-audit testing and performing the tests at year end. d. identifying specific internalcontrol policies andprocedures relevant to specificassertions.

9-21

After obtaining anunderstanding of internal control andassessing controlrisk, an auditor decidedto perform tests of controls because a. it would be efficient to perform TOC that would result in a reduction in planned TOB. b. additional evidence to support a further reduction in control risk is not available. c. an increase in the assessed level of control risk is justified for certain financial statement assertions. d. there were many internal control weaknesses that could result in many misstatements.

9-22

An auditor may decide to assess control risk at the maximum level for certain assertionsbecause theauditor believes a. the client’s control environment, monitoring, and control activities are interrelated. b. sufficient evidential matter to support the assertions is likely to be available. c. control policies and procedures are unlikely to pertain to the assertions. d. more emphasis on TOC than TOB is warranted.

9-23

After assessing control risk at below the maximum level,an auditor desires to seek a further reductionin the assessed level of control risk. At this time, the auditor would consider whether a. it would be efficient toobtain an understanding of the client’s internal controls. b. the client’s internal control policies and procedures have been placed in operation. c. the client’s internal control policies and procedures pertain to any financial statement assertions. d. additional evidential matter sufficient to support a further reduction is likely to be available.

9-24

The acceptable level of detection risk is inversely related to the a. of misapplying auditing b. risk assurance provided by tests ofprocedures. balances. c. level of preliminary judgment about materiality. d. risk of failing to detect material misstatements.


9-25

As the acceptable level of detection riskincreases (i.e., higher %), an auditor may vary the a. assessed level of control risk from below the maximum to the maximum level. b. sample size of TOB from a small to a large sample size. c. timing of TOB from year-end to an interim-audit date. d. nature of TOB from a less effective to a more effective procedure.

9-26

An auditor uses the assessed level of control risk to a. make a conclusion about the effectiveness of the client’s i nternal controls. b. determine the acceptable level of detection risk for financial statement assertions. c. determine the acceptable level of inherent risk for the client control environment. d. determine the materiality thresholds (MT) for planning the audit.

9-27

Which of the following would an auditor most likely use in determining the auditor’s materiality threshold (MT)?

a. The assessed level of control risk. b. The planned sample size for tests of balances. c. The assessed level of detection risk. d. The planned audit hours for the audit engagement. 9-28

Holding other planning considerationsconstant, a decrease in the amount of misstatements ina class of transactions thatan auditor could tolerate most likely would cause the auditor to a. perform planned TOB long before the balance sheet date. b. increase the budgeted audit hours to be applied to the class of transactions. c. increase the assessed level of control risk for relevant financial statement assertions. d. decrease the extent of auditing procedures to be applied to the class of transactions.

9-29

An auditor may compensate for a high assessed level of control risk by increasing the a. level of detection risk. b. extent of tests of controls. c. preliminary judgment about materiality. d. extent of analytical procedures.

9-30

When an auditor increases the planned assessed level of control risk because certain controls were determined to be ineffective, the auditor would most likely increase the a. extent of tests of balances. b. level of inherent risk. c. extent of tests of controls. d. level of detection risk.

9-31

An auditor assesses control risk because it a. provides evidence to the auditor’s understanding of the control environment. b. provides assurance that the auditor’s materiality levels are appropriate. c. indicates to the auditor where inherent risk may be the greatest. d. affects the level of detection risk that the auditor may accept.

9-32

On the basis of audit evidence gatheredand evaluated, anauditor decides to increase theassessed levelof control riskfrom that srcinally planned. To achieve an overall audit risk level that is substantively the same as the planned audit risk level, the auditor would a. increase inherent risk. b. increase materiality levels. c. decrease inherent risk. d. decrease detection risk.

9-33

When assessing control risk below the maximum level, an auditor i s required to document the auditor’s

a. b. c. d.

Assessment of Internal Control Yes No Yes No

Basis for Concluding that Control Risk is Below the Maximum Level No Yes Yes No

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9-34

When control risk is assessed at the maximum level for all financial statementassertions, anauditor should document the auditor’s Understanding of the Internal Control a. Yes b. Yes c. No d. Yes

9-35

Assessment of Internal Control No Yes Yes Yes

Basis for Concluding CR at Maximum Level No No Yes Yes

Which of the following is not a step in an auditor’s decision to assess control risk at below the maximum?

a. Evaluate the effectiveness of control activity with tests of controls. b. Obtain an understanding of the client’s control environment. c. Perform tests of balances to detect material misstatements in the financial statements. d. Consider whether controls can have a pervasive effect on financial statement assertions. 9-36

The ultimate purpose of assessing control risk is to contribute to the auditor’s evaluation of the risk that (Hint: The key word is ‘ultimate’)

a. tests of controls may fail to identify procedures relevant to assertions. b. material misstatements may exist in the financial statements. c. specified controls requiring segregation of duties may be circumvented by collusion. d. client policies may be overridden by senior management. 9-37

Inherent risk and control risk different from detection risk in that they a. arise from the misapplication of auditing procedures. b. may be assessed in either quantitative or non-quantitative terms. c. exist independently of the financial statement audit. d. can be changed at the auditor’s discretion.

9-38

Which of the following audit risk components may be assessed in non-quantitative terms?

a. b. c. d. 9-39

Control Risk Yes No Yes Yes

Detection Risk Yes Yes Yes No

Inherent Risk Yes Yes No Yes

Which of the following statements is not correct about materiality? a. The concept of materiality recognizes that some matters are important for fair presentation of financial statements in conformity with GAAP, while other matters are not important. b. An auditor considers materiality for planning purposes in terms of the largest aggregate level of misstatements that could be material to any one of the financial statements. c. Materiality judgments are made in light of surrounding circumstances and necessarily involve both quantitative and qualitative judgments. d. An auditor’s consideration of materiality s influenced by the auditor’s perception of the needs of a reasonable person who will rely on the financial statements.


9-1 d. 9-2 d. 9-3 d. 9-4 b. 9-5 c. 9-6 b. 9-7 a. 9-8 d. 9-9 d. 9-10 c. 9-11 d. 9-12 b. 9-13 c. 9-14 a. 19-5 c. 9-16 b. 9-17 d. 9-18 b. 9-19 a. 9-20 d. 9-21 a. 9-22 c. 9-23 d. 9-24 b. 9-25 c. 9-26 b. 9-27 c. 9-28 b. 9-29 d. 9-30 a. 9-31 d. 9-32 c. 9-33 c. 9-34 b. 9-35 c. 9-36 b. 9-37 c. 9-38 a. 9-39 b.


Simulation Question 9-1 Simulation Question 9-1 is an adaptation with permission from a case by Lindberg, D.L. inIssues the in Accounting Education , a publication of the American Accounting Association in Sarasota, Florida. This simulation question is based upon a true set of facts; however, the names and places have been changed.



Introduction



Background

Karen Rohan, the auditor-in-charge of Lakeview Lumber Inc. (hereafter LL), had a dilemma. Karen was responsible for seeing that she and her staff complete the fieldwork for LL’s FY1998 audit as soon as possible. Audit hours were already over the time that had been budgeted for the job, and Karen believed that there was still a substantial amount of time needed to finish the audit, because several audit matters had not yet been resolved. LL is located in the city of Lakeview, a metropolitan area of approximately 200,000 people. LL sells between 30,000 and 35,000 different kinds of building materials, lawn and garden products, and home improvement supplies to retail customers, as well as to contractors and other building professional. Retail customers are required to pay in cash or by a major credit card at the time of their purchase. However, the vast majorities of contractors and building professionals have established credit accounts and are billed on a mont hly basis. LL’s main competitors in the area are the Home Depot, Inc. and Eagle Hardware & Garden. Key accounting personnel at LL include Terry James, the Accounting manager, and John Mosher, the Controller. Terry has a B.B in accounting and has been with LL for four years. Prior to working for LL, Terry was the night auditor for a small hotel. John Mosher, a CPA, started his career as an auditor in Karen’s current CPA firm, Becker & Pippen (hereafter, BP). John was assigned to the audit of LL each of the six years he worked for BP. In fact, George Mufson, the manager-in-charge of LL audit, and John began their careers with BP the same year and worked on many of the same clients together. John has been the Controller for LL since 1995. BP have been the auditors for LL since 1982. LL’s Accounting Issues You should access Data File 19-in iLearn for Table 1, which presents LL’s Income Statements for the past three years; Table 2, which presents LL’s balance sheet for the past three years; Table 3, which presents LL’s Statements of Retained Earnings, and Table 4, which presents LL’s Statements of Cash Flows for the past three years.

The analytical procedures performed at the beginning of fieldwork indicated three main areas of potential concern. The first issue was that Bad Debts Expense for FY1998 seemed unusually high. The second area of concern was the amount of Warranty Expense recorded for the current fiscal year. The third issue involved the proper classification of expenses related to a tornado that struck the area at the end of the fiscal year. Bad Debts Expense. Bad Debts Expense as a percentage of credit sales was approximately 5 percent for FY1998, whereas in the prior two years it proximately 50 percent of LL’s sales are on credit. Review and testing of was 2 percent for FY1997 and 2.1 percent for FY1996, respectively. Ap the aged trial balance of Accounts Receivable indicated that the amount and percentage of accounts receivable in each aging category were comparable to prior years. However, the percentages used to estimate the uncollectible accounts were almost doubled in practically every aging category. When Karen questioned Terry James, the Accounting Manager, about the increased percentages, he stated that John Mosher, the Controller, had instructed him to use the higher percentage. Karen subsequently discussed the matter with John, who informed her that he was expecting customers to pay more slowly in 1999, due to the recent downturn in the housing market in the area in which LL does business. When Karen suggested that slower payments did not necessarily mean that the ultimate collectability of the accounts was in jeopardy, John became agitated, asking how she could possibly be questioning anincrease in the allowance for uncollectible accounts. John stated that auditors should be concerned aboutinsufficient an balance in the allowance account, not a balance that he was simply trying to assure was adequate. John ended the conversation by noting that Karen didn’t need to be concerned about his conservative approach to valuing accounts receivable. Product Warra nties Expense. The second issue of concern to Karen was that the estimated liability accrual for product warranties, and the related Warranty Expense account, seemed unusually high. LL’s warranty Expense account for FY1998 was approximately $141,000, representing a 25 percent increase from FY1997. Since the audit had not disclosed any significant changes in LL’s product mix, Karen was surprised that the Warranty Expense account has increased so much. She discussed the increase with Terry James, who stated that the charge to Warranty Expense was “just an estimate, and besides, John seems to advocating allocating as many expenses as possible to 1998.” When Karen asked Terry why this would be the case, Terry said he had heard somethingabout company executives at John’s level and above receiving bonuses based on net income, starting in FY1999. However, when Karen asked John about the increase in Warranty Expenses, John stated that in tough economic times builders tended to return wood and supplies that might be slightly flawed, whereas in a strong economic climate they were not as particular. Karen then discussed product warranties with Adam Lester, the manager of the cabinets department, since that department seemed to experience the largest number of returns. Adam stated he did not keep records of returns per se , since the cabinets that were returned were usually put back on the selling floor at a discounted price. On the other hand, if the buyer decidedkeep to the damaged cabinets, in exchange for a price discount, the adjustment records were prepared by James and then forwarded to the accounting department. Adam said he didn’tthink that the returns during FY1998 were much different from those of FY1997. Tornado Expense. To complicate matters further, about three months before the end of the fiscal year, a tornado struck the city of Lakeview. Approximately 35 percent of the homes and businesses on the city’s western edge were damaged t o some degree. Damage to LL’s main building, where retail sales occur, was extensive. However, most of the damage from the tornado was structural, and the inventory inside the building was relatively unharmed. Fortunately, LL was fully insured for the damage to its buildings and inventory. Within hours of the storm, business was brisk. Management of LL had rented several large tents and conducted business by selling relatively small items out of them. Items of inventory too large to move to the tents were covered in double layers of plastic wrap and moved by forklift to the portion of the main building with the least damage. As new inventory was delivered, it was sold out of the back of semi-trailer trucks rented for this for this purpose. Temporary employees were hired to move inventory from the building to the tens and to cover the larger items of inventory in plastic wrap. In addition, a local security company was called to provide round-the clock security for all inventory items. Even though the local competitors were not affected by the storm, LL experienced relatively high sales volumes in the days immediately following the tornado. John had made arrangements with two of the three principal insurance companies in the area to allow residents to buy certain items of inventory

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needed for repairs, with pre-approval from the insurance companies, and bill the charges directly to the insurance companies. This arrangement was advertised on the local radio stations and was also quickly disseminated by word of mouth. The sales during the period after the storm and before the end of the fiscal year, totaled approximately$1,600,000. The corresponding cost of the inventory sold was approximately $1,130,000. The cost of renting the tents, buying plastic wrap, hiring temporary employees and purchasing additional advertising was approximately $115,000 and is currently included in the “Other” Selling Expenses total of $575,000 in t he Income Statement. Bob, one of Karen’s assistants on the audit, said he t hought that a tornado was an “extraordinary event,” nd a that the expenses related to the tornado would qualify for treatment as “extraordinary” on the Income Statement. He argued that the $115,000 in“storm-related” expenses should be pulled out of Selling Expenses and listed separately on the Income Statement, net of tax. Since Karen had not yet been on an audit where an accounting event was classified as “extraordinary,” and because it had been over four years since she had n take Intermediate Accounting, she decided to look up authoritative guidelines for classifying an accounting event as extraordinary.

Required Access Data File 91 in iLearn for Table 1, which presents LL’s Income Statements for the past three years; Table 2, which presents LL’s balance sheet for the past three years; Table 3, which presents LL’s Statements of Retained Earnings, and Table 4, which presents LL’s Statements of Cash Flows for the past three years.

1. a. Perform analytical procedures to corroborate Karen’s three main areas of concern: bad debt expense, warranty expense, nd tornado-related a expense. Specifically, compute and compare both the absolute differences and percentage changes in the FY1998 and FY1997 Income Statement amounts. b. Based on your analytical procedures, are there any other areas of concern besides the three areas mentioned in 1 a.?

2. Apply the concept of materiality to determine whether bad debt expense, warranty expense, and tornado-related expense would result in material misstatements of LL’s Income stat ement. You should research (a) AU 320, Materiality in Planning and Performing the Audit, to determine the materiality of bad debt expense, warranty expense, and tornado-related expense, (b) AU 540, Auditing Accounting Estimates , Including Fair Value Accounting Estimates and Related Disclosures to evaluate the reasonableness of the bad debt and warranty expense estimates, and (c) Accounting Principles Board Opinion No.30 , related expense should be classified as “extraordinary item” Reporting the Results of Operations (AICPA1973), to determine whether the tornadoin the income statement. 3. Based on the results of 1 and 2 above, write a Client Advisory Comment letter, in the form of a memo, to advise John Mosher, the Controller, on how to deal with the three main areas of concern: bad debt expense, warranty expense, and tornado-related expense.

Simulation Question 9-2 Simulation Question 9-2 is an adaptation with permission from a case by Martin, R.D. and F. Phillips inIssues the in Accounting Education , a publication of the American Accounting Association in Sarasota, Florida. This simulation question is based upon a true set of facts.

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Aerospace Lighting, Inc.

Aerospace Lighting, Inc. (hereafter, ALI)– previously a private company based in Chicago- has been a leading supplier of airplane cabin lighting systems for nearly ten years. Until recently, ALI had been satisfied with its profits and had sold all its products to Bombardier, a major aerospace company in Canada. This comfortable position began to change in 2003, when a large publicly traded German company (hereafter, BmG) acquired 100 percent of ALI. For ALI, the transition from a private, independent company to a subsidiary of a public conglomerate has not been an easy one. Before the takeover, ALI’s management was afforded the luxury of making decisions and taking risks that affected only one owner. Being just one arm of a much larger international company,however, now requires ALI to satisfy more than its own personnel. Members of BmG’s executive team dominate ALI’s board of directors. These individuals have been very critical of ALI’s management, particularly in the area of financial performance. Beginning with the first board meeting in 2003, the German executive team has scrutinized ALI’s operating results and has never hesitated to remind ALI management that BmG views ALI as an investment that is evaluated based on its return to BmG stockholders. BmG does not tolerate any failures to meet financial targets, and is willing to replace entire management teams if required. BmG’s executives take very seriously the “Financial Handbook” that they establish each year to communicate the parent company’s financialprinciples, including equity and capital borrowing guidelines, monthly reporting requirements, and profit expectations. Since the acquisition, ALI has been pursuing a rapid expansion strategy. The German parent company directed ALI to enter the U.S. aerospace supply industry in 2004, and quickly increase the number of U.S. contracts on which it bid, with the goal of increasing its revenue by 50 percent in 2005. To reach this goal, ALI adopted a strategy of submitting bid prices to U.S. manufacturers that, after adjusting for exchange rates, are approximately 20 percent lower than the prices ALI charges to Bombardier. This strategy has been successful so far, as ALI now has several large contracts with Boeing, Lockheed Martin, and Raytheon – the largest aerospace manufacturers in the U.S. ALI has already begun preparing to work on these contracts, having accumulated a significant quantity of raw materials inventory to use in producing goods for Boeing, Lockheed Martin, and Raytheon, as well as Bombardier. ALI’s management team has not discussed its new strategy with its board because management believes BmG is interested in finan cial results rather than the means by which they are achieved. ALI’s management team also wants to keep this strategy quiet becaus e if Bombardier’s executives were to hear about it, they would likely discontinue their relationship with ALI or immediately demand a lower price, as well as insist on a refund of any excess prices charged in previous years.

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Your Audit Firm


Just last week, on June 29, 2005, your firm’s German affiliate was appointed worldwide audit services provider for BmG’s July31, 2005 year-end. Another firm had provided audit services for BmG and all its subsidiaries in the previous year, but BmG’s executive team was dissatisfied with the previous auditors’ inability to identify significant business risks that they believed should have been brought to their attention. Your firm’s office in Munich asked your San Francisco office to perform the audit of ALI for its year ended July 31, 2005, and to provide your audit working papers to the Munich office by September 5, 2005. Because BmG’s Stock i s not traded on a U.S. exchange, the company and its subsidiaries are not subject to the provisions of the Sarbanes-Oxley Act of 2002. A recently promoted partner in your San Francisco office has been assigned the responsibility for the 2005 ALI audit. She has communicated with ALI’s predecessor auditor and has provided you with the notes from her review of the predecessor’s working papers.You should access Data File 92 in iLearn for Exhibit 1, which presents notes from review of predecessor auditor’s working Shepapers. also has obtained information from preliminary discussions with ALI’s CFO. You should access Data File 9-2 in iLearn for Exhibit 2, which presents notes from discussion with ALI’s CFO. The partner has asked you –as an audit senior-to prepare a memo discussing the important audit issues and any other matters she should consider regarding the upcoming year-end engagement. She reminds you that she is required to obtain second partner approval of audit plans developed for high-risk client engagements.

Required Prepare a memo that addresses the following issues and their impact onLI’s A financial statements and/or the audit plan: 1. Client’s business risks 2. Auditor business risk 3. Audit risk (AR) 4. Inherent risk (IR) 5. Control risk (CR) 6. Preliminary judgment about materiality (PJAM) 7. Materiality threshold (MT) 8. Tolerable misstatement (TM) 9. Amount of audit evidence 10. Specific accounting and other audit issues Note: 1. Remember to include in your memo any assumptions that you have made. 2. The partner in San Francisco office expects your memo will help her to: a. Assess whether ALI should be considered a high-risk management, b. Justify that assessment to other partners in the firm, and c. Outline what will be required of you and other members of the audit team to ensure the firm meets the high expectation that BmG has for its auditors. 3. Bear in mind that the partner on this engagement is also responsible for many other client engagements. Consequently, while you should endeavor to be direct and succinct in your memo (limiting it to no more than four single-spaced and medium-font pages), you should avoid assuming that the partner will fully recall all relevant facts or that she will immediately recognize all important implications of those facts. In sum, be sure to describe the specific facts that you consider relevant and explain the implications for the ALI engagement. 4. Because the contents of your memo will form the basis of discussions that the partner is likely to have with other partners in the firm, make sure that you clearly identify any specific information that your partner should consider sensitive. Your memo must address all the above in order to earn the extra credit point.

Simulation Question 9-3 Simulation Question 9-3 is an adaptation with permission from a case by Daugherty, B. and D. G. Neely inIssues the in Accounting Education , a publication of the American Accounting Association in Sarasota, Florida. This simulation question is based upon a true set of facts.

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Introduction

Milwaukee, Wisconsin-based Koss Corporation's (Koss) founder, John C. Koss, has been recognized for creating the stereo headphone industry in 1958. Koss is a public company (ticker symbol “KOSS”), subject to the Securities and Exchange Commission's (SEC) reporting requirements. John C. Koss has served continuously as the company's Chairman of the Board of Directors since 1958 and as Chief Executive Officer (CEO) until 1991. In 1987, Michael J. Koss succeeded his father as President, Chief Operating Officer (COO), and Chief Financial Officer (CFO). He became the company's CEO in 1991 and Vice-Chairman of the Board in 1998. His brother, John Koss, Jr., is Koss' Vice President of Sales. Ninety-nine percent of Koss' product sales for the fiscal year ended June 30, 2009, were stereo headphones. For fiscal year 2009, the total compensation paid to John C. Koss, Michael J. Koss, and John Koss, Jr., was $267,242, $450,507, and $235,122, respectively. Unlike many other companies, Koss remained profitable through the economic downturn of the late 2000s, reporting net income of $2.0 million and $4.5 million for the fiscal years ended June 30, 2009 and 2008, respectively, with retained earnings of $21.6 million at June 30, 2009. You should access Data File 9-3 in iLearn for Exhibit 1, which provides Koss' audited income statements and balance sheets for fiscal years 2009 and 2008. Koss' Vice President-Finance and Secretary, Sujata Sachdeva, earned total compensation of approximately $200,000 per year for —an attorney, Ph.D., and M.D. at Children's Hospital of Wisconsin —and their children fiscal years 2008 and 2009. Ms. Sachdeva, her husband reportedly enjoyed a lavish lifestyle including numerous trips abroad, private schools for the children, and a house worth nearly $800,000 in the Milwaukee suburbs. While in her 20s, Ms. Sachdeva worked in New York for the brokerage firm of Smith Barney and the now-defunct

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—reportedly international accounting firm of Arthur Andersen. Ms. Sachdeva was portrayed as an active fundraiser in the nonprofit community raising approximately $1.5 million annually for charitable causes. She was also portrayed as an impeccable dresser with an impressive wardrobe.

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Internal Control Assertions under Sarbanes-Oxley

The Koss Corporation case relates to the financial statement audit opinions rendered by Koss' independent audit firm, Grant Thornton LLP, and senior management's attestation as to the effectiveness of internal control over financial reporting (ICFR) following the passage of the Sarbanes-Oxley Act of 2002 (SOX). Section 404 of SOX requires the CEO and CFO of U.S. registrants, and their external auditor, to separately report on and attest to the effectiveness of ICFR. However, the SEC repeatedly extended the deadline for auditor attestation on the effectiveness of ICFR for nonaccelerated filers (public companies with a market capitalization of less than $75 million, such as Koss). Koss relied on the SEC's extensions related to the required auditor attestation and never engaged Grant Thornton to opine on the effectiveness of Koss' ICFR. In an interview, Michael J. Koss said the new costs associated with SOX were galling to his family, who “pride themselves onbeing good stewards of their company. We've always complied with government regulations, so it's annoying having to deal with this extra layer of bureaucracy. Small companies like ours are spending hours in auditing committees that would be better spent on strategi c planning.” — In October 2009, the SEC announced one final extension for nonaccelerated filers for fiscal years ending on or after June 15, 2010 Koss' fiscal year ending June 30, 2010. The SEC estimates more than 6,000 public companies would meet the exemption requirements. However, one month later, the House Financial Services Committee approved a permanent exemption for nonaccelerated filers' auditor attestation on the effectiveness of ICFR—the Garrett-Adler amendment to the Investor Protection Act (IPA). In March 2010, Senator Dodd unveiled the U.S. Senate's 1,336- page version of the IPA, “Restoring American Financial Stability Act of 2010,” with the Section 404(b) exemption notably absent. In June 2010, the congressional committee reconciling the House and Senate versions of the proposed legislation agreed to permanently exempt Section 404(b) compliance requirements for nonaccelerated filers. In July 2010, President Obama signed into law t he “Dodd-Frank Wall Street Reform and Consumer Protection Act” (Wall Street Reform Act or WSRA), permanently exempting nonaccelerated filers from Section 404(b) auditor attestation on ICFR. Even though nonaccelerated filers are not required to have an audit of ICFR, management is still required to perform its assessment of ICFR effectiveness and include its report in the SEC filings. The management assessment and report requirement of ICFR came into play prior to the requirement for an audit, and thus WSRA permanently exempts the auditor's ICFR attestation for these nonaccelerated filer public companies. It is important to note that ICFR evaluations are designed to detect weaknesses in internal control over financial reporting, including anti-fraud controls, but arenot designed or intended to be a guarantee of fraud detection. The Public Company Accounting Oversight Board's (PCAOB) Auditing Standard No. 5 (AS 5) —An Audit of Internal Control over F inancial Reporting that is Integrated with an Audit of Financial Statements —provides guidance to the independent auditor in conducting an audit of the effectiveness of ICFR. AS 5 notes in an ICFR audit that the auditor may become aware of fraud or possible illegal acts, and indicates auditors must then determine their responsibilities under the authoritative guidance governing such matters. However, the Association of Certified Fraud Examiners (ACFE) released an updated Global Fraud Study in 2010. The ACFE has long believed smaller companies (similar to Koss Corporation) are particularly susceptible to fraud given their relatively limited resources. For small businesses, comparing those with fewer than 100 employees and those with 100 or more (Koss had 72 employees at June 30, 2009), the 15 most frequent anti-fraud controls cited for the smallest organizations included external audit of financial statements (#1), management's certification of financials (# 3), and an external audit of ICFR (# 6). These findings lend credence to the notion that external financial statement and ICFR audits, coupled with management certifications, are viewed to be deterrents to fraud. The following are excerpts from management's attestation on ICFR (signed by Michael J. Koss, CEO and CFO), and Grant Thornton's financial statement audit opinion, respectively, for the company's fiscal year ended June 30, 2009: Koss Attestation (in part): Management's Annual Report on Internal Controls over Financial Reporting: The Company's management, including its Chief Executive Officer/Chief Financial Officer, is responsible for establishing and maintaining adequate internal control of financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) and designing such internal control to provide reasonable assurances regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. Management conducted its evaluation of the effectiveness of its internal control over financial reporting based on the framework in “Internal Control-Integrated Framework” issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”) as of June 2009. Based on this assessment,the Company's management, including its Chief Executive Officer/Chief Financial Officer, believes that as of June 30, 2009, the Company's internal control over financial reporting was effective based on the criteria set forth by COSO in “Internal Control-Integrated Framework.” However, because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected. This annual report does not include an attestation report of the Company's registered public accounting firm regarding internal control over financial reporting. Management's report was not subject to attestation by the Company's registered public accounting firm pursuant to temporar y rules of the Securities and Exchange Commission that per mit the Company to provide only m anagement's report in this For m 10-K. (emphasis added) Grant Thornton's Financial Statement Audit Opinion Scope Paragraph (in part): The Company is not required to have, nor were we engaged to perform an audit of its internal control over financial reporting . Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express no such opinion (emphasis added). There are a number of characteristics unique to Koss Corporation in addition to the Company's independent auditor not being required to perform an audit of Koss' ICFR as specified by Section 404 of SOX. Though public, approximately 73 percent of the Company's shares are held by members of the founding family, including John C. Koss, Michael J. Koss, and John Koss, Jr. Note that as joint CEO and CFO, Michael J. Koss was the only member of senior management required to opine on the effectiveness of the Company's ICFR. The only other required — signatory on the Form 10-K (beyond directors) was the Company's Vice President of Finance, Principal Accounting Officer, and Secretary Sujata Sachdeva. Ms. Sachdeva was not required to separately issue an opinion on Koss' internal controls as she was not the Company's CFO, but rather designated as the Principal Accounting Officer.

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Embezzlement and Financial Statement Fraud at Koss


On December 21, 2009, Koss Corporation filed a Form K 8-with the SEC reporting “other events” involving Koss Corporation. The 8-K filing indicated Koss requested the NASDAQ stock exchange to halt trading of its common stock due to the discovery of information regarding certain unauthorized transactions. The company also indicated it had placed Ms. Sachdeva on unpaid administrative leave. You should access Data File 9-3 in iLearn for Exhibit 2, which contains portions of the 8-K filing. You should also access Data File 9-3 in iLearn for Exhibit 3, which provides excerpts of the second 8-K filed within the week by Koss. This filing indicated the previously issued financial statements for the fiscal years ended June 30, 2006, through June 30, 2009, should

no longer be relied upon, and referenced a press release announcing the termination of Ms. Sachdeva. On December 31, 2009, Koss, upon a recommendation from the Company's Audit Committee, dismissed Grant Thornton. In an 8K filing dated January 4, 2010, the company reported it had dismissed Grant Thornton and expanded its cautionary disclosure of nonreliance on previously issued financial statements, audit reports, and interim reviews, stating, in part: The Company's Audit Committee, on the recommendation of its advisors and management, expanded the scope of the Company's previously disclosed internal investigation of unauthorized financial transactions by Sujata Sachdeva, the Company's former Vice President of Finance and Secretary, to include fiscal years 2005 through the present. The Company has now concluded that its previously issued financial statements on Forms 10-K for the fiscal years ended June 30, 2005 through 2009 and on Form 10-Q for the three months ended September 30, 2009 should no longer be relied upon due to the unauthorized financial transactions. An internal investigation under the supervision of an independent committee of the Board of Directors with the assistance of independent counsel and forensic accountants is continuing. Preliminary estimates indicate that the amount of unauthorized transactions since fiscal year 2005 through the present has exceeded $31 million, but at this point the Company and its advisors cannot assess the potential impact on its financial statements or identify the extent that specific fiscal periods may be affected. Nor can the Company and its advisors yet assess the extent of the possible offsets through insurance, asset recoveries and other mechanisms related to the unauthorized transactions. As promptly as possible, the Company plans to restate its financial statements for applicable periods as further investigation indicates. (Item 4.02(a) of Koss Corporation's 8-K filed January 4, 2010). On January 6, 2010, Koss filed an amended 8-K with the SEC to include Grant Thornton's required response to the Company's 1 characterization of the auditor dismissal. Grant Thornton responded, in part, as follows: We have read Item 4.01 of Form 8-K of Koss Corporation dated January 4, 2010, and agree with the statements concerning our Firm contained therein. We have no basis to agree or disagree with the statements and conclusions in Item 4.02(a), some of which were not disclosed to Grant Thornton LLP prior to receipt of this filing.

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Safeguards against Fraud and Embezzlement

Theoretically, there are a number of lines of defense against fraud and embezzlement such as those alleged against Ms. Sachdeva. These include the requirement for the CEO and CFO (both Michael J. Koss in this circumstance) to separately attest as to the effectiveness of a Company's ICFR, oversight of those charged with corporate governance (including the board of directors with an independent audit committee), inside whistleblowers, anonymous tipsters, and the independent auditor's opinion as to the effectiveness of ICFR. Recall, Grant Thornton was not engaged to issue such an opinion. Koss Corporation's board of directors in 2009 was comprised of six individuals, including John and Michael J. Koss. Excluding one new member in 2006, the remaining five board members had an average tenure of 32 years. Ironically, none of these potential safety nets detected the alleged fraud, but rather an independent, outside (not the auditor) third party. According to the criminal complaint, “neither Koss' auditors nor its executives uncovered the alleged fraud. Rather, American Express alerted the company's CEO, Michael Koss, to several large wire transfers made from a Koss bank account to pay Sachdeva's personal credit card. .” The purchases in question included $382,400 at two jewelry stores and $1.4 million at one clothing boutique In February 2010, Koss sued American Express, alleging that the credit card company violated the requirements of the Bank Secrecy Act requiring companies such as American Express to have programs to detect and report activity that may suggest the existence of financial crimes. The suit alleges that American Express was aware as early as February of 2008 that Ms. Sachdeva was paying her personal credit card bill with Koss funds, but did nothing to stop the fraud until December of 2009. In the criminal complaint, Sachdeva told FBI agents she had authorized an assistant to make the wire transfers, which she later concealed by falsifying the balance in Koss' bank account. The complaint does not explain how she allegedly made these changes or why they were not detected sooner. Her attorney declined comment on the case. A federal search warrant reveals FBI agents seized 461 boxes of shoes, 34 fur coats, and 65 racks of clothing stored in rented space and at area merchants. The U.S. Marshals Service was reported to inventory some 22,000 items seized by the FBI. The items are scheduled to be auctioned online with net proceeds remitted to Koss. Ms. Sachdeva's attorney attempted to block the release of her medical records to the court. As a condition of Sachdeva's release on bail, the court had ordered a mental health evaluation be done by Pre-Trial Services. According to the criminal indictment, Sachdeva spent the money on luxury clothing, jewelry, trips, renovations to her home, and services for herself and her family. In a letter to the court, her attorney said sensitive information in Sachdeva's medical records would be “directly relevant” to her defense, adding, “We do not believe it is either necessary or appropriate that PreTrial Services be in possession of these records.” I t was previously reported that her attorney planned to raise the issue of mental state in Ms. Sachdeva's defense. Ms. Sachdeva pled not guilty to accusations that she embezzled $31 million from Koss and remained free on bond as of June 2010. The case is believed to be one of the largest embezzlements in Wisconsin history and the largest in the U.S. for 2009. Ms. Sachdeva's attorney said, “As this case proceeds, we intend t o show that Ms. Sachdeva'smental and emotional health played a significant role in her conduct.” Asked whether that was the basis for her not-guilty plea, he declined additional comment. Later, her attorney issued a statement reiterating his remarks and added, “This is the beginning of an ongoing process, and our focus will be on the arguments we make in court. However, the issues of Ms. Sachdeva's mental and emotional health are essential to this case.” Sachdeva also was ordered by the court to refrain from using alcohol and to submit to periodic drug and alcohol testing. If Sachdeva is convicted, she would forfeit her home, car, offices in Milwaukee where she is alleged to have stored thousands of items of clothing and accessories, a vacation home, profit-sharing payments she received from Koss, and money equal to the proceeds she derived

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Item 4.01 of Koss' initial auditor dismissal 8-K filing was a factual statement of previous opinions rendered by Grant Thornton indicating they did not contain adverse, qualified, or disclaimers of opinion; and further documented there were no disagreements between Grant and Koss as to any matter of accounting principles or practices, financial statement disclosure, or auditing scope or procedure.

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from her offenses. Sachdeva also would forfeit personal property, clothing, jewelry, art objects, religious statues, and household items that she purchased and that were being held for her by a number of retailers, and potentially face up to 120 years in prison and $1.5 million in fines. In April 2010, the Koss case was assigned a preliminary hearing date of June 15, 2010. On June 15, 2010, federal prosecutors indicated they were working toward a plea agreement with Ms. Sachdeva and did not anticipate the case would go to trial. On June 24, 2010, Koss Corporation filed suit against both Ms. Sachdeva and Koss' former independent auditor, Grant Thornton, alleging fraud, negligence, and breach of fiduciary duty. The suit seeks more than $30 million in damages.

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Epilogue

On June 30, 2010, Koss restated its previously audited financial statements for fiscal years 2009 and 2008. The impacts of the unauthorized transactions were treated as a theft loss in a separate operating expense line item totaling $8.5 million and $5.1 million for the fiscal years ended June 30, 2009 and 2008, respectively, and a reduction in opening retained earnings of $3.3 million. For fiscal 2009 (2008), net sales were srcinally understated by $3.5 ($2.1) million, and cost of goods sold overstated by $1.7 ($1.0) million. Substantial balance sheet adjustments at June 30, 2009, included a reduction in accounts receivable of $4.0 million, a reduction in inventories of $1.1 million, capitalization of $1.7 million in product software development costs, recognition of $2.9 million in cash surrender value of life insurance, an increase in accounts payable and accrued liabilities of $2.2 million, and an increase in long-term liabilities of $1.2 million. On July 27, 2010, Ms. Sachdeva pled guilty to all six counts of felony fraud against her. Under the plea agreement, Ms. Sachdeva agreed to pay approximately $34 million in restitution to Koss. The plea deal specifies a minimum of five years in prison though federal prosecutors may recommend a longer sentence. Sentencing was scheduled for November 17, 2010.

Required Assume you are the auditor of Koss Corporation. 1. With regard to Michael J. Koss ’s official position in Koss, how would your assessment of inherent risk (IR) at Koss be impacted when one individual (Michael J. Koss) holds multiple C-level (Chief Executive Officer, Chief Financial Officer, Chief Operating Officer, etc.) and Board of Director titles in a publicly held client? Defend your answer. ’s report of ICFR on Koss, how would your assessment of control risk (CR) at Koss be impacted when the 2. With regard to Michael J. Koss Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010” permanently exempting nonaccelerated filers from Section 404(b) auditor attestation on ICFR. Defend your answer.

3. For question 3, you should access Data File 9-3 in iLearn for Exhibit 1, which contains Koss Corporation Financial Information and Ratios.

a. Determine the materiality threshold (MT) of Koss Corporation's income statements for 2009 and 2008, respectively. Briefly describe your calculations and the factors you took into consideration for determining materiality. b. Determine the materiality threshold (MT) of Koss Corporation's balance sheets for 2009 and 2008, respectively. Briefly describe your calculations and the factors you took into consideration for determining materiality. c. Based on the materiality threshold (MT) in 3a, what dollar amount of Tolerable Misstatement (TM) you would allocate to “cost of goods sold” in Koss Corporation’s income statements for 2009 and 2008, respectively? Briefly describe your calculations and the factors you took into consideration for determining materiality. c. Based on the materiality threshold (MT)in 3b, what dollar amount of Tolerable Misstatement (TM) you would allocate to “accounts receivables” in Koss Corporation’s balance sheets for 2009 and 2008, respectively? Briefly describe your calculations and the factors you took into consideration for determining materiality.


Chapter 10 Audit Plan – Program and Technology Chapter Learning Outcomes (LOs) Checklist


LO10-1 Understand an audit program for transaction-, balance-, and presentation-related information.

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LO10-2 Distinguish among the various terms that describe Tests of Controls (TOC) and Tests Balances (TOB).

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LO10-3 Describe the Tests of Controls (TOC) strategy.

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LO10-4 Describe the Tests of Balances (TOB) strategy.

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LO10-5 Describe the Tests of Completing the Audit (TCA) Strategy.

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LO10-6 Explain the effect of information technology on documentation and evidence.

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LO10-7 Explain the effect of information technology on internal control and Tests of Controls (TOC) procedures.

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LO10-8 Explain the effect of information technology on Tests of Balances (TOB) procedures.

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LO10-9 Explain the effect of special systems on TOC and TOB procedures.

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LO10-10 Explain the effect of information technology on audit report.

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Chapter 10 Audit Plan – Program and Technology Figure 10-1 shows the last step in an audit plan – the development of an audit program for transaction-, balance-, and presentation-related Information. Figure 10-1 An Audit Program for Transaction-, Balance-, and Presentation-Related Information

The Audit Process

Audit Plan


Tests of Controls

Tests of Balances


Financial Audit

Audit Report

Integrated Audit

Objectives CH 6

An Audit Program Evidence CH 7

Internal Control CH 8 Tests of Controls Strategy (TOC Strategy)

Tests of Balances Strategy (TOB Strategy)

Tests of Completing the Audit Strategy (TCA Strategy)

A Set of TOC Procedures

A Set of TOB Procedures

A Set of TCA Procedures

Test Transaction-related Information

Test Balance-related Information

Test Presentation-related Information


Program and Technology CH 10


An Audit Program for Transaction-, Balance-, and Presentation-Related Information

Recall Chapter 6 comments that the auditor develops an audit program that consists of a Tests of Controls (TOC) strategy, a Tests of Balances (TOB) strategy, and a Tests of Completing the Audit (TCA) strategy. Each of the three strategies prescribes a set of audit procedures the auditor would use to test the three aspects (transaction-, balance-, and presentation-related) of information reflected in the financial statements. For example, an audit program may prescribe audit procedures for transaction-related information such as transactions relating to inventory actual occurred (i.e., occurrence), that they are completed (i.e., completeness or no valid transactions were left out), that they are classified properly (i.e., classification, e.g., as an asset rather than an expense), and that they are recorded accurately (i.e., accuracy) and in the correct period (i.e., cutoff). Similarly, the audit program may prescribe audit procedures for balance-related information such as inventory represented in the inventory account balance exists (i.e. existence), the client owns (i.e., rights and obligations) the inventory, that the balance is complete (i.e., completeness), and that the inventory is properly valued (i.e., valuation and allocation). Finally, the audit program may prescribe audit procedures for presentation-related information such as the financial statements properly classify and present (i.e., classification) the inventory (e.g., inventory is appropriately presented as a current asset on the balance sheet) and that all required disclosures (i.e., understandability) having to do with inventory (e.g., footnote indicating that the client uses the LIFO inventory method) are complete (i.e., completeness), accurate (i.e., accuracy), and understandable (i.e., understandability). Terms that Describe Tests of Controls and Tests of Balances

Figure 10-2 shows the various terms that describe Tests of Controls and Tests Balances Figure 10-2 Terms that Describe Tests of Controls and Tests of Balances Tests of Controls (TOC) (Also known as Compliance Tests) An Account Accounts Receivable Beginning Balance X

Cash Receipts X

Sales

X

Sales Returns X

Balance

X

Tests of Details of Balances (TOB) (Also known as Substantive Tests) e.g., Test for accuracy of balances

e.g., Test for separation of duty Compliance Tests of Transactions e.g., Test for adequate documentation Substantive Tests of Transactions e.g., Tests for accuracy of unit price

Analytical procedures e.g., compare with previous balances for reasonableness

 Tests of Control (Also Known as Compliance Tests) There are two categories of tests of controls: 1. Tests of Controls. 2. Compliance Tests of Transactions. The auditor performs tests of controls to assess the effectiveness of the design and operation of the client's internal control policy and procedures. For example, the auditor tests the effectiveness of a proper separation of duties between the person who is responsible for recording cash transactions and the person who is responsible for depositing cash in the bank daily. Many tests of controls involve examining documents. When transaction documents are examined to determine if internal control policies and procedures have been followed, the tests are referred to as compliance tests of transactions. For example, the auditor examines credit memos for the initials of an accounting clerk responsible for

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their authorization. The presence or absence of the initials indicates whether the control procedure of authorization has functioned properly. Since the term tests of controls usually stands for both categories of tests; hereafter, only the term tests of controls (TOC) is used in the discussion.

 Tests of Balances (Also Known as Substantive Tests) There are three categories of tests of balances: 1. Tests of Details of Balances. 2. Substantive Tests of Transactions. 3. Analytical Procedures. The auditor performs tests of details of balances to assess the accuracy of the ending balances in the financial statements. For example, the auditor confirms individual customer accounts to determine the correctness of the accounts receivable balance in the financial statements. Many tests of details of balances involve examining documents to identify any material misstatements in the recording of the transactions. When transaction documents are examined to determine if dollar errors have occurred during the processing of the transactions, the tests are referred to as substantive tests of transactions. For example, the auditor performs a sales cut-off test by tracing sales invoices to the sales journal to determine the occurrence, accuracy, and completeness of the sales figure in the financial statements. Since the term tests of balances usually stands for both the tests of details of balances and substantive tests of transactions; hereafter, only the term tests of balances (TOB) is used in the discussion. Analytical procedures are used by the auditor to assess the reasonableness of financial and non-financial information. The auditor studies and compares plausible relationships among the information. For example, the auditor compares the client's current ratio with the industry average to identify potential misstatements of the current assets and/or current liabilities balances in the financial statements. Tests of Controls (TOC) Strategy

A typical audit client has five major transaction cycles: 1. Revenue cycle, 2. Expenditure cycle, 3. Inventory cycle, 4. Payroll cycle, 5. Capital cycle, and General cash and Investments. For each of these transaction cycles, the auditor implements a Tests of Controls (TOC) Strategy. The auditor’s TOC strategy consists of five audit tasks. Table 10-1 provides some comments on these five audit tasks. Figure 10-3 shows the TOC strategy, the five audit tasks, and the five transaction cycles. It can be seen from Figure 10-3 that the auditor’s TOC strategy follows closely the recommendations of the Committee of Sponsoring Organizations of the Treadway Commission - COSO’s Internal Control-I ntegrated Fra mework (recall Chapter 8). Table 10-1 Five Audit Tasks in the TOC Strategy

TOC Strategy Audit Tasks (1) Understanding of Internal Control

Comments

(4) Perform TOC Procedures Apply Attribute Sampling Plan

For each transaction cycle, the auditor obtains sufficient knowledge on five components of its internal control (recall Chapter 8): (1) Control environment. (2) Risk assessment. (3) Control activities. (4) Information and communication. (5)Monitoring. For risk assessment, the auditor shouldunderstand how the management meets the five basic assertions of: (1) Existence or Occurrence. (2) Completeness. (3) Valuation or Allocation. (4) Rights and Obligations. (5) Presentation and Disclosure. For information and communication, the auditor’s TOC and TOB procedures should meet the eight types of specific audit objectives: (1) Existence or Occurrence. (2) Completeness. (3) Rights and Obligations. (4) Valuation and Allocation. (5) Classification. (6) Cutoff. (7) Accuracy. (8) Understandability (Recall Chapter 6). The auditor may use a narrative description, internal control questionnaires, or flow chart to document the understanding of internal control. After the documentation, the auditor identifies the presence and absence of the five basic control activities (the rd3 component of internal control) to assess the strength and weakness of the internal control. The five basic control activities are: (1) Adequate separation of duties. (2) Proper authorization of transactions and activities. (3) Adequate documents and records. (4) Physical control over assets and records. (5) Independent checks on performance. Based on the auditor’s understanding and documentation of internal control, s/he assesses CR(control risk) for account-balances or classes of transactions at either the maximum of 100% or less than the maximum of 100% (recall Chapter 9). If CR were at the maximum, then the auditor would normally make no reliance on internal controls and would plan to perform only TOB. One the other hand, if CR were at below the maximum of 100%, the auditor would plan to perform both TOC and TOB procedures. The auditor performs the TOC procedures that address the nature, extent, and timing of evidence. For the nature and timing, if CR were assessed at the maximum of 100%, the auditor would not perform TOC

(5) Communicating Internal Control-related Matters

procedures but perform only TOB procedures. For the extent, if CR were assessed at below the maximum of 100%, the auditor would apply an attribute sampling plan (discuss in Chapter 11) to determine the sample size of evidence. The auditor communicates the results of the TOC in either a material weakness report or a client’s advisory comments letter (recall Chapter 8).

(2) Documenting the Understanding of Internal Control

(3) Assess CR (Control Risk)


Figure 10-3 Tests of Controls (TOC) Strategy, Audit Tasks, and Transaction Cycles

The Audit Process

Audit Plan

Tests of Controls

Tests of Balances


Audit Report

Tests of Controls (TOC) Strategy 1. Revenue Cycle CH 13

1. Understanding of Internal Control

2. Expenditure Cycle CH 14 2. Documenting the Understanding of Internal Control

3. Inventory Cycle CH 15 3. Assess CR (Control Risk)

4. Perform TOC Procedures Apply Attribute Sampling Plan

4. Payroll Cycle CH 16

5. Communicating Internal Control-related Matters

5. Capital Cycle CH 17

General Cash and Investments CH 18

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Tests of Balances (TOB) Strategy

A typical audit client has five major transaction cycles: 1. Revenue cycle, 2. Expenditure cycle, 3. Inventory cycle, 4. Payroll cycle, 5. Capital cycle, and General cash and Investments. For each of these transaction cycles, the auditor implements a Tests of Balances (TOB) Strategy. The auditor’s TOB strategy consists of five audit tasks. Table 10-2 provides some comments on these five audit tasks. Figure 10-4 shows the TOB strategy, the five audit tasks, and the five transaction cycles. It can be seen from Figure 10-4 that the auditor’s TOC strategy follows closely the requirements of AU 320 Materiality in Planning and Performing the Audit (recall Chapter 9). Figure 10-5 provides an example of a partial program of TOB procedures for Accounts Receivable Table 10-2 Five Audit Tasks in the TOB Strategy

TOB Strategy Audit Tasks (1) Allocate PJAM to TM (2) Derive DR (Detection Risk)

(3) Perform Analytical Procedures

(4) Perform TOB Procedures Apply Variable Sampling Plan

(5) DocumentTotal Misstatements

Comments The auditor allocates PJAM (Preliminary Judgment about Materiality) to TM (Tolerable Misstatement) at the individual account-balance or class of transaction level of a transaction cycle. (Recall Chapter 9) The auditor derives the DR (Detection Risk), based on a pre-specified AR (Audit Risk), assessed IR (Inherent Risk) and CR (Control Risk), by using the audit risk model of AR = IR x CR x DR at the individual account-balance or class of transactions level of a transaction cycle (recall Chapter 9). The derived DR drives an optimum mix of the nature, extent, and timing of the TOB procedures used by the auditor. The auditor performs six common types of analytical procedures: (1)Compare client and industry data. (2) Compare client data with similar prior-period data. (3) Compare client data with client-determined expected results. (4) Compare client data with auditor-determined expected results. (5) Compare client data with expected results, using non-financial data. (6) Compare financial ratio analysis on client data (recall Chapter 7). The auditor performs the TOB procedures that address the nature, extent, and timing of evidence. For the nature and timing, if CR were assessed at the maximum of 100%, the auditor would not perform TOC procedures but perform only TOB procedures. In addition, the auditor would apply a variable sampling plan (discuss in Chapter 12) to determine the sample size of evidence. The auditor documents allmisstatements found byperforming the TOBprocedures and compares thetotal misstatements with the PJAM. Based on the misstatement found, the auditor may revise PJAM if necessary. The auditor should perform additional audit work or request the management to make adjustment for the misstatements.

Figure 10-5 Example of a Partial Program of TOB Procedures for Accounts Receivable

A Partial Program of TOB Procedures for Accounts Receivable (1) Audit Objective: To test for completeness Procedure: Obtain the December 31, 200x, aged accounts receivable trial balance and (a) Foot the trial balance and agree total to accounts receivable control account. (b) Judgmentally select five accounts from the aged trial balance; agree the information per the aged trial balance to the srcinal sales invoice and determine if the invoice was included in the appropriate aging category. (2) Audit Objective: To test for existence Procedure: Confirm accounts receivable using a monetary-unit sampling technique. Set the risk for incorrect acceptance = 10%, tolerable misstatement = $50,000, and expected misstatement = $20,000. (a) For all responses with exceptions, follow up on the cause of the error. (b) For all non-responses, examine subsequent cash receipts and/or supporting documents. (c) Summarize the statistical test results. (d) Summarize the confirmation results. (3) Audit Objective: To test for cutoff Procedure: Test sales cutoff by identifying the last shipping advice for the year and examining five large sales for three days before and after the year-end. (4) Prepare a memo summarizing the tests, results, and conclusion.

W/P Ref:

Completed By:

Date


Figure 10-4 Tests of Balances (TOB) Strategy, Audit Tasks, and Transaction Cycles

The Audit Process

Audit Plan

Tests of Controls

Tests of Balances


Audit Report

Tests of Balances (TOB) Strategy 1. Revenue Cycle CH 13

1. Allocate PJAM to TM

2. Expenditure Cycle CH 14 2. Derive DR (Detection Risk)

3. Inventory Cycle CH 15 3. Perform Analytical Procedures

4. Perform TOB Procedures Apply Variable Sampling Plan

5. Document Total Misstatements




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Tests of Completing the Audit (TCA) Strategy

After the auditor has completed the TOC (Tests of controls) and TOB (Tests of Balances), s/he completes the engagement by following a Tests of Completing the Audit (TCA) Strategy to test presentation-related information. The TCA procedures include: 1. reviewing contingent liabilities, 2. reviewing subsequent events, 3. reviewing working papers, and 4. considering subsequent discovery of facts (discuss in Chapter 20). Nature, Extent, and Timing of Audit Procedure

According to AU 330 Performing Audit Procedures in Response to Assessed Risks and Evaluating the Audit Evidence Obtained , in developing an audit program, the auditor considers the nature (i.e., what audit procedures to use), extent (i.e., how many items to test) and timing (i.e., when to perform the audit procedures) of audit procedures necessary to accomplish specific audit objectives.

 Nature of Audit Procedure Nature of audit procedure refers to the type (e.g., inspection, observation, confirmation, etc.) of audit procedure that the auditor uses to gather audit evidence. The auditor has a variety of audit procedures from which to choose. A criterion for choosing among them is which audit procedure produces persuasive evidence. The persuasiveness of evidence is determined by the appropriateness (reliability + relevant) and sufficiency (amount or sample size) of evidence (Recall Chapter 7). In short, the nature of audit procedure is closely related to the persuasiveness of evidence. For example, an auditor may choose between an inspection and examination of a client's invoices. Here, the former is a less persuasive audit procedure than the latter. Another criterion for choosing the type of audit procedure is based on the risk of material misstatement. The higher the auditor’s assessment of risk, the more reliable and relevant is the audit evidence sought by the auditor from TOC and TOB procedures (Recall Chapter 9). For example, an auditor may choose to confirm the completeness of the terms of a contract with a third party, in addition to inspecting the document and obtaining management’s representation letter.

 Extent of Audit Procedure Extent of audit procedure refers to the scope of audit procedures that the auditor uses to gather audit evidence. A criterion for determining the scope of audit procedures is the amount of evidence gathered or sample size used by the auditor (recall Chapter 7). For example, when all of the invoices of a client are examined by the auditor, the scope of the examination is larger than when just a small sample of the invoices is examined. In addition, the auditor considers the representativeness of individual sample items in determining how many items to tests. In practice, the auditor also uses the number of budgeted audit hours to determine the scope of audit procedures to use, which is sometime referred to as the “audit effort” or “costs of audit.” Finally, an auditor may uses techniques such as computer-assisted audit techniques (CAATs) to enable him/her to extensively test electronic transactions and account files (discuss in later half of this chapter). Such techniques can be used to select sample transactions from key electronic files, to identify transactions with specific characteristics, or to test an entire population instead of a sample.

 Timing of Audit Procedure Timing of audit procedure refers to whether some of the audit work can be performed before year-end. Typically, an audit engagement is characterized by two major time frames, an "interim audit" and a "year-end audit." 1. Interim Audit. During an interim audit, the auditor first obtains an understanding of the client's internal controls; makes an assessment of the control risk, and prepares an interim audit program. Second, the auditor performs TOC according to the interim audit program. Based on the results of the TOC, the auditor determines the detection risk (DR), and prepares a year-end audit program necessary for the year-end audit. Interim audit work is typically conducted during the second half of the client's financial year; however, for very large clients, the interim work may be performed in both the first and second halves of the financial year to even out the workloads and time constraints. 2. Year-End Audit (or Final Audit). During a year-end audit, also known as a "final audit," the auditor performs TOB. For the tests, the auditor performs the year-end audit program prepared at the interim audit. Final audit work is typically conducted at year-end shortly after the balance date, however, for very large clients, the final audit may be performed prior to the balance sheet


date to avoid excessive year-end workloads and time constraints. Figure 10-6 shows an example of a timeline for performing the audit procedures. In general, the higher the risk of material misstatement, the more likely it is that the auditor may decide it is more effective to perform TOB procedures nearer to, or at, the unpredictable time (i.e. a spot check). In addition, certain audit procedures can be performed only at or after period end, for example, agreeing the financial statements to the accounting records, or examining adjustments made during the course of preparing the financial statements. Finally, in considering the timing of audit procedures, the auditor should consider such matters as: 1. The control environment. 2. When relevant information is available. For example, electronic files may subsequently be over-written, or procedures to be observed may occur only at certain times. 3. The nature of the risk. For example, if there is a risk of inflated revenues to meet earnings expectations by subsequent creation of false sales agreements, the auditor may examine contracts available on the date of the period end. 4. The period or date to which the audit evidence relates. In addition to performing the TOB procedures at the year-end audit, the auditor also performs TCA (Tests of Completing the Audit) procedures that address a set of presentation-related information. Typically, the TCA procedures are performed between the client ’s balance sheet date and the a udit report issue date. The year-end TCA procedures are discussed in Chapter 20. Figure 10-6 Example of a Timeline for Performing the Audit Procedures

Beginning of Financial Year

Middle of Financial Year Interim Audit

| 1/1

|

Audit Plan

End of Financial Year Year-End Audit

| 6/30

Perform TOC

Audit Report

| 12/31

Perform TOC

| 1/31

Perform TCA Perform TOB

Transactionrelated information

Transactionrelated information

Balancerelated information

Presentationrelated information

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Effect of Information Technology on the Audit Process

When a client uses information technology to process and store accounting information, the audit process is impacted in several ways. Figure 10-7 provides an overview of the effect of information technology on the audit process. Figure 10-7 Effect of Information Technology on the Audit Process

The Audit Process

Audit Plan

Tests of Controls

Tests of Balances


Documentation

Internal Control

Evidence

TOC Procedures

TOB Procedures

Special Systems

Special System

Audit Report

Report on Web site

Effect of Information Technology on Documentation

The auditor uses information technology to convert traditional paper-based documentation into electronic files and to store audit documents electronically. Some CPA firms develop their own software, while others use commercially available documentation software. Examples of such software are described in Table 10 -3. Table 10-3 Examples of Documentation Software

Documentation Software

Description

CPA firms developed ACE that can be used to prepare a working trial balance, lead schedules, financial statements, and to perform ratio analysis. Tick marks and other explanations, such as senior reviewer notes, can be entered directly into computerized files. In addition, data can be imported and exported to other applications, for example, downloading a client’s general ledger into ACE and exporting tax information to a commercial tax preparation package such as TurboTax. Commercially available spreadsheet software can be used to prepare a working trial balance, lead  Spreadsheet Software, e.g., schedules, financial statements, and to perform ratio analysis. Typically, a spreadsheet software isused Excel, Lotus 1-2-3, and Quattro in an audit engagement as follows: Pro. (1) Cash – preparing cash lead schedules, and preparing bank reconciliations or proofs of cash. (2) Receivables – computing estimated bad debts expense, computing turnover ratios, preparing confirmation requests, and preparing aging summaries. (3) Inventory – computing LIFO indexes and final balances, computing turnover ratios, tracing inventory test counts to perpetual inventory records, and analyzing variances. (4) Fixed assets – computing depreciation, computing capitalized interests, and computing saleleaseback gain deferral. (5) Investments – determining portfolio valuation at the lower of costs or market, and obtaining market prices at year end from public data sources.



Automated Client Engagement (ACE)


Documentation Software



Database Management (DBM) Systems Software, e.g., dBASE, FoxPro/Lan, and DataEase.

Description (6) Liabilities– computing warranty provisions, determining debt covenant compliance, and preparing loan amortization schedules. (7) Income taxes – analyzing permanent and timing differences, reconciling pretax accounting and taxable income, computing deferred taxes, and computing effective tax rate. (8) Equity – computing earnings per share, computing stock splits and preferred stock dividends, and analyzing treasury stock. DBM systems software can be used to store and analyze data in a relational structuring form across several files. For example, an auditor may store and relate date in an accounts receivable file and a cash receipts file to monitor collection of past due accounts. The DBM Systems Software can also be used in analytical procedures, confirmation requests, sampling, monitoring audit hours charged, and global data links for multinational clients.

Retrieval Software can be used to access and retrieve any electronically stored text such as the  Text Retrieval Software, e.g., Text FASB’s Original Pronouncements and AICPA’s Professional Standards, both of which are available on Folio Views, Lotus Magellan, from the SEC’s CD-ROM. Similarly, such software can be used to retrieve on-line financial information ZyIndex, and Adobe Reader. EADGAR database. The auditor also uses the internet to retrieve information for understanding a client’s business and industry during the audit plan phase. For example, internet Explorer, Communicator or Firefox can be used to access the web site of a client’s competitor for a company overview, annual report, or product information.

Effect of Information Technology on Evidence

AU 500 Audit Evidence states that, “Because of the growth in the use of computers and other information technology, many entities process (transmit, maintain, or access) significant information electronically.” When evidence can be examined only in electronic form, there are commercially available windows-based software, for example, ACL (Audit Command Language) and IDEA (Interactive Data Extraction and Analysis) software that can be used to obtain copies of client databases or master- file and perform a variety of tests of the client’s electronic data. The software usually can be applied to a wide variety of clients with minimal customization. Table 10-4 summarizes the guidance of AU 500 on audit evident in electronic form. Table 10-4 Auditing Electronic Evidential Matter

Electronic Evidential Matter







Tests of Balances

Availability of Information

Data Mining

The Auditor Should: When a client transmits, processes, maintains, or accesses significant information in an electronic form, AU 500 states that an auditor may determine that it is not practical or possible to achieve detection risk (DR) at an acceptably low level by performing only TOB for one or more financial statement assertions. In those cases, the auditor should perform TOC to gather evidence to support an assessed level of control risk (CR) below the maximum level for the affected assertions. Evidence gathered from these TOC, in conjunction with evidence provided by the performance of TOB, should be sufficient to support the auditor’s opinion. When information is available in electronic form, it may not be accessible after a specified period of time if files are changed, unless backup files are created. The auditor should consider the time when information is available in determining the nature, timing, and extent of TOC and TOB. Examples of such electronic information include: (1) EDI (Electronic Data Interchange)– With EDI, a client and its customers/vendors (i.e., trading partners) transact business electronically where purchasing, shipping, billing, cash receipt, and cash disbursement functions are achieved through electronic exchanges, ordinarily without paper documents. However, the electronic exchanges require translation software to convert transactions from the client’s internal format to a worldwide standard EDI format. The client may use either the Internet or WAN (Wide Area Network) to transmit and exchange electronic data to trading partners instantaneously. See Figure 107 for an example of EDI. (2) Image Processing – With image processing systems, paper documents are scanned into electronic images for electronic storage and retrieval. A client might only keep paper documents for a limited time after this conversion. Data mining is the discovery of previously unknown information from raw data. An example of a data mining tool is the application of Benford’s Law as an analytical procedure (recall Chapter 7). Such a data mining tool allows the auditor to sift through large amount of data quickly, identify and analyze questionable relationships, and discover fraud in a timely manner.

Effect of Information Technology on Internal Control

The use of information technology affects the classification of internal control into two categories: 1. General controls

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Those controls that relate to all or many computerized accounting applications and often include control over the development, modification, and maintenance of computer programs and control over the use of and changes to data maintained on computer files. General controls also concern with off-site backup o f hardware facilities in the case of a power outage or disaster. A hot site backup is a service bureau that is a fully operational processing facility and is promptly available to backup hardware facilities. On the other hand, a cold site backup is a shell facility suitable for quick installation of computer equipment which would take some time to do so in the case of a power outage or disaster. Finally, if an auditor anticipates assessing control risk at a relatively low level, the auditor will initially focus on the general controls. Some general controls that an auditor usually focuses on for potential fraud include: a. The information technology environment regularly undergoes periods of internal re-organization. b. The information technology division has an unusual alliance with a single computer supplier. c. Financial and non-financial from the information technology division takes much longer to produce. d. Employees promoted to manage senior level of the information technology division have no adequate training/experience in internal controls. e. Internal and external auditors are blocked from accessing the back-end system logs of the financial application by the information technology division. f. Staff of the information technology division password-protected and file-encrypted their My Documents folder on their local hard drive or insist on taking key records home on USB sticks. g. Executives of the information technology division demand 24/7 access to the company’s electronic financial systems, yet the system records indicate they have never used them. 2. Application controls Those controls that relate to specific computerized accounting applications, i.e., input (e.g., check digit), processing (e.g., parity check), and output controls (e.g., encryption) for a specific accounting application such an accounts receivable application. There is usually a lot of interdependency of controls among computerized accounting applications. Accordingly, an auditor usually focuses more on the general controls than application controls because the latter is often dependent upon the former. Effect of Information Technology on TOC Procedures

In fully computerized accounting systems, the nature of an auditor’s TOC procedures depend on whether audit evidence generated by the computer is external to the computer (i.e., directly observable), or internal to the computer (i.e., not directly observable). TOC procedures involving external, directly observable audit evidence usually take the form of inquiries, observation, and inspection of documents. For example, for testing the general control of “segregation of computer department and users,” the TOC procedures would include inquiries of computer personnel, management, and operating employees; observation of actual operations; and inspection of documentary evidence such as management reports and organization charts. In contrast, TOC procedures involving internal, unobservable audit evidence require the auditor to use CAAT (Computer Assisted Audit Techniques) to obtain a reasonable degree of assurance that controls are operating as planned. Table 10-5 provides brief comments on some common CAATs. Table 10-5 Brief Comments on Some Common CAATs

Common CAATs



 



Test Data

BCSE (Base Case System Evaluation) ITF (Integrated Test Facility)

Parallel Simulation

Brief Comments The auditor prepares a limited number of fictitious transactions (test data), some of which are valid and some of which contain errors that should be detected by the controls the auditor wants to test. The auditor uses the client’s programs to process the test data and then examines the output (including error listing) to identify controls that have been compromised. Test data provides no assurance that the programs tested are actually used by the client. BCSE is a special type of test data that the auditor uses to test every possible internal controls that are related to a client’s programs. BCSE would provide the auditor with greater assurance about the client’s internal controls than the test data would. However, it is more time-consuming and expensive to develop. ITF is another type of test data that allows the auditor to test whether a client actually uses the programs that hich is run independent of client data, an ITF integrates the auditor’s the auditor tests. Unlike test data, w fictitious dataclient’s file (e.g., a fictitious file) with theauditor. client’sW actual data file throughout allowing thetheauditor to compare the output with the company output expected by the hen processed year, ITF provides assurance that the programs tested are actually used to compile financial statements. In Parallel Simulation, the auditor prepares programs to process the client’s data on the client’s computer. If controls have been operating effectively, the client’s programs should generate the same exceptions as the auditor’s programs. Like test data, Parallel Simulation provides no assurance that the client’s programs are


Common CAATs





EAM (Embedded Audit Modules)

Audit Hooks and Tagging

Brief Comments actually used throughout the year to process all data. EAM involves planting program code in the client’s application program to collect audit evidence for the auditor. For example, the auditor plants an accounts receivable confirmation program code (known as a module) within a client’s monthly billing program. When desired, the planted audit module is activated by the auditor to select customer accounts for confirmation, and to print the confirmation requests. The EAM are sometimes used to create what is referred to as SCARFs (Systems Control Audit Review Files), which are computer logs that collect transaction information for review subsequently by the auditor. Audit Hooks are exit points in a client’s program that allow the auditor to modify the program by inserting specific commands to accumulate data or manipulate data for audit purpose. The auditor sometime uses Audit nsactions are “tagged” (i.e., are specially marked) at the auditor’s Hooks to accomplish Tagging, in which tra discretion. Then, as they are processed, additional documentation is generated so that the auditor can see how the transactions are processed at various control points inside the computer system.

Effect of Information Technology on TOB Procedures

Large CPA firms use GAS (Generalized Audit Software) as TOB procedures when a client uses information technology to process and store accounting data. GAS is a set of programs (i.e., software package) specifically designed to perform certain data processing functions that are useful to the auditor. The two most widely used GAS are ACL (Audit Command Language) software and IDEA (Interactive Data Extraction and Analysis) software that can be used to obtain copies of client databases or master-file and perform a variety of TOB of the client’s electronic data. A primary advantage of using GAS to perform TOB procedures on a client is that the auditor may access information stored on computer files w hile having a limited understanding of the client’s hardware and software features. Table 10-6 describes some basic features of the GAS as TOB procedures. Table 10-6 Some Basic Features of GAS for TOB

Basic Features of GAS



Examining Records



Testing Computations



Comparing Data files



Analyzing Samples



Summarizing data

Comments on Using GAS as TOB Procedures GAS can be used to examine accounting records for quality, completeness, consistency, and correctness. It can be instructed to scan the records, store in a file, and print those that are exceptions to auditor-specified criteria. Examples include: (1) Examining accounts receivable balances for amounts that are over the credit limit. (2) Examining inventory quantities for negative or unreasonably large balances. (3) Examining payroll files for terminated employees. (4) Examining bank demand deposit files for unusually large deposits or withdrawals. GAS can be used to test the accuracy of mathematical computations and perform quantitative analyses to evaluate the reasonableness of client representations. Examples include: (1) Re-computing the extensions of inventory items, depreciation amounts, the accuracy of sales discounts, and interests. (2) Testing the accuracy of the net pay computations for employees. Gas can be used to determine if identical information on separate files agrees. Example include: (1) Comparing changes in accounts receivable balances between two dates with details of sales and cash receipts on transaction files. (2) Comparing payroll details with personnel records. (3) Comparing current and prior-period inventory files to assist in locating obsolete or slow-moving inventory. GAS can be used to select statistical samples, print the sample items for the auditor’s working papers or on special confirmation forms (e.g., accounts receivable confirmation requests), and when the results are know (e.g., when the accounts receivable confirmations are returned), analyze the data statistically. Examples include: (1) Select and print accounts receivable confirmations. (2) Select inventory items for observation. (3) Select fixed asset additions for vouching. GAS can be used to summarize, reformat and aggregate data in a variety of ways. Examples include: (1) Re-footing account files. (2) Testing accounts receivable aging. (3) Preparing general ledger trial balances. (4) Summarizing inventory turnover statistics for obsolescence analysis. (5) Re-sequencing inventory items by location to facilitate physical observations.

Effect of Special Systems on TOC and TOB

Special accounting information systems affect the auditor’s TOC and TOB. Table 10-7 provides brief comments on some special systems and their effect on TOC and TOB.

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Table 10-7 Effect of Special Systems on TOC and TOB

Special Systems

Effect on TOC and TOB

Because of the technical complexity of OLRT systems, the auditor OLRT (On-line Real-time) System must have higher technical expertise to perform the TOC and TOB. In an OLRT system, transactions are processed and files updated as The auditor must also exercise care not to disrupt the system which is transactions occur. The transactions are processed fast enough to get perpetually on-line and real-time processing. CAATs such as test data, the response back in time to influence the process. Examples of OLRT ITF, and Tagging may be used to perform the TOC. GAS may be used systems include: to perform TOB on the data files. (1) Airline reservations systems in which the customer receives the

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reservations confirmation almost instantaneously. (2) POS (Point-Of-Sales) terminals in retail stores where a customer’s credit limit is checked while the customer waits for approval. Because of the smaller computers (nodes) are in a vast different  Distributed Systems geographical locations, the auditor must perform TOC and TOB for Distributed systems are a network of remote computer sites consisting each of these computer nodes separately. A primary concern of the of smaller computers (known as computer nodes) that are connected to auditor is adequate control over access at each of the computer nodes. a main computer system in a variety of system configurations. EAM is commonly used to perform TOC across all or selected Examples of Distributed Systems include: numbers of the computer nodes. IDEA is commonly used to perform (1) National rental car companies that use Distributed Systems to track TOB on the nodes and their links to the main computer. the customer’s renting, dropping off, and payment of a rental car at different locations throughout the country. (2) International hotel chains that use Distributed System to do on-line reservations, receiving payments, and remitting receipts from all over the world to the hotel’s head-office. The auditor may visit the client’s service bureau to observe the internal control. The service bureau must have effective internal control to protect the client’s data. Moreover, it must have adequate reconstruction (back-up) procedures in case the audit client’s data are destroyed or deleted accidentally. It is increasingly common to have one independent auditor obtain an understanding and perform TOC and TOB of the service bureau for use by all the bureau’s customers and their independent auditors. Before performing TOC and TOB on LANs and WANs, the auditor  LANs (Local Area Networks) and WANs (Wide Area must have a good knowledge of the network configuration, including Networks) the location of servers, workstations, and computer links to one LANs link equipment within a single or small cluster of buildings and another, and knowledge of network software used to manage the are used only for intra-company computing purposes. WANs link equipment in larger geographic regions, including global operations. In system. The auditor must also have detail knowledge about controls over access and changes to application programs and data files located LANS and WANs, the application software and data files used to on the servers. process transactions reside on servers. Access to the application from workstations is managed by network server software.

 Service Bureau (Service Center) A service bureau provides EDP services to its clients for a fee. Processing of client data occurs at the service bureau and the client’s computerized master files are usually maintained at the bureau. An example of a service bureau is a payroll service center that processes monthly payroll for its client.

The auditor’s TOC and TOB on E -commerce System focus on:  E-commerce System (1) Providing assurance about the reliability of the internal and E-commerce System links a company’s internal computer accounting external accounting systems, such as the WebTrust and SysTrust systems to external computer accounting systems of outside parties, assurance services provided by the auditor. such as customers and suppliers. Business transactions, such as EDI (2) Preventing exposure of sensitive data, programs, and hardware to transactions, are electronically conducted among the internal and potential interception or sabotage by external parties, such as creating external computer accounting systems using either the WANs or the Firewall to control the flow of e-commerce communication or use Internet. The cost of transmitting and processing EDI transactions Encryption to protect the security of e-commerce communication. using the Internet is usually less than that using the WAN. (3) Verifying the authenticity of external computer accounting systems, such as the use of Digital Signature where a trusted EDI- A simplest form of E-Commerce System certification authority issues a digital certificate to individuals and A simplest form of E-Commerce System is EDI, which can be defined companies engaging in e-commerce. as an exchange of business documents between economic trading The auditor’s risk assessments of TOC and TOB on E-commerce partners, computer to computer, in a standard format. The documents System focus on: are received, validated, and accepted into the job stream of the (1) Security of system and protection against malicious intrusion or receiving computer, and immediately processed if so desired. Because penetration by outsiders. EDI is computer-to-computer communication, organization must (2) Integrity and completeness of processing. decide if they should have direct linkages with specific trading (3) Integrity of data communications. partners, or if they will be linked by an intermediary. The (4) Trading partner agreements. intermediary, which serves as an electronic mail service, is referred to (5) Systems interdependences. as a VAN (value-added network) An example of EDI is shown in Figure 10-7. (6) Paperless systems resulted in soft controls.


Figure 10-7 An example of EDI – A Simplest Form of E-Commerce System

A Company (Automated, Paperless)

B Company (Trading Partner)

Automated Accounting Information System

Automated Accounting Information System

Purchase Order

Vendor Invoice

Sales Order

Internet/ WAN Translation Software

Value Added Network

Internet/ WAN Translation Software

Sales Invoice

VAN Receiving Report

Shipping Document

Electronic Funds Transfer

Electronic Funds Transfer

For example, A Company wishes to place an order with B Company, a purchase order is generated and translated into a format that can be read by every company that uses EDI. In the United States, the agreed-upon format is referred to as ANSI.X12. It is a standard agreed upon by the American National Standards Institute (ANSI). Once the purchase order is in the standard format, it is communicated to the VAN, which stores the message in a mailbox. B Company periodically polls the VAN to determine if it has any messages. It reads the purchase order from A Company, determines if it can meet the order at the requested time, price, and location, and sends an electronic acknowledgement back to A Company’s mailbox. Subsequently, B Company generates a sales order, sales invoice, and shipping document and transmits them to A Company – all without generating paper documents. When A Company receives goods, most likely they will contain a bar code that is read by an electronic scanner and transmitted directly into A Company ’s accounts payable system. The accounts payable system matches the purchase order, receiving report, and vendor invoice for discrepancies. If they are no discrepancies, it generates an order to electronically transfer the appropriate amount of funds to B Company. If they are discrepancies, an exception report is generated and sent to a supervisor for investigation.

Effect of Information Technology on Audit Report

Many audit clients provide access to financial information through their home Web page on the Internet. Visitors to a client’s Web site can view the company’s most recent audited financial statements, including the auditor’s report. In addition, it is common for the client to include such information as unaudited quarterly financial statements, other selected financial information, and press releases that are often labeled as “About the Company” or “Investor Relations” on its Web site. Under current AICPA and PCAOB’s auditing standards, the auditor has no obligation to perform any procedures to test financial information published on the client’s Web site. Also, the auditor is not required to read financial information published on the Internet, including the audited financial statements on the client’s home Web page. Auditing standards note that electron sites; specifically, a Web page containing financial information is a means of distributing information and are not considered “documents,” as that term is used in auditing standards.

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The auditor looksfor an indication onduplicate salesinvoices to see whether the invoices havebeen verified. Thisis an example of a. test of details of balances b. a test of control. c. a substantive test of transactions d. both a test of control and a substantive test of transactions.

10-2

Analytical procedures may be classified as being primarily a. tests of controls. b. tests of balances. c. tests of ratios. d. compliance tests of transactions.

10-3

To support the auditor’s initial assessment of control risk below maximum, the auditor performs procedures to determine t hatinternal controls are operating effectively. Which of the following audit procedures is the auditor performing?

a. Tests of details of balances. b. Substantive tests of transactions c. Tests of controls. d. Tests of trends and ratios. 10-4

The auditor faces a risk that the audit will not detect materialmisstatements thatoccur in the accounting process.To minimize this risk, the auditor relies primarily on a. tests of balances. b. tests of controls. c. internal control. d. statistical analysis.

10-5

The sequence of steps in gathering evidence as the basis of the auditor’s opinion is:

a. substantive tests, assessment of control risk, an tests of controls. b. assessment of control risk, substantive tests, and tests of controls. c. assessment of control risk, tests of controls, and substantive tests. d. tests of controls, assessment of control risk, and substantive tests. 10-6

Which of the following ultimately determines the specific audit procedures necessary to provide an independent auditor with a reasonable basis for the expression of an opinion? a. The audit program. b. The auditor’s judgment. c. Generally accepted auditing standards. d. The auditor’s working papers.

10-7

If the results of the tests of controls are not consistent with the auditor’s expectations, the tests of balances will be

a. decrease b. increase c. unaffected d. changed. 10-8

Tests to determine whether the accounting transactions have been properly authorized, correctly recorded and summarized in the journals, and correctly posted to subsidiary ledgers and the general ledger are a. tests of controls. b. substantive tests of transactions. c. substantive tests of balances. d. analytical procedures.


10-9

Which of the following statements is false? a. Analytical procedures emphasize the overall reasonableness of transactions and the general ledger balance. b. Substantive tests of transactions emphasize the verification of transactions recorded in the journals and then posted in the general ledger. c. Tests of controls are concerned with evaluating whether controls are sufficiently effective to justify reducing control risk and thereby reducing analytical procedures. d. Tests of balances emphasize the ending balances in the general ledger.

10-10

Which of the following audittests is usually the most costly to perform? a. Analytical procedures. b. Tests of controls. c. Tests of balances. d. Substantive tests of transactions.

10-11

Which of the following isconsidered acomponent of a local area network (LAN) ? a. Program flowchart. b. Key verification. c. Transmission media. d. Input routine.

10-12

Which of the following best represents an additional cost of transmitting business transactions by means of electronic data interchange (EDI) rather than in a traditional paper business environment? a. Translation software is needed to convert transactions from the client’s internal format to a standard EDI format. b. Internal audit work is needed because of the potential for random data entry errors in an EDI system. c. More supervisory personnel are needed because the amount of data entry is greater in an EDI system. d. Redundant data checks are needed to verify that individual EDI transactions are not recorded twice.

10-13

Many audit clients use the Internet as a network to transmit EDI transactions. An advantage of using the Internet to transmit EDI transactions rather than a traditional WAN (Wide Area Network) is the Internet a. permits EDI transactions to be sent to trading partners as transactions occur. b. automatically batches EDI transactions to trading partners. c. possesses superior characteristics regarding disaster recovery. d. converts EDI transactions to a standard format without translation software.

10-14

Which of the following would an auditor ordinarily consider the greatest risk regarding a client’s use of EDI?

a. Authorization of EDI transactions. b. Duplication of EDI transactions. c. Improper distribution of EDI transactions. d. Elimination of paper documents. 10-15

Which of the following istrue when a client use EDI to conduct E-commerce? a. The cost of sending EDI transactions using a WAN (Wide Area Network) is less than the cost of using the Internet. b. Software maintenance contracts are unnecessary because translation software for EDI transactions need not be updated. c. EDI transactions are formatted using strict standards that have been agreed to worldwide. d. EDI commerce is ordinarily conducted without establishing legally binding contracts between trading partners.

10-16

Which of the following control procedures most likely could prevent EDP personnel from modifying programs to bypass programmed controls? a. Periodic management review of computer using reports and systems documentation. b. Segregation of duties within EDP for computer programming and computer operations. c. Participation of user department personnel in designing and approving new systems. d. Physical security of EDP facilities in limiting access to EDP equipment.

10-17

An auditor anticipates assessing control risk (CR)at a low levelin a computerized accounting information system. On which of the following procedures should the auditor initially focus? a. control procedures. procedures. b. Programmed Application control c. Output control procedures. d. General control procedures.

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10-18

An auditor would most concern with which of the following controls in a special Distributed System? a. Hardware controls. b. System documentation controls. c. Access controls. d. Disaster recovery controls.

10-19

Which of the following input controls is a numeric value computed to provide assurance that the srcinal value had not been altered in construction or transmission? a. Hash total. b. Parity check. c. Check digit. d. Encryption.

10-20

When an auditor tests a computerized accounting information system, which of the following is true of the test data procedure? a. Test data are processed by the client’s computer programs under the auditor’s control. b. Test data must consist of all possible valid and invalid conditions. c. Several transactions of each type must be tested. d. The program tested is different from the program used throughout the year by the client.

10-21

When an auditor creates a fictitious company within the client’s actual data files, the auditor is using which of the following CAATs?

a. Parallel Simulation. b. ITF. c. GAS. d. EAM. 10-22

A primary advantage of using generalized audit software (GAS) to audit a client’s computerized accounting information system is that the auditor may a. consider increasing the use of TOB procedures instead of analytical procedures. b. substantiate the accuracy of data through self-checking digits and hash totals. c. access information stored on computer files while having a limited understanding of the client’s EDP system. d. reduce the level of required tests of controls to a relatively small amount.

10-23

As the acceptable level of detection riskincreases, anauditor may change the a. assessed level of control risk from below the maximum to the maximum level. b. assurance provided by TOC by using a larger sample size than planned. c. timing of TOB from year-end to an interim audit date. d. nature of substantive tests from a less effective to a more effective procedure.

10-24

Which of the following TOBprocedure isleast likelyto be performed beforethe balance sheetdate? a. Observation of inventory. b. Testing bank reconciliation. c. Search for unrecorded liabilities. d. Confirmation of receivables.

10-25

Which of the following computer-assistedauditing techniques (CAATs) allows fictitious andreal transactions tobe processed together without the knowledge of client operating personnel? a. Integrated test facility (ITF). b. Input controls matrix. c. Parallel simulation. d. Data entry monitor.


10-26

Processing datathrough theuse of fictitious data files provides an auditor withinformation aboutthe operating effectiveness of controls. One of the techniques involved in this approach makes use of a. controlled reprocessing. b. an integrated test facility. c. input validation. d. program code checking.

10-27

Which of the following statementsis not true of the test data approach to testing an accounting system? a. Test data are processed by the client’s computer programs under the auditor’s control. b. The test data need consist of only those valid and invalid conditions that interest the auditor. c. Only one transaction of each valid and invalid condition need be tested. d. The test data must consist of all possible valid and invalid conditions.

10-28

An auditor mostlikely would test for the presence of unauthorized computerprogram changesby running a a. test data. b. ITF. c. parallel simulation. d. audit hooks and tagging.

10-29

To obtain evidencethat user identification andpassword controlsare functioning asdesigned, anauditor wouldmost likely a. review the online transaction log to ascertain whether employees using passwords have access to data files and computer programs. b. examine a sample of assigned passwords and access authority to determine whether password holders have access authority incompatible with their other responsibilities. c. extract a random sample of processed transactions and endure that transactions are appropriately authorized. d. observe the file librarian’s activities to discover whether other systems personnel are permitted to operate computer equipment without restriction.

10-30

An auditor anticipatesassessing controlrisk at a low level in a computerized environment.Under thesecircumstances, on which of the following procedures would the auditor initially focus? a. Programmed controls. b. Application controls. c. Output controls. d. General controls.

10-31

To obtain evidence that online access controls are properly functioning, anauditor most likely would a. create checkpoints at periodic intervals after live data processing to test for unauthorized use of the system. b. examine the transaction log to discover whether any transactions were lost or entered twice because of a system malfunction. c. enter invalid identification numbers or passwords to ascertain whether the system rejects them. d. vouch a random sample of processed transactions to assure proper authorization.

10-32

Which of the following controlsmost likely could prevent computer personnel frommodifying programsto by pass programmed controls? a. Periodic management review of computer utilization reports and systems documentation. b. Segregation of duties for computer programming and computer operations. c. Participation of user department personnel in designing and approving new systems. d. Physical security of computer facilities in limiting access to computer equipment.

10-33

For control purposes, whichof the following should be organizationally separatedfrom the computer operations function? a. Data conversion. b. Surveillance of email messages. c. Computer system development. d. Minor maintenance according to a schedule.

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10-34

An auditor should design the written audit program so that a. all material transactions will be selected for substantive testing. b. substantive tests prior to the balance sheet date will be minimized. c. the audit procedures selected will achieve specific audit objectives. d. each account balance will be tested under either tests of controls or tests of transactions.

10-35

An audit program should be designed so that a. most of the required procedures can be performed as interim work. b. inherent risk is assessed at a sufficiently low level. c. the auditor can make constructive suggestions to management. d. the audit evidence gathered supports the auditor’s conclusions.

10-36

In designing anaudit program, anauditor should establishspecific audit objectives thatrelate primarily to the a. timing of audit procedures. b. cost-benefit of gathering evidence. c. selected audit techniques. d. financial statement assertions.

10-37

Ordinarily, anaudit program cannotbe finalized (i.e.,the nature, timing,and extent of audit tests cannotbe determined) until the a. understanding of internal control and assessment ofontrol c risk have beencompleted. b. engagement letter has been signed by the auditor and the client. c. material weaknesses have been communicated to those charged with governance. d. search for unrecorded liabilities has been performed and documented.

10-38

In an E-commerce System, a purchasing companywith just-in-time inventorysystems specified itsshipping requirementsto a supplier company. The shipments are loaded directly into production with no inspection or counting. Which of the following best describes the auditor’s risk assessments for TOC and TOB on this feature of the E-commerce System? a. Integrity of data communication. b. Paperless systems resulted in soft control. c. Trading partner agreements. d. Integrity and completeness of processing.


10-1 b. 10-2 b. 10-3 c. 10-4 a. 10-5 c. 10-6 b. 10-7 d. 10-8 b. 10-9 c. 10-10 c. 10-11c. 10-12 a. 10-13 a. 10-14 c. 10-15 c. 10-16 b. 10-17 d. 10-18 c. 10-19 c. 10-20 a. 10-21 b. 10-22 c. 10-23 c. 10-24 c. 10-25 a. 10-26 b. 10-27 d. 10-28 c. 10-29 b. 10-30 d. 10-31 c. 10-32 b. 10-33 c. 10-34 c. 10-35 d. 10-36 d. 10-37 a. 10-38 b.


Simulation Question 10-1 Simulation Question 10-1 is an adaptation with permission from a case by Splettstoesser, I. B. in Issues the in Accounting Education , a publication of the American Accounting Association in Sarasota, Florida. This simulation question is based upon atrue set of facts; however, the names and places have been changed.

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Overview

Marthra Tool, Inc. (hereafter MTI) is owned by George Mathra, an experienced machinist. George established the business over 20 years ago, and it has grown into a $10-million-a-year business, with an excellent reputation for high-quality machined parts. MTI has clients in the automobile sector and the health-care sector and has recently begun producing parts for environmentally friendly products, such as recycling containers, due to the business’s versatility in dealing with a variety of metals as well as plastics.

 MTI has a broad range of equipment, ranging from grinders, stampers, cutters and small presses to numerically controlled machiningand-turning centers, some of which individually cost over $250,000. This latter group of equipment is tied into the company’s computer-aided design and manufacturing (CAD/CAM) system used by the four senior tool and die personnel. Machining-and-turning center suppliers have helped MTI develop efficient operations, by furnishing sample numerical control programs for standard machine operations and by providing training to employees. One of the suppliers unfortunately sent sample programs that had been infected with a virus. George’s daughter, Tiffany, had to cleanse the servers and each of the machines, using her copy of an anti-virus software. When contacted, the supplier did not know that his software was infected and apologized profusely. The four CAD/CAM terminals and printers are connected to the company’s local area network (LAN), which is maintained by Tony Lee, the owner of a computer shop conveniently located three blocks away. All computer equipment, software and supplies are purchased from Mr. Lee, who is responsible for attaching and maintaining equipment, upgrading software and maintaining user security profiles on the network. There is one user identification and password for accounting (shared by Tiffany, George and the accounting clerk). Each of the plan supervisors has individual password, and a common password is used to initiate the timekeeping system. The two word processing staff members have their own password and use the common accounting password when they need to do data entry. A standard routine has been set up to back up the accounting systems. One of the accounting staff inserts one of seven tape cartridges into the system at the end of the day (they are labeled with the day of the week) so that the company has a full set of backups for the week. Tiffany keeps these in her office. These are particularly important, since during the last office move, two years ago, the srcinal disks for the accounting system were misplaced. Tiffany, George’s youngest daughter, has been working in the business for 15 years. She started as a machine operator and has finished several college diplomas in numeric control and in accounting over the years. She is being groomed to take over the business in two years and is proving herself competent both on the shop floor and in administration. She works along with the tool and die machinists and the shop supervisors in discussing design problems, quality control methods, and costing of quotes for potential orders. Every Wednesday morning at 7:00 AM, Tiffany and George hold a meeting with the supervisors (one purchasing, three production, one design, one quality control) to maintain a good working relationship and to review any problems that need to be addressed in the coming week. This includes any potential scheduling changes required due to “rush” jobs that have been accepted or are being quoted. This good working relationship is ex tremely important for satisfying some of the company’s larger customers. MTI has paid for computer for each of the supervisors, so that they have fully functioning microcomputers at home. If a rush job requires weekend work, then these senior personnel canwork at home to get the necessary quoting or design work completed. Since the “at home” systems are identical with the office systems (Mr. Lee simply copied the image from the MTI systems to the home computer hard drives), diskettes can easily be taken home and then brought back to the office. It is understood that when work slows down, a day off can be taken to compensate for this weekend work. Almost ten years ago, Tiffany arranged for the implementation of the network, and the purchase of a standard integrated accounting package (general ledger, order entry/accounts receivable, purchases/payable, payroll), and for the purchase of the job-costing and timekeeping system. The job-costing package is used to prepare and print quotes. For automotive customers, the quote is entered into the stand-alone EDI system for transmission. Customer purchase orders received via EDI are simply printed and filed. Once a quote has been accepted, the job is given a unique job number. The job control sheets include a list of the machining center, labor and quality control tasks, each with a unique optical scanning label used by the employees to “sign in “ and “sign out” of particular tasks by machine t ype and by operation. Standard control sheets are also used for overhead tasks, such as cleaning or machine setup. Employees have plastic cards with their employee number and the operation label for each activity, as it is commenced or completed. To sign out, they simply scan their employee card again. Information Systems and Business Processes

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Accounting Systems

A variety of reports are printed daily, weekly, or monthly from the costing system; these are used for monitoring employee hours, the status of jobs, the costs accumulated for particular jobs and the work-in-progress inventory. The weekly report of hours from the costing system is approved by the production supervisors and is used as a data entry input source into the payroll system for hours worked. The accounting clerk enters the hours into the accounting system, sothat weekly payroll checks and reports canbe produced. When volume is high, one of the administrative staff also do filing or document matching. Tiffany is really pleased with her accounting clerk, Isabel, who has been with the company for three years. She insists that fate had a hand in getting Isabel for MTI. Isabel was “pounding the pavement,” having recently immigrated, and had no local business experience. Her accounting skills were rudimentary, but she quickly learned the accounting software and has reorganized the filing system. Tiffany considers her indispensable. When Isabel goes on vacation, many things simply don’t get done. Tiffany can do the payroll in a pinch, but Isabel always does accounts payable and cash disbursements. If she is away, suppliers are simply told to wait, or Tiffany issues a manual check, which is recorded later. Isabel is very good at responding to queries from suppliers and ensuring that new suppliers are set up properly. The purchasing supervisor and his staff rely on Isabel, for she checks the account allocation of purchases and makes any necessary corrections. Isabel also ensures that necessary EDI acknowledgments are sent and reports printed. Tiffany and George are signing officers, although Tiffany realizes that she checks supporting materials more thoroughly than George, who usually just queries Isabel verbally about larger purchases. George normally handles the bank deposits, while Tiffany does the monthly bank reconciliation. Every three months, an accountant from Moss Adams CPA firm (MTI’s auditor) reviews ht e regulatory returns for reasonableness, as well as journal entries made in the last three months. He updates the recurring journal entries and advises Tiffany of any changes in procedures

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or modifications to monthly journal entries that are required to help ensure accuracy and completeness of transaction processing. Tiffany runs the standard financial statements every month from the accounting package, but normally some additional adjustments are required when the accountant comes in. These are adjustments to depreciation expenses, changes to prepaid expenses and some account reallocation (e.g., repairs and maintenance to capital accounts) based on discussions with Tiffany. The regular accountant assigned to MTI is Louis Jaborwock, who has just completed the most recent month-end entries. Louis informed Mark that MTI had a problem with one of their systems on Friday. Apparently, one of the servers might have “crashed.” Luckily, this was the server with the accounting systems and was fully backed up on tape. A new server was to be installed the next day, and Mr. Lee was reconfiguring the network so that the remaining systems could function from the single server.

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Work-in-Progress Inventory

Ezen Momota, the engagement partner from Moss Adams believes that MTI’s growth may have expanded the company sufficiently to warrant increased levels of controls reliance during the audit. She is particularly interested in work-in-progress (WIP) inventory, the largest item on the balance sheet; typically close to three m onths’ sales. She has requested an updated controls analysis and that computer-assisted audit techniques (CAATs) using the firm’s generalized audit software be considered. To this end, Mark Green, the in-charge audit manager, has updated the narrative description associated with WIP inventory. To calculate the WIP inventory for any particular month, one of the purchasing staff transfers data from a report in the job-costing system into a spreadsheet (Exhibit 1). Since the job-costing system does not have sales information, progress billings are added manually, and the spreadsheet total i s used for the monthly financial statement’s work-in-progress figure. You should access Data File 10-1 in iLearn for Spreadsheet 1, which shows a portion of the work-in-process accounting spreadsheet. The purchasing staff has explained the contents of her spreadsheet and described the srcin of the information. Following is an explanation of the spreadsheet on a column-by-column basis: Job Number: A unique job number is assigned by one of the production supervisors. There is a manual log in the production area, and the supervisors write down the customer, purchase order number and the job numbers used. Where a purchase order lists multiple parts, a different job number must be used for each part produced. Customer Code: Each customer has a unique customer code. Tiffany assigns these codes, so that the same code can be used in the accounting system and in the job-costing system. Customer P urchase Order Number: These match the purchase orders received from customers. Due Date and Scheduled Com pletion Date : The customer purchase order will indicate the date that an order is due. The production supervisors will schedule the job so that it is completed prior to the due date. Customer Part Number and Part Description : MTI always uses the part numbers of its customers and the customer description when describing parts being produced. These must match customer purchase orders. Quantity Ordered : The quantity ordered on the purchase order is entered into the job-costing system. Quantity on Hand : The quantity on hand is based upon the figures in the job-costing system. This is initiated with the first operation. For example, if component parts are purchased and then additional work is done on a component part, then the quantity on hand is based upon the parts purchased. If raw material is purchased and cut on the premises, then the person who completes the first operation notes the quantity cut, for subsequent entry by the production supervisor. Any damaged parts that cannot be passed on to the next operation are reported to the quality control staff, who enters the part into the system as damaged, thereby reducing the quantity on hand. All data entry is accomplished using the common job-costing password. Such entries will show ion a damagedparts report, which is discussed every Wednesday at the supervisors’ meeting. Percentage Complete : Each operation on the job control sheet is assigned a percentage of the job. The system tracks which operations have been completed and reports the percentage completed based upon the last operation that has been fully completed for all the parts. Quoted Costs (L abor Center, Materials, a nd Total): These costs are all listed at a rate-per-individual-unit part. Labor center rates are based upon standard rates that have been developed by George and Tiffany. They include the labor rate of the employee multiplied by a factor, depending upon the machine used. The factor incorporates both plant overhead charges plus machine charges. The lowest factor is 2.5, the highest 23. Thus, an employee earning $10 per hour would result in a labor center cost at the lowest factor of $25 per hour and $230 per hour at the highest factor. Material cost is based upon quotes from suppliers, plus a markup. Some customers have a fixed arrangement with the markup as low as 5 percent, while others are marked up as much as 150 percent. During the last year, the company has changed its costing and overhead allocation methods to absorption costing, based upon Moss Adams, the CPA firm’s advice. MTI reduced its labor center factors by 10 percent and added a flat materials handling charge ($50) and ordering charge ($25) to each of its quotes. Actual Cost-to-Date: As work is completed and supplier invoices are received, these costs are entered into the job-costing system. Actual hours worked on an operation may be higher or lower than quoted. The hours worked are automatically posted using the timekeeping system. The production supervisors review each daily printout of hours worked, to ensure that employees have properly clocked out. Production supervisors must approve any job-cost system adjustments, which are entered by one of the purchasing staff. As supplier invoices are received, they are recorded into the job-costing system by the purchasing staff and then forwarded to Isabel for entry into the accounts payable system. Sales Price : This is the price that the customer has agreed to pay, according to the purchase order. Progress Billings : Normally, MTI does not request advance payments or progress billings. However, if a customer is new or a part requires a substantial material purchase, an advance payment is requested to cover the cost of the material. MTI then considers this material as already owned by the customer and deducts this progress billing from the cost of its WIP. Work-in-Progress Inventory Value: Isabel updated the spreadsheet template this year, applying a formula to calculate inventory as follows: – [progress billings]. She reviews the inventory list prepared by ([quantity on hand] x [percentage complete/100] x [actual cost to date]) purchasing for one of two necessary adjustments. First, if a job has not been started it will show as zero percentage complete. Sometimes, parts have been ordered on a subcontract basis and been placed into production. Then, the WIP value must be increased from zero to the value of these parts. Second, if a job has an overrun and the actual costs exceed the sales price, then the value of the inventory must be reduced so that it does not exceed the sales price. Isabel makes these changes by manually scanning the inventory listing and changing the inventory value for these items.

Required Ezen Momota, the engagement partner has requested a meeting tomorrow to discuss engagement planning for MTI. To prepare for that meeting, she has requested you to provide a description of specific computer-assisted audit tests that could be conducted for the WIP inventory using


generalized audit software. These generalized audit software tests should cover the following areas: (Some test descriptions are provided to help you complete the rest) 1. Tests of Mechanical Accuracy/Data Entry Accuracy a. On the Control Total: Recalculate the extended value of inventory as defined by the client: ([quantity on hand] x [percentage complete/100] x [actual cost to date]) – [progress billings]. Investigate errors for possible causes. b. Formula for WIP Calculation: c. Duplicate Job Numbers: d. Duplicate Part Numbers: 2. Classification Tests a. Percentage Complete Equal to 100: Such goods would likely be “finished goods” and should be reclassified on the financial statements. Investigate these goods to determine whether any additional operations, such as subcontracted plating, are requires. If the latter is the case, they are appropriately considered WIP. b. Percentage Complete Equal to 0: 3. Valuation Tests a. Net Realizable Value: Calculate gross margin, both as a dollar amount and as a percentage. Provide a listing of all products with unreasonably low gross margins based upon the percentage complete. Depending upon the perception of average gross margins in this industry, “unreasonably low” could be anything less than 20 percent. b. Sales Pricing Against Costs: c. Sales Pricing Against Quotes: d. Total Costs Against Material Costs: e. Pricing: 4. Obsolescence Tests a. Due Dates Against Production Schedule: To determine whether goods in inventory will be sold, look at due dates and scheduled completion dates. Print a list of all items that have a scheduled completion date later than the due date. These could represent data entry errors or items where the company has missed a due date and could be liable for penalties or may be unable to sell its goods. b. Due Dates and Cut-off:

Simulation Question 10-2 Simulation Question 10-2 is developed by F. Choo in Financial a nd Integrated Audit s, a publication of the CSU AcademicPub in San Francisco, California. This simulation question is based upon a true set of facts; however, the names and places have been changed.

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Information Technology and Internal Control a t EA Inc.

The information systems (IS) department at Electronic Arts Inc. (hereafter, EA) consists of eight employees, including the IS manager, Golden Warrior. Golden is responsible for the day-today oversight of the IS function and reports to EA’s chief operating officer (COO). The COO is a senior vice president responsible for the overall retail operations. The COO reports directly to the president and chief executive officer. The COO attends board of director meetings to provide an update of key operating performance issues. Because Golden takes an active role in managing the IS department, the COO rarely discusses IS issues with the board or CEO. Golden and the COO identify hardware and software needs and are authorized to approve those purchase. In addition to Golden, the IS department is composed of seven other individuals: three programmers, three operators, and one-data control clerk. Golden has been employed by EA for 12 years, working her way up through various positions in the department. Fortunately, she has been able to retain a fairly stable staff and has experienced minimal turnover. All IS personnel have been employed in their current positions since mid-2006. When hiring personnel, Golden does extensive background checks on prospective employees, including reference, credit, and criminal checks. Golden has developed a trust with each employee and, as a result, delegates extensively to each individual. This is especially beneficial because Golden spends most of her time working with user departments in a systems analyst role, identifying changes needed to existing applications. She conducts weekly IS departmental meetings on Tuesday mornings. Each staff member attends, including night operators, to discuss issues affecting the performance of the department. The three programmers are responsible for maintaining and updating systems and application software. The lead programmer is responsible for assigning duties among the programming staff. All three programmers have extensive experience with the operating, utility, security, and library software as well as all of EA’s application software packages. Programming assignments are made based on who is least busy among the programming staff at the time. This method of management keeps all programmers familiar with most software packages in use at EA and keeps programmers excited about the job tasks because of the variety of assignments they receive. Golden encourages each programmer to take continuing education courses to keep current with the latest technical developments. In addition to programming responsibilities, the programming staff maintains the library of programs and data tapes, which is located in a locked room nearby. The programming staff maintains extensive logs of tape use and of changes made to program files. The three operators consist of a day operator and two night operators. Most of the applications are based on online inputting from various user departments for batch processing overnight. Thus, the heaviest volume of processing occurs during the night shift, although there is some daytime processing of payroll and general ledger applications. All operators are responsible for monitoring the operation of the equipment and correcting system-caused errors. In addition, when a small change is identified for an application program, Golden asks the day shift operator to implement that change to avoid overburdening the programming staff. Operators follow the production schedule prepared by Golden, who consults with user departments to develop the schedule. The day shift operator reviews the job processed log generated at the end of the previous

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day shift for deviations from the schedule. If jobs processed reconcile to the job schedule, the job processed log is discarded. When there are deviations, the operator doing the review leaves a copy for Golden, highlighting the deviation. Before doing batch processing jobs, the operators generate an input listing report that summarizes the number of online input entries submitted during the day for processing. This number is recorded and then later compared by the operators with the computer output generated after batch processing and file updating occur. This provides a check figure of the number of transactions processed. When the numbers agree, the output is submitted to the data control clerk. When the number disagrees, the operators identify the error and resubmit the application for processing. The data control clerk collates all computer output, including output reports and exception listings. The data control clerk reviews exception reports and prepares correction forms for reprocessing. Examples of changes that the data control clerk might make include correcting inputting errors (that is, amounts accidentally transposed) and preparing change request forms for changes to existing master files (that is, revising sales price lists and inventory product numbers in the sales master file and adding new employee names, addresses, and social security numbers to the payroll master file). After all corrections are made, the data control clerk distributes all computer output to the various user departments. User departments have high regard for the IS staff. Output reports are reconciled to input reports by users on a test basis quarterly.

Required You are the senior auditor assigned to the audit of EA. The audit partner has asked you to assist in doing the IS internal controls review. The partner has asked you to review the above narrative information and write him a memo that addresses the following issues: 1. a. What is your assessment of the control strength of the lines of reporting from IS to senior management? b. What is your assessment of the control deficiencies of the lines of reporting from IS to senior management? c. For control deficiencies assessed in 1b., provide recommendations that can be included in the management letter (also known as client’s advisory comments letter). 2. a. What is your assessment of the control strength of Golden Warrior fulfilling her IS management responsibilities? b. What is your assessment of the control deficiencies of Golden Warrior fulfilling her IS management responsibilities? c. For control deficiencies assessed in 2b., provide recommendations that can be included in the management letter. 3. a. What is your assessment of the control strength of the programming function at EA? b. What is your assessment of the control deficiencies of the programming function at EA? c. For control deficiencies assessed in 3 b., provide recommendations that can be included in the management letter. 4. a. What is your assessment of the control strength of the IS operations function at EA? b. What is your assessment of the control deficiencies of the IS operations function at EA? c. For control deficiencies assessed in 4b., provide recommendations that can be included in the management letter. 5. a. What is your assessment of the control strength of the data control function at EA? b. What is your assessment of the deficiencies of the data control function at EA? c. For control deficiencies assessed in 5b., provide recommendations that can be included in the management letter. 6. Make some recommendations for improving controls over the involvement of the various users/user departments.

Simulation Question 10-3 Simulation Question 10-3 is an adaptation with permission from a case by A. F. Borthick, G. P. Schneider, and A. Vance inIssues the in Accounting Education , a publication of the American Accounting Association in Sarasota, Florida.

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Scene 1: Kiran, the accountant, interviewing Pat, the payables manager

The time is early in the year, when 24-Seven accounting staff members are documenting internal control for accounts payable for vendors supplying store inventory. Kiran: “Thank you for making time to talk to me. I really appreciate it because I know you're busy!” Pat:

“Not a problem. What would you like to know?”

Kiran: “I'm familiar with the payables process up to the point where we receive invoices from vendors. Would you start there?” Pat:

“Sure. On the 5th and 20th of the month, the system matches all unprocessed invoices to purchase orders (POs).”

Kiran: “Just what gets matched?” Pat:

“PO number on the invoice to purchase order number on the PO, and PO and invoice amounts. When matched, invoice status is set to ‘A' for payable.”

Kiran: “What happens if there's not a match?” Pat:

“The system sets invoice status to ‘S' for ‘suspended,' and payables staff resolve the mismatch and set status to payable.”

Kiran: “How are payments made?” Pat: “The payables system requests the bank to send an electronic funds transfer (EFT) to the vendor's bank.” Kiran: “How do you know an EFT was made?” Pat:

“On the 10th and 25th of the month, EFT requests are prepared. Before the EFT request goes to the bank, the system sets the EFT status for an invoice to ‘P' for ‘pending.' After the system sends a batch of EFT requests to the bank, it changes the EFT status for


each one in the batch to ‘R' for ‘requested.' After making payments, the bank returns EFT confirmations to us.”

Kiran: “How do you know the process works correctly?” Pat:

“As part of closing the month, we run a report that verifies that payments were made only for valid requests.”

Kiran: “Are there adjusting entries for payables each month?” Pat:

“Yes. To close the month, we download the payables file from the system i nto a spreadsheet on the first of the month, which ums s the amounts of invoices with status = ‘R.' The sum becomes the amount for the adjusting entry to the general ledger that enters the payables amount for the month being closed.”

Kiran: “And the prior month's entry is reversed?” Pat:

“Yes. The spreadsheet keeps up with the monthly amounts.”

Kiran: “Where is the spreadsheet, and how do you know that it does what it is supposed to do and nothing else?” Pat:

“The spreadsheet is on Bern's PC. That's because when we started using a spreadsheet to calculate the entry, Bern [an accounts payable staff member] had the time to develop it.”

Kiran: “When Bern isn't here, who runs the spreadsheet to create the adjusting entries, and was it t ested by anybody else?” Pat:

[thinking] “I looked over test results based on the month beforewe started using it, and everything looked fine to me. I know it's easy to use because when Bern's not here, other accounts payable staff members go to Bern's PC to run it.”

Kiran: “I've got to ask. Is there a reason the enterprise system (ES) doesn't do t he adjusting entries every month?” Pat:

“I'm with you on that one. We started using a spreadsheet when we acquired the first company that wasn't integrated into our existing ES. Over time, there were more of these. If you look at other financial statement balances, you'll find spreadsheets used similarly. And there's a monster spreadsheet that consolidates all the financial data from all the different systems run by all the subs (subsidiaries). As long as we keep acquiring companies, but not integrating them into our ES, I guess we'll keep using spreadsheets to prepare the adjusting entries.”

Kiran: “So are the subs volatile, i.e., is there much change in them?” Pat:

“Actually, there will be changes several times a year. Some are acquisitions and some are spin-offs. You just never know what —there are no data when we go to download it. Usually, we see a press will happen next. Finding out about the spin-offs is easy change.” release when there's a new acquisition. Bern just adds and deletes columns as the companies

Kiran: “How hard is it to set up the data download for a new acquisition?” Pat:

“Must not be too hard because Bern doesn't spend much time setting them up.”

Kiran: “Has anybody ever cross-checked the entries calculated in the spreadsheetagainst the trial balances of the subs?” Pat:

“I don't think so. Because each of the subs has its own idiosyncrasies, whichmight be quite a job.”

Kiran: “Can we go back to the process for a moment? Where was the status set to ‘R'?” Pat:

“When we receive an invoice from a vendor, the system sets status = ‘R' for ‘received.'”

Kiran: “Okay. What can you tell me about how the payables application was developed?” Pat:

“Unfortunately, not much because I wasn't here when it was installed a couple of years ago.”

Kiran: “I understand. Have there been problems with it? Does it get updated often?” Pat:

“I guess the best responses are ‘no' and ‘no.' You'll have to talk to one of the application developers.”

Kiran: “I'll do that. Can you tell me who has accessto payables?” Pat:

“Now, that I can answer. All t he payables staff (eight full-time and four part-time) have ready access to payables transactions and reports. All the staff can edit payables transactions. Only my two supervisors and I can develop reports that run against the transactions in the database or enter adjusting entries. Depending on their job functions, payables staff members can runorts.” rep

Kiran: “What kind of reports do you have?” Pat:

“Some of them are analysis reports, e.g., we just wrote one that identifies groups of similar payables so we can inspect them visually for potential duplicates. Another one matches employee addresses to vendor addresses.”

Kiran: “How did you get started writing reports? In Structured Query Language (SQL)?” Pat:

“We got started because it took so long to get ad hoc reports developed by the IT development group. When one of the IT analysts indicated an interest in rotating through payables to understand the business better, I jumped at the chance. Jan, who knew SQL, wrote the first ones and explained them to us. When we saw how powerful the report writer was, we paid attention because we realized that we could answer a lot of our questions ourselves by querying the data. The pressure to analyze data is relentless. A lot of people want information about payables. The report writer we're using supports SQL and Query-By-Example (QBE). Although I'm not exactly a whiz at it and Jan has long since rotated out, I have friends in IT and in other app areas that will answer occasional questions. Sometimes, I can search the web for answers to specific querying questions. Now that we've written several reports, we can use them as models for new ones.”

Kiran: “How hard was it to learn to write reports yourself?” ® “Not very. We'd already been experimenting with the QBE interface in Microsoft Access , which worked the same way in the report writer. Access® is on all our PCs. Once you get familiar with one relational database manager, you're familiar with them all!” Kiran: “What do you do about checking for errors in the queries?”

Pat:

Pat:

[looking puzzled] “We just keep modifying reports until they run t o our satisfaction.”

Kiran: “Do you modify them often? Do you run them only for yourselves?”

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Pat:

“Mostly, the reports are just for us and, yes, we modify them often. Actually, it's more like we take an existing report and work with it to create a new one. Sometimes, though, one of our reports strikes the fancy of others, who clamor to get access to it. For example, buyers like the report that shows purchases by inventory item ID grouped by vendor. They can use that information to manage their buying better.”

Kiran: “Do the buyers run the reports from your private program library?” Pat:

“The libraries are organized into a hierarchy. When I get a request for running one of our reports from non-payables staff members, I decide whether it makes business sense. If so, I request the database administrator (DBA) to copy the report to a library that they can access. If the DBAs are busy, it might take a while.”

Kiran: “Would buyers have access to updated versions of reports?” [thinking] “I never thought of that. I haven't asked the DBAs to republish reports for buyers or anybody else. Maybe I should .”

Pat:

Kiran: “There's one more area to talk about. How will the payables application change with the contemplated system?” “The current plan is to use the existing application to the extent feasible. I'm looking forward to doing away with the payables flowing from the delivery tickets. I've never been quite sure how accurate the tickets were and whether they were accurately reflected in the invoices.”

Pat:

Kiran: “Why was that?” Pat:

“I guess I'm just a born skeptic. Everywhere else we have receiving reports, but not with these deliveries. Another change will be that instead of all invoices coming over leased lines from vendors, some invoices will be created in web forms.”

Kiran: “Which ones?” Pat:

“The ones from small vendors, e.g., the souvenir makers. For these, the vendor will complete a web form and submit it. If the validation routine detects missing or inconsistent fields, it will prompt for changes until the invoice passes all the edit checks. Once validated, the invoices will go straight to the database, where they'll be handled like any other invoice. When stores take delivery, the store manager (or designee) will indicate receipt to the system.”

Kiran: “Cool! Thank you very much for talking to me!” “You're welcome!”

Pat:

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Scene 2: Kiran Interviewing Denny, the IT Applications Development M anager

Kiran: “Thank you for finding time to talk to me. Would you explain your development process? Maybe illustrate it with the payables application.” Denny: “Sure. Users and management get together to agree on application functions. When they sign off on them, we start. Sometimes, we suggest changes based on the difficulty and cost of implementing features. Usually, we're able to come to agreement that pleases everyone involved. Analysts develop the specs in more detail. If they encounter surprises, they go back to users with them and work them out.” Kiran: “Are there many surprises?” to be athe lot,business.” but that was before the new CIO (chief information officer) helped management develop a strategic IT Denny: “There plan forused supporting

Kiran: “How did that change the process?” Denny: “Part of the plan is the requirement that every user proposal be vetted against the plan. As long as proposals enable the plan and fit the budget, everything's fine. When they don't enable the plan, the proposal has to go to the IT steering committee. If the proposal improves on the plan in some way, the committee is likely to incorporate it into the plan. If not, the committee suggests changes users might make.” Kiran: “Okay. What happens after the analyst has developed the specs?” Denny: “Programmers develop programs and test them. Once they're satisfied that programs pass program-level tests, they check them into the development program library. Once a week, all the programs are compiled together into a build, and integration tests are run against all the programs in that build. Any programs that break the build are returned to programmers for rework. When the build is deemed complete, we do what we call stress testing, i.e., throw enough transactions at the application to see how fast it will run before stalling. Part of the stress testing is maxing out on the volume t o see where the app breaks.” Kiran: “Is this the electronic version of running one's car at high speed to see how long it lasts?” Denny: “Sort of, but in the case of programs, there's no damage analogous to blowing out the engine after redlining the tach for toolong. themselves are intact.” It may be tedious to analyze the results to see what broke first, but the programs Kiran: “This kind of testing must be expensive. How did you come to this approach?” Denny: “Once you get in the pattern, this testing is probably no more expensive than what we used to do. The reason we do it is beca use several years ago, when we brought up a new system, everything came to an abrupt halt because the load was too much. In hindsight, we figured out that the throughput and volume were predictable. We think we learned our lesson. Once an app passes stress testing, users get a shot at it in user acceptance testing. When users sign off, the app goes to QA (quality assurance), which occasionally finds things that need fixing. From there, QA authorizes the DBAs to install the app in the production library.” Kiran: “Who can run programs from the production library?” Denny: “Only operations personnel. When programmers need data for the next program iteration, whatever extracts they need are made available to them in their development libraries.” Kiran: “Do you have much of a backlog?” Denny: “Not as much as we used to have. The st rategic plan helped, and more users are writing more of their ownad hoc reports now. I'm skeptical of their quality, but can't do anything about it because we just don't have the staff to write reports for everyone. But even


BI (business intelligence) reports would be better than spreadsheets. Another thing that worries me is desktop control. Users actually want IT to defend their desktops against viruses and bots. After that, it's a mess. Users want to install new software before IT can vouch for its good behavior. Even worse, users can plug in external media like USB drives. Although users need flexibility, it makes us vulnerable. In my opinion, it's just a matter of time before we're written up in the business press about some unintended data exposure.” Kiran: “I see balancing control and ease of use getting even more complex. Thank you for talking to me.”

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Scene 3: Kiran Interviewing Kwan, the IT Security Manager

Kiran: “Thank you for finding time to talk to me. This won't take long. Tell me who authorizes access.” Kwan: “It all goes back to user management. When employees are hired, their managers specify the access privileges they get based on existing profiles. For example, there's a base-level profile for entry-level accounts payable staff. When employees move to different positions, their managers authorize us to add privileges consistent with their new roles.” Kiran: “When do you t erminate access?” Kwan: “Usually, it's when employees leave the company. We remove the employees from the access tables, and that takes care of that. You won't hear about our former employees still having access to IT resources! We get lists of terminated employees daily from to rely on managers to tell us.” HR (human resources), which means we do not have Kiran: “How secure is the system?” Kwan: “Of course, it's very secure. Employees gain access to their areas with radio frequency identification badges, and passwords have to be eight characters with some upper and lower case letters and some numbers. The system enforces password changes every 90 d within a year.” days, and passwords can't be reuse Kiran: “What can you tell me about server security?” Kwan: “You mean the computers in the operations center?” Kiran: “Yes.” Kwan: “You need to see Dana in systems support.” Kiran: “Thanks!”

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Scene 4: Kiran Interviewing Dana, Systems Support Mana ger

Kiran: “Kwan said you could tell me about server security.” Dana: “I'd like to say ‘secure,' but I know better. After reading about the holes in one company's security perimeter, we did a little sleuthing. As a result, we identified over a hundred servers that weren't protected. We're in the process of protecting them, although some users aren't exactly ecstatic about it.” Kiran: “Has there ever been a penetration test of perimeter security?” Dana: “No, we haven't been able to budget for it. Finding that many unprotected servers is giving us reasons to ask for more securityrelated funding. Now that we've identified all the servers (I think!), we're working through changing all the default settings. The stuff to fix is endless!” Kiran: “At least you know why you're doing it!” Dana: Yes, but users don't always appreciate their work being rearranged.” Kiran: [puzzled] “What's ‘rearranged'?” Dana: “Changing default settings entails users having to deal with harder passwords and more of them. In some cases, access privileges were removed. The end result is that it takes users longer to get their work done.” Kiran: “Okay, I get it.” Dana: “After we get the servers protected, we'll worry about how to deal with the growing tide of personal technology that users want to have all the time.” Kiran: “How's that a problem?” Dana: “We can't support every personal technology, e.g., iPhones, but users figure out how to use them anyway. If we could work with users, we'd be more likely to help them take advantage of personal technology for business use without creating information or system vulnerabilities. The security risks are enormous.” Kiran: “I think I understand—the personal technologies aren't going away. They're multiplying instead.” Dana: “Like rabbits!”

Required Part 1

Select the best response for each of the following multiple-choice questions based on 24-Seven's situation, as represented in the conversation above. The questions are independent of each other.

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1.

In the current system, the process with the most manual effort is: a. Preparing and posting month-end adjusting entries. b. Sending purchase orders to vendors. c. Receiving and entering invoices from vendors. d. Updating corporate inventory and sales.

2.

The use of a spreadsheet model for calculating month-end adjusting entries represents a control: a. Strength because the spreadsheet sums the payable amounts. b. Weakness due to the potential for undetected errors. c. Strength because all staff members can use it for the entries. d. Weakness because the spreadsheet program was bundled with other office applications.

3.

The best approach to strengthening control over the calculation of month-end adjusting entries would be by: a. Sending the payables transactions to an independent person to perform the calculations. b. Verifying that backups of payables transactions are usable as backups. c. Calculating them with a query manager that can access the transactions directly. d. Comparing the entries to those from prior months as a form of consistency checking.

4.

Verifying that each EFT request has a corresponding EFT confirmation would ensure the: a. Existence or occurrence of payments. b. Completeness of payments. c. Valuation of payments. d. Existence or occurrence, and completeness of payments.

5.

Payables staff could ensure the validity of EFT requests by verifying that each: a. EFT request has a corresponding payable invoice. b. Payable invoice has a corresponding EFT request. c. EFT request has a corresponding EFT confirmation. d. EFT confirmation has a corresponding EFT request.

6.

The coding scheme for values of the invoice status and EFT status attributes is: a. Desirable because no values are duplicated. b. Desirable because some values are duplicated. c. Undesirable because no values are duplicated. d. Undesirable because some values are duplicated.

Part 2

The table below has separate sections for (1) control weaknesses only in the current payables system, (2) control weaknesses only in the contemplated payable system, and (3) control weaknesses in both payables systems. Complete the table of control weaknesses and their potential effects on the financial statements and operational effectiveness. Current Payables System Only Control Weakness

Potential Effect On Financial Statements Operational Effectiveness

1 2 3 Contemplated Payables System Only Control Weakness

Potential Effect On Financial Statements Operational Effectiveness

1 2 3 Current and Contemplated Payables Systems Potential Effect On 1 2 3

Control Weakness

Financial Statements

Operational Effectiveness


Chapter 11 Audit Sampling for Tests of Controls Chapter Learning Outcomes (LOs) Checklist


LO11-1 Distinguish among audit sampling approach, plan, technique, and method.

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LO11-2 Apply the 14 steps of an Attribute Estimation Sampling (AES) technique in TOC.

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LO11-3 Understand the Sequential (Stop-or-Go) Sampling technique in TOC.

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LO11-4 Understand the Discovery Sampling technique in TOC.

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Chapter 11 Audit Sampling for Tests of Controls Figure 11-1 shows where the audit sampling for tests of controls fits in the audit process. Figure 11-1 Audit Sampling for Tests of Controls

The Audit Process

Audit Plan

Tests of Controls

Tests of Balances


Audit Report




3. Assess CR (Control Risk)



3. Inventory Cycle CH 15





AU 530 Audit Sampling defines audit sampling as: the application of an audit procedure to less than 100 percent of the items within an account balance or class of transactions for the purpose of evaluating some characteristics of the balance or class. Accordingly, audit sampling is a process of selecting certain items from an audit population consisting of all items within an account balance or class of transactions and using the characteristics of the selected sample to draw inferences about the characteristics of all items in the entire population. The underlying assumption is that the sample characteristics are representative of the population characteristics. Audit Sampling Approach

There are two general approaches auditors use to conduct audit sampling:

 Statistical audit sampling approach. This audit sampling approach applies the laws of probability to determine the sample size, the selection of sample items, and the evaluation of sample results.  Non-statistical audit sampling approach. This audit sampling approach applies judgmental reasoning rather than the laws of probability to decide the sample size, the selection of sample items, and the evaluation of sample results. The choice between a statistical and a non-statistical audit sampling approach depends on the auditor's consideration of the relative costs and effectiveness. Both statistical and non-statistical audit sampling approaches require that the auditor use professional judgment. In addition, both can provide sufficient appropriate evidential matter required under the Third Standard of Field Work. However, there is one important difference between the two. Statistical audit sampling approach allows an auditor to quantify sampling risk. In contrast, non-statistical audit sampling approach provides no means of quantifying sampling risk. Sampling risk is the risk that the sample characteristics are not representatives of the population characteristics. In other words, the risk that the auditor's conclusion based on a sample may be different from the conclusion he or she would reach if the test were applied to the entire population. Sample risk varies inversely with sample size. That is, the larger the sample size, the smaller the sampling risk. However, auditing a larger sample size is more costly. All aspects of audit risk not due to sampling are referred to as non-sampling risk. Non-sampling risk includes: 1. The risk of selecting inappropriate or ineffective procedure for a given audit objective. For example, confirmation of accounts receivable should not be relied on to reveal unrecorded accounts receivable. 2. The risk of not recognizing misstatements in the documents examined by the auditor, which makes the audit procedure ineffective. Non-sampling risk cannot be quantified but can be guarded against. It can be reduced by adequate planning and supervision of audit work in accordance to AU 300 Planning an Audit in a financial audit and AS 9 Audit P lanning in an integrated audit, and adherence to CPA firms' quality control standards. Audit Sampling Plan

Depending on the auditor’s characteristic of interest in the sample items, there are two common audit sampling plans:

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Attribute sampling plan In TOC, audit sampling is designed to obtain evidence about whether a client is complying with the control procedures prescribed by management. A characteristic of the control procedure that is of interest to the auditor is called an attribute . When this characteristic of interest to the auditor is absence, it is called an exception. An attribute sampling plan is used to test the extent of the exception, that is, the exception rate (or deviation rate) of a prescribed control procedure.

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Variable sampling plan In TOB, audit sampling is designed to obtain evidence about whether monetary misstatement exists within an account balance or a class of transactions. A characteristic of the account balance or class of transactions that is of interest to the auditor is called a variable . When this characteristic of interest to the auditor is absence, it is called an

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exception. A variables sampling plan is used to test the extent of the exception, that is, the exception rate (or misstatement rate) of a recorded amount. Table 11-1 summarizes the differences between the two sampling plans. Table 11-1 Differences between Attribute Sampling and Variable Sampling Pla ns

Attribute Sampling Plan

 

For TOC

Estimate the exception rate (deviation rate) from prescribed controls in a population. For example, the % of sales order without supporting documents.



Results stated in terms of population exception rate (in %).

Variable Sampling Plan

 

For TOB

Estimate the exception rate (misstatement rate) of a recorded amount. For example, the % of sales (or book value) is misstated.



Results stated in terms of population misstatement within a range of $ values.

Audit Sampling Technique

Within the attribute sampling plan, there are several attribute sampling techniques that the auditor can use to determine a sample size for a test of controls. These are:

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Attribute estimation sampling technique Attribute estimation sampling technique is the most commonly used technique to determine a sample size for a test of controls. This technique enables the auditor to estimate the maximum rate of exception (deviation) from a prescribed control procedure. The auditor is primarily concerned that the sample estimation of the maximum population exception rate (MPER) does not exceed the pre-specified tolerable exception rate (TER).

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Sequential (stop-or-go) sampling technique In attribute estimation sampling technique, one sample is audited and a conclusion is reached based on that sample. In sequential (stop-or-go) sampling technique, the audit sampling is a multi-stage process. The auditor starts with the smallest possible sample. If the results of this initial sample do not provide enough information to make a decision about the control procedures, the auditor expands the sample size and repeats the process until a decision about the control procedures can be made.



Discovery sampling technique Discovery sampling technique is typically used for special audit, for example, fraud investigation. This technique is most suitable when the expected rate of exception is very low, for example, zero or near zero, and when the auditor's objective is to find at least one exception to indicate possible manipulation of records supporting the financial statements. In this technique, a single exception in a sample is sufficient to conclude that the actual population exception rate exceeds or equals a predetermined critical exception rate. Audit Sample Selection Method

Once the auditor has applied one of the audit sampling techniques to determine a sample size for a test of controls, one of several sample selection methods is used to select the sample items for TOC. These sample selection methods apply a basic principle of the laws of probability, which requires each sample unit to be given an equal chance of being selected, that is, the sample unit must be selected at random. If each sample unit is not given an equal chance of being selected, the sample will be biased toward those items in the population that have a greater chance of selection. Two common sample selection methods in auditing are:

 Random number sampling method. Random number sampling method can be applied by the use of random number tables or computer generated random numbers to select the sample units. Random number tables contain columns and rows of randomly generated digits. Table 11-2 shows a partial page of a random number table. There are three steps in using the random number table: 1. Establish a random start on the random number table. For example, the auditor may blindly point to a spot on the table with a pencil as the random starting point, or the auditor may find the number of the table that correspond to the serial number on a dollar bill. 2. Establish a correspondence between the digits on the random number table and the numbering system of the population. For example, assuming that the auditor is selecting a sample of 150 sales invoices from a population of


sales invoices beginning with sales invoice number 1886 and ending with 9732. Since the sales invoices in the entire population carry a maximum of 4 digits, a corresponding 4 digits from the 5 digits random number table should be established. To illustrate, if the auditor decides on using the first 4 digits of the table, and the random starting point is row 7 and column 4, then the first sales invoice to be select is one that has an invoice number that matches the 4 digits '6499' in the table. If the sampling units in the population do not have a numbering system, the auditor should arbitrarily assign a number to each of the items in the population in order to establish a correspondence between the population items and the digits on the random number table. 3. Establish a consistent pattern of selecting the digits from the table. The pattern can be established by reading down a column of digits, or a row of digits, or even diagonally across digits on the table. Once a pattern is established, it must be consistently followed. To illustrate, if the auditor decides to read down a column of digits starting from the random starting point of '6499' above, the next sales invoice to be selected will be invoice number '3453', followed by '4872'. Note that the next 4 digits on the table are '0800', which is outside the range of the population numbering system. This is discarded and the next 4 digits '9225' will be used. In using the random number selection method, it is possible that the same number from the table may be picked more than once. If the duplicated number is ignored, the auditor is said to be sampling without replacement (else it is sampling with replacement). In practice, the auditor typically samples without replacement because no new information will be obtained from examining the same corresponding item (e.g., a sales invoice) in the population twice. Instead of using the random number table, computer programs can also be used to select the random numbers. This computer programs, called random number generators, may be programmed to provide a list of random numbers that falls within the numbering system of the population. This is done by pre-specifying certain characteristics or parameters such as the range of value to be input to the program. Table 11-2 A Partial Page of a Random Number Table ____________________________________________________________ Column Row 1 2 3 4 5 6 7 8 1 37039 97547 64673 31546 99314 66854 97855 99965 2 25145 84834 23009 51584 66754 77785 52357 25532 3 98433 54725 18864 65866 76918 78825 58210 76835 4 97965 68548 81545 82933 93545 85959 63282 61454 5 78049 67830 14624 17563 25697 07734 48243 94318 6 50203 25658 91478 08509 23308 48130 65047 77873 7 40059 67825 18937 64998 49807 71126 77818 56893 8 84350 67241 54031 34535 04093 35062 58163 14205 9 30954 51637 91500 48722 60988 60029 60873 37423 10 86723 36464 98305 08009 00666 29255 18514 49158 11 50188 22554 86160 92250 14021 65859 16237 72296 12 50014 00463 13906 35936 71761 95755 87002 71667 13 66023 21428 14742 94874 23308 58533 26507 11208 14 04458 61862 63119 09541 01715 87901 91260 03079 15 57510 36314 30452 09712 37714 95482 30507 68475 16 43373 58939 95848 28288 60341 52174 11879 18115 17 61500 12763 64433 02268 57905 72347 49498 21871 18 78938 71312 99705 71546 42274 23915 38405 18799 19 64257 93218 35973 43671 64055 88729 11168 60260 20 56864 21554 70445 24841 04779 56774 96129 73594 ____________________________________________________________ Source: Interstate Commerce Commission,Table of 105,000 Random Decimal Digits.

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Systematic sample selection method. This method involves selecting every nth item in the population after establishing a random start number. To illustrate, assuming that the auditor determines that the sample size is 200 sales invoices from a population of 6000 sales invoices; the auditor first calculates a sample interval (SI) by dividing the population size (6000) by the sample size (200). The sample interval is therefore 6000/200 = 30. Next, within this sample interval of 30, the auditor selects a random start number between 0 and 30. If the random start number is 8, then the first invoice to be selected is invoice number 8. This is followed by the 38th invoice, which is calculated by adding the random start number 8 to the sample interval 30. The remaining invoices to be selected are the 68th (38+30), 98th (68+30), 128th (98+30), and so on till 200 samples are selected from the entire population. A problem with using the systematic sample selection method is that it could result in biased sample if the control characteristic of interest, such as certain types of supporting documents to the sales invoice, is not randomly

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distributed throughout the population. An advantage in using the systematic sample selection method is that it enables the auditors to select a sample from a population that does not have a numbering system. This is because under the systematic sample selection method, it is not necessary to number the items, as required under the random number selection method. The auditor simply counts off the sampling interval to select t he sample item. Attribute Estimation Sampling (AES) Technique in TOC

An attribute estimation sampling (AES) technique for tests of controls involves 14 main steps as presented in Table 11-3. Table 11-3 Fourteen Steps in an AES Technique for Tests of Controls

Steps in Attribute Estimation Sampling (AES) Technique 1. State the objective of the test. The objective of TOC is to assess the effectiveness of the control procedures in preventing and detecting material misstatements. The auditor uses an AES technique to efficiently assess the effectiveness of these control procedures. Example: An auditor is interested in testing a control procedure under the occurrence objective (recall Chapter 6, the occurrence objective translated from the existence or occurrence assertion), and the control procedure of interest is the client's matching of sales invoices to customer orders, sales orders, and shipping documents. Here, the occurrence objective will be documented in the auditor's working paper for audit sampling as: Audit Objective: To perform a test of controls with regard to the occurrence of the sales invoices. The TOC procedure is to inspect individual sales invoices for supporting documents.

2. Decide whether audit sampling applies. The auditor examines the audit program (recall Chapter 10) and identifies the audit procedures for which audit sampling technique applies. Example: The TOC procedure, inspect individual sales invoices for supporting document, requires the application of an AES technique to the population of sales invoices.

3. Define the exception condition. As stated earlier, an attribute is a characteristic of a control procedure whereas an exception is the absence of the attribute. There can be more than one attribute to a control procedure. Also, when a sample item does not have one or more of the attributes it is classified as an exception. As an example, the control procedure that sales invoices are supported by shipping documents will have several attributes including: 1. The quantities on the invoices match with the quantities on the shipping documents. 2. The descriptions on the invoices match with the customer orders. 3. Each matching set of sales invoices, shipping documents, and customer orders contains the appropriate initials. The absence of these attributes is exceptions. In this case, exceptions are: 1. The quantities on the invoices do not match with the quantities on the shipping documents. 2. The descriptions invoices not matchinitials. with An theexception customer has orders. 3. Each set offound sales one invoices, customer orders doesonnotthe contain the do appropriate occurred eachmatching time anauditor or moreshipping of thesedocuments, exceptions. and It is important that the exception conditions must be clearly defined before the TOC is performed; otherwise, the auditor performing the TOC may not identify an exception when s/he sees one. Example: The prescribed control procedure of interest is whether each sales invoice is supported by the relevant shipping document, sales order, and customer order. This control procedure addresses the management assertion on existence and occurrence of the sales invoices. The audit TOC procedure is to inspect the relevant documents.

4. Define the population. There are three factors to be considered in defining the population: 1. The defined population must be appropriate for the specific audit objective. For example, if the auditor's objective is to test controls designed to ensure that all shipments have been recorded as sales, the appropriate population should be all shipping documents issued during the period. It should not be all sales invoices issued during the period because there might be goods shipped but not invoiced. 2. The period covered by the population must be noted. Typically, the auditor performs the TOC during the interim audit. As such, the population will only cover the period up to the interim audit. The auditor must also consider testing a population that covers the period after the interim audit and before the year-end. 3. The defined population must contain the appropriate sampling unit. A sampling unit is the individual items making up the population. It could be a document, a line item on a document, a journal entry, or a physical item depending on the audit objective and the control procedure being tested. For example, a sample unit for proper authorization of disbursements might be identified in terms of a voucher, which is a summary form attached to a vendor's invoice. On the other hand, if one voucher pays several invoices from the same vendor, the sampling unit might be identified in terms of a line item on a voucher, with each line item representing an individual vendor invoice. Example: The population is the total number of sales invoices for the financial year, i.e., 6240.

5. Define the sampling unit. As stated above, a sampling unit is the individual items making up the population and it could be a document, a line item on a document, a journal entry, or a physical item. The major consideration in defining a sampling unit is to make it consistent with the objectives of the TOC. For the auditor wants tothe determine the client fails the to fill a customer’s order, the sampling unitonshould be example, customer’sif order. If, however, objectivehow is tooften determine whether proper quantity of the goods described the custom er’sdefined orderthe isas correctly shipped, the sample unit should be defined as the shipping document. Example: The sampling unit is individual sales invoices.

6. Specify the tolerable exception rate (TER).


Steps in Attribute Estimation Sampling (AES) Technique The TER is the maximum population exception rate (MPER) from a prescribed control procedure that an auditor is willing to tolerate without modifying the assessed level of control risk (CR). The auditor relates the TER directly to the assessed CR as follows: CR TER low 2-6% moderate 7-10% high 11-20% For example, a lower level of CR (or a stronger control) means a smaller % of TER (or a less tolerance for exceptions). In other words, the stronger the control, the more the auditor would place reliance on that control, and for which the auditor would tolerate less for any exceptions. In addition, TER is inversely related to the sample size. For example, a smaller % of TER (or a less tolerance for exceptions) means a larger sample size (or a better chance to detect those exceptions that are less tolerated). Example: The assessed level of CR is low and the TER is specified at 4%.

7. Specify the acceptable risk of over-reliance (ARO) or acceptable risk of assessing CR (ARACR) too low. When an auditor applies statistical sampling approach to TOC, the auditor must apply professional judgment in assessing sampling risk. Two aspects of the sampling risk are critical in the TOC:

 Acceptable riskof under-reliance (ARU) or ARACR too high. This is the risk that the assessed level of CR based on the sample is greater than the true operating effectiveness of the internal controls. This risk is also known as the acceptable risk of under-reliance (ARU) on a client's internal controls procedures. When the sample results caused the auditor to assess CR at a higher level than it actually is, the auditor will perform more TOB (because of lower detection risk) than is necessary in the circumstance. This unnecessary increased TOB (also known as over auditing) reduces the efficiency of the audit, but it does not lessen the effectiveness of the audit as a means of detecting material misstatements. For this reason, the auditor usually does not attempt to directly control (meaning does not specify) the ARU. Another reason for not controlling ARU is that it decreases the risk of potential litigation. In statistics, ARU is equivalent to Type I error or alpha risk.  Acceptable risk of over-reliance (ARO) or ARACR too low. This is the risk that the assessed level of CR based on the sample is less than the true operating effectiveness of the internal controls. This risk is also called the acceptable risk of over-reliance (ARO) on a client's internal controls. When the sample results caused the auditor to assess CR at a lower level than it actually is, the auditor will perform less TOB (because of higher detection risk) than is justified in the circumstance. This unjustified reduction in TOB (also known as under auditing) lessens the effectiveness of the audit as a means of detecting material misstatements. For this reason, the auditor usually directly controls (meaning does specify) the ARO. Another reason for controlling ARO is that it increases the risk of potential litigation. In statistics, ARO is equivalent to Type II error or beta risk. The auditor directly controls ARO by exercising professional judgment in specifying the appropriate level of this risk. Some auditors specify a low 5% of this riskfor all TOC. Other auditors relate AROdirectly to the assessed level of CR as follows: CR ARO low 5% moderate 10% high 20% For example, a lower CR (a stronger control) means a lower % ARO (a smaller risk of over-reliance on a control which is strong in its true state). Instead of specifying the ARO, some auditors specify the compliment of the risk, that is, reliability the or confidence level (one minus the risk). Thus specifying a 95% reliability or confident level is the same as specify a 5% ARO. In addition, the AROinversely is related to the sample size. For example, at a 1% ARO, the sample size will be larger (or a better chance of detecting weak internal controls) than at a 10% ARO. Example: The assessed level of CR is low and the ARO is specified at 5%. 8. Estimate the expected population exception rate (EPER). EPER is the auditor’s expectation with regard to the excepti on rate from prescribed control procedures for the entire population before performing the tests of controls. The auditor needs to exercise professional judgment in estimating the EPER. In practice, the auditor makes the estimation using one of three ways:

 Estimate based on prior year's sample exception rate (SER). The prior year's sample exception rate is applicable only if the effectiveness of the control procedures has not changed since last year's tests of controls using audit sampling. If there were changes, the last year's sample exception rate might need to be adjusted judgmentally for current year's changes in the effectiveness of the internal controls. 

Estimate based on the auditor’s professional judgment about the internal controls. This assessment is commonly obtained via the initial walk-through tests of the internal controls.

 The rate found in a preliminary sample of 50 items randomly selected from the current year's population. If a preliminary sample is used, it can be used as part of the actual sample. For example, the preliminary sample is 50 items. Later, if the actual audit sample is 200 items, then only an additional sample of 150 items will need to be selected and tested. The EPER has a directly relationship to sample size. For example, a larger EPER (more exceptions are expected in the population) means a larger the sample size (a better chance to detect the larger number of exceptions that are expected in the population). Example: Based on the exception rate found in a preliminary sample of 50, the auditor estimates the EPER to be 1%. 9. Determine Once the auditorthe hassample specifiedsize. the TER, ARO, and EPER, the sample size can be determined from standard tables as show in Table 11-4. Apart from these three factors, the population sizealso affects the determination of samplesize. However, the effect of population size is very little, particularly for population over 5,000 items. The standard tables are compiled on the assumption of a large population. To use the tables, the auditors perform the following four steps: 1. Select the table that corresponds to the specified ARO. 2. Locate the EPER at the far left column of the table. 3. Locate the TER at the top row of the table. 4. Read the sample size from the intersection of the specified EPER column and TER

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Steps in Attribute Estimation Sampling (AES) Technique row. Example: ARO = 5%, EPER = 1%, and TER = 4%, the sample size is 156 being the intersection of 1% EPER and 4% TER in Table 11-4.

10. Select the sample item. After the sample size is determined, the auditor selects the sample items by using either the random or systematic sample selection method (see earlier discussion). In addition to these two sample selection methods, the auditor may also use a stratified sample selection method. Under this method, the auditor first subdivides the population items into homogeneous subgroups, called strata, and then selects separate samples for each of these subgroups by using either the random or systematic sampling method. To illustrate, the auditor may divide inventory items into groups according to their types.

11. Perform the TOC procedure on sample items. For testing the selected sample items, the auditor examines each sample item for the attributes of interest according to the predetermined audit program detailed in the audit working papers. Each item will be examined according to the TOC procedures in the audit program for any exception from the prescribed control procedure. Items with an exception from the prescribed control procedure are tabulated in the audit working papers. Example: After inspecting the sample sales invoices, the auditor found 2 sales invoices without adequate supporting documents.

12. Evaluate the sample results. After performing the TOC procedures on the sample items, and items containing exceptions tabulated, the auditor evaluates the sample results. The auditor's evaluation will include the following two steps:

 Determine the sample exception rate (SER). This step involves calculating the SER by dividing the number of exceptions found in the sample by the sample size. In the example, two exceptions are found in a sample of156, the SER is therefore 2/156 X 100 =1.3%. Note, this calculation is primarily performed and documented to provide an option for estimating the EPER for the following year’s audit. Also note that the SER is typically about the mesa as the population exception rate, but the chance that the two rates are exactly or positively the same is very small.  Determine the maximum population exception rate (MPER). The MPER is also called the computed upper exception rate (CUER) or achieved upper precision limit. The auditor may use the computer to calculate this rate, hence the term "computed" upper exception rate (CUER). The auditor may also use standard sample results evaluation tables, as shown in Tables 11-5, to identify this rate. This exception rate represents the MPER rate that the auditor can expect based on the number of the exceptions found in the sample. To use the tables, the auditor performs the following four steps: 1. Select the table that corresponds to the specified risk of ARO for determining the sample size. 2. Locate the sample size used at the far left column of the table. 3. Locate the number of exceptions found by the TOC procedure on the sample items at the top row of the table. 4. Read the MPER rate from the intersection of the sample size and the number of exceptions. Note: MPER can also be determined by adding SER and the auditor’s subjective allowance for sampling risk (ASR). Example: ARO = 5%, a sample size of 156, and 2 exceptions found in the sample, the MPER is 4.1 being the intersection of the 156 sample size and the 2 exceptions. Statistically, this result is expressed as: based on the TOC procedure applied to the sample, there is a 95% probability (i.e., 5% ARO) that the true but unknown population exception rate is less than or equal to 4.1 %.

13. Analyze qualitative characteristics of exceptions. For each exception found in the sample, the auditor must also analyze its qualitative characteristics. For example, exceptions that are result from intentional misrepresentations (fraud), rather than those that are due to misunderstanding of instructions or carelessness, will have more impact on the auditor's evaluation of the internal controls and the subsequent TOB.

14. Draw a conclusion about the population. The auditor compares the MPER with the TER. When the MPER is greater than the TER, the control is not effective in preventing or detecting material misstatements. The auditor may decide to take one of the following four courses of action:

 Revise the TER or ARO. Assuming everything else stays constant, the TER may be relaxed so that it will not smaller be than the MPER. Likewise, assuming everything else stays constant, if the ARO isincreased from 5% to 10%, the corresponding MPER will decrease; thereby reducing its probability of being greater than the TER. Examine Tables 11-4 for the impact of these changes on the MPEP. Since the auditor will need to justify any revision of either the TER or the ARO, this course of action is most suitable when the MPER is marginally greater than the tolerable exception rate.  Expand the sample size. Assuming everything else stays constant, an increase in the sample size will decrease the MPER, thereby reducing its probability of being greater than the TER. Depending on the nature of the sample items, sometimes it may neither be cost effective nor practical to increase the sample size. Also, the sample exception rate for the additional sample must not increase.  Revise assessed control risk (CR). If the result of the sample tests indicates that that MPER is greater than TER, the prescribed control procedure is judged to be ineffective in preventing or detecting material misstatements. In fact, this is the same as saying that the result of the sample tests does not support the auditor's assessed CR. In this case, the auditor should revise the assessed CR upward, for example from 40% to 60%. The effect of this revision will increase the TOB because the detection risk DR component of the audit risk model will be smaller. The costs of additional TOB must be considered when this course of action is to be deployed.  Inform the management. The auditor should always inform the management when the population is not acceptable and when one of the above three courses of action is taken. If the auditor has decided not to take one of the abov e three actions, s/he may inform the management in writing (in a client’s advisory comments letter or management letter) about the ineffectiveness of the prescribed control procedure.


Steps in Attribute Estimation Sampling (AES) Technique Example: MPER is 4.1% and TER is 4%. Since MPER > TER, the prescribed control is not operating at an acceptable level. Moreover, the MPER is marginally greater than TER (4.1 > 4%), the auditor should revise the TER or ARO.

Table 11-4 Statistical Sample Sizes Table for TOC __________________________________________________________________ 5% ARO (ARACR) __________________________________________________________________ Expected Tolerable Exception Rate (TER) Population _______________________________________________________ Exception Rate (EPER) 2% 3% 4% 5% 6% 7% 8% 9% 10% 15% 20% __________________________________________________________________ 0.00 149 99 74 59 49 42 36 32 29 19 14 0.25 236 157 117 93 78 66 58 51 46 30 22 0.50 * 157 117 93 78 66 58 51 46 30 22 0.75 * 208 117 93 78 66 58 51 46 30 22 1.00 * * 156 93 78 66 58 51 46 30 22 1.25 * * 156 124 78 66 58 51 46 30 22 1.50 * * 192 124 103 66 58 51 46 30 22 1.75 * * 227 153 103 88 77 51 46 30 22 2.00 * * * 181 127 88 77 68 46 30 22 2.25 * * * 208 127 88 77 68 61 30 22 2.50 * * * * 150 109 77 68 61 30 22 2.75 * * * * 173 109 95 68 61 30 22 3.00 * * * * 195 129 95 84 61 30 22 3.25 * * * * * 148 112 84 61 30 22 3.50 * * * * * 167 112 84 76 40 22 3.75 * * * * * 185 129 100 76 40 22 4.00 * * * * * * 146 100 89 40 22 5.00 * * * * * * * 158 116 40 30 6.00 * * * * * * * * 179 50 30 7.00 * * * * * * * * * 68 37 __________________________________________________________________ Audit Sampling. * Sample size is too large to be cost effective for most audit applications. Source: AICPA, Audit and Accounting Guide,

Table 11-5 Statistical Sample Results Evaluation Table for TOC

____________________________________________ 5% ARO (ARACR) __________________________________________________________________ Actual Number of Exception Found ___________________________________________________________ Sample Size 0 1 2 3 4 5 6 7 8 9 10 __________________________________________________________________ 25 30 35 40 45 50 55 60 65 70 75 80 90

11.3 9.5 8.3 7.3 6.5 5.9 5.4 4.9 4.6 4.2 4.0 3.7 3.3

17.6 14.9 12.9 11.4 10.2 9.2 8.4 7.7 7.1 6.6 6.2 5.8 5.2

* 19.6 17.0 15.0 13.4 12.1 11.1 10.2 9.4 8.8 8.2 7.7 6.9

* * * 18.3 16.4 14.8 13.5 12.5 11.5 10.8 10.1 9.5 8.4

* * * * 19.2 17.4 15.9 14.7 13.6 12.6 11.8 11.1 9.9

* * * * * 19.9 18.2 16.8 15.5 14.5 13.6 12.7 11.4

* * * * * * * 18.8 17.4 16.3 15.2 14.3 12.8

* * * * * * * * 19.3 18.0 16.9 15.9 14.2

* * * * * * * * * * * * * * * * * * * * * * * * * * * 19.7 * * 18.5 20.0 * 17.4 18.9 * 15.5 16.8 18.2

100 3.0 4.7 6.2 7.6 9.0 10.3 11.5 12.8 14.0 15.2 16.4 125 2.4 3.8 5.0 6.1 7.2 8.3 9.3 10.3 11.3 12.3 13.2 150 2.0 3.2 4.2 5.1 6.0 6.9 7.8 8.6 9.5 10.3 11.1 200 1.5 2.4 3.2 3.9 4.6 5.2 5.9 6.5 7.2 7.8 8.4 _________________________________________________________________ * Over 20 %. Source: AICPA, Audit and Accounting Guide, Audit Sampling.

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Sequential (Stop-or-Go) Sampling Technique in TOC

As illustrated above, the attribute estimation sampling technique is a single-stage process where one sample is audited and a conclusion is reached based on that sample. In sequential (stop-or-go) sampling technique, the audit sampling is a multi-stage process. The auditor starts with the smallest possible sample. If the results of this initial sample do not provide enough information to make a decision about the control procedures, the auditor expands the sample size and repeats the process until a decision about the control procedures can be made. Sequential sampling technique is most suitable when it is relatively easy to expand the sample size, and either zero or very few population exceptions are expected. However, for a few exceptions found in the sample items, large expansions of sample sizes are required, thus rendering the stop-or-go process of drawing samples at several stages an inefficient audit procedure. The sequential sampling technique follows the same 14 steps for the AES technique in Table 11-3. However, unlike the AES technique, step 8, the EPER, needs not be specified because sequential sampling technique is applied only when an auditor expects zero or very few population exceptions rate. In addition, step 7 on risk, step 9 on sample size determination, and step 12 on sample results evaluation differ from the AES technique as follows:

 Step 7 Specify acceptable reliability instead of ARO Acceptable reliability is the complement of the ARO, that is, 100% - % of ARO. In sequential sampling technique, the auditor commonly specifies a relatively low ARO, such as 1 %. The acceptable reliability is therefore 99% (i.e. 1.00 - 0.01). Note that the higher the acceptable reliability, the lower the ARO, and the larger the sample size. Example: ARO = 5% and TER = 5%. The acceptable reliability is (1.00 –0.05 ARO) = 0.95 or 95%  Step 9 Sample size determination In sequential sampling technique, a sample size can be determined from standard tables such as Table 11-6, which is also used to evaluate the sample results . The steps to determine the sample size are: 1. Locate the column corresponds to the TER. 2. Locate the row corresponds to zero exception. 3. Read the smallest sample size corresponds to the intersection of the specified TER and zero exception that yields the acceptable reliability. Example: The acceptable reliability = 95%. The intersection of the 5% TER and zero exception yields a reliability level of 97.24. This is an acceptable reliable level because it meets the requirement of at least 95% reliability level. Therefore, the sample size is 70 (read from the left most column of the table). Note that 70 is the smallest sample size because if the auditor selects 50 (the next smaller sample size on the table), the intersection of the 5% TER and zero exception will yield a reliability level of 92.31, which is below the requirement of at least 95% reliability level.

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Step 12 Sample results evaluation After the initial sample size is determined and the sample items tested for control effectiveness, the auditor then decides from the sample result whether to stop or go on with a new expanded sample and repeat the TOC. If no exception is found in testing the sample, the auditor can conclude that the MPER is less than the TER, and therefore will stop going on to select a new expanded sample size and repeated the testing process. If one exception is found, the acceptable reliability level may or may not be met. If the acceptable reliability level is not met, the auditor will expand the sample size and test the additional sample items for exceptions. Again, depending on the result of the additional tests, the auditor may either accept the effectiveness of the prescribed control; or expand the sample size and repeat the testing process, or stop the sequential sampling technique and reduce the acceptable of reliability level. Example: a. If no exception is found after testing the initial sample size of 70, the auditor can conclude that there is a 97.2% reliability level that the MPER is less than the 5% TER and accept the prescribed control to be effective. b. If one exception is found after testing the initial sample size of 70, the intersection for one exception and 5% TER yields a reliability level of 87.03%, which is below the requirement of at least 95% reliability level. From Table 11-6, the sample size should be expanded to 100 where the intersection of 5% TER and one exception yields an acceptable reliability level of 99.41%. Accordingly, an additional will be selected If no additional exception is found in the additional 30 sample items, 30 thesample auditoritems can conclude that thereand is atested. 99.41% reliability level that the MPER is less than the 5% TER. However, if one additional exception is found in the additional 30 sample items, the reliability level is 96.29 % (the intersection of one exception and 5% TDR for 100 samples). Accordingly, the auditor can still conclude that the MPER is less than the 5% TER and accept the


effectiveness of the prescribed control. Note that if two additional exceptions are found in the additional 30 sample items, the reliability level is 88.17% which is below the requirement of at least 95% reliability level. The auditor may expand the sample size to 120 or stop the sequential sample technique and reduce the acceptable reliability level to say 89% (i.e. increase the ARO from 5% to 11%). Table 11-6 Statistical Sampling Tables for Sample Size Determination and Sample Results Evaluation in Sequential Sampling Technique ________________________________________________________________ Tolerable Exception Rate Sample Number of Size Exception 1% 2% 3% 4% 5% 6% 7% 8% ________________________________________________________________ 50 0 39.50 63.58 78.19 87.01 92.31 95.47 97.34 98.45 1 8.94 26.42 44.47 59.95 72.06 81.00 87.35 91.73 2 1.38 7.84 18.92 32.33 45.95 58.38 68.92 77.40 3 0.16 1.78 6.28 13.91 23.96 35.27 46.73 57.47 4 0.02 0.32 1.68 4.90 10.36 17.94 27.10 37.11 5 0.05 0.37 1.44 3.78 7.76 13.51 20.81 6 0.01 0.07 0.36 1.18 2.89 5.83 10.19 ________________________________________________________________ 70 0 50.52 75.69 88.14 94.26 97.24 98.69 99.38 99.71 1 15.53 40.96 62.47 77.51 87.03 92.81 96.10 97.93 2 3.34 16.50 35.08 53.44 68.63 79.87 87.59 92.60 3 0.54 5.19 15.87 30.71 46.61 61.15 73.07 82.10 4 0.07 1.32 5.93 14.85 27.21 41.13 54.77 66.80 5 0.28 1.86 6.12 13.72 24.27 36.58 49.24 6 0.05 0.50 2.18 6.04 12.61 21.75 32.70 ________________________________________________________________ 100 0 63.40 86.74 95.25 98.31 99.41 99.80 99.93 99.98 1 26.42 59.67 80.54 91.28 96.29 98.48 99.40 99.77 2 7.94 32.33 58.02 76.79 88.17 94.34 97.42 98.87 3 1.84 14.10 35.28 57.05 74.22 85.70 92.56 96.33 4 0.34 5.08 18.22 37.11 56.40 72.32 83.68 90.97 5 0.05 1.55 8.08 21.16 38.40 55.93 70.86 82.01 6 0.01 0.41 3.12 10.64 23.40 39.37 55.57 69.68 ________________________________________________________________ 120 0 70.06 91.15 97.41 99.25 99.79 99.94 99.98 100.0 1 33.77 69.46 87.82 95.53 98.45 99.48 99.83 99.95 2 11.96 43.13 70.16 86.28 94.25 97.75 99.17 99.71 3 3.30 22.00 48.67 71.13 85.56 93.40 97.19 98.87 4 0.74 9.38 29.24 52.67 72.18 85.27 92.83 96.75 5 0.14 3.41 15.29 34.83 55.86 73.23 85.23 92.47 6 0.02 1.07 7.03 20.57 39.37 58.50 74.26 85.35 ________________________________________________________________ Source: Ernst & Young,Audit Sampling (Ernst & Young, 1979)

Discovery sampling in TOC

As indicated earlier, a discovery sampling technique is typically used for special audit, for example, fraud investigation. This technique is most suitable when the expected rate of exception is very low, for example, zero or near zero, and when the auditor's objective is to find at least one exception to indicate possible manipulation of records supporting the financial statements. In this technique, a single exception in a sample is sufficient to conclude that the actual population exception rate e xceeds or equals a predetermined critical exception rate (CER). Like the AES and the sequential sampling techniques, the discovery sampling technique follows the same 14 steps in Table 11-3. However, step 6 on TER specification; step 7 on ARO specification; step 9 on sample size determination and step 12 on sample results evaluation differ from the two previous techniques as follows:

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Step 6 Specify critical exception rate (CER) instead of TER The CER is the minimum population exception rate that must exist if one exception is to be observed at a specified probability. The auditor exercises professional judgment in determining this rate, which partly depends on CR and partly on materiality of the population under consideration. The CER bears a direct relationship to sample size, that is, increasing the critical exception will increase sample size. Example: CER = 1% of 6000 payroll checks (population) to discover at least one fictitious check.

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Step 7 Specify desired probability of observing at least one exception instead of ARO The desired probability of observing at least one exception is comparable to the acceptable reliability in sequential sampling technique. Thus, like the acceptable reliability, the desired probability is the complement of the ARO. The auditor exercises professional judgment in specifying this probability. Note that the higher the desired probability, the lower the ARO, and the larger the sample size. Example: ARO = 5%, therefore, the desired probability of observing at least one fictitious check = 95% (i.e. 1.00 - 0.05)

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Step 9 Sample size determination Sample size can be determined from standard tables such as Tables 11-7. The steps are: 1. Locate the column

corresponds to the 2. Read down the to theprobability. desired probability. 3. Read across the row to the sample size corresponds to CER. the critical exception ratecolumn and desired Example: First locate the table for population between 5,000 to 10,000 items, that is, Table 11-7. The sample size can then be determined by: 1. Locate the column corresponds to 1% CER. 2. Read down the column to the 95% desired probability. 3. Read across the row corresponds to the CER and desired probability, the sample size is therefore 300.

 Step 12 Sample results evaluation A random sample selection method should be used to select the sample items for testing. If no exception is found, the auditor can conclude that the desired probability of observing at least one exception in the population is less than or equal to the CER (or minimum population exception rate) for one such exception to be observed. If one exception is observed, the auditor will not conclude a statistical statement but will likely stop testing and investigate the cause of exception. Example: a. If the auditor discovers no fictitious payroll check, his/her statistical conclusion would be that the desired 95% probability of observing at least one bogus payroll check in the population is less than or equal to the 1% CER (or minimum population exception rate) for one such exception to be observed. b. If the auditor discovers one fictitious payroll check, s/he will not make a statistical conclusion such as the one in a. above, rather, s/he will likely stop testing and investigate the cause of the fictitious payroll check. Table 11-7 Statistical Sampling Tables for Sample Size Determination in Discovery Sampling Technique

____________________________________ For population between 5,000 and 10,000: ______________________________________________________ Critical Exception Rate Sample Size .1% .2% .3% .4% .5% .75% 1% 2% ______________________________________________________ 50 5% 10% 14% 18% 22% 31% 40% 64% 60 6 11 17 21 26 36 45 70 70 7 13 19 25 30 41 51 76 80 8 15 21 28 33 45 55 80 90 9 17 24 30 36 49 60 84 100 10 18 26 33 40 53 64 87 120 11 21 30 38 45 60 70 91 140 13 25 35 43 51 65 76 94 160 15 28 38 48 55 70 80 96 200 18 33 45 56 64 78 87 98 240 22 39 52 62 70 84 91 99 300 26 46 60 70 78 90 95 99+ 340 29 50 65 75 82 93 97 99+ 400 34 56 71 81 87 95 98 99+ 460 38 61 76 85 91 97 99 99+ 500 40 64 79 87 92 98 99 99+ 600 46 71 84 92 96 99 99+ 99+ 700 52 77 89 95 97 99+ 99+ 99+ 800 57 81 92 96 98 99+ 99+ 99+ 900 61 85 94 98 99 99+ 99+ 99+ 1,000 65 88 96 99 99 99+ 99+ 99+ 1,500 80 96 99 99+ 99+ 99+ 99+ 99+ 2,000 89 99 99+ 99+ 99+ 99+ 99+ 99+ _______________________________________________________ Source: Ernst & Young,Audit Sampling (Ernst & Young, 1979)


Table 11-8 summarizes the relationships among the factors in an attribute sampling plan. Table 11-8 Relationships between Factors in an Attribute Sampling Plan

Factor CR CR ARO (ARACR) ARO (ARACR) TER TER MPER (CUER) EPER Acceptable Reliability Acceptable Reliability CER Desired probability of observing at least one exception Desired probability of observing at least one exception Population

Relationship* ARO (ARACR) Sample Size MPER (CUER) Sample size CR Sample Size Sample Size Sample Size ARO (ARACR) Sample Size Sample Size ARO (ARACR)

Direct Direct Inverse Inverse Direct Inverse Inverse Direct Inverse Direct Direct Inverse

Sample Size

Direct

Sample Size

Population has no effect on determining sample size unless the population is small (less than 5000)

*Read each row of relationship independent of the relationships in other rows. Table 11-8 is simply a memory aid; it is not meant to link all factors across all rows.

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In audit sampling, the auditor acknowledges the presence of inevitable sampling risk that results from a. using a systematic instead of a random sample item selection method. b. specifying an inappropriate risk of assessing control risk too low (ARO or ARACR). c. testing less than the entire population. d. the sample size being too small.

11-2

Which the following isnot a necessary condition forselecting a sample item through a random number table? a. Establish correspondence between the population and random number table. b. Determine the selection pattern or route. c. Consistently following a sample interval. d. Selecting a random starting point.

11-3

The risk that the auditor is willing to accept a control as being effectivewhen, in fact, it is not, is known as a. acceptable risk of over-reliance, ARO. b. tolerable exception rate, TER. c. expected population exception rate, EPER. d. computed upper exception rate, CUER.

11-4

Assuming everything else remains constant, a larger tolerable exception rate, TER, will result in a. a lager sample size. b. a smaller sample size. c. no effect. d. sometimes larger, sometimes smaller sample size.

11-5

Assuming everything else remains constant, the relationship between maximum population exception rate (MPER or CUER) and sample size is a. direct. b. indirect. c. no effect. d. inverse.

11-6

In attribute estimationsampling technique, whichof the following factorsis not necessary for evaluating theresults of a sample? a. Computed upper exception rate (CUER). b. Risk of assessing control risk too low (ARACR). c. Number of sample exceptions found. d. Sample exception rate (SER).

11-7

If the sample items are not consecutively prenumbered, whichof the following sample selecting methods is most appropriate? a. Systematic sample selection method. b. Random sample selection method. c. Judgmental sample selection method. d. Random sample selection without replacement method.

11-8

If a random numberthat is drawn from a random number table is outside therange of the population, suchnon-corresponding number is a. noted in the audit working papers. b. used if it is large enough to be material. c. ignored and scan for the next number. d. set aside if it is sampling without replacement.

11-9

In discovery samplingtechnique, anincrease inthe critical exception rate(CER) willresult in an increase in the a. maximum population exception rate (MPER). b. sample size. c. risk of assessing control risk too low (ARACR). d. control risk (CR).


11-10

In sequential sampling technique, which of the following is not a true statement? a. Acceptable reliability is inversely related to the acceptable risk of over-reliance (ARO). b. Acceptable reliability is inversely related to the sample size. c. Critical exception rate (CER) is directly related to the sample size d. Acceptable reliability is directly related to the sample size.

11-11

In the evaluation of the results of an attributes sample, if the exception rate in the sample (SER) is 2%, then the population exception rate will most likely be a. about the same 2%. b. exactly equal to 2%. c. much greater than 2%. d. cannot be determined from the information given.

11-12

Which combination of the following factors determines the initial sample size in an attribute sampling plan? a. TER, ARO, and EPER. b. TER, ARO, and Population Size. c. TER, ARO, EPER, and Population Size. d. None of the above.

11-13

When audit procedures have been completed for an attributes sampling application, the auditor must generalize from the sample to the population. Which of the following statements would be incorrect regarding this process? a. The auditor would use an attributes sampling table to determine the computed upper exception rate. b. The computed upper exception rate is the lowest exception rate in the population that the auditor is willing to accept. c. It would be wrong for the auditor to conclude that the population exception rate is exactly the same as the sample exception rate. d. In selecting the table corresponding to the risk of over-reliance, it should be the same as the ARACR used for determining the initial sample size.

11-14

Which of the following neednot be known to evaluate the results of a sample for a particular attribute? a. Exception rate in the sample. b. Size of the sample. c. Acceptable risk of assessing control risk too low. d. Actual number of exceptions in the sample.

11-15

An increase inthe sample size has the effect of decreasing thecomputed upperexception rate(CUER) if the a. actual sample exception rate increases. b. actual sample exception rate does not increase. c. number of exceptions in the sample increase. d. number of exceptions in the sample does not increase.

11-16

The acceptable risk of assessing control risk too low (ARACR) has a significant effect on sample size. The relationship of ARACR to sample size is a. variable (sometimes larger, sometimes smaller) b. direct c. inverse d. no effect.

11-17

Which of the following isan advantage of systematic samplingselection overrandom number sampling? a. It provides a stronger basis for statistical conclusions. b. It enables the auditor to use the more efficient sampling tables. c. There may be correlation between the location of items in the population, the feature of sampling interest, and the sample interval. d. It does not require establishment of correspondence between random numbers and items in the population.

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11-18

Which of the following isa valid criticism of the use of non-statistical sampling methods? a. Many audit tests, such as footing of journals, must be performed outside a statistical sampling context. b. The cost of performing random selection or testing often exceeds the benefits. c. Non-statistical sampling does not differ substantially from statistical sampling methods. d. Conclusions may be drawn in more precise ways when using statistical sampling methods.

11-19

When the computed upperexception rate(CUER) is marginally greater thanthe tolerable exceptionrate (TER), it is necessary for the auditor to take specific action. Which of the following courses of action would be most difficult to defend if the auditor is ever subject to review by a court? a. Revise and relax the tolerable exception rate (TER) or the acceptable risk of assessing control risk too low (ARACR). b. Expand the sample size. c. Revise the assessed control risk. d. Write a letter to management.

11-20

The risk which the auditor is willing to take of accepting a control as being effectivewhen it is not is the a. finite correction factor. b. tolerable exception rate. c. acceptable risk of over-reliance. d. estimated population exception rate.

11-21

In determining thenumber of documents to select fora test to obtain assurance thatall sales returns have been properly authorized, an auditor should consider the tolerable exception rate (TER) from the control activity. The auditor should also consider the I. assessed levelof control risk (CR). II. acceptable risk of assessing control risktoo high (ARACR toohigh). a. I only. b. II only. c. Both I and II. d. Either I or II.

11-22

An advantage ofstatistical samplingover non-statistical sampling is that statistical samplinghelps an auditor to a. quantify the sampling risk. b. use professional judgment. c. provide sufficient appropriate evidential matter. d. reduce the failure to detect errors and fraud.

11-23

An auditor who uses statistical sampling for attributes in testing internal controls should reduce the planned reliance on a prescribed control when the a. sample exception rate (SER) is less than the expected population exception rate (EPER). b. sample exception rate (SER) plus the allowance for sampling risk equals the tolerable exception rate (TER). c. sample exception rate (SER) plus the allowance for sampling risk is less than the tolerable exception rate (TER). d. sample exception rate (SER) plus the allowance for sampling risk is more than the tolerable exception rate (TER).

11-24

For which of the following audittests would an auditor most likely use attributesampling plan? a. Selecting accounts receivable for confirmation of account balances. b. Inspecting employee time cards for proper approval by supervisors. c. Making an independent estimate of the amount of a LIFO inventory. d. Examining voucher packets to determine the valuation and allocation of fixed asset additions.

11-25

Which of the following statementsis correct concerning statisticalsampling in tests of controls? a. As the population size increases, the sample size should increase proportionately. b. As the assessed level of control risk (CR) increases, the sample size increases. c. There is an inverse relationship between the expected population exception rate and the sample size. d. In determining tolerable exception rate, an auditor considers detection risk (DR) and the sample size.


11-26

Which of the following factorsis (are) considered indetermining thesample size for a tests of controls?

a. b. c. d. 11-27

Expected Population Exception Rate (EPER) Yes No No Yes

Tolerable Exception Rate (TER) Yes No Yes No

A principal advantageof statistical methodof attribute sampleover non-statistical isthat the statistical methodprovides a scientific basis for planning the a. risk of assessing control risk too low. b. tolerable rate. c. expected population exception rate. d. sample size.

11-28

The risk of over-reliance oninternal controls(ARO) or the risk of assessingcontrol risktoo low ARACR) relateto the a. effectiveness of the audit. b. efficiency of the audit. c. preliminary estimates of materiality levels. d. tolerable misstatements.

11-29

Which of the following combinationsresults ina decrease insample size in attribute sample?

a. b. c. d. 11-30

ARO (ARACR) Increase Decrease Increase Increase

TER Decrease Increase Increase Increase

EPER Increase Decrease Decrease Increase

In planning a statistical sample for a test of controls, an auditor increased the EPER from the prior year’s rate because of the results of the prior year’s tests of controls and the overall control environment. The auditor most likely would then increase the planned

a. tolerable exception rate (TER). b. allowance for sampling c. risk of assessing controlrisk risk(ASR). too low (ARACR). d. sample size. 11-31

The sample size of a test of controls varies inversely with

a. b. c. d. 11-32

Expected Population Exception Rate (EPER) Yes No Yes No

Tolerable Exception Rate (TER) Yes No No Yes

For which of the following audit testswould an auditor most likely use attribute sampling? a. Making an independent estimate of the amount of a LIFO inventory. b. Examining invoices in support of the classification of fixed assets additions. c. Selecting accounts receivable for confirmation of account balances. d. Inspecting employee time cards for proper approval by supervisors.

11-33

Which of the following factorsis usually not consideredin determining thesample size for a test of controls? a. Population size, when the population is large. b. Tolerable exception rate. c. Risk of assessing control risk too low. d. Expected population exception rate.

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11-34

Which of the following factorsdoes an auditor usuallyneed to consider in planning a particular auditsample for a test of controls? a. Number of items in the population. b. Total dollar amount of the items to be sampled. c. Acceptable level of risk of assessing control risk too low. d. Tolerable misstatement.

11-35

Which of the following statements is true concerning statisticalsampling in tests of controls? a. The population size has little or no effect on determining sample size except for very small populations. b. The expected population exception rate has little or no effect on determining sample size except for very small populations. c. As the population size doubles, the sample size also should double. d. For a given tolerable exception rate, a larger sample size should be selected as the expected population exception rate decreases.

11-36

As a result of sampling proceduresapplied as tests of controls, anauditor incorrectlyassesses controlrisk (CR) lower than appropriate. The most likely explanation for this situation is that a. the exception rates of both the auditor’s sample (SER) and the population (PER) exceed the tolerable exception rate (TER). b. the exception rates of both the auditor’s sample (SER) and the population (PER) are less than the tolerable exception rate (TER). c. the auditor’s sample exception rate (SER) is less than the tolerable exception rate (TER), but the population exception rate (PER) exceeds the tolerable exception rate (TER). d. the auditor’s sample exception rates (SER) exceeds the tolerable exception rate (TER), but the population exception rate (PER) is less than the tolerable exception rate (TER).

11-37

In addition to evaluating thefrequency ofexceptions intests of controls, anauditor shouldalso consider certainqualitative aspects of the exceptions. The auditor most likely would give qualitative consideration of an exception if it was a. the only exception discovered in the sample. b. identical to an exception discovered during the prior year’s audit. c. caused by an employee’s misund erstanding of instructions. d. initially concealed by a forged document.


11-1 c. 11-2 c. 11-3 a. 11-4 b. 11-5 d. 11-6 d. 11-7 a. 11-8 c. 11-9 b. 11-10 b. 11-11a. 11-12 c. 11-13 b. 11-14 a. 11-15 b. 11-16 c. 11-17 d. 11-18 d. 11-19 a. 11-20 c. 11-21 a. 11-22 a. 11-23 d. 11-24 b. 11-25 b. 11-26 a. 11-27 d. 11-28 a. 11-29 c. 11-30 d. 11-31 d. 11-32 d. 11-33 a. 11-34 c. 11-35 a. 11-36 c. 11-37 d.


Simulation Question 11-1 Simulation Question 11-1 is developed by F. Choo in Financial a nd Integrated Audit s, a publication of the CSU AcademicPub in San Francisco, California.

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The Sampling Issues

Bon Jovi has just joined the CPA firm of Yao Ming & Associates LLP. His first audit engagement was Voyage Import & Export Inc. (hereafter VIE). Bon was assigned the specific audit objective of completeness and was to apply an attribute sampling plan to ascertain whether all the VIE shipments had been properly billed. He started out by considering the control risk (CR) of the design and operation of the VIE shipping and billing functions. Based on the evidence gathered on internal controls, Bon assessed the CR to be low. He reasoned that since CR was low, he could tolerate more departures from proper internal controls of the shipping and billing functions. Thus, he set his tolerable exception rate (TER) at a high percentage. For the same reason, Bon also set his acceptable risk of over-reliance (ARO) at a high percentage. Since Bon was new on the job, he looked up prior year’s audit working paper to formulate his expectation of the current syear’ population exception rate (EPER). Based on what was documented in the prior year’s audit working paper, he set the current year’s EPER to be the same at 1%. Bon then looked up the statistical sample sizes table to determine the sample size. But the sample size table showed a * symbol for the given ARO, TER, and EPER. At the bottom of the table, the * indicated that the sample size was too large to be cost effective. Bon was unsure how to proceed. He decided to look up prior year’s working paper and set the sample size to be the same, which were 0. 10 Bon then used a random number table to select 100 shipping documents for testing. He randomly read 100 numbers from the random number table. Next, he went to the VIE’s shipping department to search for the 100 bill of lading that matched the 100 random numbers from the random number table. However, he could only found 92 matching bill of lading. He decided to make up the 8 un-matched random numbers by 8 randomly selected bill of lading. Next, Bon vouched sales transactions in sales journal to the 100 selected bill of lading and customer orders. He found 2 shipments were not billed and 3 sales invoices were overstated by a total of $35,000. He documented a total of 5 exceptions and assumed they were all unintentional mistakes of the client’s shipping clerk. Finally, Bon looked up the statistical sample results evaluation table to determine the maximum population exception rate (MPER) for the 5 exceptions found. He then compared the MPER to the EPER and found the MPER to be marginally more than the EPER. He remembered the decision rule that if MPER was more than EPER, eh should just reject the management’s completeness assertion. Accordingly, Bon documented in his audit working paper that the specific audit objective of completeness was not meet.

Required 1. Assume you are the manager-in-charge of the VIE audit engag ement. Review Bon’s work to identify any incorrect assumption, statement, and computation in his application of the attribute estimation sampling technique in testing the completeness of bill of lading at VIE. You should identify at least a total of 10 such incorrect assumption, statement, and computation. 2. Based on your review in question 1, draft a review note to Bon pointing out his incorrect assumption, statement, and computation. Your review note should provide constructive criticism and feedback; for example, show Bon how to use the random number table properly.

Simulation Question 11-2 Simulation Question 11-2 is an adaptation with permission from an article by Lanza, R. B. in The the White Paper, a publication of the Association of Certified Fraud Examiners in Austin, Texas. This simulation question is based upon a true set of facts; however, the names and places have been changed. Bruce Lee was a member of an audit team who was assigned to inv estigate possible embezzlement at one retail store. Bruce’s responsibility was to examine the questionable actions of one of the cashiers named Helen Uddin. The regional manager of that retail store informed Bruce that he knew Helen was up to no good. “Maybe she is playing with her refunds or discounts, but something fishy is going on!” he lamented. Helen knew the store cameras and informants were watching her and that management regularly counted the cash. Therefore, Bruce determined that he would not be able to detect any unrecorded cash skimming schemes because, obviously, if there were no recorded sales then there were no sales transaction data. But Bruce knew that he could look for register adjustment schemes such as phony discounts, refunds, and sales voids. For example, Helen might say to a customer that her computer was down, wrote a manual receipt at the full price, and accepted cash for the sale. Then, after the customer left, she would book the sale with a large discount and take the difference in cash. Another scenario was Helen might book the sale with the large discount but never gave the receipt to the customer. Finally, Helen could fake a large number of refunds and sales voids. Bruce obtained a copy of the sales register data file from the MIS department of the retail store. You should access Data File 11-2 (Excel file) in iLearn for the sales register data file, which contains 10,240 sales transactions. After reviewing the sales register data file, Bruce planned to analyze the data to find out if Helen was in fact posting large number of phony discounts, sales voids and refunds. Bruce made y Helen’s employee number0000000003, and he planned to: cross-reference to his working papers on payroll cycle to identif 1. Extract sales with discounts over 90% and summarize by employee; 2. the top 10 employees by produced register adjustments (discounts,(discounts, refunds, and sales voids), andvoids) over 300 % more than the average employee. 3. List Identify employees that have register adjustments refunds, and sales Bruce conducted what he had planned to do and produced three reports as follows: Report No.1 – Extract sales with discounts over 90% and summarize by employee. Report No.2 – List the top 10 employees by register adjustments (discounts, refunds, and sales voids). Report No.3 – Identify employees that have produced register adjustments over 300% more than the average employee.

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2 (Word file) in iLearn for Bruce’s Reports 1, 2, andAfter 3. reviewing the three Reports, Bruce was You should access Data File 11-

confident that Helen (employee number 0000000003) is the number one suspect in the retail store. In light of this discovery, Bruce planned to use the attribute estimation sampling (AES) technique to test the retail store’s internal control (i.e., control procedure or control activity) over authorization of sales transactions (an entry of 1=Yes with authorization and 0=No with no authorization in the sales register data file).

Required Access Data File 11-2 (Excel file) in iLearn for the sales register data file, which shows a column of sales authorization with an entry of 1=Yes with authorization and 0=No with no authorization.

1. Refer to the 14 steps for implementing the AES technique in Chapter 11 and document how Bruce used the technique to test whether the retail store’s internal control (i.e., control procedure or control activity) over authorization of sales transactions was acceptabl e. Some information for using the AES techniques are given, you are to use them to complete the documentation. Documenting Bruce’s Application ofthe AES Technique 1. State the objective of Bruce’s test. … 2. Decide whether audit sampling applies. … 3. Define the exception condition. … 4. Define the population. … 5. Define the sampling unit. Bruce chose individual sales receipt number as the sample unit. 6. Specify the tolerable exception rate (TER). Bruce related his TERto the assessed level of CR as follows: CR TER low 2-6% moderate 7-10% high 11-20% The assessed level of CR is low and the TER was specified at 4%. 7. Specify the acceptable risk of over-reliance (ARO). Bruce related his ARO to the assessed level of CR as follows: CR ARO low 5% moderate 10% high 20% The assessed level of CR was low and the ARO was specified at 5%. 8. Estimate the expected population exception rate (EPER). Based on the exception rate found in a preliminary sample of 50, Bruce estimated the EPER to be 1%. 9. Determine the sample size. … 10. Select the sample item. Bruce used the systematic sample selection method as follows: … The random start sales receipt number was 1000000020 … 11. Perform the TOC procedure on sample items. … Bruce found _______ sales receipts without proper authorization, i.e., sales receipts with 0=No with no authorization in the sales register data file. 12. Evaluate the sample results. … 13. Analyze qualitative characteristics of exceptions. Bruce analyzed and found no qualitative characteristics of concern. 14.Draw a conclusion about the population. …

2. Do you think the resultof Bruce’s AES sampling test supports the fact that Helen probably embezzled from the retail store due to its weak internal control over proper authorization of sales transactions? a. If yes: i. Should Bruce take further actions such as expand the sample size and/or revise CR, TER, and ARO? Explain. ii. Should Bruce use an alternative sample selection method such as the random number sample selection method? Explain. iii. Should Bruce use an additional statistical sampling technique such as the discovery sampling technique? Explain. b. If no: i. Should Bruce take further actions such as expand the sample size and/or revise CR, TER, and ARO? Explain. ii. Should Bruce use an alternative sample selection method such as the random number sample selection method? Explain. iii. Should Bruce use an additional statistical sampling technique such as the discovery sampling technique? Explain.


Simulation Question 11-3 Simulation Question 11-3 is developed by F. Choo in Financial and Integrated Audits , a publication of the CSU AcademicPub in San Francisco, California.



The Sampling Issues

Curry, CPA, was engaged to audit Warriors Company’s financial statements for the year ended September 30. After studying Warriors’ internal control , Curry decided to obtain evidence about the effectiveness of both the design and the operation of the controls that may support a low assessed level of control risk (CR) concerning Warriors’ shipping and billing functions. During the prior years’ audits, Curry had used nonstatistical sampling approach, but for the current year Curry used a statistical sampling approach in the tests of controls to eliminate the need for judgment. Curry wanted to asses control risk (CR) at a low level, so a tolerable exception rate (TER) of 20 percent was established. To determine the maximum population exception rate (MPER), Curry decided to apply an attribute estimation sampling (AES) technique that would use an expected population exception rate (EPER) of 3 percent for the 8,000 shipping documents and to defer consideration of the acceptable risk of over-reliance (ARO) until the sample results were evaluated. Curry used the tolerable exception rate (TER), the population size, and the expected population exception rate (EPER) to determine that a sample size of 80 would be sufficient. When it was subsequently determined that the actual population was about 10,000 shipping documents, Curry increased the sample size to 100. Curry’s objective was to ascertain whether Warriors’ shipments had been properly billed. Curry took a sample of 100 invoices by selecting the first 25 from the first month of each quarter. Curry then compared the invoices to the corresponding prenumbered shipping documents. When Curry tested the sample, 8 exceptions were discovered. Additionally, one shipment that should have been billed at $10, 443 was actually billed at $10,434. Curry considered this $9 to be immaterial and did not count it as an error. In evaluation the sample results, Curry made the initial determination that a 5 percent risk of acceptable risk of over-reliance (ARO) was appropriate and, using the appropriate statistical sampling table, determined that for 8 observed exceptions from a sample size of 100, the maximum population exception rate (MPER) was 14 percent. Curry then calculated the difference between the actual sample exception rate (SER) of 8 percent and the expected population exception rate (EPER) of 3 percent. Curry reasoned that the actual sample exception rate (SER) of 8 percent was less than the maximum population exception rate (MPER) of 14 percent; therefore, the sample supported a low level of control risk (CR).

Required 1. Assume you are the manager-in-charge of the Warriors Company audit engagement. Review Curry ’s work to identify any incorrect assumption, statement, and computation in his application of the attribute estimation sampling technique in testing the shipping and billing functions at Warriors. You should identify at least a total of 5 such incorrect assumption, statement, and computation. 2. Based on your review in question 1, draft a review note to Curry pointing out his incorrect assumption, statement, and computation. Your review note should provide constructive criticism and feedback; for example, show Curry how to evaluate the sample results properly.

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Chapter 12 Audit Sampling for Tests of Balances Chapter Learning Outcomes (LOs) Checklist


LO12-1 Distinguish between Classical Variable Sampling (CVS) technique and Monetary Unit Sampling (MUS) technique in TOB.



LO11-2 Apply the 14 steps of a Monetary Unit Sampling (MUS) technique in TOB.


Chapter12 Audit Sampling for Tests of Balances Figure 12-1 shows where the audit sampling for tests of balances fits in the audit process. Figure 12-1 Audit Sampling for Tests of Balances

The Audit Process

Audit Plan

Tests of Controls

Tests of Balances


Audit Report










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Variable Sampling Plan

As explained in Chapter 11, the auditor can use one of two audit sampling approaches in tests of balances (TOB). These are statistical and non-statistical sampling approaches. If the auditor uses the statistical sampling approach, the sampling plan for testing the misstatement rate of an account balance or a class of transactions is called the variable sampling plan . Under the variable sampling plan, there are a number of audit sampling techniques for the TOB. These audit sampling techniques can be divided into two categories depending on which of the two statistical sampling theories from which they are derived. The two categories of audit sampling techniques are:



Classical variable sampling (CVS) technique. Classical variable sampling (CVS) techniques include mean-per-unit estimation, difference estimation, and ratio estimation. These techniques are derived from the normal distribution theory and they were popular in the past. In general, the CVS techniques are used when many errors are expected in the population. The population is defined as an account balance or a class of transactions.



Monetary unit sampling (MUS) technique. Monetary unit sampling (MUS) is a sampling technique that is derived from the attribute sampling theory and it is presently the most popular sampling technique for TOB. This technique is also known as probabilityproportional-to-size (PPS), Dollar Unit Sampling (DUS), and Cumulative Monetary Amount Sampling (CMA). In general, MUS is used only when a few misstatements are expected in the population. The population is defined as the individual dollar unit comprising the population's book value (PBV). Only the MUS technique is discussed here. Monetary Unit Sampling (MUS) Technique in TOB

A MUS technique uses the individual dollar in the population as a sampling unit. Each dollar in the population has an equal chance of being selected. However, when a dollar in the population is selected, the entire account balance or class of transactions of the selected dollar is subjected to TOB. This procedure results in a large account balance in the population having a greater probability of being selected, that is, the likelihood of selecting an account balance for testing is directly proportional to its size, hence, its other name "probability-proportional-to-size sampling technique" (PPS). Since a larger account balance or class of transactions have a higher probability of being selected, the MUS technique automatically stratifies the population, thereby rendering it the most appropriate technique for audit populations that are stratified. In addition, since larger account balance or class of transactions have a higher probability of being selected, the MUS is more likely to select overstatements than understatements, thereby rendering it the most appropriate technique for auditors desire to test material overstatements. The MUS technique for TOB involves 14 main steps as presented in Table 12-1. Table 12-1 Fourteen Steps in a MUS Technique for Tests of Balances

Steps in Monetary Unit Sampling (MUS) Technique 1. State the objective of the test. The objective of TOB is to determine whether a recorded account balance is fairly stated. The auditor chooses a variable sampling plan either to obtain evidence that a recorded account balance is not materially misstated (use MUS technique) or to develop an independent estimate of the true book value of the recorded account balance (use CVS technique). Depending on which type of variable sampling technique is used, the objective of the test will be stated accordingly. When MUS technique is used, the auditor is interested in testing whether the recorded account balance is fairly stated, and the characteristic of interest is the presence of monetary misstatement, that is, monetary difference between recorded and audited dollar amounts of the account balance. On the other hand, when CVS technique is used, the objective of the test is to develop an independent check of the accuracy of the recorded book valued by estimating its true book value. Example: An auditor is interested in testing that the recorded inventory account balance is not materially misstated. The auditor documents in the working paper: Audit Objective: To determine the proper valuation and allocation of the inventory account balance in terms of the monetary differences between the recorded and the audited dollar amounts of the inventory account balance. The TOB procedure is to use MUS sampling technique to select a sample of inventory accounts the purposeinventory of inventory unit-price compilation. The entire inventory $1,723,254. The population of for 50 individual accounts is documented as shown in Table 12-2. account balance, as at December 31st is

2. Decide whether audit sampling applies. The auditor examines the audit program (recall Chapter 10) and identifies account balances for which audit sampling technique applies. Example: The TOB procedure requires the application of the MUS technique to the recorded $ 1,723,254 book value of the inventory account balance.


Steps in Monetary Unit Sampling (MUS) Technique 3. Define the exception condition. A characteristic of the account balance or class of transactions that is of interest to the auditor is called a variable (hence the term a variable sampling plan). When this characteristic of interest to the auditor is absent, it is called an exception. Example: The characteristic of interest to the auditor is any misstatement in the recorded $1,723,254 book value of the inventory account balance.

4. Define the population. There are three basic factors to be considered in defining the population. (a) The defined population must be appropriate for the specific audit objective. For example, if an auditor's objective is to uncover unrecorded accounts payable, it will not be appropriate to define the population as all recorded accounts payable, since the population would not include unrecorded accounts. (b) The period covered by the population for TOB must be noted. (c) The defined population must contain the appropriate sampling unit. Depending on the audit objective, a sampling unit in a variable sampling plan may be a customer account balance, an individual transaction, an inventory account, and so on. In MUS technique, the population is defined as the total number of dollar units of the entire account balance or class of transactions, which is referred to as the population book value (PBV). Example: The auditor wants to perform the TOB procedure on the inventory account balance; hence, the audit population will be 1,723,254 dollar units, and the selected dollar units will subject individual inventory accounts for the TOB procedure. The individual inventory accounts may consist of debit balances, credit balances, and zero balances. In practice, credit balances (that is, negative balances) are often excluded from the sample and tested separately because they often contain characteristics not present in debit balances (that is, positive balances). In addition, zero balances (zero dollar balances) often require special consideration because they will never be selected.

5. Define the sampling unit. The sampling unit for TOB is almost always the item or individual accounts making the account balance. Example: The sampling unit is individual inventory accounts consisting of individual inventory names and balances.

6. Specify the tolerable misstatement rate (TMR). The tolerable misstatement rate (TMR) is the maximum monetary error that can exist in an account balance without causing the financial statements to be materially misstated. TMR is related to the auditor’s assessment of materiality (recall Chapter 9), and depending on which of the two categories of the variable sampling techniques is used, the TMR is specified as follows:

 In MUS technique, the auditor uses the preliminary judgment about materiality (PJAM) at the overall financial statement level and its allocation (i.e., tolerable misstatement, TM) to individual account balances to determine the tolerable misstatement rate. To illustrate, assume that the auditor quantifies the PJAM (based on materiality threshold, MT, recall Chapter 9) to be $500,000 for the financial statements taken as a whole and allocates $50,000 of TM to an inventory account balance. The TMR for the inventory account balance is therefore 10% ($50,000/500,000 x 100) of thepopulation book value (PBV) ($1,723,254) of the inventory account balance.  In CVS technique, the $ amount of the auditor’s allocation (TM) to individual account balances from the PJAM for the financial statement taken as a whole is the TMR (in $ amount). To illustrate, assume that the auditor decides to allocate $50,000 of TM from the PJAM of $500,000 to an inventory account balance, the TMR expressed in $ amount for the inventory account balance is therefore $50,000. The TMR is inversely related to the sample size. An increase in TMR will result in a decrease in the sample size, and a decrease in TMR rate will result in an increase in the sample size. The auditors must also consider that a smaller sample size reduces the probability of detecting a misstatement, and an unnecessary large sample size results in an inefficient use of audit time; thereby increasing audit costs. Example: The PJAM = $500,000. The auditor decides to allocate $50,000 of TM to the inventory account balance. The TMR for the inventory account balance = 10%. 7. Specify the acceptable risk of incorrect acceptance (ARIA). Two aspects of the sampling risk are critical in the TOB:

 Acceptable risk of incorrect rejection (ARIR). The acceptable risk of incorrect rejection (ARIR) is the risk that a sample supports the conclusion that a recorded account balance is materially misstated; when unknown to the auditor, the account is not materially misstated. Like the ARU in an attribute sampling plan discussed in Chapter 11, the ARIR relates to theefficiency of an audit. If an auditor makes an initially erroneous conclusion that an account balance is misstated, the auditor might unnecessary increase sample size, perform more TOB, and gather more evidence to conclude that the account is ultimately not materially misstated. Alternatively and less likely, the auditor might unnecessary propose an audit adjustment, thereby materially misstating an otherwise fairly stated account. In MUS technique, the ARIR is not specified (controlled). On the other hand, in CVS technique such a risk must be specified.  Acceptable risk of incorrect acceptance (ARIA). The acceptable risk of incorrect acceptance (ARIA) is the risk that a sample supports the conclusion that a recorded account balance is not materially misstated; when unknown to the auditor, the account is materially misstated. Like the ARO in an attribute sampling plan, the ARIA relates to the effectiveness of an audit, that is, the incorrect acceptance lessens the effectiveness of the audit as a means of detecting material misstatement by limiting the extent of TOB. If an auditor incorrectly accepts an account balance, the auditor will ordinarily not perform further tests or gather more evidence, thereby rendering the audited financial statements materially misstated and misleading. Both the MUS and CVS techniques require the ARIA to be explicitly specified. The auditor uses the following form of the audit risk model that is suggested AU 530 Audit Sampling to quantify the ARIA: AR =risk) IR X=CR DRof misstatements not detected by the auditor's specific TOB procedures. Since the auditor's TOB procedures where DR (detection theXrisk may involve a sampling or non-sampling approach, the DR component can be further divided into sampling risk and non-sampling risk. Sampling risk arises when the auditor uses a sampling approach for TOB, and it represents the risk of the sample characteristics not representing the population characteristics. Non-sampling risk (NSR) includes the risk of applying inefficient or ineffective analytical and TOB procedures. In addition, the sampling risk component can be further divided into the risk of incorrect rejection (ARIR) and the risk of incorrect acceptance

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Steps in Monetary Unit Sampling (MUS) Technique (ARIA). The audit risk model can therefore be expanded as follows: AR = IR X CR X DR ______________|______________ | | Sampling Risk Non-sampling Risk (NSR) __|____________ | | ARIR ARIA In MUS technique, the ARIR component is not specified, therefore, the audit risk model can be expanded by the remaining components as follows: AR IRaudit X CRrisk X NSR X the ARIA Given this form of=the model, ARIA is therefore ARIA = AR / (IR X CR X NSR) Example: The AR = 5%, IR = 100%, CR = 50%, and NSR = 67%. The acceptable risk of incorrect acceptance will be ARIA = 0.05 / (1.0 X 0.50 X 0.67) = 0.15 (or 15%).

8. Estimate the expected population misstatement rate (EPMR). As stated earlier, the MUS technique is most appropriate only when a few misstatements are expected. Zero expected population misstatement rate (EPMR) is commonly specified. Note, zero EPMR is commonly specified even when misstatements are expected in the population. Note also, this zero EPMRis always used for determining the reliability factor of the sample size formula in step 9. Example: EPMR = 0.

9. Determine the sample size. In MUS technique, the formula for determining sample size is PBV X RF n = __________________ TMR - (EPMR X EF) Where n = sample size PBV = population book value RF = reliability factor for specified ARIA TMR = tolerable misstatement rate EPMR = expected population misstatement rate EF = expansion factor

 Reliability Factor (RF) for Specified ARIA. As explained above, in the MUS technique, the ARIA is quantified using the expanded audit risk model: AR = IR X CR X NSR X ARIA The reliability factor measures the reliability (or confident level) of the auditor's assessment of the ARIA for a given number of misstatements detected in the sample. The reliability factor is determined from a reliability factor table (see Table 12-3) after the auditor derives the ARIA from the audit risk model and specifies the EPMR.  Expansion factor (EF) Since in the MUS technique, the EPMR is ordinarily set at zero (even when misstatements are expected in the population, zero EPMR is commonly specified), the (EPMR X EF) part of the sample size formula is not required because it will all be zero. Accordingly, the formula for determining sample size is reduced to: PBV X RF n = __________________ TMR The EF is related to the auditor’s ARIA. The EF is required only when the EPMR is set higher than zero and it is determined rom f a standard EF table. Example: ARIA = 15% and EPMR = 0. From Table 12-3, the RF is 1.9 being the intersection of the column associated with a 15% ARIA and the row for zero EPMR. After the RF is identified, the sample size (n) is calculated using the reduced formula of n = (PBV x RF)/TMR. Given PBV = $1,723,254 and TMR = 10%of PBV, the sample size, n = ($1,723,254 x 1.9)/(0.10 x 1,723,254) = 19.

10. Select the sample item. In MUS technique, the auditor commonlyuses the systematic sample selection method.Since the population is defined asthe individual dollar unit comprising the population book value (PBV), the sample interval (SI) is also based on the individual dollar unit and is calculated as follows:

Sample interval (SI) =

PBV _____________________ Sample Size


Steps in Monetary Unit Sampling (MUS) Technique To facilitate the sample selection process, the auditor customarily lists the individual account balances (known as logical units) in the population and compiles a cumulative listing based on their individual dollar balances. Individual account balances are then selected from the cumulative listing for the TOB procedure. Note, when a specific dollar unit in the cumulative list is selected, the entire account balance associated with that dollar unit is selected for testing. Example: The SI = PBV / n = 1,723,254/19 = $90,698. The first 10 inventory items to be selected by using the systematic sample selection method with an initial random start of $50,000 are shown in Table 12-4.

11. Perform the TOB procedure on sample items. For testing the selected sample items, the auditor examines each sample item for the variables of interest according to the predetermined audit program detailed in the audit working papers. In some instances, the supporting documents of certain sample items that are selected for testing may be missing. The auditor will need to exercise professional judgment on whether the missing documents for these sample items are misstated and whether they will affect the overall evaluation of the account balance or class of transactions. If the auditor judges that the missing documents for these sample units are misstated and that they will affect the overall evaluation of the account balance or class of transactions, the auditor will apply alternative TOB procedures to compensate for the lack of evidence caused by the missing documents. Example: price compilations to determine the value for each sample inventory account. The auditor’s TOB on the sample The auditor performs unitinventory accounts reveal three overstatements. They are inventory account #019 (scanner), #039 (Excel), and #041 (Motherboard). The audited values for these three inventory accounts are $60,000, $10,000, and $240,000, respectively.

12. Evaluate the sample results. After performing the TOB procedure on the sample items, and items containing misstatements tabulated, the auditor evaluates the sample results by projecting the detected sample misstatement (SM) to the entire population. However, the projected misstatement may not be a good representation of the true misstatement in the population. Accordingly, the auditors must also consider sampling risk, the risk that the sample characteristics are not representative of the population characteristics. Both categories of the variable sampling technique (CVS and MUS) project the SM to the population (PPM) by considering the sampling risk (ASR). The way SM is projected to the PPM depends on whether the auditor uses the MUS technique for observing onlyoverstatement misstatements or for observing bothoverstatement and understatement misstatements.

 Using MUS technique to observe only overstatement misstatements. In evaluating the sample results for overstatements, the auditor calculates a computed upper misstatement rate (CUMR), which is also known as upper misstatement limit (UML), upper error bound (UEB), upper precision limit (UPL), and estimated upper error limit (EUEL ). The CUMR is calculated as follows: CUMR

= PPM ______|______ | | SM (TP x SI)

+

ASR _________|_________ | | BP = (SI x RF) BP + IA

[For BV>SI] [For BVSI] Where CUMR = computed upper misstatement rate. PPM = projected population misstatement. SM = sample misstatement. TP = tainting percentage. SI = sample interval. ASR = allowance for sampling risk. BP = basic precision. RF = reliability factor for the specified ARIA. IA = incremental allowance. BV = book value of misstated sample item.

[For BV
The computed upper misstatement rate (CUMR) is analogous to the computed upper exception rate (CUER) in attribute sampling. The CUMR is an estimate of the maximum population misstatement rate, that is, an estimate of the maximum amount of misstatement in the account under consideration. CUMR is calculated by adding up two components, the projected population misstatement (PPM) in the population added to the allowance for sampling risk (ASR). The projected population misstatement (PPM) is determined by the sample misstatement (SM) for each misstated sample items. The SM for each misstated sample items is calculated differently depending on whether the account balance or recorded book value (BV) of the SM is (1) equal to or greater than the sample interval (SI) or (2) less than the sample interval (SI). (1) When the BV of the SM is equal or greater than the SI When the BV of the SM is greater than the SI, any misstatement (i.e. book value, BV - audited value, AV) of the SM represents the misstatement rate of the entire SI and is projected in its entiretyto the PPM as follows: Misstatement (BV - AV) of SM = PPM. – AV) = $200 ($1,000 - $800 = $200). To illustrate, assume the BV of a SM is $1,000, the AV is $800, and the SI is $50, the PPM = (BV (2) When the BV of the SM is less than the SI – audited value, AV) of the SM only representscertain When the BV of the SM is less than the SI, any misstatement (i.e., book value, BV percentage , known as tainting percentage (TP), of the entire SI. The TP for SM is determined simply by dividing the misstatement (BV - AV) of the SM by its recorded or book value, BV. The calculated TP is then projected to the PPM by multiplying it with the SI as follows:

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Steps in Monetary Unit Sampling (MUS) Technique Misstatement (BV - AV) Tainting percentage(TP) = _______________________ BV and TP X SI = PPM To illustrate, assume the BV of a SM is $6,000, the audited value is $4000, and the SI is $12,000. The TP = 33% [(6,000 - 4,000) / $6,000 = 0.33]. The PPM = TP xSI = 0.33 X $12,000 = $3,960. The allowance for sampling risk (ASR) consists of two components: (1) basic precision (BP) and (2) incremental allowance (IA). (1) Basic precision (BP) The basic precision (BP) is allowance for (SI) the closeness of the estimate of projected sample misstatement to of theincorrect population misstatement. It is calculated by multiplying theansample interval by the reliability factor (RF) for the specified acceptable risk acceptance (ARIA). To illustrate, assume the SI = $100, the ARIA = 10%, and the EPMR = 0. From Table 12-3, the reliability factor is 2.31. Accordingly, the BP = SI x RF = $100 x 2.31 = $231. (2) The incremental allowance (IA) The incremental allowance (IA) for sampling risk is an allowance for the risk arising from not auditing all the sample items in the sample intervals. The IA for each SM is calculated differently depending on whether the account balance or recorded BV of the SM is (a) equal to or greater than the SI or (b) less than the SI. (a) When the BV of the SM is equal or greater than the SI When the BV of the SM is greater than the SI, any misstatement (i.e., book value, BV - audited value, AV) of the SM represents the misstatement rate of the entire SI and is projected in its entirety to the PPM. Accordingly, all sampling risk associated with that particular SI has been considered and it isnot necessary to calculate the incremental allowance (IA). To illustrate, assume the BV of a SM is $1,000, the AV is $800, and the SI is $50, the PPM = $200 ($1,000 - $800 = $200) and no IA for sampling risk is calculated. Thus, the ASR consists of only the basic BP. (b) When the BV of the SM is less than the SI When the BV of the SM is less than the SI, any misstatement (i.e., book value, BV – audited value, AV) of the SM only representscertain percentage , known as tainting percentage (TP), of the entire SI. The IA is determined in four steps: (i) Rank the PPM for SM indescending order of the TP. (ii) Multiply the ranked PPM by the incremental change in RF at a specified ARIA. (iii) Find the sum of the product in (ii). (iv) Subtract the total adjusted PPM from the initial PPM to obtain the IA for sampling risk. To illustrate, assume the BV forthree SM are $2,000, $3,000, and $6,000, respectively, and the audited values are$1,000, $1,000, and $4,000, respectively. The SI is $12,000 and ARIA is 5%. The TP and total PPM are: Misstated Account (SM) (BV-AV)

Tainting % (TP) (BV-AV)/BV

Projected Misstatement (PPM) TP x SI

__________________________________________________________________________ #1 $(2,000-1,000) =1,000 $1,000/2,000 =0.05 0.50 x 12,000 = 6,000 #2 $(3,000-1,000) =2,000 $2,000/3,000 =0.66 0.66 x 12,000 = 7,920 #3 $(6,000-4,000) =2,000 $2,000/6,000 =0.33 0.33 x 12,000 = 3,960 Total PPM $17,880 The IA for sampling risk is computed as follows: Account Projected No. of Incremental Projected No Misstatement Misstatement change in Misstatement x Increment . TP (PPM) RF RF (Adjusted PPM) _____________________________________________________________________________________________ 0 3.00 #2 0.66 $ 7,920 1 4.75 (4.75 –3.00) = 1.75 $7,920 x 1.75 = $13,860 #1 0.50 6,000 2 6.30 (6.30 - 4.75) = 1.55 6,000 x 1.55 = 9,300 – #3 0.33 3,960 3 7.76 (7.76 6.30) = 1.46 3,960 x 1.46 = 5,782 ________ Total adjusted PPM $28,942 17,880 Less total initial PPM $17,880 IA for sampling risk $11,062 The computed upper misstatement rate (CUMR) is the sum of the projected population misstatement (PPM) and allowance for sample risk (ASR) as follows: CUMR = PPM + ASR (ASR = BP + IA) To illustrate, PPM = $249,000, BP = $231, and IA = $11,062, the CUMR is: CUMR = $249,000 + ($231 + $11,062) = $260,293 Example: The auditor’s TOB on the 19 sample inventory accounts reveal three overstatements. They are inventory account #019 (scanner), #039 (Excel), and #041 (Motherboard). The audited values (AV) for the three accounts are $60,000, $10,000, and $240,000, respectively. The auditor computes the total PPM as follows:


Steps in Monetary Unit Sampling (MUS) Technique Inventory Book Audited Tainting PPM = Account No. Value Value (BV-AV) % (TP) = SI (TPXSI) (BV) (AV) (BV-AV)/BV ___________________________________________________________________________ #019 #039

$64,800 11,100

$60,000 10,000

$4,800 1,100

#041

241,112

240,000

1,112

0.07 0.10 N/A*

$90,690 90,690

$ 6,348 9,069 15,417 N/A 1,112 Total PPM $16,529

TP = (BV-AV)/BV For inventory account #019, TP = $4,800/64,800 = 0.07 For inventory account #039, TP = $1,100/11,100 = 0.10 PPM = TP X SI For inventory account #019, PPM = (0.07 X 90,690) = 6,348 For inventory account #039, PPM = (0.10 X 90,690) = 9,069 * For inventory account #041, its BV is greater than the SI, therefore, its (BV-AV) = $1,112 is projected to the PPM = $1,112 in its entirety. The auditor computes basic precision (BP) as follows: The BP = SI X RF = 90,698 X 1.9 = $172,326. The auditor computes incremental allowance (IA) as follows: For inventory account #041, since its BV, $241,112, is greater than the SI, therefore, no IA is computed. For inventory account #019 and #039, their BV are less than the SI, the IA is computed as follows: Account Projected No.of Incremental Projected No Misstatement Misstatement change in Misstatement x Increment . TP (PPM) RF RF (Adjusted PPM) _____________________________________________________________________________________________ 0 1.90 #039 0.10 $ 9,069 1 3.38 (3.38 –1.90) = 1.48 $9,096 x 1.48 = $13,422 #019 0.07 6,348 2 4.72 (4.72 - 3.38) = 1.34 6,348 x 1.34 = 8,506 ________ Total adjusted PPM $21,928 $15,417 Less total initial PPM $15,417 IA for sampling risk $ 6,511 The CUMR is the sum of the PPM and ASR as follows: CUMR = PPM + ASR (where ASR = BP + AI) = $16,529 + 172,326 + 6,511 = $195,366

 Using MUS technique to observe both overstatement and understatement misstatements. The application of MUS technique to observe both overstatement and understatement misstatements follows the same procedure as that used only for overstatement misstatements. Five minor procedural differences are as follows: (1) Place observed overstatements and understatements into two separate groups - one for overstatements and one for understatements. (2) Determine the TP for each observed misstatement in the overstatement group and the understatement group. (3) Determine the total PPM in the overstatement group and the understatement group. (4) Determine the IA for sampling risk in the overstatement group and the understatement group. (5) Determine the CUMR for the overstatement group, CUMR o, and the understatement group, CUMR u. Example: The auditor's TOB on the sample inventory accounts reveal: Three overstatements. They are inventory account #019 (scanner), #039 (Excel), and #041 (Motherboard). The audited values for these three inventory accounts are $60,000, $10,000, and $240,000, respectively. Two understatements. They are inventory account #011 (Pentium Chip) and #029 (Microsoft Word). The audited values for these two accounts are $644,270 and $79,890, respectively. For the overstatement group: The auditor determines CUMR for the overstatement group, CUMR o, in the same manner as when the MUS technique is used to observe only overstatement misstatements. That is, CUMRo = PPM + ASR (ASR = BP + AI) = $16,529 + 172,326 + 6,511 = $195,366 For the understatement group: The auditor determines of the CUMR for the understatement group, CUMR u, as follows:

311

312


Steps in Monetary Unit Sampling (MUS) Technique Compute TP and PPM. Inventory Book Audited Tainting Projected Account Value Value (BV-AV) % (TP) (SI) (TPXSI) _______________________________________________________________________________ #029 #011

$78,890 $79,890 642,270 644,270

$1,000 $2,000

0.01 N/A*

90,690 $ 906.9 N/A 2,000.0 Total PPM $2,906.9

TP =inventory (BV-AV)/BV For account #029, TP = $1,000/78,890 = 0.01 PPM = TP X SI For inventory account #029, PPM =(0.01 X 90,690) = $906.9 * For inventory account #011, its book value is greater than the sample interval, therefore, its (BV-AV) = $2,000 is projected to the PPM = $2,000 in its entirety. Compute incremental allowance. For inventory account #011, since its book value, $642,270, is greater than the sample interval, therefore, no incremental allowance (IA) is computed. For inventory account #029, its book value is less than the sample interval, the incremental allowance is computed as follows: Account Projected No. of Incremental Projected No Misstatement Misstatement change in Misstatement x Increment . TP (PPM) RF RF (Adjusted PPM) _____________________________________________________________________________________________ 0 1.90 #029 0.01 $ 906.9 1 3.38 (3.38 –1.90) = 1.48 $906.9 x 1.48 = $1,342.2 ________ Total adjusted PPM $1,342.2 $ 906.9 Less total initial PPM $ 906.9 IA for sampling risk $ 435.3 The computed upper misstatement rate for the understatement, CUMR u, is the sum of the PPM and ASR as follows: CUMRu = PPM + ASR (where ASR = BP + AI) = $2,906.9 + 172,326 + 435.3 = $175,668

13. characteristics of exceptions. LikeAnalyze in attributequalitative sampling, the auditor also considers the qualitative characteristics, such as the nature and cause of the detected misstatement. For example, misstatements that result from intentional misrepresentations (frauds), rather than those that are due to misunderstanding of instructions ’s overall evaluation of the sample account balance or class of transactions, and the choice or carelessness, will have more impact on the auditor of alternative TOB procedures. Example: Before an overall conclusion about the acceptability of the inventory account balance is made, the auditor should consider the qualitative characteristics of the sample inventory account misstatements. For example, the auditor should consider whether the sample misstatements (SM) are errors or frauds. Also, if the SM indicates that the initial assessment of the client's CR used in determining the ARIA is inappropriate, the auditor should reconsider the ARIA and redesign the sampling plan. Finally, if the SM provides evidence inconsistent with corroborative evidence gathered from performing analytical procedures and other TOB procedures, the auditor should re-evaluate the assertion supported by the evidence.


Steps in Monetary Unit Sampling (MUS) Technique 14. Draw a conclusion about the population.

 When the MUS technique is used toobserve only overstatement misstatements To draw a conclusion when the MUS technique is used to only observe overstatement misstatement, the auditor compares the CUMR with TMR. If the CUMR is less than the TMR, the auditor canstate statistically that the client's book value is fairly stated at the specified level of ARIA. However, the precise procedure of comparing CUMR and TMR depends on whether misstatements are found in the sample: (1) No Misstatement found in the sample. If the auditor finds no misstatement in the sample, then the CUMR is equal to the basic BP: Since CUMR = PPM + ASR, if SM = 0, then TP = 0 and PPM = 0, also SM = 0, then IA = 0, and ASR = BP, therefore CUMR = BP. If no misstatement is found, both thesample misstatement (SM) and tainting percentage (TP) are equal to zero.Therefore, the projected population misstatement (PPM) is zero. In addition, the allowance for sample risk is equal to the basic precision (BP) because the incremental allowance (IA) for sampling risk is not computed when there is no misstatement. Accordingly, when no misstatement is found, the computed upper misstatement rate (CUMR) is simply equal to the basic precision (BP). The auditor makes a statistical statement about the population book value (PBV) by comparing the CUMR with the TMR. To illustrate, assume the SI is $100, the ARIA is 10%, and the EPMR is zero. From Table 12-3, the RF is 2.31 for ARIA = 10% and EPMR = 0. Therefore, the BP = (SI x RF) = ($100 x 2.31) = $231.Since no misstatement is found, SM = 0 and TP = 0. Therefore, ethPPM = 0. Moreover, there is no IA when nomisstatement is found. The CUMR is simply: CUMR = PPM + BP + IA = 0 + $231 + 0 = $231. The auditor makes a statistical statement about the population book value (PBV) by comparing the CUMR with the TMR. Assume the PBV is $5,000 and the TMR is $500, the auditor can conclude that the PBV, $5,000, is not overstated by more than $231 at a 10% ARIA. (2) Misstatement found in the sample When misstatements are found, the auditor determines all the subcomponents of the CUMR: (a) the SM whose book values are equal or greater than the SI, (b) the TP for misstatements whose book values are less than the SI, (c) the BP, and (d) the IA for SM whose book values are less than the SI. No IA is computed for SMwhose book values are equal or greater than theSI. Finally, the auditor makes a statistical statement about the PBV by comparing the CUMR with the TMR. To illustrate, SM = $213,000, (TP x SI) = $36,000, BP = $231, and IA = $11,062, the CUMR is: CUMR = PPM + ASR CUMR = [SM + (TPXSI)] + (BP + IA) CUMR = (213,000 +$36,000) + ($231 + $11,062) = $260,293 Assume the ARIA is 5%, the PBV is $10,000,000, and the TMR is $500,000, the auditor can state statistically that the PBV, $10,000,000, is not overstated Example: by more than $260,293 at a 5% ARIA. To draw a conclusion, the auditor compares the CUMR with the TMR. Since TMR = $172,325, CUMR = $195,366, and CUMR > TMR, the auditor can state statistically that the client's inventory book value is materially misstated at 15% ARIA. The auditor draws a final conclusion that the inventory book value is not acceptable if (1) as indicate by the comparison of CUMR and TMR, the inventory book value is materially overstated at 15% ARIA, (2) evidence gathered from other TOB procedures is consistent with the sample results, and (3) qualitative analysis of the misstatements indicates no fraud.

 When the MUS technique is used to observe both overstatement and understatement misstatements To draw a conclusion when the MUS technique is used to observe both overstatement and understatement misstatements, the auditor compares the CUMRo and CUMRu with the TMR for the overstatement group, TMR o and the understatement group, TMR u and makes a statistical statement about the PBV using the following statistical decision rule: (1) If both the CUMRo and CUMRu fall between the TMRo for the overstatement and the TMRu for the understatement groups, the auditor can state statistically that the PBV is not materially misstated. (2) If either the CUMRo or CUMRu falls outside the TMRo for the overstatement and the TMRu for the understatement groups, the auditor can state statistically that the PBV is materially misstated. The decision rule can be depicted as follows: Both the CUMRo and CUMRu fall between the TMRo and TMRu, the PBV is not materially misstated. TMR0u TMR |_________________|____________________| CUMRu CUMRo |_____________________|

o

313

314


Steps in Monetary Unit Sampling (MUS) Technique Either the CUMRo or CUMRu falls outside the TMRo and TMRu, the PBV is materially misstated. TMR0u TMR |_________________|____________________|

o

CUMRu CUMRo |_____________________________|

Either the CUMRo or CUMRu falls outside the TMRo and TMRu, the PBV is materially misstated. TMR0u TMR |_________________|____________________|

o

CUMRu CUMRo |______________________________________|

Example: To draw a conclusion, the auditor compares CUMR o and CUMRu with TMRo and TMRu: CUMRo = $195,399 which is greater than TMR o = $172,325. CUMRu = $175,668 which is greater than TMR u = $172,325. Since both the CUMRo and CUMRu fall outside the TMRo for the overstatement and the TMRu for the understatement groups, the auditor can state statistically that the PBV is materially misstated at 15% ARIA. The decision rule can also be depicted in the form of a diagram as follows: = TMR $172,325 u

0

TMR

o = $172,325

|__________________|_____________________|

CUMRu CUMRo = $175,668 = $195,399 |__________________________________________________|


Table 12-2 A list of Individual Inventory Accounts Inventory Account Number

Description of Inventory

Recorded Book Value

Cumulative Monetary Amount

________________________________________________________________ #001 #002 #003 #004 #005

Bubble jet printer CD-Rom drive Keyboard Multi-media speakers Port

$ 24,410 79,130 460 2,355 1,225

$ 24,410 103,540 104,000 106,355 107,580

#006 #007 #008 #009 #010 #011 #012 #013 #014 #015 #016 #017 #018 #019 #020 #021 #022 #023 #024 #025 #026 #027 #028 #029 #030 #031

Laptop Sound blaster card Video card Fax/modem Surge protector Pentium chip Cords Anti-glare screen Mouse Joystick Dot-matrix printer Ethernet card Floppy drive Scanner Laserjet printer Graphic card Internal battery Ac/dc adapter MS-DOS Windows QEMM Lotus 1-2-3 Word Perfect Microsoft Word Wordstar Quicken

28,210 3,380 710 525 755 642,270 550 3,585 8,960 4,520 3,380 5,530 3,995 64,800 117,140 4,865 770 2,305 965 55,600 425 5,663 6,250 78,890 2,440 35,935

135,790 139,170 139,880 140,405 141,160 783,430 783,980 787,565 796,525 801,045 804,425 809,955 813,950 878,750 995,890 1,000,755 1,001,525 1,003,830 1,004,795 1,060,395 1,060,820 1,066,483 1,072,733 1,151,623 1,154,063 1,189,998

#032 #033 #034 #035 #036 #037 #038 #039 #040 #041 #042 #043 #044 #045 #046 #047 #048 #049 #050

Norton Antivirus Freelance SPSS+ Flight Simulator XtreeGold Desqview CAD Excel Dbase Motherboard 486 Hard disk drive SVGA monitor Connector Myst 7 Guest Corel gallery G encyclopedia Microsoft pub Expert maps

5,595 1,830 4,045 9,480 3,360 2,145 6,400 11,100 8,435 241,112 68,000 45,988 432 56,000 40,876 458 3,000 18,000 7,000

1,195,593 1,197,423 1,201,468 1,210,948 1,214,308 1,216,453 1,222,853 1,233,953 1,242,388 1,483,500 1,551,500 1,597,488 1,597,920 1,653,920 1,694,796 1,695,254 1,698,254 1,716,254 1,723,254 ________

Total inventory account balance

$ 1,723,254 (PBV)

=====

315

316


Table 12-3 Reliability Factor for Specified Risk of Incorrect Acceptance _____________________________________________________________ Number* Risk of Incorrect Acceptance of Mis- _____________________________________________________ statements 1% 5% 10% 15% 20% 25% 30% 37% 50% _____________________________________________________________ 0 1 2

4.61 3.00 6.64 4.75 8.41 6.30

2.31 1.90 3.89 3.38 5.33 4.72

1.61 1.39 1.21 1.00 0.70 3.00 2.70 2.44 2.14 1.68 4.28 3.93 3.62 3.25 2.68

3 10.05 9.16 7.76 8.00 6.69 7.27 6.02 6.73 5.52 6.28 5.11 5.90 4.77 5.43 4.34 4.68 3.68 4 11.61 5 13.11 10.52 9.28 8.50 7.91 7.43 7.01 6.49 5.68 6 14.57 11.85 10.54 9.71 9.08 8.56 8.12 7.56 6.67 7 16.00 13.15 11.78 10.90 10.24 9.69 9.21 8.63 7.67 8 17.41 14.44 13.00 12.08 11.38 10.81 10.31 9.68 8.67 9 18.79 15.71 14.21 13.25 12.52 11.92 11.39 10.74 9.67 10 20.15 16.97 15.41 14.42 13.66 13.02 12.47 11.79 10.67 11 21.49 18.21 16.60 15.57 14.78 14.13 13.55 12.84 11.67 12 22.83 19.45 17.79 16.72 15.90 15.22 14.63 13.89 12.67 13 24.14 20.67 18.96 17.86 17.02 16.32 15.70 14.93 13.67 14 25.45 21.89 20.13 19.00 18.13 17.40 16.77 15.97 14.67 15 26.75 23.10 21.30 20.13 19.24 18.49 17.84 17.02 15.67 16 28.03 24.31 22.46 21.26 20.34 19.58 18.90 18.06 16.67 17 29.31 25.50 23.61 22.39 21.44 20.66 19.97 19.10 17.67 18 30.59 26.70 24.76 23.51 22.54 21.74 21.03 20.14 18.67 19 31.85 27.88 25.91 24.63 23.64 22.81 22.09 21.18 19.67 20 33.11 29.07 27.05 25.74 24.73 23.89 23.15 22.22 20.67 _____________________________________________________________ * Number of misstatement applies to overstatements but not understatements, as negative and zero balances are often excluded from the sample and tested separately. Source: AICPA, Audit andAccounting Guide,Audit Sampling.

Table 12-4 The Selection of the First 1 0 Sample Inventory Accounts The SI = BV / n = 1,723,254/19 = $90,698. The random start is $50,000, the first 10 sample inventory accounts are: Dollar Unit Selected Account Selected Balance to Test Cumulative Amount ________________________________________________________________________________________________________ 50,000th 1. #002 CD-Rom drive $ 79,130 103,540 50,000+1(90,698) = 140,698 2. #010 Surge protector 755 141,160 50,000+2(90,698) = 231,396 3. #011 Pentium chip 642,270 783,430 50,000+3(90,698) = 322,094 No matching account 50,000+4(90,698) = 412,792 No matching account 50,000+5(90,698) = 503,490 No matching account 50,000+6(90,698) = 594,188 No matching account 50,000+7(90,698) = 684,886 No matching account 50,000+8(90,698) = 775,584 No matching account 50,000+9(90,698) = 866,282 4. #019 Scanner 64,800 878,750 50,000+10(90,698)= 956,980 No matching account 50,000+11(90,698)=1,047,678 5. #025 Windows 55,600 1,060,395 50,000+12(90,698)=1,138,368 6. #029 Microsoft Word 78,890 1,151,623 50,000+13(90,698)=1,229,058 7. #039 Excel 11,100 1,233,953 50,000+14(90,698)=1,319,748 8. #041 Motherboard 486 241,112 1,483,500 50,000+15(90,698)=1,410,438 No matching account 50,000+16(90,698)=1,501,128 9. #042 Hard disk drive 68,000 1,551,500 50,000+17(90,698)=1,591,818 10. #043 SVGA monitor 45,988 1,597,488 ______________________________________________________________________________________________________



It is wrong for the auditor to conclude that the population misstatementrate will be exactly the same as the sample misstatement rate because a. sample size is independent of population size. b. there are not enough items in the sample to make that conclusion. c. the population is less than 5000. d. the presence of sampling risk representingthe probability that the sample characteristics will not be representative of the population characteristics.

12-2

When MUS technique is used to examine the book value of inventories, each inventory a. has an unknown probability of being selected. b. has an equal probability of being selected. c. has a probability proportional to its dollar value of being selected. d. has a probability proportional to one dollar unit.

12-3

When MUS technique isused to examine the book value of inventory, ifthe 80th dollar of inventory isselected, a. the entire inventory account associated with the 80th dollar is examined. b. an inventory account withexactly $80 is examined. c. an inventory account more than $80 is examined. d. only the one 80th dollars in an inventory account is examined.

12-4

In MUS technique, assumingall other factors remain constant, whichone of the following would lead to a larger sample size? a. Higher detection risk, DR. b. Lower acceptable risk of incorrect acceptance, ARIA. c. Higher tolerable misstatement rate, TMR. d. Lower reliability factor, RF.

12-5

If MUS technique isused to observe both overstatements and understatement, abook value is rejected if a. both its computed upper misstatement rate, CUMR o, and computed lower misstatement rate, CUMR u, are within the tolerable misstatement range. b. its computed upper misstatement rate, CUMR is less than the tolerable error for overstatement. o c. its computed upper orupper lower and misstatement rate is beyond thewithin tolerable misstatement range. range. d. either the average of its computed lower misstatement rate is the tolerable misstatement

12-6

In MUS technique,assuming allother factorsremain constant, whichone of the followingwould lead to a smaller sample size? a. An increase in both the computed upper and lower misstatement rates bounds. b. A lower tolerable misstatement rate. c. A higher reliability factor, RF. d. A larger population size.

12-7

Which one of the following statements best describes what the auditor meant by incremental allowance in MUS technique? a. An allowance for the risk arising from auditing all the sample items in the sample intervals. b. An allowance for the risk arising from not auditing some of the sample items in the sample intervals. c. An allowance for the risk arising from not auditing the same sample items in the sample intervals. d. An allowance for the risk arising from not auditing all the sample items in the sample intervals.

12-8

When using MUS technique, evaluating the likelihood of unrecorded items in the population a. is impossible. b. is unnecessary. c. is possible but difficult. d. is an automatic outcome of the sampling process.

317

318


12-9

In MUS technique, the decision rule to determine whether the population is acceptable is “Accept the conclusion that the book value is not misstated by a material amount if

a. the upper error bound (CUMRO ) falls between the understatement and overstatement tolerable misstatement amounts.” b. both the lower (CUMRU) and upper (CUMRO) error bound falls between the understatement and overstatement tolerable misstatement amounts.” c. both the understatement and overstatement tolerable misstatement amounts fall between the upper (CUMR O) and lower (CUMRU) error bound.” d. the overstatement tolerable misstatement amount falls between the lower (CUMR O) and upper (CUMR U) error bound.” 12-10

In MUS technique, items containing large understatement errors a. have an increased probability of being included in the sample. b. are of less concern than those with large overstatement errors. c. may have a small recorded value due to those errors. d. all of the above.

12-11

The relationship betweensample size and the acceptable risk of incorrect acceptance (ARIA)is a. variable (sometimes large, sometimes small). b. inverse. c. direct. d. indeterminate.

12-12

In MUS technique, when using systematic sample selection method on accounts receivable, the sample interval is determined by a. consulting a random number table. b. dividing the population size by the accounts receivable with the largest dollar value. c. dividing the sample size by the account with the largest dollar value. d. dividing the population size by the desired sample size.

12-13

For MUS technique, normally the expected population exception rate (EPER) is a. 0% b. between 1% and 5%, inclusive. c. between 6% and 10% inclusive. d. greater than 10%.

12-14

In confirming a client’s accounts receivable in prior years, an auditor found that there were many differences between the recorded account balances and the confirmation replies. These differences, which were not misstatements, required substantial audit time to resolve. In defining the sample unit for the current year’s audit, the auditor most likely wouldchoose

a. small account balances. b. large account balances. c. individual overdue balances. d. individual invoices. 12-15

The acceptable risk of incorrect acceptance (ARIA) is related to the a. tolerable misstatement (TM) of the audit. b. preliminary judgment about materiality (PJAM) of the audit. c. efficiency of the audit. d. effectiveness of the audit.

12-16

While performing a TOB during an audit, an auditor determined that the sample results supported the conclusion that the recorded account balance was materially misstated. It was, in fact, not materially misstated. This situation illustrates the risk of a. acceptable risk of under-reliance (ARU). b. acceptable risk of over-reliance (ARO). c. acceptable risk of incorrect acceptance (ARIA). d. acceptable risk of incorrect rejection (ARIR).


12-17

Which of the following is not true about a probability-proportional-to-size (PPS) sampling technique? a. PPS automatically stratifies the population; therefore, it is appropriate for audit populations that are stratified. b. Inclusion of zero and negative balances in PPS often requires special consideration. c. An estimate of the standard deviation of the normally distributed population’s record amounts is required in PPS. d. In PPS, a larger account balance or class of transactions have a higher probability of being selected for testing.

12-18

When planning a sample for a TOB, an auditor should consider tolerable misstatement rate (TMR) for the sample. This consideration should a. be related to the auditor’s business risk. b. be related to the preliminary judgment about materiality (PJAM). c. be directly related to the sample size. d. be related to the reliability factor (RF).

12-19

Which of the following is correct concerning monetary unit sampling (MUS)? a. The sampling distribution should approximate the normal distribution in MUS b. Overstated units have a lower probability of sample selection than understated units in MUS c. The auditor controls the acceptable risk of incorrect acceptance (ARIA) by specifying that risk level for the MUS sampling plan. d. The sample interval is calculated by dividing the number of physical units in the population by the sample size in MUS

12-20

How would increases in tolerable misstatement rate (TMR) and acceptable risk of incorrect acceptance (ARIA) affect the sample size in a TOB?

a. b. c. d. 12-21

Increase in TMR Increase sample size Increase sample size Decrease sample size Decrease sample size

Increase in ARIA Increase sample size Decrease sample size Increase sample size Decrease sample size

Which of the following samplingplans is used to estimate a numerical measurementof a population, sucha dollar value? a. Attribute sampling plan. b. Stop-or-go sampling plan. c. Monetary unit sampling plan. d. Random-number sampling plan.

12-22

When planninga sample fora test of balance, an auditor shouldconsider tolerablemisstatement rate(TMR) for the sample. This consideration should a. be related to the auditor’s business risk. b. not be adjusted for qualitative factor. c. be related to preliminary judgments about materiality (PJAM) levels. d. not be changed during the audit process.

12-23

While performing atest of balances duringan audit, the auditor determinedthat the sample results supportedthe conclusion that the recorded account balance was materially misstated. It was, in fact, not materially misstated. This situation illustrates the risk of a. Incorrect rejection. b. Incorrect acceptance. c. Assessing control risk too low. d. Assessing control risk too high.

12-24

Which of the following samplingplanning factorswould influencethe sample size for a TOB for a specific account?

a. b. c. d.

Expected Amount of Misstatements No Yes No Yes

Measure of Tolerable Misstatement No Yes Yes No

319

320


12-25

Which of the following statementsis true concerning PPSsampling technique, alsoknown as MUS sampling technique? a. The sampling distribution should approximate the normal distribution. b. Overstated balances have a lower probability of sample selection than units that are understated. c. The auditor controls the risk of incorrect acceptance by specifying that risk level for the sampling plan. d. The sampling interval is calculated by dividing the number of physical units in the population by the sample size.

12-26

In MUS samplingtechnique, whichof the followingis correct forcalculating theallowance forsampling risk(ASR) when the basic precision (BP) is less than the sample internal (SI)? a. Projected Population Misstatement (PPM) + Incremental Allowance (IA). b. Basic Precision (BP) + Sample Interval (SI). c. Book Value of misstated sample item (BV) + Sample Interval (SI). d. Basic Precision (BP) + Incremental Allowance (IA).


12-1 d. 12-2 c. 12-3 a. 12-4 b. 12-5 c. 12-6 a. 12-7 d. 12-8 a. 12-9 b. 12-10 c. 12-11 b. 12-12 d. 12-13 a. 12-14 d. 12-15 d. 12-16 d. 12-17 c. 12-18 b. 12-19 c. 12-20 d. 12-21 c. 12-22 c. 12-23 a. 12-24 b. 12-25 c. 12-26 d.





The Sampling Issues

You are the manager-in-charge of auditing Bio Med Co. at South Francisco. For its current year audit, you are concerned that Mina Sung, a new recruit, may not perform her assigned task to the quality control standard of your CPA firm. She is assigned to apply MUS sampling to test the accounts receivable of Bio Med Co. Since you are responsible for supervising Mina, you ask her for a memo on her application of the MUS sampling procedures. Below is the memo she wrote to you:

MEMORANDUM

To: Audit Manager-in-Charge From: Mina Sung Date: 1/1/2013 Re: My work on applying MUS to Bio Med Co.’s Accounts Receivable I decided to apply an attribute sampling plan in performing tests of balances on Bio Med Co.’s accounts receivable. Specifically, I chose the MUS technique for confirming its accounts receivable because the MUS uses each account in the population as a separate sampling unit. Moreover, I expected to discover many misstatements, as such, the MUS would be an efficient technique for that purpose. I reasoned that the MUS would automatically result in a stratified sample because each account would have an equal chance of being selected for confirmation. Moreover, the selection of negative (credit) balances would be facilitated without special considerations. I computed the sample size using the materiality threshold (MT) from the preliminary judgment about materiality (PJAM), acceptable risk of incorrect acceptance (ARIA), the total recorded book amount of the receivables (PBV), and setting the expected population misstatement rate (EPMR) equal to 2. I then divided the PBV by the sample size to determine the sample interval and calculated the standard deviation of the dollar amounts of the accounts selected for evaluating the receivables. My calculated sample size was 100, and the sampling interval was determined to be $10,000. However, only 95 different accounts were selected because five accounts were so large that the sampling interval caused each of them to be selected twice. I proceeded to send confirmation requests to 90 of the 95 accounts receivables because five of the 95 selected accounts had insignificant recorded balances under $10. The confirmation process revealed two differences. One account with an audited amount of $1,000 had been recorded at $2,000. I projected this to be a $1,000 overstatement. However, I did not use a tainting percentage to determine the projected overstatement because I did not know how to do it. Another account with an audited amount of $3,000 had been recorded at $2,000. I did not project this understatement because the purpose of the MUS test was to detect only overstatements.

In evaluating result, I concluded that the total accounts receivable balance (PBV) was not overstated because the computed upper misstatement ratethe forsample the overstatement (CUMR O) is less than the tolerable misstatement rate for overstatement (TMR O) and the computed upper misstatement rate for the understatement (CUMR u) is more than the tolerable misstatement rate for understatement (TMR u).

Required 1. Review Mina’s memo for each incorrect assumption, statement, and computation in her application of the MUS technique in confirming Bio Med Co.’s accounts receivable. You should identify at least a total of 10 such incorrect assumption, statement, and computation.

2. Based on your review in question 1, draft a reply memo to Mina pointing out her incorrect assumption, statement, and computation. Your memo should provide constructive criticism and feedback; for example, show Mina how to use the tainting percentage to determine the projected misstatement.

Simulation Question 12-2 Simulation Question 12-2 is an adaptation with permission from an article by Lanza, R. B. in The the White Paper, a publication of the Association of Certified Fraud Examiners in Austin, Texas. This simulation question is based upon a true set of facts; however, the names and places have been changed. Bruce Lee was a member of an audit team who was assigned to investigate possible embezzlement at one retail store. Bruce’s responsibility was to examine the questionable actions of one of the cashiers named Helen Uddin. The regional manager of that retailstore informed Bruce that he knew Helen was up to no good. “Maybe she is playing with her refunds or discounts, but something fishyis going on!” he lamented. Helen knew the store cameras and informants were watching her and that management regularly counted the cash. Therefore, Bruce determined that he would not be able to detect any unrecorded cash skimming schemes because, obviously, if there were no recorded sales then there were no sales transaction data. But Bruce knew that he could look for register adjustment schemes such as phony discounts, refunds, and sales voids. For example, Helen might say to a customer that her computer was down, wrote a manual receipt at the full price, and accepted cash

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for the sale. Then, after the customer left, she would book the sale with a large discount and take the difference in cash. Another scenario was Helen might book the sale with the large discount but never gave the receipt to the customer. Finally, Helen could fake a large number of refunds and sales voids. Bruce obtained a copy of the sales register data file from the MIS department of the retail store. You should access Data File 12-2-1 (Excel file) in iLearn for the sales register data file, which contains 10,240 sales transactions. After reviewing the sales register data file, Bruce planned to analyze the data to find outif Helen was in fact posting large number of phony discounts, sales voids and refunds. Bruce made cross-reference to his working papers on payroll cycle to identify Helen’s employee number0000000003, and he planned to: 1. Extract sales with discounts over 90% and summarize by employee; 2.List the top 10 employees by register adjustments (discounts, refunds, and sales voids), and 3.Identify employees that have produced register adjustments (discounts, refunds, and sales voids) over 300 % more than the average employee. Bruce conducted what he had planned to do and produced three reports as follows: Report No.1 – Extract sales with discounts over 90% and summarize by employee. Report No.2 – List the top 10 employees by register adjustments (discounts, refunds, and sales voids). Report No.3 – Identify employees that have produced register adjustments over 300% more than the average employee. You should access Data File 122 (Word file) in iLearn for Bruce’s Reports 1, 2, andAfter 3. reviewing the three Reports, Bruce was confident that Helen (employee number 0000000003) is the number one suspect in the retail store. In light of this discovery, Bruce further suspected that Helen probably colluded with Janet, the bank deposit staff, to cover up her embezzlements by under reporting the daily bank deposits. Bruce obtained from Janet the daily bank deposit slips for the financial –year a total of 313 daily deposits.You should access Data File 12-2-2 (Excel file) in iLearn for the daily bank deposit data file, which shows the recorded 313 daily deposit amounts for the financial year. Bruce planned to use the monetary unit sampling (MUS) technique to test the total bank deposits for the financial year was not materially misstated. The audited daily deposit amounts are show in the last column of the daily bank deposit data file.

Required Access Data File 12-2-2 (Excel file) in iLearn for the daily bank deposit data file, which shows the recorded 313 daily deposit amounts and the audited daily deposit amounts for the financial year.

1. Refer to the 14 steps for implementing the MUS technique in Chapter 12 and document how Bruce used the technique to test the total bank deposits for the financial year was not materially misstated. Some information for using the MUS techniques are given, you are to use them to complete the documentation. Documenting Bruce’s Application of the MUS Technique 1. State the objective of Bruce’s test. … 2. Decide whether audit sampling applies. … 3. Define the exception condition. … 4. Define the population. … 5. Define the sampling unit. Bruce used individual daily bank deposit slips as the sample unit. 6. Specify the tolerable misstatement rate (TMR). Based on the TM that was allocated from PJAM tobank deposits, Bruce calculated the TMR = 5% of the $ 41,712,455 total bank deposits. 7. Specify the acceptable risk of incorrect acceptance (ARIA). Based on the expanded audit risk model AR = IR X CR X NSR X ARIA, Bruce calculated the ARIA = 15%. 8. Estimate the expected population misstatement rate (EPMR). Following AICPA’s guidance, Bruce specified EPMR = 0%. 9. Determine the sample size. … 10. Select the sample item. Bruce used the systematic sample selection method as follows: … The random start daily bank deposit amount was $ 100,000. … 11. Perform the TOB procedure on sample items. … Bruce found _______ daily bank deposits were understated, i.e., sample daily deposit amounts in the audited daily deposit amount column were less than those in the recorded daily deposit amount column in the daily bank deposit data file. 12. Evaluate the sample results. Bruce calculated the CUMRU = $4,338,246 and CUMRO = $213,000. 13. Analyze qualitative characteristics of exceptions. Bruce analyzed and found no qualitative characteristics of concern. 14. Draw a conclusion about the population. …


2. Do you think the result of Bruce’s MUS sampling test supports the fact that Helen probably covered up her embezzlements by colluding with Janet to under report the daily bank deposits of the retail store? that B ruce might take t o confirm Helen’s embezzlements: a. If yes, suggest at least three further ctions/procedures a i. Further actions/procedures … ii. Further actions/procedures … iii. Further actions/procedures … b. If no, i. Should Bruce take further cations such as expandthe sample size and/orrevise PJAM/TM or NSR?Explain. ii. Should Bruce use an alternative sample selection method such as the andom r number sample selection method? Explain. iii. Should Bruce use an additional statistical sampling technique such as the mean-per-unit estimation technique? Explain.




Your MUS Sampling

a client’s accounts receivable balance. Few, if any, You have decided to use MUS (Monetary Unit Sampling technique) in testing misstatements of account balance overstatement are expected.

Required 1. Compare and contrast MUS (Monetary Unit Sampling technique) with CVS (Classical Variable Sampling technique) for TOB (Tests of Balances). 2. Calculate your sample size using MUS given the following information: Recorded amount of accounts receivable (PBV) = $330,482.73 Tolerable misstatement rate = 10% Expected population misstatement rate (EPMR) = 0 Acceptable risk of incorrect acceptance (ARIA) = 15% 3. Calculate your sample interval using systematic sample selection method. 4. Calculate your CUMR (Computer Upper Misstatement Rate) using MUS to observe only overstatement misstatements and given the following information: Sample misstatement (SM) = $2,986.54 Projected population misstatement (PPM) = $3,187.80 Allowance for sampling risk (ASR) = $165,976.20 5. Based on your above calculations, draw a statistical conclusion on whether the client’s accounts receivablebalance is materially overstated at 15% ARIA.

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Chapter 13 Revenue Cycle – Tests of Controls and Tests of Balances Chapter Learning Outcomes (LOs) Checklist


LO13-1 Understand the accounting information system of a typical revenue cycle.



LO13-2 Describe some common TOC procedures for sales.



LO13-3 Describe some common TOC procedures for cash receipts.



LO13-4 Apply the analytical procedures in a revenue cycle.



LO13-5 Describe some common TOB procedures for accounts receivable.



LO13-6 Distinguish between positive and negative accounts receivable confirmations.



LO13-7 Identify the factors for choosing between positive and negative accounts



LO13-8 Understand TOB cut-off procedures for sales and sales returns.

receivable confirmations.


Chapter 13 Revenue Cycle – Tests of Controls and Tests of Balances An overview of the strategy for tests of controls in a revenue cycle is presented in Figure 13-1. Figure 13-1 TOC Strategy in Revenue Cycle

The Audit Process

Audit Plan

Tests of Controls

Tests of Balances


Audit Report











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Understand Internal Controls in a Revenue Cycle

TOC strategy in a revenue cycle starts with an understanding of internal controls relating to a revenue cycle. Table 13-1 provides a brief discussion of the various components relating to the understanding of internal controls in a revenue cycle. Table 13-1 Understanding Internal Controls in a Revenue Cycle

Understanding Internal Control in a Revenue Cycle 1. Control environment

2. Risk assessment

3. Control activities

4. Information andcommunication

5. Monitoring

Table 8-1 in Chapter 8 listed seven factors affecting the control environment. Since these factors affect all accounting understanding of the control environment is generally conducted for allfactors the accounting cycles takencycles, as a whole. The auditor should, however, consider any control environment that may have a special effect on the revenue cycle. Table 8-1 in Chapter 8 listed the five basic management assertions that must be met by the management’s risk assessment. The auditor must understand how management assesses risks that are relevant to the revenue cycle, estimates their significance, assesses the likelihood of their occurrence, and takes action to address those risks in order to meet the five basic management assertions. Table 8-1 in Chapter 8 listed the five basic control activities that must be established in an accounting cycle. If the auditor plans to conduct both TOC and TOB on the revenue cycle, then s/he needs to identify the control activities relating to specific audit objectives and for the purpose of assessing control risk (CR). The auditor usually identifies these control activities from documentations of the understanding using narrative descriptions, internal control questionnaires, or flowcharts. Figure 13-8 shows an example of a revenue cycle flowchart. The auditor mustobtain sufficient knowledgeof the accounting information system relatingto the revenue cycle to ensure that the TOC and TOB procedures meet the eight types of specific audit objectives listed in Table 8-1 in Chapter 8. Specifically, the auditor must obtain sufficient knowledge in three areas as shown in Figure 13-2. A brief discussion of these three areas is provided in Table 13-2. The auditor must understand the management’s monitoring processes over the revenue cycle. This includes understanding how the management monitors the internal controls of the revenue cycle over time and what corrective action is initiated to improve the design and operation of controls in the revenue cycle.

Figure 13-2 Understanding of Information and Communication in a Revenue Cycle

Key Functions

Understand 8 key functions of a revenue cycle

Accounts and Classes of Transactions Understand how the 8 key functions are recorded in accounts and grouped in classes of transactions

Documents and Records Understand how the accounts and classes of transactions are supported by documents and records


Table 13-2 Understanding of Information and Communication in a Revenue Cycle

Accounts and Classes of Transactions

Key Functions

Accounts (control ledger) 1. Order entry Accepting and processing customer orders for goods and services.

 

Sales

Accounts receivable

Classes of Transactions



Sales

Documents and Records (form, list, schedule, report, book, subsidiary ledger, file)

 Customer (Purchase) order This document contains the details of the type and quantity of products or services ordered by the customer. It may be forwarded by a the salesperson, received throughinthe on-line order order over internet. It is frequently themail, form fax, of aor purchase prepared by the customer's purchasing department. Purchase orders are generally recorded on sale invoices so that the auditors can match the purchase order to which a sales invoice relates. Figure 13-3 shows an example of a purchase order from customer.

 Sales order An internally prepared document that specifies the goods or services requested in the customer order. The sales order generally records the customer's purchase order number, a description of the goods, the quantity, price, credit terms, and shipping terms. The auditors can check for the numerical sequence of the sales orders to determine that shipments are made for all sales orders and that all sales are billed. Figure 13-4 shows an example of a sales order.  Customer order file A file of unfilled customer orders. The auditor inspects the customer order file for explanations of an unusually large number of unfilled customer orders. 2. Credit authorization Approving and granting customer orders.

 Credit approval form A form that approves credit granted to a customer. This form is also used to establish the credit limit of the customer.  Approved customer list A list of customers in good standing. Orders from customers on this list can be accepted without special approval. The auditor inspects the approved customer list for proper authorization of credit terms.

3. Shipping Shipping of goods that have been authorized.

 Shipping document A document that specifies the terms (F.O.B. srcin or F.O.B. destination), date, description, and quantity of goods shipped to customers. The shipping document may be in the form of a bill of lading, a document governed by the Uniform Commercial Code, which serves as a contract between a seller and a freight carrier, and a formal acknowledgment of the receipt of goods for delivery by the freight carrier. The auditors check for the signature of the freight carrier on the bill of lading to provide external evidence that goods have been shipped. Figure 13-5 shows an example of a bill of lading.

4. Billing Billing customers for goods shipped or services provided and recording sales.

 Sales invoice A document used to bill customers for goods or services, specifying the description, quantity, and price of goods sold and the date and terms of sales. The auditors use the sales invoices to identify credit terms, shipping terms, and prices charged for merchandise. The auditors also account for the numerical sequence of the sales invoices to ensure that all sales are recorded. Figure 13-6 shows an example of a sales invoice.  Sales journal A book of srcinal entry that records credit sales transactions. Some clients record each credit sale in the sales journal and others accumulate a total for a day or a week and record them. The auditor checks the sales journal for srcinal entries of credit sales.

 Accounts receivable subsidiary ledger (file) A record of sales, cash receipts, and sales returns and allowances

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Key Functions

Accounts (control ledger)



for each customer. The auditors check the accounts receivable subsidiary ledger to confirm the closing balance for each customer.

 Monthly statement A document sent to customers each month showing opening balance, transactions for sales, sales adjustments, and cash collections during the months, and closing balance. The auditors use the receivable monthly statement accounts balance. to confirm with the customer's 5. Cash receipts Processing and recording of the receipts of cash from customers.



Cash Account (Cash in bank)



Cash receipts



Accounts receivable

 Remittance advice A document that accompanies the sales invoice mailed to the customer and for the customer to return with the cash or check payment. If a customer does not return a remittance advice, the employee opening the mail usually prepares one. The auditors check the remittance advice for the date and amount of payment and the invoices paid.  Daily cash summary An internal report that summarizes cash collections from customer accounts and from cash register sales. The auditor examines the daily cash summary to ensure that all cash receipts are deposited in the bank.  Cash receipts journal A book of srcinal entry for recording cash receipts transactions. All cash receipts transactions, including cash sales, collections on sales, and funds from borrowing or the issuance of stock, are recorded in the cash receipts journal. The auditor checks the cash receipts journal for srcinal entries of cash receipts.

6. Adjusting sales returns and allowances Adjusting sales for sales returns, discounts, and returns.



Sales returns and allowances





Sales returns and allowances

Sales

discounts discounts)

(Cash

 Credit memo A document indicating a reduction in the amount due from a customer because of returned goods or an allowance granted. The auditor checks the credit memo for evidence that a seller has reduced the amount previously billed a customer. The auditors also account for the numerical sequence to ensure that all credit memos are recorded. Figure 13-7 shows an example of a credit memo.



Accounts receivable

 Sales returns and allowances journal A book of srcinal entry for recording returns of goods or adjustments to invoice prices. The auditor checks the sales returns and allowance journal for srcinal entries of sales returns and allowances. 7. Determining uncollectible accounts Analyzing accounts receivable and providing allowance for uncollectible accounts.





Accounts receivable



Allowance for uncollectible accounts


 Aging schedule of accounts receivable This report prepared by the computer breaks customer balances into categories of 30 days, 30-60 days, 60-90 days, and more than 90 days old. It is used to monitor the collection of receivables and to check that the individual accounts receivable subsidiary ledgers matches with the accounts receivable control ledger. The auditor uses this schedule for conducting TOB.  General journal A book of srcinal entry for recording all transactions for which a specific journal has not been created. In the revenue cycle, entries for allowance for uncollectible accounts and write-offs of uncollectible accounts are often recorded in this journal. The auditor checks the general journal of srcinal entries of transactions that do not belong to any specific journals.

8.

Writing-off

of

uncollectible accounts Approving and recording the writing-off of uncollectible accounts.



Bad expense



debt




Write-off



Write-off authorization A document that authorizes form the write-off of an accounts receivable as uncollectible. The auditor accounts for the numerical sequence to ensure that all write-offs are recorded.


Figure 13-3 An Example of a Purchase Order from Customer PO #168 PURCHASE ORDER ABC Company 1st Street, San Francisco CA 94132 To: XYZ Company 3rd Street, San Francisco CA 94132 Customer Reference No. 966 Process Our Order For: Quantity 10 10

Description Computer Parts #11128 Computer Parts #11138

Contact Person:Fred

Date: Oct. 8, 201x

Price $100 $200

Ship Via: FedEx Ground

Total $1000 $2000

Terms: 2/10, n/30

Figure 13-4 An Example of a Sales Order SO #963 SALES ORDER XYZ Company 3rd Street, San Francisco CA 94132 To: ABC Company 1st Street, San Francisco CA 94132 Customer Reference No. 966 Description

Part No. #11128 #11138

Computer Parts Computer Parts Credit Approval Person:Ray

Quantity 10 10

Date: Oct. 16, 201x

Figure 13-5 An Example of a Bill of Lading BOL #45892 BILL OF LADING XYZ Company 3rd Street, San Francisco CA 94132 Consigned To: ABC Company 1st Street, San Francisco CA 94132 Sales Order #963 Quantity 2 Boxes 3 Boxes

Description

Weight 12 kilograms 26 kilograms

Computer Parts #11128 Computer Parts #11138

Shipper: FedEX Ground

Shipper’s Acceptance:John

Date: Nov. 22, 201x

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Figure 13-6 An Example of a Sales Invoice SI #82843 SALES INVOICE XYZ Company 3rd Street, San Francisco CA 94132 Sold To: ABC Company 1st Street, San Francisco CA 94132 Your Purchase Order #168 Quantity 10 10

Description Computer Parts #11128 Computer Parts #11138

Price $100 $200 Tax

Shipped: Nov. 22, 201x

Shipped Via: FedEX Ground

Total $1000 $2000 240 $3240

Date: Nov 25, 201x.

Figure 13-7 An Example of a Credit Memo CM #7459 CREDIT MEMORANDUM XYZ Company 3rd Street, San Francisco CA 94132 Customer: ABC Company 1st Street, San Francisco CA 94132 Customer Reference No. 966 Sales Invoice #82843 Receiving Report# N/A Description Allowance for substandard computer parts Authorized By:Bill

Date: Dec 7, 201x

Amount $50


Figure 13-8 An Example of a Revenue Cycle Flowchart

Functions Enter Sales

Documents & Records Enter Purchase Order

Computer Process

Computer Files & Storage Customer Master File

ORDER PROGRAM Perform edit and credit Checks. Print sales orders.

Perpetual Inventory File

Sales Order Authorized Price List

Open Orders File

Shipping Of Goods

Approval to Ship Goods

Enter Goods Shipped

SHIPPING PROGRAM Retrieve open orders Add shipping data. Transfer to shipping file. Print shipping documents back order/unfilled report.

Perpetual Inventory

Shipping File

Shipping Document Unfilled & Back ReportOrder

Record Sales

Sales Invoice

Report

Sales Journal

BILLING PROGRAM Retrieve shipped order data. Prepare sales invoices. Perform edit checks. Enter data in sale transaction file.

MASTER FILE UPDATE PROGRAM Update master files. Print sales journal, general ledger, monthly statements, daily sales report, and error report.

General Ledger

Sales Transaction File

General Ledger Master File

Error Report Accounts Receivable Master File Monthly Statements Daily Sales Report

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Functions Process Cash Receipts

Documents & Records Customer Remittance

CASH RECEIPTS PROGRAM Print Bank Deposit Control Total Listing. Print Credit Memo. Enter Data in Cash Receipts Transaction File.

Enter Receipts Data

Sales Returns Approval

Computer Process

Computer Files & Storage

Cash Receipts Transaction File

Error Report

Bank Deposit Control Total Listing

Credit Memo

Sales Journal

MASTER FILE UPDATE PROGRAM Update master files. Print sales journal, general ledger, cash receipts journal & error report

General Ledger


Accounts Receivable Master File Cash Receipts Journal Error Report

Customer Master File

Consider Potential Misstatements in a Revenue Cycle

After the auditors have obtained an understanding of the internal controls relating to the revenue cycle and documented such an understanding; the auditors would consider potential misstatements that could occur due to weaknesses in internal control. Table 13-3 describes some of these potential misstatements in the revenue cycle. Table 13-4 describes some potential misstatements that are specific to cash receipts in the revenue cycle. Note that effective internal control, including personnel practices that stress the hiring of trustworthy people, does not guarantee against losses from embezzlement and other fraudulent acts committed by a cashier. Accordingly, an employer may obtain a fidelity bond to insure against losses arising from fraudulent/illegal acts by the covered cashier. Prior to issuing this form of insurance, the underwriters usually investigate the cashier to be covered. Also, the cashier should be informed that bonding (insurance) companies are diligent in prosecuting bonded cashiers who committed fraud/illegal acts. Another way of reducing the risk of cashier misappropriate cash is to implement a bank lockbox system. A bank lockbox system assures that cash receipts are not abstracted by the cashier because customer payments are mailed to a post office box and collected directly by the bank.


Table 13-3 Potential Misstatements in a Revenue Cycle due to Weaknesses in Internal Control

Potential Misstatements



Example of Fraud



Recording unearned revenue.

Recording fictitious sales without receiving a customer order or shipping the goods.



Intentional over-shipment of goods.

Example of Error



Recording sales based on the receipt of orders from customers rather than on the shipment of goods.



Inaccurate billing and recording of

sales.



Recording cash that represents a liability as revenue (e.g., receipt of an of



advance deposit from the customer).  Recording of sales in the wrong period based on incorrect shipping information.

when

















Early revenue.

or

late

recognition



Recording revenues significant uncertainties exist.

Recording revenues when significant services must still be performed by the seller. Overestimation of the amount of revenue earned.

Intentionally holding the sales journal open to record next year’s sales as having occurred in the current year. Recording sales when the customer is likely to return the goods.

Recording franchise revenues when the franchises are sold even though an obligation to perform significant services still exists.

Recording sales when the customer’s payment is contingent upon the customer receiving financing or selling the goods to another party (e.g., consignment sales).

Amount of revenue franchises is miscalculated.

earned

on

Misstating the percentage of completion of several projects by a construction company that uses the percentage-of-completion method of revenue recognition.



Overestimating the percentage of completion on projects by a construction company using the percentage-of-completion method of revenue recognition.

Table 13-4 Potential Misstatements of Cash Receipts in a Revenue Cycle due to Weaknesses in Internal Control




Recording fictitious cash receipts.

Example of Fraud

Example of Error



Overstating cash receipts on the books by transferring cash between bank accounts without appropriate recording of the transfer to cover up an embezzlement of cash. This is known as kiting (discuss further in Chapter 18).













Failure to record receipts from cash sales. Failure to record cash from collection of accounts receivable.

A cashier fails to ring up and record cash sales and embezzles the cash. A cashier embezzles cash payments by customers on receivables, without recording the receipts in the customers’ accounts.



A cashier embezzles cash payments by customers on receivables by delaying the recording of cash receipts. This fraud is known as lapping . To cover up the embezzlement by lapping, cash collected from customer A is withheld by the cashier, a subsequent collection from customer B is entered as a credit to A’s account. B’s account will not be shown as paid until a payment by customer C is entered as a credit to B’s account, and so on.



An accounting clerk who has access to cash receipts embezzles cash collected from customers and writes off the related accounts

An accounting clerk accidentally omits the recording of the receipts from one cash register for the day. An accounting clerk accidentally fails to record cash payment by a customer on an accounts receivable.

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Example of Fraud

Example of Error

receivable. For example, to cover up the embezzled cash, the accounting clerk creates fictitious credit memos for the related accounts receivable.



Early or late recognition of cash receipts.



Intentionally holding the cash receipts journal open to record next year’s cash receipts as having occurred in this year.



Recording cash receipts based on incorrect information about date of receipt.

Assess Control Risk and Perform TOC Procedures

After considering potential misstatements, the auditors assess control risk (CR) and perform TOC procedures as per the audit program for the revenue cycle. Table 13-5 and Table 13-6 describe some common TOC procedures that the auditors perform on sales and cash receipts of the revenue cycle. Table 13-5 Specific Audit Objectives, Internal Controls, and Common TOC Procedures for Sales


Internal Controls

Existence or Occurrence: Sales transactions are authorized.

Proper authorization is maintained for granting of credit, pricing of goods, and shipment of goods. Recorded sales are for goods actually Recorded sales are supported by shipping shipped and services actually rendered. documents and customer orders. Completeness: Sales transactions are recorded.

Sales invoices and shipping documents are prenumbered. Shipments of goods have been billed. Billed sales are correctly posted to ledger.

Common TOC Procedures Inspect credit policies, price lists and bill of lading for proper authorization. Vouch sales transactions in sales journal to supporting shipping documents and customer orders Scan for numerical sequence of sales invoices and shipping documents. Trace shipping documents to sales transactions in sales journal. Trace daily sales summaries to daily postings to the accounts receivable ledger.

Accuracy and Classification: Sales transactions are accurately recorded Internal independent checks on sales invoice Recompute information on sales invoices. and classified. preparation. A chart of accounts is used. Read chart of accounts for adequacy. Scan for sales transactions entered wrongly in the general journal instead of the usual sales journal. Valuation and Allocation: Sales transactions are recorded at net Accounts receivable are collectible. Observe the client’s policy of obtaining credit realizable value. approval before shipping goods to customers. Understandability: Sales transactions are properly recorded in Separation of duties between recording of sales Observe separation of duty procedures. cash receipts and accounts receivable. transactions and cash receipts. Internal independent checks on accounts Inquiry of management about independent receivable subsidiary ledgers agree with check and review of sales records. accounts receivable control ledger.

Table 13-6 Specific Audit Objectives, Internal Controls, and Common TOC Procedures for Cash Receipts

Specific Audit Objectives Existence or Occurrence: Recorded cash receipts actually received.

are for

Internal Controls

Common TOC Procedures

funds Separation of duties between handling of cash Observe separation of duty procedures. and record keeping. Use of bank lockbox system Inquiry of management about bank lockbox policy

Completeness: Cash received is recorded in the cash Remittance advices are used. receipts journal. Incoming checks are immediately endorsed.

Scan for numerical sequence of remittance advices. Observe immediate endorsement of incoming checks. Observe the consistency of the cashier’s use of cash registers and tapes.



Internal Controls

Accuracy: Cash receipts are deposited and recorded at Bank accounts and cash accounts the amounts received. reconciled on a regular basis. Classification: Cash receipts transactions are properly An adequate chart of accounts is used. classified.

Common TOC Procedures are Inspect monthly bank reconciliations.

Read chart of accounts for adequacy. Examine documents supporting cash receipts for proper classification.

Cutoff: Cash receipts are recorded on the correct Procedures require recording of cash receipts Examine cash receipts and daily cash summary dates. on a daily basis. for daily bank deposit. To detect lapping: Compare dates of daily entries in the cash receipts journal with dates of daily bank deposit, and Compare dates of checks deposited per bank statements with the dates remittance credits are recorded.

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An overview of the strategy for tests of balances in a revenue cycle is presented in Figure 13-9. Figure 13-9 TOB Strategy in Revenue Cycle

The Audit Process

Audit Plan

Tests of Controls

Tests of Balances


Audit Report











Apply TOB Strategy

Table 13-7 provides a brief discussion of the TOB strategy as it is applied to a revenue cycle. Table 13-7 TOB Strategy in Revenue Cycle

TOB Strategy – Revenue Cycle 1. Allocate PJAM to TM

2. Derive DR

3. Perform analytical procedures

4. Perform TOB procedures Apply variable sampling plan

5. Document total misstatements

Chapter 9 discussed how the auditor allocates PJAM to TM at the individual account-balance or class of transaction level of a transaction cycle. In a revenue cycle, accounts receivable is perhaps the most material account in the financial statements for companies that sell on credit. In addition, even if the accounts receivable balance is small, the transactions in the revenue cycle that affect the accounts receivable balance is usually large. Thus, the auditor considers accounts receivable carefully when allocating TM. The auditor derives the DR, based on a pre-specified AR, assessed IR and CR, by using the audit risk model of AR = IR x CR x DR at the individual account-balance or class of transactions level of a transaction cycle (recall Chapter 9). The derived DR drives an optimum mix of the nature, extent, and timing of the TOB procedures used by the auditor. In the revenue cycle, inherent risk for the accounts receivable is usually moderate or high. This is because it is relatively easy for the management to intentionally misstate accounts receivable. The auditor performssix common types of analytical procedures(recall Chapter 7): (1) Compare clientand industry data. (2) Compare client data with similar prior-period data. (3) Compare client data with clientdetermined expected results. (4) Compare client data with auditor-determined expected results. (5) Compare client data with expected results, using non-financial data. (6) Compare financial ratio analysis on client data. In the revenue cycle, analytical procedures are usually done for the all-key accounts, not only for accounts receivable. This is because of the close relationship between income statement and balance sheet accounts in the revenue cycle. For example, if the auditor detects misstatement in sales or sales returns and allowances in the income statement through analytical procedures, accounts receivable in the balance sheet will likely be the offsetting misstatement. Table 13-8 describes some analytical procedures and potential misstatements that may be detected by them in the revenue cycle. The auditor performs the TOB procedures that address the nature, extent, and timing of evidence. For the nature and timing, if CR were assessed at the maximum of 100%, the auditor would not perform TOC procedures but perform only TOB procedures. In addition, the auditor would apply a variable sampling plan to determine the sample size of evidence. Table 13-9 summarizes some specific audit objectives and common TOB procedures in a revenue cycle. The auditor documentsall misstatements foundby performing theTOB procedures and compares the total misstatements with the PJAM. Based on the misstatements found, the auditor may revise PJAM (RJAM) if necessary. The auditor should perform additional audit work or request the management to make adjustments for the misstatements.

Table 13-8 Analytical Procedures for the Revenue Cycle

Analytical Procedure Revenue: Comparison of gross profit % by product line with previous years and industry data. Comparison of reported revenue to budgeted revenue.

Detect Possible Misstatement of: Unrecorded (understated) revenue. Fictitious (overstated) revenue. Changes in pricing policies. Product-pricing problems.

Accounts Receivable, Allowance for Uncollectible Accounts, and Bad-Debt Expense: Comparison of turnover and days outstanding in accounts receivable to previous years. Understatement or overstatement of Comparison of aging categories and aged trial balance of accounts receivable to previous years. allowance for uncollectible accounts and Comparison of bad-debt expense as a % of revenue to previous years. bad-debt expense. Comparison of allowance for uncollectible accounts as a % of accounts receivable to previous years. Sales Returns and Allowances and Sales Commissions: Comparison of sales returns as a % of revenue to previous years. Understatement or overstatement of sales Comparison of sales discounts as a % of revenue to previous years. returns and sales discounts.

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Table 13-9 Specific Audit Objectives and Common TOB Procedures for a Revenue Cycle


Common TOB Procedures

Existence or Occurrence: Accounts receivable balance is not Confirmation of selected accounts receivable by using MUS sampling approach (recall Chapter overstated by including fictitious customer 12). Confirmation of accounts receivable is an important procedure that the auditors are required to accounts. perform in conformity with AU 505External Confirmations . Table 13-10 provides further discussion on the confirmation procedures. All goods ordered by customers are shipped correctly. Completeness: All accounts receivable balances are included in the aged trial balance. Shipments to customers are invoiced correctly. Cutoff: All sales transactions and related accounts receivable balances are recorded in the proper period.

Rights and Obligations: Accounts receivable that have been sold are not included in the financial statements. Accuracy: Accounts receivable balances in the aged trial balance agree with the accounts receivable general (control) ledger. Valuation and Allocation: Accounts receivable are stated at realizable value. Classification: Accounts receivable on the aged trial balance are properly classified. Short-term receivable longterm notesaccounts receivable are and properly classified. Understandability: All related accounts in the revenue cycle are properly presented and disclosed in the financial statements.

Vouch a sample of shipping documents to sales orders.

Trace a sample of accounts receivable balances to the aged trial balances. Trace a sample of prenumbered sales invoices to shipping documents.

Examine a sample of sales invoices and shipping documents for a few days before and after yearend for recording sales in proper period. Review large sales returns and allowances before and after the balance sheet date to determine whether they are recorded in the correct period. Table 13-12 provides further discussion on sales and sales returns cut-off procedures. Review the minutes of the board of directors meeting for any indication of pledged or factored accounts receivable. Inquire of management whether any receivables are pledged or factored. Foot the accounts receivable balances in the aged trial balance and agree total to accounts receivable control (general) ledger. Vouch a sample of accounts receivable balances from the aged trial balance to sales invoices for proper amount and aging. Inquiry of credit manager the likelihood of collecting older (>90 days) accounts receivable. Examine the adequacy of the allowance for uncollectible accounts. Analyze accounts receivable in the aged trial balance for long-term notes receivable and related party receivables. Inquire of management whether are any long-term notes receivable and related party receivables included in the aged there trial balance.

Inquiry of management about related party receivables and assurance that they are properly disclosed. Read the minutes of the board of directors meetings for any indication of pledged or factored accounts receivable.

Confirmation of Accounts Receivable

In Table 13-9, confirmation of accounts receivable is an important TOB procedure for achieving the specific audit objective of existence. There are two types of accounts receivable confirmations: positive (see Figure 13-10) and negative (see Figure 13-11). A positive confirmation requests that customers indicate whether they agree with the amount due to the client stated in the confirmation. Thus, a response is required regardless of whether the customer believes the amount is correct or incorrect. A negative confirmation requests that customers respond only when they disagree with the amount due to the client. Table 13-10 summarizes the characteristics of positive and negative confirmations. Given the different characteristics between positive and negative confirmations in Table 13-10, the auditor considers several key factors in choosing between positive or negative confirmations. Table 13-11 summarizes the auditor’s consideration of these factors in choosing between the two types of confirmation. For example, if the “Cost of auditing” factor is “High”, then choose “Negative confirmation” instead of “Positive confirmation.”


Figure 13-10 An Example of a Positive Confirmation ABC Company 1st Street, San Francisco DEF Company 2nd Street, San Francisco Dear Customers: Please examine the accompany statement carefully and either confirm its correctness or report any differences to our auditors XYZ CPA, LLP P. O. Box 888, San Francisco who are auditing our financial statements. Your prompt attention to this request will be appreciated. An envelope is enclosed for your reply. Please do not send your payments to the auditors. Sincerely, ___________________________ Mr. A Controller, ABC Company _________________________________________________________________________________________________________ Confirmation: The balance receivable from us for $168,188 as of December 31, 200x, is correct except as noted below: __________________________________________________________________________________________________________ __________________________________________________________________________________________________________ __________________________________________________________________________________________________________ DEF Company Date _____________________

By_______________________

Figure 13-11 An Example of a Negative Confirmation Auditor’s Account Confirmation

Please examine this statement carefully. If it does NOT agree with your records, please report any differences to our auditors XYZ CPA, LLP P. O. Box 888, San Francisco who are auditing our financial statements. Your prompt attention to this request will be appreciated. An envelope is enclosed for your reply. Please do not send your payments to the auditors.

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Table 13-10 Characteristics of Positive and Negative Confirmation

Positive Confirmation

Negative Confirmation









The confirmation should be mailed with the auditor’s CPA  firm return address to ensure that any confirmations that are undelivered by the post office are returned to the auditor and not the client.

The confirmation should be mailed with the auditor’s CPA  firm return address to ensure that any confirmations that are undelivered by the post office are returned to the auditor and not the client.

















negative confirmation. Even after waves of follow-up positive confirmation requests and the customers still do not reply, the auditor must apply alternative procedures to verify the existence of the accounts receivable such as: (1) Examine subsequent cash receipts for payments of specific sales invoices included in the customers’ accounts receivable balances that were outstanding at the date of the confirmation. (2) Examine customer orders, shipping documents, and duplicate sales invoices. This is to verify the actual issuance of a sales invoice and actual shipment of goods. (3) Examine other correspondence with the customers to obtain adequate evidence on existence of the accounts receivable.

less expensive in negative than in positive confirmation.





Positive confirmation is usually prepared in the form of a computer printout. The name and address of the customers, and their accounts receivable balances are downloaded and printed directly from the accounts receivable master file. The auditor may ask the client to prepare the positive confirmations. However, the auditor must mail the confirmations to prevent interception or alteration of the accounts receivable.

The confirmation must include a statement that asks the customers not to send their payment to the auditors. It is important that the customers do not mistake the confirmation requests as requests for prompt payment of their accounts. Recipients of positive confirmation must respond to the auditor regardless whether the balances stated are correct or incorrect. Since the auditor makes no assumption about non-responses, the evidence obtained is stronger in positive than in negative confirmation. If recipients of positive confirmation respond by e-mail, the auditor should ask the e-mail respondents to sign and mail the srcinal hard-copy confirmation requests to the auditor. If recipients of positive confirmation respond by fax, the auditor should verify the sources and contents of the faxes in telephone calls to the respondents. The auditor must follow-up any non-responses with waves of follow-up positive confirmation requests. Since the auditor must receive a reply for all positive confirmations that are sent to the customers, this audit procedure is more expensive in positive than in

Negative confirmation is usually prepared in the form of a rubber stamp consisting of a short paragraph about a customer’s balance and the auditor’s request for confirmation. It is usually stamped at the back of each customer’s monthly statement. The auditor may ask the client to prepare the negative confirmations. However, the auditor must mail the confirmations to prevent interception or alteration of the accounts receivable.

The confirmation must include a statement that asks the customers not to send their payment to the auditors. It is important that the customers do not mistake the confirmation requests as requests for prompt payment of their accounts. Recipients of negative confirmation need to respond to the auditor only when the balances stated are incorrect. Since the auditor must make an assumption that non-responses contain correct balances, the evidence obtained is weaker in negative than in positive confirmation. If recipients of negative confirmation respond by e-mail, the auditor should ask the e-mail respondents to sign and mail the srcinal hard-copy confirmation requests to the auditor. If recipients of negative confirmation respond by fax, the auditor should verify the sources and contents of the faxes in telephone calls to the respondents. The auditor does not need to follow-up any non-responses. Non-responses are assumed to contain the correct balances. Since he auditor does not need to receive a reply for all negative confirmations that are sent to the customers, this audit procedure is

The auditor must analyze positive confirmation requests returned by the customers that indicate the balances are incorrect. A balance may be reported to be different because: (1) Payment has already been made by the customer just before the confirmation date. (2) Goods have not been received by the customer. Goods in transit often cause the difference between the customer’s balance and the confirmation request balance. (3) Goods returned by the customer but the client has yet to issue a credit memo. (4) Disputed amounts for certain goods purchased or returned by the customers.

The auditor must analyze negative confirmation requests returned by the customers that indicate the balances are incorrect. A balance may be reported to be different because: (1) Payment has already been made by the customer just before the confirmation date. (2) Goods have not been received by the customer. Goods in transit often cause the difference between the customer’s balance and the confirmation request balance. (3) Goods returned by the customer but the client has yet to issue a credit memo. (4) Disputed amounts for certain goods purchased or returned by the customers.





The auditor sometimes uses a special form of positive

confirmation referred to as blank-balance confirmation. This type of positive confirmation does not state the balance owed. Instead, the confirmation requests that the recipient fill in the amount or furnish other information. It also usually requests additional information on notes payable and consigned inventory. The auditor uses this special form of positive confirmation when the recipients are likely to sign

Not applicable for negative confirmation requests.


Positive Confirmation

Negative Confirmation

and return them without paying much attention to what information is requested.

Table 13-11 Choosing Between Positive and Negative Confirmations

Factor*

      

Tolerable Misstatement (TM) Reliability of evidence Cost of auditing Number of accounts receivable with small balances Number of accounts receivable with large balances IR and CR Response rate

High

Low

Negative confirmation

Positive confirmation













*Read each factor in each row independent of other factors in other rows. Table 13-11 is simply a memory aid; it is not meant to link all factors across all rows.

Table 13-12 Sales and Sales Returns Cut-off Procedures

Account

Cut-off Procedures

Sales: If there is not a proper cut-off of sales transactions; both revenue and The auditor first identifies the number of the last shipping document accounts receivable will be misstated for the current and following issued in the current period. Then a sample of sales invoices and their years. In most instances, errors related to sales cut-off are related shipping documents is selected for a few days just prior to, and unintentional and are due to delays in recognizing the shipment of subsequent to, the end of the period. Assuming that sales are recorded at goods or the recognition of the sales. In other instances, the client the time of shipment, sales invoices representing goods shipped prior to may intentionally fail to recognize sales transactions in the current year-end should be recorded in the current period, and invoices for period or may recognize sales from the next period in the current goods shipped subsequent to year-end should be recorded as sales in the period. next period. Sales Returns: GAAP requires that sales returns be matched with related sales if the The auditor examines supporting documents for a sample of sales amounts are material. For most clients, however, sales returns are returns recorded during several weeks subsequent to the closing date to recorded in the accounting period in which they occur, under the determine the date of the srcinal sales. If the amounts recorded in the assumption of approximately equal, offsetting amounts at the subsequent period are significantly different from unrecorded returns at beginning and end of each accounting period. This is acceptable as the beginning of the period, an adjustment must be considered. long as the amounts are not material.

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Which one of the following major activities is not in a typical revenue cycle? a. Cash collection. b. Purchase requisitions. c. Sales adjustments. d. Sales transactions.

13-2

A sales document whichspecifies theterms (FOB), date, description,and quantity of goods shipped to customers is known as a a. sales invoice. b. monthly statement. c. bill of lading. d. sales order.

13-3

A sales document which indicates a reduction in accounts receivable is known as a a. customer order file. b. accounts receivable subsidiary ledger. c. remittance advice. d. credit memo.

13-4

A common test of controls in a revenue cycle is to check that sales invoices have the necessary support documents and customer orders. This is a test of a. the existence assertion. b. the completeness assertion. c. the valuation and allocation assertion. d. the understandability assertion.

13-5

For an effective internal control, the cashier who receives remittance from the mail room should not a. prepare a bank deposit slip. b. endorse the incoming checks. c. post the receipts in the accounts receivable subsidiary ledger. d. deposit the remittance at a bank.

13-6

For an effective internalcontrol, theperson that is responsible forthe posting of accounts receivablesubsidiary ledgershould not also handle a. acceptance of customer orders b. credit granted to customers. c. filling and shipping customer orders. d. cash payment functions.

13-7

For an effective internal control, the billing function should be performed by which of the following departments? a. Credit department. b. Sales order department. c. Shipping and warehousing department. d. Accounting department.

13-8

Assuming cashierembezzled cashreceived over the counter from a customer and covered it up by writing off the accounts receivable as bad debt. Which of the following internal control procedures is effective in preventing such an occurrence? a. All customer order are properly prenumbered. b. All credit memos are properly authorized by a separate person. c. All journal entries and recording of transactions are done by a separate person. d. Daily cash receipts are deposited by a separate person.


13-9

Which of the following is not an auditor’s concern about a key authorization point in the revenue cycle?

a. The receiving room must have authorization before releasing items to inventory control. b. Credit must be authorized before the sale. c. Goods must be shipped after the authorization. d. Prices must be authorized. 13-10

An effective TOC procedure to test for unbilled shipments is to a. vouch from the sales journal to the shipping documents. b. trace from the shipping documents to the sales journal. c. trace sales journal to the accounts receivable ledger. d. trace sales journal to the general ledger sales account.

13-11

For most companies, the function of indicating credit approval is recorded on the a. sales order. b. customer order. c. sales invoice. d. remittance advice.

13-12

A document sent to each customer showing his/her beginning accounts receivable balance and the amount and date of each sale, cash payment received, credit memo issued, and the ending balance is the a. accounts receivable subsidiary ledger. b. remittance advice. c. monthly statement. d. sales invoice.

13-13

An auditor suspects that a client’s cashier is misappropriating cash receipts for personal use by lapping customer checks received in the mail. In attempting to uncover this embezzlement scheme, the auditor most likely would compare the

a. dates checks are deposited per bank statements with the dates remittance credits are recorded. b. daily cash summaries with the sums of the cash receipts journal entries. c. individual bank deposit slips with the details of the monthly bank statements. d. dates uncollectible accounts are authorized to be written off with the dates the write-offs are actually recorded. 13-14

An auditor most likely would limit TOC of sales transactionswhen controlrisk (CR) is assessed as low for the existence or occurrence assertion concerning sales transactions and the auditor has already gathered sufficient evidence supporting a. opening and closing inventory balances. b. shipping and receiving activities. c. cutoffs of sales and purchases. d. cash receipts and accounts receivable.

13-15

Which of the following audit procedures would an auditor most likely perform to test controls relating to management’s assertion concerning the completeness of sales transactions? a. Comparing the invoiced prices on prenumbered sales invoices to the client’s credit granting policies. b. Inquire about the client’s credit granting policies and the consistent application of creditchecks. c. Inspect the client’s reports of prenumbered shipping documents that have not been recorded in the sales journal. d. Footing and cross-footing of the client’s monthly customer statements.

13-16

Which of the following internalcontrol procedures most likely would deter lapping ofcollections fromcustomers? a. Independent internal verification of dates of entry in the cash receipts journal with dates of daily cash summaries. b. Authorization of write-offs of uncollectible accounts by a supervisor independent of credit approval. c. Segregation of duties between receiving cash and posting the accounts receivable ledger. d. Supervisory comparison of the daily cash summary with the sum of the cash receipts journal.

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13-17

An auditor scansfor the numerical sequence of sales invoices and shipping documents to support management’s financial statements assertion of a. existence or occurrence. b. rights and obligations. c. valuation or allocation. d. completeness.

13-18

A client’s financial statements were misstated over a period of years because large amounts of revenue from sales were intentionally debited and credited to an illogical combination of accounts. The auditor would most likely have been alerted of this fraud by

a. scanning the general journal for unusual entries. b. performing a sales cut-off test at year end. c. tracing a sample of journal entries to the general ledger. d. examining documentary evidence of sales returns and allowances recorded after year-end. 13-19

Which of the following auditprocedures concerningaccounts receivable wouldan auditor most likely perform to obtain evidential matter in support of an assessed level of control risk below the maximum level? a. Observing proper authorization is maintained for granting of credit to principal customers. b. Sending confirmation requests to principal customers to verify the existence of accounts receivable. c. Analyzing accounts receivable for unusual balances. d. Comparing uncollectible accounts expense to actual uncollectible accounts receivable.

13-20

Which of the following internalcontrol procedure ismost likely to prevent the improper disposition ofequipment? a. A separation of duties between those authorized to dispose of equipment (asset custody) and those authorized to approve removal work orders on disposed equipment (authorization). b. The use of serial numbers to identify equipment that could be sold. c. Periodic comparison of removal work orders with authorizing documentation. d. A periodic analysis of the scrap sales and the repairs and maintenance accounts.

13-21

At which point in an ordinary salestransaction ofa wholesaling business isa lack of specific authorization ofleast concern to the auditor in the conduct of an audit? a. Granting of credit. b. Shipment of goods. c. Determination of discounts. d. Selling of goods for cash.

13-22

During the consideration of a small business client’s internal control, the auditor discovered that the accounts receivable clerk approves credit memos and has access to cash. Which of the following internal control procedures would be most effective in offsetting this weakness?

a. The owner reviews errors in billings to customers and postings to the subsidiary ledger. b. The controller receives the monthly bank statement directly and reconciles the checking accounts. c. The owner reviews credit memos after they are recorded. d. The controller reconciles the total of the detail accounts receivable accounts to the amount shown in the ledger. 13-23

Which of the following internalcontrol procedures mostlikely would be effective inoffsetting thetendency ofsales personnel to maximize sales volume at the expense of high bad debt write-offs? a. Employees responsible for authorizing sales and bad debt write-offs are denied access to cash. b. Shipping documents and sales invoices are matched by an employee who does not have authority to write off bad debts. c. Employees involved in the credit-granting function are separated from the sales function. d. Subsidiary accounts receivable records are reconciled to the control account by an employee independent of the authorization of credit.

13-24

An auditor tests a client’s policy of obtaining credit approval before shipping goods to customers in support of management’s financial statement assertion of

a. valuation or allocation. b. completeness. c. existence or occurrence. d. rights and obligations.


13-25

Which of the following internalcontrol procedures mostlikely would assurethat all billed salesare correctly postedto the accounts receivable ledger? a. Daily sales summaries are traced to daily postings to the accounts receivable ledger. b. Each sales invoice is supported by a prenumbered shipping document. c. The accounts receivable ledger is reconciled daily to the control account in the general ledger. d. Each shipment on credit is supported by a prenumbered sales invoice.

13-26

Which of the following internal controlprocedures mostlikely wouldnot be designed to reduce the risk of errors in the billing process? a. Comparing control totals for shipping documents with corresponding totals for sales invoices. b. Using computer programmed controls on the pricing and mathematical accuracy of sales invoices. c. Matching shipping documents with approved sales orders before invoice preparation. d. Reconciling the control totals for sales invoices with the accounts receivable subsidiary ledger.

13-27

Which of the following controlsmost likely wouldhelp ensure that all credit salestransactions ofa client are recorded? (Hint: Completeness assertion) a. The billing department supervisor sends copies of approved sales orders to the credit department for comparison to authorized credit limits and current customer account balance. b. The accounting department supervisor independently reconciles the accounts receivable subsidiary ledger to the accounts receivable control account monthly. c. The accounting department supervisor controls the mailing of monthly statements to customers and investigates any differences reported by customers. d. The billing department supervisor matches prenumbered shipping documents with entries in the sales journal.

13-28

An auditor would consider a cashier’s job description to contain compatible duties if the cashier receives remittances from the mail room and also prepares the

a. prelist of individual checks. b. monthly bank reconciliation. c. daily deposit slip. d. remittance advices. 13-29

Effective internal control procedures require that, immediately upon receiving checks from customers by mail, a responsible employee should a. add the checks to the daily cash summary. b. verify that each check is supported by a prenumbered sales invoice. c. prepare a duplicate listing of checks received. d. record the checks in the cash receipts journal.

13-30

Upon receipt of customers’ checks in the mail room, a responsible employee shouldprepare a remittance listing that is forwarded to the cashier. A copy of the listing should be sent to the

a. internal auditor to investigate the listing for unusual transactions. b. treasurer to compare the listing with the monthly bank statement. c. accounts receivable bookkeeper to update the subsidiary accounts receivable records. d. client’s bank to compare the listing with the cashier’s deposit slip. 13-31

Cash receipts fromsales on account have been misappropriated. Whichof the following actswould conceal this defalcation and be least likely to be detected by an auditor? a. Understating the sales journal. b. Overstating the accounts receivable control account. c. Overstating the accounts receivable subsidiary ledger. d. Understating the cash receipts journal.

13-32

Employers bond employees who handle cash receiptsbecause fidelitybonds reduce the possibility ofemploying dishonest individuals and a. protect employees who make unintentional errors from possible monetary damages resulting from their errors. b. deter dishonesty by making employees aware that insurance companies may investigate and prosecute dishonest acts. c. an independent monitoring depositing of cash receipts. d. facilitate force employees in positions of trust of to the takereceiving periodic and vacations and rotate their assigned duties.

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13-33

Which of the following internal control procedures would reduce the risk of diversion of customer receipts by a client’s employees?

a. A bank lockbox system. b. Prenumbered remittance advices. c. Monthly bank reconciliations. d. Daily deposit of cash receipts. 13-34

Which of the following procedures would an auditor most likely perform to test controls relating to management’s assertion about the completeness of cash receipts for cash sales at a retail outlet? a. Observe the consistency of the employee’s use of cash registers and tapes. b. Inquire about employee’s access to recorded but un-deposited cash. c. Trace the deposits in the cash receipts journal to the cash balance in the general ledger. d. Compare the cash balance in the general ledger with the bank confirmation request.

13-35

Which of the following mostlikely would be the result ofineffective internalcontrol in the revenue cycle? a. Final authorization of credit memos by personnel in the sales department could permit an employee defalcation scheme. b. Fictitious sales transactions could be recorded, causing an understatement of revenues and an overstatement of receivables. c. Fraud in recording sales transactions in the subsidiary accounts could result in a delay in goods shipped. d. Omission of shipping documents could go undetected, causing an understatement of inventory.

13-36

Effective internalcontrol procedures dictatethat defective merchandisereturned by customers be presented initially to the a. accounts receivable supervisor. b. receiving clerk. c. shipping department supervisor. d. sales clerk.

13-37

Proper authorization ofwrite-offs of uncollectible accounts shouldbe approved inwhich of the following departments? a. Accounts receivable. b. Credit. c. Accounts payable. d. Treasurer.

13-38

An online salesorder processingsystem most likely would have an advantage overa batch salesorder processing system by a. detecting errors in the data entry process more easily by the use of edit programs. b. enabling shipment of customer orders to be initiated as soon as the orders are received. c. recording more secure backup copies of the database on magnetic tape. d. maintaining more accurate records of customer accounts and finished goods inventories.

13-39

Company C uses a batch processing method to process its sales transactions. Data on C’s sales transaction tape are electronically sorted by customer number and are subjected to programmed edit checks in preparing its invoices, sales journals, and updated customer account balances. One of the direct outputs of the creation of this sales transaction tape most likely would be a (Hint: The key word is ‘edit checks’)

a. report showing exceptions and control totals. b. printout of the updated inventory records. c. report showing overdue accounts receivable. d. printout of the sales price master file. 13-40

13-41

When an auditor has determined that accounts receivable have increased as a result of slow collections in a “tight money” environment, the auditor would be likely to a. increase the balance in the allowance for bad debt expense. b. review its impact on going concern status of the client. c. review the credit granting policy. d. expand tests of collectability. Negative confirmation of accounts receivable should be used except when a. internal control of accounts receivable is considered to be effective. b. a large number of small balances are involved. c. the response rate is low. d. individual account balances are relatively large.


13-42

Negative confirmation ofaccounts receivable is less effective than positive confirmation ofaccounts receivable because a. a majority of recipients usually lack the willingness to respond objectively. b. some recipients may report incorrect balances that require extensive follow-up. c. the auditor cannot infer that all non-respondents have verified their account information. d. negative confirmation do not produce evidential matter that is statistically quantifiable.

13-43

An auditor should perform alternative procedures to substantiate the existence of accounts receivable when a. no reply to a positive confirmation request is received. b. no reply to a negative confirmation request is received. c. the collectability of the receivables is in doubt. d. pledging of the accounts receivables is probable.

13-44

Which of the following is most likely to be detected by an auditor’s sales cut-off test? a. Unrecorded sales for the year. b. Lapping of year-end accounts receivable. c. Excessive sales discounts. d. Unauthorized goods returned for credit.

13-45

When evaluating the adequacy of the allowance for uncollectible accounts, an auditor examines the age of accounts receivable to support management’s assertion of a. existence or occurrence. b. valuation or allocation. c. completeness. d. rights and obligations.

13-46

Which of the following auditprocedures wouldbest uncover an understatement ofsales and accounts receivable? a. Test a sample of sales transactions, selecting the sample from pre-numbered shipping documents. b. Test a sample of sales transactions, selecting the sample from sales invoices recorded in the sales journal. c. Confirm accounts receivable. d. Analyze the aged accounts receivable trial balance.

13-47

Positive confirmation of accounts receivable should be used when a. internal control of accounts receivable is considered to be effective. b. a large number of small balances are involved. c. the response rate is low. d. a substantial number ofaccounts receivable may bein dispute.

13-48

When positive confirmationsare used, which of the following wouldnot be considered analternative procedureto positive confirmations? a. Send a second confirmation request. b. Examine subsequent cash receipts to determine if the receivable has been paid. c. Examine shipping documents to verify that the merchandise was shipped. d. Examine customer’s purchase order and the duplicate sales invoice to determine that the merchandise was ordered.

13-49

The most important TOB procedure for accounts receivable is a. re-calculation of the aged receivables and un-collectible accounts. b. tracing credit memos for returned merchandise to receiving room reports. c. confirmations. d. tracing from shipping documents to journals to the accounts receivable ledger.

13-50

When the client’s internal control is adequate, the specific objective of cutoff can usually be achieved by a. reading client’s representation letter. b. inquiring the client’s controller. c. obtaining the last shipping document number of the year and comparing it with current and subsequent period recorded sales.

d. confirmation of the receivable for the last recorded sale.

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13-51

An auditor discoversthat the client records salesreturns andallowances inthe accounting periodin which they occur, under the assumption of approximately equal offsetting errors at the beginning and end of each period. The auditor would consider this accounting practice to be a. acceptable. b. not acceptable. c. acceptable as long as the amounts are not significant. d. not acceptable as long as the amounts are not significant.

13-52

Which of the specific auditobjectives isperformed first when doing the TOB procedures foraccounts receivable? a. Recorded accounts receivable exist. b. Accounts receivable in the aged trial balance agree with related master file amounts, and the total is correctly added and agrees with the general ledger. c. Existing accounts receivable are included. d. Accounts receivable are owned.

13-53

An auditor’s purpose in reviewing credit ratings of customers with delinquent accounts receivable most likely is to obtain evidence concerning management’s assertions about

a. valuation or allocation. b. presentation and disclosure c. existence or occurrence. d. rights and obligations. 13-54

Which of the following most likely would be detected by an auditor’s review of a client’s sales cut-off?

a. Shipments lacking sales invoices and shipping documents. b. Excessive write-offs of accounts receivable. c. Unrecorded sales at year end. d. Lapping of year-end accounts receivable. 13-55

In auditing accountsreceivable, thenegative form of confirmation requestmost likely would be used when a. the total recorded amount ofaccounts receivable is immaterial to the financial statements taken as a whole. b. response rates in prior years to positive confirmation requests were high. c. recipients are likely to return positive confirmation requests verifying the accuracy of the information. d. the combined assessed level of inherent risk (IR) and control risk (CR) relative to accounts receivable is low.

13-56

To reduce therisks associated withaccepting e-mailresponses to requests for confirmation ofaccounts receivable,an auditor most likely would a. ask the e-mail respondents to sign and mail the srcinal hard-copy confirmation requests to the auditor. b. examine subsequent cash receipts for the accounts in question. c. consider the e-mail responses to the srcinal hard-copy confirmation requests to be exceptions. d. mail second hard-copy confirmation requests to the e-mail respondents.

13-57

Under which of the following circumstanceswould the blank-balance form of positive confirmationrequests of accounts receivable most likely be used? a. Analytical procedures indicate that few exceptions are expected. b. Subsequent cash receipts are usually difficult to verify. c. The recipients are likely to sign the confirmations without devoting proper attention to them. d. The combine assessed level of inherent risk and control risk is low.

13-58

When an auditor does not receive replies to positive confirmation requestsfor year-end accountsreceivable, theauditor most likely would a. inspect the allowance account to verify whether the accounts were subsequently written off. b. ask the client to contact the customers to request that the confirmation requests be returned. c. increase the level of detection risk for the valuation and allocation, and completeness assertions. d. increase the level of inherent risk for the revenue cycle.

13-59

To reduce therisks associated withaccepting faxresponses torequests for confirmations ofaccounts receivable,an auditor most likely would a. examine the shipping documents that provide evidence for the existence assertion. b. verify the sources and contents of the faxes in telephone calls to the respondents. c. consider the faxes to be non-responses and evaluate them as unadjusted difference. d. inspect the faxes for forgeries or alterations and consider them to be acceptable if none are note.


13-60

Which of the following statementis correct concerning theuse of negative confirmation requests? a. Negative confirmation requests are effective when understatements of account balances are suspected. b. Unreturned negative confirmation requests indicate that alternative procedures are necessary. c. Negative confirmation requests are effective when detection risk is low. d. Unreturned negative confirmation requests rarely provide significant explicit evidence.

13-61

Which of the following analytical procedures would be most useful to an auditor in evaluating the results of a client’s operations?

a. Prior year accounts payable to current year accounts payable. b. Prior year payroll expense to budgeted current year payroll expense. c. Current year revenue to budgeted current year revenue. d. Current year warranty expense to current year contingent liabilities. 13-62

If the objectiveof a TOB procedure isto detect overstatementsof sales, the auditor should comparetransactions inthe a. cash receipts journal with the sales journal. b. sales journal with the cash receipts journal. c. source documents with the accounting records. d. accounting records with the source documents.

13-63

Tracing balances inshipping documents to balances in prenumbered salesinvoices provides evidence that a. no duplicate shipments or billings occurred. b. shipments to customers were properly invoiced. c. all goods ordered by customers were shipped. d. all prenumbered sales invoices were accounted for.

13-64

Cutoff testsdesigned to detect creditsales made beforethe end of the year that have been recordedin the subsequentyear provide assurance about management’s assertion of a. presentation. b. valuation or allocation. c. rights and obligations. d. existence or occurrence.

13-65

Which of the following mostlikely would give the most assurance concerningthe valuation assertionof accounts receivable? a. Vouching amounts in the subsidiary ledger to details on shipping documents. b. Comparing receivable turnover ratios with industry statistics for reasonableness. c. Inquiring about receivables pledged under loan agreements. d. Assessing the allowance for uncollectible accounts for reasonableness.

13-66

AU 505, External Confirmations , defines confirmation as “the process of obtaining and evaluating a direct communication from a third party in response to a request for information about a particular item affecting financial statement assertions.” Two assertions for which confirmation of accounts receivable balances provides primary evidence are a. completeness, and valuation or allocation. b. valuation or allocation, and rights and obligations. c. rights and obligations and existence. d. existence and completeness.

13-67

An auditor confirms a representative number of open accounts receivable as of December 31 and investigates respondents’ exceptions and comments. By this procedure the auditor would be most likely to learn which of the following? (Hint: Note the key word “open”) a. One of the cashiers has been covering a personal embezzlement by lapping. b. One of the sales clerks has not been preparing charge slips for credit sales to family and friends (i.e., no accounts receivable balances). c. One of the computer control clerks has been removing all sales invoices applicable to his account from the data file. (i.e., sales invoices not processed). d. longer The credit has. misappropriated remittances from customers whose accounts have been written off (i.e., no openmanager accounts)

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13-68

An auditor who has confirmed accountsreceivable maydiscover that the sales journal was held open past year-endif a. positive confirmations sent to debtors are not returned. b. negative confirmation sent to debtors are not returned. c. most of the returned negative confirmations indicate that the debtor owes a larger balance than the amount being confirmed. d. most of the returned positive confirmations indicate that the debtor owes a smaller balance than the amount being confirmed.

13-69

During theprocess of confirming receivablesas of December 31, 2000, a positive confirmationwas returned indicatingthe “balance owed as of December 31 was paid on January 9, 2001.” The auditor would most likely a. determine whether there were any changes in the account between January 1 and January 9, 2001. b. determine whether a customary trade discount was taken by the customer. c. reconfirm the zero balance as of January 10, 2001. d. verify that the amount was received.

13-70

An auditor is auditing the financial statements of a small rural municipality. The receivable balances represent residents’ delinquent real estate taxes. Internal control at the municipality is ineffective. To determine the existence of the accounts receivable balances at the balance sheet date, the auditor would most likely a. send positive confirmation requests. b. send negative confirmation request. c. examine evidence of subsequent cash receipts. d. inspect the internal records such as copies of the tax invoices that were mailed to the residents.

13-71

Which of the following procedureswould an auditor most likely perform for year-end accountsreceivable confirmations when the auditor did not receive replies to second requests? (Hint: Think of the specific audit objective of confirmations) a. Review the cash receipts journal for the month prior to year-end. b. Intensify the study of internal control concerning the revenue cycle. c. Increase the assessed level of detection risk for the existence assertion. d. Inspect the shipping records documenting the merchandise sold to the debtors.

13-72

In which of the following circumstanceswould the use of the negative formof accounts receivableconfirmation most likely be justified? a. A substantial number of accounts may be in dispute and the accounts receivable balance arises from sales to a few major customers. b. A substantial number of accounts may be in dispute and the accounts receivable balance arises from sales to many customers with small balances. c. A small number of accounts may be in dispute and the accounts receivable balance arises from sales to a few major customers. d. A small number of accounts may be in dispute and the accounts receivable balance arises from sales to many customers with small balances.

13-73

Auditors mayuse positive and/ornegative formsof confirmation requests.An auditor most likely will use a. the positive form to confirm all balances regardless of size. b. the negative form for small balances. c. a combination of the two forms, with the positive form used for trade balances and the negative form for other balances. d. the positive form when the combined assessed level inherent and control risk for related assertions is acceptably low, and the negative form when it is unacceptably high.

13-74

The confirmation of customers’ accounts receivable rarely provides reliable evidence about the completeness assertion because (Hint: Think of the type of assertions)

a. many customers merely sign and return the confirmation without verifying its details. b. recipients usually respond only if they disagree with the information on the request. c. customers may not be inclined to report understatement errors in their accounts. d. auditors typically select many accounts with low recorded balances to be confirmed. 13-75

In confirming a client’s accounts receivable in prior years, an auditor found that there were many differences between the recorded account balances and the confirmation replies. These differences, which were not misstatements, required substantial time to resolve. In defining the sample unit for the current year’s audit, the auditor most likely would choose

a. individual overdue balances. b. individual invoices. c. small account balances. d. large account balances.



13-1 b. 13-2 c. 13-3 d. 13-4 a. 13-5 c. 13-6 b. 13-7 d. 13-8 c. 13-9 a. 13-10 b. 13-11 a. 13-12 c. 13-13 a. 13-14 d. 13-15 c. 13-16 c. 13-17 d. 13-18 a. 13-19 a. 13-20 a. 13-21 d. 13-22 c. 13-23 c. 13-24 a. 13-25 a. 13-26 d. 13-27 d. 13-28 c. 13-29 c. 13-30 c. 13-31 a. 13-32 b. 13-33 a. 13-34 a. 13-35 a. 13-36 b. 13-37 d. 13-38 b. 13-39 a. 13-40 d. 13-41 d. 13-42 c. 13-43 a. 13-44 a. 13-45 b. 13-46 a. 13-47 d. 13-48 a. 13-49 c. 13-50 c.

13-51 c.

13-52 b. 13-53 a. 13-54 c. 13-55 d. 13-56 a. 13-57 c. 13-58 b. 13-59 b. 13-60 d. 13-61 c. 13-62 d. 13-63 b. 13-64 b. 13-65 d. 13-66 c. 13-67 a. 13-68 d. 13-69 d. 13-70 a. 13-72 d. 13-73 b. 13-74 c. 13-75 b.

13-71 d.

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Simulation Question 13-1 Simulation Question 13-1 is an adaptation with permission from a case by Borthick, A. F., and J. E. Kiger inIssues the in Accounting Education , a publication of the American Accounting Association in Sarasota, Florida. This simulation question is based upon a true set of facts; however, the names and places have been changed.

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Overview

E-Ticket Airline’s (ETA’s) revenue generation begins when a customer selects a flight for a specific date and time. The process is similar whether a ticket agent or the customer interacts with the system to make the reservation. If the customer is paying with a credit card, the system validates the credit card number the customer presents for billing before making the reservation. When it obtains approval of the credit charge (electronically, from the card issuer), the system records the charge and other details of the reservation. The customer gets a confirmation number and itinerary immediately, and gets a boarding pass at the gate only by presenting picture identification. Daily, the system batches each day’s charges by credit card issuer and transmits them electronically to credit card issuers. Until a flight occurs, ticket sales are recorded as unearned revenue. After a flight, the system records earned revenue based on the reservations for the flight and decreases unearned revenue accordingly. Furthermore, ETA’s bank provides electroni c bank statements. In addition to offering flights to customers and allowing customers to make reservations, ETA’s system accommodates changing reservations, handling cash and credit card receipts, boarding passengers, and booking revenues. The system includes procedures for setting fares and for passengers flying free. In addition, the system includes monitoring activities designed to ensure the effectiveness of operations and information analysis that management uses to maximize revenue per seat-mile. You should access Data File 13-1 in iLearn for Figure 1, which presents an overview of the system data flow chart, and Figure 2, which illustrates the system database.

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Offering Flights to Customers

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Creating Reservations

ETA offers flights to customers through a system that customers and agents access through the Internet. Customers and ticket agents enter the srcination and destination cities and the dates and preferred times for travel. The system generates information that permits customers to choose specific flights. In collaboration with other ETA units, flight operations establish the flight schedule. To change the schedule, flight operations enters changes into a flight change edit program. After the flight operations manager has approved schedule changes by attaching an electronic signature to the schedule change file, the system schedules the changes for application on the right day (at midnight); counts the number of schedule changes; creates a hash total of the flight numbers; adds a header record to the charge fileontaining c the count, the hash total, and the manager’s electronic signature; copies the file to the update queue, and notifies computer operations of the pending update of the flight table. A file of schedule changes is maintained. Fares vary based on the route to be traveled, whether travel is during peak or off-peak times, and whether the ticket purchase is an advance or regular purchase. Tickets bought 14 days before the flight date are advance purchase tickets. Given the destination and whether the purchase is an advance or regular purchase, the system determines, based on the date and hour of the flight, whether travel is during peak or offpeak times and displays the appropriate fare. While customers and ticket agents do not actually see the flight table (Figure 2), its contents determine the fare the system displays. Marketing personnel are responsible for maintaining fares. Once they decide on fare changes, marketing personnel enter approved fare changes and their effective dates into a fare change edit program. This program verifies the flights exist and determines that the changes meet a reasonableness criterion such as not falling below minimum fares or exceeding maximum fares and as functions of the destination, type of purchase, and time of day.Once all changes pass input edits, the fare change edit program creates a fare change file for the marketing manager’s approval. After the marketing manager has approved the fare change file by attaching an electronic signature, the system schedules the fare changes for application on the right day (at midnight); counts the number of fare changes; creates a hash total of the flight numbers, adds a header record to the charge file containing the count, the hash total, and the manager’s electronic signature;copies the file to the fare update queue, and notifies computer operations of the pending update of the flight table. A file of fare changes is maintained. Once the customer selects an acceptable flight, the system determines whether seats are available by examining the seat inventory table and the applicable fare. Ticket agents may not override fares. The flight operations department provides data for the seat inventory table (Figure 2), which contains dates, flight numbers, seat capacity, and the number of seats remaining. The system automatically updates the number of seats remaining by reducing/increasing it by one each time a reservation is made/canceled. When making a reservation, the system prompts customers (or ticketing agents) for a customer number, which it uses to look up information about the customer. If the customer is new, the system prompts for a customer name, address, phone number, email address, credit ites the information in the customer table (Figure 2). ETA’s system, linked with credit card number, credit card issuer, and expiration date and wr card issuers, requests approval for the charge. If the charge is not approved, the customer may enter new credit card information and request approval. If credit authorization is unobtainable, no reservation can be made unless the customer is at the airport with cash to pay for the ticket. Once credit has been authorized, the system writes information about the charge (a unique charge number generated by the system, the credit card issuer and card number and expiration date, the amount of the charge, the authorization code from the credit card issuer, and the charge date) in the charge table. If a customer pays cash at the ticket counter in the airport, the system records the cash receipt in the cash receipts table. For complimentary fliers such as employees, members of employees’ families, or employees of other airlines, the system looksup the customer number and the affiliation that entitles the person to fly free (such as an employee) in the free flier table. If the customer number and affiliation match a record in the free flier table, the system writes the appropriate record in the free flights table. Each day, the system generates reports about changes of the free flier table and free fliers, which the personnel director reviews daily. After creating an entry in the charge table, the cash receipts table, or the free flights table, the system writes the reservation record in the reservation table. The record includes a unique confirmation number generated by the system; either the charge number in the charge table, the cash receipt number in the cash receipts table, or the free flight number in the free flights table; the flight date, the flight number; the customer number; and the date the reservation was made. The system displays the confirmation number and itinerary and emails a receipt and an itinerary to the customer.


When the data tables were first created, the charge number field in the reservation table was designated as a foreign key to the charge table; the cash receipt number in the reservation table was designed as a foreign key to the cash receipts table; and the free flight number in the 1 reservation table was designated as a foreign key to the free flights table. This means that before an entry can be made or updated in a record in the reservation table, the system verifies that the charge number already exists in the charge table, that the cash receipt number already exists in 1 the cash receipts table, or that the free flight number already exists in the free flights table. If a corresponding number does not exist in any of the tables, then either credit has not been approved, cash payment has not been received, or free flying has not been authorized. In this case, the system will not write a reservation record, and no supervisor can override the prohibition.

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Changing Reservations

To change a reservation using a website, a customer selects the flight to be changed and then the change function. After the customer selects the new flight, the system requests credit card authorization and writes the appropriate charges (a $100 change fee and the amount by which the new fare exceeds the fare amount for the previously purchased flight) in the charge table. The customer forfeits any difference if the fare for the new flight is less than the earlier one. Then the system writes the new reservation in the reservation table and changes the status of the old reservation to canceled. The system adjusts the values of seats remaining in the seat inventory table for the old and new flights. Similarly, to change a reservation, a ticket agent selects the change function and records the change in either the charge table or the cash receipts table. r conditions, the unavailability of suitable aircraft, or other circumstances beyond an airline’s Flights may be canceled due to weathe control. Most customers are rerouted on other flights. To cancel a flight, a flight operations supervisor indicated to the system that the flight is canceled and the reason for the cancellation. Upon receiving the cancellation, the system permits the customer to be rerouted on another flight. These reservation changes do not incur the $100 change fee. Handling Cash and Credit Card Receipts Agents at airports may record cash receipts and credit card transactions while the website may record only credit card transactions. Each agent has a drawer with a change fund that only he or she operates. At the completion of each shift, agents submit the cash collected to their supervisors. The system determines the amount of cash a ticket agent should have based on charges for tickets issued, change fees, and credit card charges. The amount of cash an agent is over or short is recorded. Agents that are careless in handling cash receipts are dismissed. The system generates a cash receipts total that is reconciled with total cash receipts for all cash drawers each day. If a supervisortheincashier’s office cannot reconcile the cash receipts within 24 hours, the system notifies the treasurer electronically. For each bank deposit, the employee making the deposit enters the amount from the deposit ticket receipt into the system. Daily, the system performs a reconciliation of deposits per deposit tickets to the cash collections determined by the system. If the totals differ, details of the deposit ticket receipts are recorded in a suspense file. A cash receipts supervisor can remove the amounts from the suspense file only after reconciling the amounts and entering an explanation of the cause of the discrepancy. Whenever ticket receipts are not reconciled to system-determined totals within one day, the treasurer is notified electronically. Daily, the system generates a reconciliation of credit card charges by issuer with total credit card charges for the day. If balancing does not occur, electronic notification goes to a supervisor and details of the day’s activity go into a suspense file. If the supervisor fails to reconcile the amounts and clear the suspense file within one day, the system notifies the treasurer electronically. The actions undertaken to reconcile the amounts are recorded online. The system batches each day’s charges by credit card issuer and electronically transmits charges to credit card issuers.itCred card charges by issuer by day are reconciled with bank account receipts that occur in the airline’s online ticket receipts bank account. If the charges do not reconcile, electronic notification goes to a supervisor and details of the day’s activity go into a suspense file. If the supervisor fails to reconcile the amounts and clear the suspense file within one day, the system notifies the treasurer electronically. The actions undertaken to stitutes a daily reconciliation of bank records with the airline’s cash reconcile the amounts are recorded online. In effect, the procedure con journal. Monthly bank statements are available online from the bank.

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Boarding Passengers

Before boarding begins, the system writes records in a manifest table (Figure 2) for the flight that contains an entry for each confirmed passenger. The manifest table is a real table, not a view, because it is the permanent record of persons on the flight. At the gate, the boarding agent verifies fliers’ identification; the system logs the seat occupancy in the manifest table. Based on the number of boarding passes issued, the system generates a total number of passengers, which must match a count determined by the on-plane flight attendant. The attendant counts the passengers (or the number of empty seats) and enters the number into the system. If the numbers differ, the attendant recounts the passengers and reenters the number. If the numbers still differ, the gate agent must enter an explanation into the system. The plane is permitted to depart after the pilot enters his or her electronic signature into the system.

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Recording Revenue

Ticket sales are recorded as unearned revenue when reservations are recorded, and change fees are recorded as revenue when reservations are changed. When a plane departs, operations record a time for its departure that triggers the system to record earned revenue. Revenue for a flight may not be recorded until the system has received notification of the flight’s departure. Based on the manifests for all the flights that occur, the system records earned revenue by type (domestic or international, by flight in the flight table) and decreases unearned revenue accordingly. A flight is designated as domestic or international when the operations manager adds the flight to the flight table. Fortyeight hours after a flight’s arrival, entries associated with it are removed from the reservation table, the charge table, the cash receipts table, and the manifest table. Before being archived, the removed entries are added to a flight history data warehouse. Each day’s revenue consists of fares for the flights that occurred that day plus the fees charged for reservation changes that day. The system prepares a summary of revenue by flight, a summary of charges for reservation changes, and a total for the day. This total is posted as earned revenue. Flight operations personnel have access to the summary, which shows for each flight the number of paying fliers, the number of complimentary fliers, and the averages for each of those on the same day of the week during the preceding month. Daily, the system performs a balancing routine that verifies that (1) unearned revenue by type (domestic or international) reconciles to the charges for which reservations have been made and the flight time had not yet passed, and (2) earned revenue by type (domestic or 1

In database terminology, this way of linking records in two different files is known as referential integrity. That is, before a record containing a foreign key can be written, the object of the reference must exist as the primary key of the target table. In this case, the charge number is the primary key of the charge table, the cash receipt number is the primary key of the cash receipts table, and the free flight number is the primary key of the free flights table. Thus, through the system-implemented referential integrity, the reservation system will not record a reservation for which there is no charge, payment, or authorized fare waiver.

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international) reconciles to the charges made to unearned revenue for flights that occurred. If the amounts differ, details are recorded in a suspense file and a supervisor is notified electronically. The supervisor must bring the system into balance, clear the suspense file, and record the cause of the difference.

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Assessing the Effectiveness of Monitoring

The airline’s risk management department has the responsibility for assuring the integrity of monitoring activities. Risk management personnel have read-only access to all files containing: (1) notifications of un-reconciled amounts, e.g., for cash drawers, deposit ticket receipts, credit card charges, credit card collections, earned and unearned revenue; and (2) explanation of the causes of reconciliation failures and attempts to reconcile accounts.

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Controlling Operations and Improving the System

The files containing the underlying causes for reconciliation failures are available to department managers, who are responsible for identifying system changes consistent with more effective operations. Department managers consult with system development personnel on proposed changes andsystem authorize those the thatincidence appear toof bereconciliation cost-effectivefailures processbetween improvements. For example, a cash and receipts modifications to the to reduce system-determined revenue cash manager receipts. might suggest Each department has read-only access to system-calculated statistics for financial and operating results and is responsible for using the information to control its area and to recommend changes with the potential to improve any aspect of the airline’s operation. For example, supervisors are responsible for investigating excessive numbers that fail to be reconciled within one day and recommending corrective action. Marketing personnel are responsible for evaluating the effectiveness of the fare structure and recommending changes to it. Together, flight operations and marketing personnel are responsible for evaluating the effectiveness of the flight schedule and recoding changes to it. Executives also have access to the financial and operating results, which prompt them to suggest changes to be evaluated by one or more departments.

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Maintaining System Integrity and Continuity Controlling System Development through Change Control

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The airline uses a proprietary program library management system to ensure that all program code and system changes are authorized and documented. A quality assurance (QA) group provides test data to programmers and migrates programs from development libraries to test libraries to production libraries after users have authorized changes. Changes and approvals are documented with electronic signatures. For emergency program changes made in response to system failures, QA personnel monitor subsequent authorization and documentation. Program development and testing are done on servers that are independent of the production system and large enough to conduct volume tests. Attaining System Reliability and Access Control

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The airline uses a proprietary system to monitor and manage its information technology (IT) infrastructure. From an operations center room, technicians monitor processes whose degradation or failure would threaten system operability. Aspects subject to monitoring include application availability, application performance, file availability, application interfaces, data transfers, and response levels. For customer interfacing applications, the service goal is to detect and correct problems before customers notice them. From their desks, technicians investigate problem situations, summon hardware, software, and network specialists, and reconfigure the network and servers to avoid problem areas until full capabilities can be restored. For example, if particular network paths seem prone to failures, technicians shift network traffic to other paths. Through the use of software and hardware monitors, some of the technicians specialize in analyzing unusual activity on the network that might be indicative of hacker penetration, denial-of-service attacks, or laxity in administration of passwords or access privileges. These technicians are also responsible for detecting security lapses in the way hardware, software, and network resources are configured and proposing system parameter changes and security patches to correct security lapses. Once management authorizes the changes and patches, QA personnel implement them on the production system. Recovering from Processing Interruptions

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All the groups with a role in the IT infrastructure are responsible for recomme nding changes to the airline’s business continuity plan. Because the online systems require 24 hours per day, 7 days a week availability, the continuity plan has never been tested in its entirety at one time. Some aspects of the plan are executed every time a component fails or a component is replaced or added. Individual components are occasionally disabled to test specific functions. For example, some servers might be varied offline at a non-peak time to enable operating personnel to practice planned recovery efforts. Maximizing Revenue per Seat-Mile

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s. The airline’s Because of fierce competition and large fixed costs, a significant risk to the airline is inability to maintain profit margin approach to managing this risk is to use a load-forecasting model and data mining software to maximize flight profitability. The airline’s flight history data warehouse contains the number of passengers in each fare category for each flight for each day. The forecasting model incorporates factors such as day of the week,holiday occurrence, time of the year, fuel cost by location, and competitors’ flights and fares. Analysts investigate flights whose actual loads are outside the forecasted load ranges, and recommend changes to flight schedules and fares and abandonment of unprofitable flights. In addition to using the load-forecasting model, the marketing department looks for revenue enhancement opportunities with proprietary data mining software. Yield-management analysts make recommendations for allocating seats between cheap leisure travel (off-peak times and advance purchases) and on-demand business travel (peak times and regular purchases). Based on load forecasting and data mining results, marketing personnel change fares and flights to maximize revenue per seat-mile. After each set of flight and fare changes, the marketing department evaluates whether the changes had the intended effect on revenue. Another significant risk to the airline is unanticipated escalation of fuel costs. The airline manages this risk by placing forward contracts for fuel and minimizing fuel purchases in the highest-cost areas. Other risks for the airline are that it will miss deadlines for implementing mandated security checking of passengers and luggage, and be sluggish relative to its peers in using information technology to enable effective operations or revenue management. In addition to the uses

already cited, information technology could important in the following ways: airportexpediting employee passenger schedules boarding to flight to arrivals and departures, routing and tracking baggage andbe freight to minimize handling and lostmatching item recovery, minimize ground time and employee staffing, and rerouting flights and passengers when weather or other conditions disrupt flight schedules to minimize losses. The airline manages this risk by charging its chief technology officer with the responsibility of recommending new uses and enhancements to existing information systems on a monthly basis and evaluating the success of each technology implementation project.


Required Identify specific audit objectives, state related internal controls, and suggest tests of control procedures in the following format, adding rows as needed. The first row, containing a specific audit objectives, related internal controls, and test of control procedures, illustrates the level of detail for the entries. You should also refer to Chapter 7 on designing audit procedures when evidence is electronic. Specific Audit Objectives Internal Controls Test of Control Procedures Existence or Occurrence: 1. Ticket sales or change fee transactions 1. Supervisors monitor the daily reconciliation 1. Observe that the system performs a valid arising from credit card transactions exist of credit card charges by issuer by day with daily reconciliation of credit card charges by (and hence are not fictitious). subsequent bank account receipts. issuer by day with subsequent bank account receipts. 2. Review the reconciliation logs to confirm that supervisors monitor the control daily.

2. … 3. … Completeness: 1. … 2. … 3. … Rights and Obligations: 1. … 2. … 3. … Valuation and Allocation: 1. … 2. … 3. … Classification: 1. … 2. … 3. … Cutoff: 1. … 2. … 3. … Accuracy: 1. … 2. … 3. … Understandability: 1. … 2. … 3. …

Simulation Question 13-2 Simulation Question 13-2 is an adaptation with permission from a case by Peters, M.F., K.W. Shaw, and R.B. Thompson inIssues the in Accounting Education , a publication of the American Accounting Association in Sarasota, Florida. This simulation question is based upon a true set of facts; however, the names and places have been changed.

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Background

ShopShopShop.com, Inc. (hereafter, SSS) is an online grocery shopping service operating in San Francisco. SSS customers order groceries over the World Wide Web (WWW) using software created by the company. The software draws on a database that is updated daily, and that contains current prices, product weight and volume data, and nutritional information for all items available in the nearest participating Giant Supermarket. After selecting a grocery order, which typically requires about 20 minutes of pointing and clicking, the customer specifies a 90minute delivery time slot, and SSS does the rest. The customer’s order is transmitted to an SSS shopper at the relevant Giant Supermarket store. The shopper fills the order from stock in the store at a time just before the customer-specified delivery period, checks the order through a cashier, and helps an SSS driver pack the order in specially designed containers that keep frozen foods frozen, crushable foods uncrushed, etc. The driver then delivers the order to the customer. SSS bears responsibility for any losses or damages incurred during grocery delivery. In exchange for this service, the customer pays SSS a monthly membership fee of $5.95. In addition, for each order the customer pays (1) the store price of the groceries ordered, (2) a flat fee of &6.95, and (3) 5 percent of the store price of the groceries ordered. The monthly

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membership fee is charged to the customer’s credit card at the beginning of each month. All per-order amounts are charged to the cu stomer’s credit card on the date of purchase. SSS was formed at the beginning of 1998 by R. Food, and advertising executive, and G. Wine, an ex-supermarket manager and recent M.B.A. graduate from San Francisco State University. During 1998, SSS developed and tested its WWW-based order-entry system. During the same period, the company negotiated a cooperative arrangement with Giant Grocers, Inc., the dominant Bay Area super market chain. Under this agreement, SSS agreed to focus all Bay Area operations exclusively on Giant Supermarket stores, while Giant Grocers, Inc agree to facilitate SSS’s order processing, and to provide daily feeds of inventory and price data for each participating store at a nominal cost. In January 1999, SSS formally began operations at four participating Giant Supermarket stores San in Mateo and Hayward Counties. By the end of 2000, the company’s operations encompassed 12 participating stores in four counties, providing the capability to reach about 70 percent of the potential customers in Bay Area suburbs. SSS served (on average) about 3,000 customers during 1999, and about 10,000 customers during 2000. Experience over these two years showed that SSS’s customer retention rate is extremely high, partly due t o a ver y positive response to the company’s customer software interface, and partly because customers’ orders are processed with fanatical care by SSS’s highly paid shoppers and drivers. By the end of 2000, Food and Wine had plans well underway for expansion into the outer Bay Area. Funds required for expansion were to be raised through an initial public offering of SSS common shares, scheduled tentatively for May 2001.

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Software Development Expenditures

The reliability and “user-friendliness” of SSS’s customer order-entry software play a central role in attracting and retaining the company’s customers. SSS devoted considerable resources to developing and maintaining this software during the 1998-2000 period, as indicated by the summary below. 1998 The first version of the software was designed, developed, and tested during 1998. The software provides a web-based interface that allows customers to order groceries over the WWW using SSS’s servers. During January and February, Food, Wine, and a staff of programmers worked exclusively on establishing program specification, and on developing and validating a detailed program design and software interfaces. During this period, programmers earned salaries of $31,000. From the beginning of March through the end of November, the programming staff worked exclusively on the coding activities required to produce the program, earning salaries of $154,350. Food worked almost exclusively on supervising the programming effort during this period, while Wine conducted negotiations with Giant Grocers, Inc. and formulated policies for the order-filling side of the business. Throughout the month of December, SSS tested the completed software by providing service at no charge to 250 customers. During this stage, the programming staff dealt with last-minute software problems, earning salaries of 414,150, while Food and Wine supervised the shopping and delivery aspects of the process. Food and Wine estimated that the order-entry software would produce significant benefits for the company over its first four years of operations. 1999 SSS commenced actual operations at the beginning of January. New Software development continued throughout 1999, as SSS strived to enhance the security of the order-entry process. SSS devoted one server entirely to the order entry process, and made substantial improvements to the srcinal order- entry program to ensure data security on this server. This “enhanced-security” version of the software was launched on March 30. While this security system enhances the overall functionality of the order-entry program, it does not extend its useful life. Anticipating potential benefits from collecting detailed data on customer preferences and shopping patterns, SSS also began work on new customer preferences and shopping patterns, SSS also began work on a new customer management system. This software, used in conjunction with the secured server, collects voluminous data on customer purchases. SSS hopes to use these data to develop marketing

campaigns and coupon offers that better match individual customer preferences. By the end of the year, the programming staff had developed and validated a detailed design for SSS’s customer management system. During 1999, neither Food nor Wine was much involved in the software development effort. Of salaries earned by the programming staff during 1999, about 40 percent, 50 percent, and 10 percent were for the development of the enhanced security version of the software, the customer management software, and routine maintenance of all versions of the software, respectively. 2000

The programming staff completed development work on the customer management software by the end of September, and brought the new system online at the beginning of October. Of Salaries earned by the programming staff during the year, 80 percent and 20 percent were attributable to development of the customer management software and routine maintenance of existing programs, respectively. Food and Wine estimated that the new customer management system would produce significant benefits for the company over a period of six years. At the end of 2000, Food and Wine anticipate little additional software development work will be needed over the next two years, and that most work by the programming staff during that period will deal with routine maintenance problems. As a consequence, the owners expect that programming staff salaries in 2001 and 2002 will be about 50 percent less than in 2000.



Accounting Issues: Software Development Costs and Recognition of Gro cery Revenue

When SSS offers shares to the public in 2001, the company’s 1998-2000 financial statements will be an important source of information for prospective shareholders. Food and Wine know that they are responsible for ensuring that SSS’s financial statements fairly present the company’s resources, obligations, and performance. The tow owners agree that standard accrual accounting procedures will result in a fair portrayal of most of the everyday transactions and events that affect the company. Their two points of disagreement are with (1) the accounting for costs incurred to develop and enhance the order-entry and customer management software, and (2) the recognition of grocery revenue. Regarding costs incurred to develop the software, Food believes that the orderentry software is the company’s most important assets, and that “fair presentation” of SSS’s financial performance and position can best be achieved by capitalizing and subsequently amortizing all readily identifiable software development costs. Wine believes that SSS should dopt a a more conservative approach, expensing all software development costs in the period in which they are incurred. Regarding the recognition of revenue, Food favors a more conservative approach that nets grocery sales revenue with the cost of those sales, and thus only reports fees and commissions as revenue. Wine, on the other hand, believes that investors would be better served by reporting revenue from grocery sales and the cost of sales as separate line itemse.,(i.“gross”) in the

income statement.

Required


Using the information above and the schedule of SSS’s cash receipts and disbursements during 1998-2000 to answer the following requirements (Ignore income taxes).Access Data File 132 in iLearn for SSS’s comparative schedules of cash receipts and disbursements, 1998-2000. Available guidance and resources that may help you include: (1) For resolving Food and Wine’s disagreement over the accounting for software development costs – (a) Statement of Financial Accounting Standards No. 86, Accounting for the Costs of Software to be Sold, Leased, or Otherwise Marketed, and (b) AICPA Statement of Position 98-1, Accounting for the Costs of Computer Software Developed or Obtained for Internal Use. (2) For resolvingFood and Wine’s disagreement over the recognition of grocery revenue – (a) SEC’s Staff Accounting Bulletin No.101, Revenue Recognition in Financial Statements (SEC 1999), available online at http:// www.sec.gov/interps/account/sab101.htm

1. Prepare a set of financial statements for SSS under the assumptions that (1) all software development costs are expensed when incurred, and (2) revenue from grocery sales and associated costs are each reported as separate line items in the income statement. Your financial statements should include (a) comparative balance sheets at December 31, 1998, 1999, and 2000; (b) comparative income statements of cash flows for the years ended December 31, 1998, 1999, and 2000; (c) comparative statements of cash flows for the years ended December 31, 1998, 1999, and 2000, and (d) any notes needed to make the financial statements understandable. Note: Apart from the issue of how to account for software development costs, balance sheets and income statements should be prepared using standard accrual accounting procedures. 2. Now assume that the company’s policy is to capitalize all software development costs. Prepare a schedule showing the typesand amounts of development costs that should be capitalized in connection with (a) the srcinal customer order-entry software, (b) the enhanced security version of the order-entry software, and (c) the customer management software. Note: You must also compute the net (of accumulated amortization) software asset remaining at the end of each of the years 1998-2000.

3. Based on your answers to 1. and 2. above, prepare a table that compares the financial statement items and ratios listed below, assuming that (a) all software development costs are expensed as incurred, as in 1. above. (b) all software development costs are capitalized, as in 2. above (1) Total assets at 12/31/98, 12/31/99, and 12/31/00. (2) Total stockholders’ equity at 12/31/98, 12/31/99, and 12/31/00. (3) Net income for 1998, 1999, and 2000. (4) Return on assets for 1999 and 2000. (5) Return on stockholders’ equity for 1999 and 2000. (6) Net cash flow from operations for 1998, 1999, and 2000. (7) Net cash flow from investing activities for 1998, 1999, and 2000. (8) Ratio of net cash flow from operations to total liabilities at 12/31/99 and 12/31/00. Note: Refer to the financial-ratio formulae provided in Chapter 7. 4. Forecast SSS’s net income and return on stockholders’ equity for 2001 under (a) the capitalization accounting treatment for software development costs, and (b) the immediate expensing accounting treatment for software development costs. (c) Comment on which of the two earnings forecasts is most likely to reflect SSS’ssustainable earnings , that is, the level of earnings that is most likely to persist in the future. Note: In formulating your forecasts, (i) ignore the potential effects of both the planned share offering and the projected expansion into the outer Bay Area, and (ii) assume that sales in the Bay Area suburban market grow at a rate of 10 percent.

5. Comment on which accounting treatment for software development costs – capitalization or immediate expensing– do SSS’s financial statements provide the “fairest” presentation of the company’s resource, obligations, and performance? Note: Assume that “fairest” means the accounting approach that most accurately presents the underlying economic reality assoc iated with the software development costs. Note: You must answer all 5 questions above to earn the extra credit point.

Simulation Question 13-3 Simulation Question 13-3 is an adaptation with permission from a case by M.R. Gujarathi inIssues the in Accounting Education , a publication of the American Accounting Association in Sarasota, Florida. This simulation question is based upon a true set of facts; however, the names and places have been changed.



Company Overview

Super Electronics, Inc. (SE or the Company) is a regional specialty retailer of consumer electronics, home office products, entertainment software, appliances, and related services. The Company has committed to the goals of growth and innovation ever since its incorporation in 1990. It was among the first few large retailers to sell emerging electronics items such as digital cameras, camcorders, flat-panel

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televisions, and GPS navigation systems to the mass market. SE provides extensive training about the new products to its sales associates so that they can make it easier for even the least technologically savvy customer to try newer electronic gadgets. In the last decade, the Company has focused not only on increasing the sales of electronic products but also on capturing a significant share of the electronics installation market. SE services products purchased from its stores as well as from other retail or online outlets. The Company's reputation for large attractive stores, technical assistance for product selection, and expert installation and repair services has enabled it to achieve double-digit growth in revenues and a number of stores over the last several years. In 1999, SE launched an e-commerce site that sells a full range of the Company's products.



Performance

Compared to other firms in the specialty retailing industry, the Company has demonstrated above-average growth in sales and gross margins in the last decade. The Company's management is optimistic that this trend will continue for the foreseeable future. In fiscal 22008, SE 3 reported the highest comparable stores' sales growth in the specialty electronics industry. However, preliminary results for fiscal year 2008 (ending on February 28, 2009) indicate that the Company might not be able to meet the $3.00 per share analysts' earnings estimate. The Company's Board of Directors has placed SE's performance in the top quintile in the industry on many dimensions. Externally, too, SE's financial performance is well recognized. Moody's has assigned an investment grade rating (Aa) to the Company's bonds, and SE's stock trades at a multiple of 16 to its earnings (in comparison with the average of 12 for the industry). Analysts have attributed the high price multiple to the Company's growth prospects and the strategic direction articulated by its management. SE's preliminary financial statements for the 2008 fiscal year are provided in ExhibitYou 1. should access Data File 13-3 in iLearn for Exhibit 1, which present s SE’s preliminary financial statements for the 2008 fiscal They year.are not final; only upon further evaluation and approval by the external auditing firm will the financial statements be filed with the Securities and Exchange Commission (SEC).



Recent Initiatives

In its 2008 annual report, SE's management has reported implementation of the following new initiatives : Customer Loyalty Pr ogram SE initiated Super Rewards Program (SRP) in fiscal 2008 to compete with other retailers that have started customer loyalty programs. Such programs are deemed cost-effective because enticing a new customer tends to be more expensive than getting an existing customer to purchase more.4 SE's program aims at acquiring information regarding customers' spending habits and motivates them to return often to SE for additional purchases. By tracking the frequency, amounts, and types of purchases made by the customers, the Company can design more effective sales and promotion strategies. For an annual membership fee of $24, customers enrolled in SRP receive announcements of special sales, product coupons, and invitations to shopping events. The annual membership fee comes with a “complete satisfaction” guarantee. If a customer is not satisfied with SRP for any reason, the Company is obliged to refund the fees for the unused period of membership. Strategic Sourcing (Vendor Allowance) The Company made concerted efforts in the area of strategic sourcing and aggressive sales promotion of flat-panel televisions and digital cameras. According to the 2008 annual report, the Company's procurement policies and large size enabled it to secure low prices from its vendors, which were passed on as savings to the customers. In 2008, the Company has established long-term strategic alliances with select suppliers, including one with a major vendor of flat-panel televisions. In addition, the management of the Company expects to finalize negotiations with several additional vendors in the near future. Price Protection Plan To secure an edge over the competition, SE introduced a price protection plan for “big-ticket” items (priced at $499 and above) in fiscal 2008. If an item purchased by a customer goes on sale at SE at a lower price within 60 days of sale, the customer can present the srcinal sales receipt and get a refund for the difference between the price paid and the new lower price.



Financial Reporting for Recent Initiatives

During the annual audit for fiscal 2008, the audit team asked SE's management about the financial transactions relating to the new initiatives of the Company and the financial reporting policies it has followed for them. A summary of this discussion is given below: Customer Loyalty Pr ogram The Company sold 25,000 SRP memberships per month in fiscal year 2008, resulting in proceeds of $7,200,000 (25,000 memberships × 12 months × $24 membership price) in net sales. SRP members earn two points for each qualifying purchase of $1 of products and services of the Company. Points earned enable members to receive a certificate that can be redeemed on future purchases. SE issues a $5 certificate for every 100 points earned by a member. The certificate expires one year after issuance. SRP members made qualifying purchases totaling $330 million during 2008. With no historical experience with point redemption, the Company recorded the entire retail value ($33 million) of the certificates issued as a reduction in sales and an increase in accrued liabilities. Customers “spent” (i.e., used) $23 million of the certificates in fiscal 2008, and $5 million of the certificates expired before February 28, 2009. When SRP certificates are used or expired, they have been recorded as a sale and a decrease in accrued liabilities. Strategic Sourcing (Vendor Allowance)5 Because of the strategic sourcing initiative, the Company was able to negotiate significant allowances from a major vendor of flat-panel televisions. The vendor agreement stipulates that SE receives a 7 percent refund on all purchases if it commits to purchase at least $100 million of flat-panel televisions over a three-year period. If the purchase commitment exceeds $150 million, the vendor will give an additional 1 percent refund, making the total refund 8 percent. The vendor granted higher allowances and flexible payment terms to SE in order to lock in the multi-

2 3

The Company's fiscal year begins on March 1 and concludes at the end of February. Comparable stores sales growth is a commonly used measure in the retail industry to measure the growth in revenue from the existing stores.

In the United States, it is estimated that almost 75 percent of consumers own at least one loyalty card, with over a third of all shoppers owning two or more. The popularity of customer loyalty programs is on the rise. Even luxury hotel chains such as Ritz-Carlton have added such programs recently (Wall Street Journal 2010). 5 Vendor allowances, widely prevalent in the retailing industry, are the amounts manufacturers or dealers pay to the retailers in exchange for a promise of guaranteed volume of purchases and for benefits such as premium shelf space or an end-of-aisle display at the retail outlets. Typically, the vendor allowance amounts are paid in advance of the purchases promised by the retailer. 4


year purchase commitment. Obtaining such commitments has lately become challenging to vendors because of the poor economic environment in the retailing industry. The vendor has agreed to pay SE 5 percent of the amount of the total three-year purchase commitment at the end of the first year and 1 percent at the end of the second year. In the third year, the vendor will pay the remaining amount depending on the total purchases made by SE over the three-year period. If the cumulative purchases do not meet the agreed-upon targets, SE will need to return the unearned portion of the refund to the vendor. In 2008, the Company made a commitment to purchase at least $150 million of flat-panel televisions from the vendor. It has made purchases of $45 million in fiscal 2008, and expects to make purchases of $55 million and $60 million, in 2009 and 2010, respectively. Almost all of the $45 million of flat-panel televisions purchased from the vendor have been sold by SE during 2008. They are recorded in the statement of operations as cost of sales, buying, and warehousing. The Company has recorded the entire cash refund of $7.5 million (5 percent × $150 million) received during fiscal 2008 as sales.6 Price Protection Plan SE's net sales in fiscal year 2008 included $240 million of “big-ticket” products (priced at $499 and above) covered under the price protection plan. The Company has refunded $7,000,000 in 2008 under the price protection plan and has recorded these as reductions in sales. During the coming year, the Company expects further reductions in prices of “big-ticket” products in light of the deteriorating economic conditions in the consumer electronics markets.



Management Proposals during the audit Process

During the process of annual audit for fiscal 2008, the senior management of the Company has proposed making the following adjustments to SE's accounts. These adjustments are not reflected in the preliminary financial statements given in Exhibit You 1. should access Data File 13-3 in iLearn for Exhibit 1, whi ch present s SE’s preliminary financial statements for the 2008 fiscal year. Unredeemed SRP Certificates

SE's management proposes to record as sales the estimated amount of SRP certificates that will not be redeemed. Management estimates that 15 percent of the remaining $5 million of outstanding certificates will not be redeemed. Thus, the expected amount of non-redemption would be $750,000. Vendor Allowances SE's management wants to recognize the $5.3 million difference between the total expected refund of $12.8 million (8 percent × $160 million) and the amount received from the vendor of $7.5 million (5 percent × $150 million) in fiscal 2008 as sales and as a receivable from the vendor. Management believes that such recognition is appropriate given the high likelihood that the refund will be earned; it expects total purchases over the three-year period to be $160 million, exceeding the threshold of $150 million needed to earn a refund of 8 percent. Executive Compensation To attract, retain, and motivate key executives, the Board of Directors of SE has approved a generous executive compensation package to its senior management. The compensation package consists of a base salary (which is not performance-based), a short-term incentive bonus plan (for achieving the specified performance targets), and long-term incentive stock option plan (to incentivize senior management for increasing shareholder value). Pertinent details of the short-term incentive bonus plan for fiscal 2008 are given in Exhibit You 2. should access Data File 13-3 in iLearn for Exhibit 2, w hich present s SE’s short -term incentive bonus plan for the 2008 fiscal year.

Required Assume that you are an audit senior assigned to SE. The audit partner has asked you to provide an analysis of the Company's existing accounting policies for the three new initiatives and an evaluation of the proposals made by SE's management during the annual audit process. Your answers should (1) provide an assessment of whether the policies comply with Generally Accepted Accounting Principles (GAAP), and (2) Explain your rationale and support your position with citations from the applicable authoritative pronouncements using the FASB Accounting Standards Codification, and other relevant resources, if an authoritative pronouncement is unavailable. Specifically, address the following questions: 1. Membership fees received for the Super Rewards Program. a. Is it appropriate for SE to record the entire membership proceeds of $7,200,000 as revenue of fiscal 2008? If yes, why? If not, explain why and compute the amount of membership fees revenue that should be recognized in fiscal 2008. (Note: For ease of calculations, assume that each membership fee is received at the midpoint of the month and that the actual and estimated cancellations of membership are immaterial.) b. Should the membership revenue be presented as sales or as other income in SE's statement of operations? If the net effect of the two alternatives on income is the same, should this matter? Why? c. If the membership does not come with the “complete satisfaction” guarantee (i.e., if membership fees are non-refundable), determine the amount of membership fees revenue that SE should recognize in fiscal 2008. 2. SRP certificates issues, used and expired. a. Explain whether SE's accounting for SRP certificates issued, used and expired complies with GAAP. Identify at least one other company whose accounting for customer loyalty program is similar to SE's accounting for the Super Rewards Program. Describe how that company has reported its accounting for the customer loyalty program in its annual report. b. Is SE's financial reporting for the SRP certificates (issued, used and expired) the only GAAP-compliant method to account for a customer loyalty program? If not, (a) describe the alternative(s) and cite authoritative support for the alternative(s), and (b) identify at least one company that follows the alternative(s) and describe how that company reported its accounting for the customer loyalty program in its annual report. c. If alternative accounting methods are acceptable per GAAP, what are some factors that will affect SE's management's choice of an accounting method? What adjustments to the statement of operations in Exhibit 1 will SE need to make if it chooses an alternative method to account for the SRP certificates issued, used and expired? 3. Vendor allowances. a. Does SE's recording of the cash refund of $7.5 million from the vendor as sales of fiscal 2008 comply with GAAP? Why? Explain.

6

SE recognizes revenue when the customer takes possession of the merchandise. Although SE uses separate accounts (such as gross sales, sales discounts, sales returns, and sales allowances) to record individual transactions, net sales reported in the statement of operations represent an aggregate sum of those accounts.

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b. Determine the amount of vendor allowance that should be recognized in fiscal 2008 and indicate where in the financial statements it should be presented. Does the presentation matter if the effect on net income is the same? Why? Explain. 4. Price protection plan. What adjustments, if any, should be made to the statement of operations in Exhibit 1 to ensure that SE's financial reporting for the price protection plan complies with GAAP? (Note: Assume that the sales of “big-ticket” products have occurred uniformly over fiscal 2008, i.e., $20 million per month). Since this is the first year of initiating a price protection plan, SE cannot reliably estimate eventual refunds from the plan. Based on your research and interviews with SE's management, you have determined that the history of price changes on “big -ticket” items (when the price protection plan was not in use) is unavailable for the Company or the industry. 5. Effect of GAAP adjustments on statement of operations. As an audit senior, you want to ensure that SE's existing financial reporting policies for the new initiatives are GAAP-compliant. What adjustments, if any, would you suggest to the Company's reported net sales, cost of sales, gross profit, operating income, other (loss) income, net earnings, and earnings per share? Provide your answer in the format given in Exhibit 3. Assume the average income tax rate to be 40 percent. You should access Data File 13-3 in iLearn for Exhibit 3, w hich provides the format for the adjustments.


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Chapter 14 Expenditure Cycle – Tests of Controls and Tests of Balances Chapter Learning Outcomes (LOs) Checklist

After reading this chapter, you should be able to: 

LO14-1 Understand the accounting information system of a typical expenditure cycle.



LO14-2 Describe some common TOC procedures for purchases.



LO14-3 Describe some common TOC procedures for cash disbursements.



LO14-4 Apply the analytical procedures in an expenditure cycle.



LO14-5 Describe some common TOB procedures for accounts payable.



LO14-6 Identify some characteristics of accounts payable confirmation.



LO14-7 Describe some common TOB procedures for property, plant, and equipment



LO14-8 Describe some common TOB procedures for legal expense.



LO14-9 Describe some common TOB procedures for 3 industry-specific-accounts of the expenditure cycle: intangible assets, natural resources, and leases

account.


Chapter 14 Expenditure Cycle – Tests of Controls and Test of Balances An overview of the strategy for tests of controls in an expenditure cycle is presented in Figure 14-1. Figure 14-1 TOC Strategy in Expenditure Cycle

The Audit Process

Audit Plan

Tests of Controls

Tests of Balances


Audit Report



2. Expenditure Cycle CH 14

2. Documenting the Understanding of Internal Control








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Understanding Internal Control in an Expenditure Cycle

TOC strategy in an expenditure cycle starts with an understanding of internal controls relating to an expenditure cycle. Table 14-1 provides a brief discussion of the various components relating to the understanding of internal controls in an expenditure cycle. Table 14-1 Understanding Internal Controls in an Expenditure Cycle

Understanding Internal Controls in an Expenditure Cycle 1. Control environment

2. Risk assessment


4. Information and communication

5. Monitoring

Table 8-1 in Chapter 8 listed seven factors affecting the control environment. Since these factors affect all accounting cycles, understanding of the control environment is generally conducted for all the accounting cycles taken as a whole. The auditor should, however, consider any control environment factors that may have a special effect on the expenditure cycle. Table 8-1 in Chapter 8 listed the five basic management assertions that must be met by the management’s risk assessment. The auditor must understand how management assesses risks that are relevant to the expenditure cycle, estimates their significance, assesses the likelihood of their occurrence, and takes action to address those risks in order to meet the five basic management assertions. Table 8-1 in Chapter 8 listed the five basic control activities that must be established in an accounting cycle. If the auditor plans toconduct both TOC and TOB onthe expenditure cycle, then s/he needs to identify the control activities relating to specific audit objectives and for the purpose of assessing control risk (CR). The auditor usually identifies these control activities from documentations of the understanding using narrative descriptions, internal control questionnaires, or flowcharts. Figure 14-8 shows an example of an expenditure cycle flowchart. The auditor must obtain sufficient knowledge of the accounting information system relating to the expenditure cycle to ensure that the TOC and TOB procedures meet the eight types of specific audit objectives listed in Table 8-1 in Chapter 8. Specifically, the auditor must obtain sufficient knowledge in three areas as shown in Figure 14-2. A brief discussion of these three areas is provided in Table 14-2. The auditor must understand the management’s monitoring processes over the expenditure cycle. This includes understanding how the management monitors the internal controls of the expenditure cycle over time and what corrective action is initiated to improve the design and operation of controls in the expenditure cycle.

Figure 14-2 Understanding of Information and Communication in an Expenditure Cycle

Key Functions Understand 4 key functions of an expenditure cycle




Table 14-2 Understanding of Information and Communication in an Expenditure Cycle


Key Functions

Accounts (control ledger) 1. Purchasing Processing request to purchase goods and services from authorized employee.

 





Inventory

Purchases

Property, plant, and equipment



 Purchase requisition This document requests goods or services for an authorized individual or department. Figure 14-3 shows an example of a purchase requisition. 

Prepaid expenses

Purchaseincludes order the description, quality, and quantity of This document the goods and services being purchased. The purchase order also indicates who authorizes the acquisition of goods and services. The purchase order may be mailed, faxed, or placed by phone or internet with the supplier or vendor. Figure 14-4 shows an example of a purchase order.



Leasehold improvements



Accounts payable



Manufacturing expenses



Selling expenses



Administrative expenses 2. Receiving Receiving, counting, and inspecting goods received from vendors. 3. Processing and recording liability Processing vendor invoices for the receipts of goods and services. Recording of accounts payable.

 Receiving report This document records the date, description, and quantity of the goods received. It is usually just a copy of the purchase order with the dollar amount omitted. Figure 14-5 shows an example of a receiving report. 

Purchase returns allowances



Purchase discounts

and



Purchase returns and allowances

 Vendor invoice This document is the bill from the vendor, which includes the description and quantity of the goods shipped or services provided, the price including freight and trade discounts, and the date of billing. Figure 14-6 shows an example of a vendor invoice. Voucher  document This establishes a formal means of recording and controlling purchases. It includes a cover sheet or folder to create a voucher packet containing the purchase order, copy of the packing slip, receiving report, and vendor invoice. After payment, a copy of the check is added to the voucher packet.

 Purchases journal A purchases journal is used to record all goods and services purchased. It usually includes several classifications for the major types of purchases, such as the purchase of inventory, repairs and maintenance, supplies, the entry to accounts payable, and miscellaneous debits and credits. The purchases journal may also include purchase returns and allowances for which a separate journal has not been created. Details from the purchases journal are posted to the accounts payable subsidiary ledger. An alternative to the purchases journal is a voucher register that is used to record all vendor invoices for goods and services purchased.  Accounts payable subsidiary ledger (file) An accounts payable subsidiary ledger is used for recording individual purchases, cash disbursements, and purchase returns and allowances for each vendor. The total of the accounts payable subsidiary ledger is post to the accounts payable in the general (control) ledger. When a voucher register is used instead of a purchases journal, the total of unpaid vendor invoices in the voucher register is the total accounts payable.

 Accounts payable trial balance (list) An accounts payable trial balance lists the amount owed to each vendor at a point in time and is prepared from the accounts payable subsidiary ledger.

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Key Functions




 Vendor Statement This statement is sent monthly by the vendor to indicate the beginning balance, current-period purchases and payments, and the ending balance. The vendor statement may differ from the client’s records because of errors or timing differences. The auditor can verify the accuracy of the client’s records by comparing vendor statements with the accounts payable subsidiary 4. Cash disbursement Processing and recording of the payment of cash to vendors.



Cash account (cash in bank)



Disbursem

ents



Accounts payable

ledger. Figure 14-7 shows an example of a vendor statement.  Check This document, signed by an authorized employee, pays for goods or services. When the check is cashed by the vendor and cleared the client’s bank, it i s called a cancelled check. Some clients make payment to the vendor electronically through an electronic funds transfer (EFT) between the company’s bank and the vendor’s bank.

 Cash disbursements journal This journal records disbursements made by check. It is sometimes referred to as a check register. The cash disbursements journal contains columns for recording credits to cash and debits to accounts payable and cash discounts. Columns may also record miscellaneous debits and credits. Payments recorded in the cash disbursements journal are also recorded in the voucher register (if this is used instead of the purchases journal) and in the accounts payable subsidiary ledger.

Figure 14-3 An Example of a Purchase Requisition PR #582 PURCHASE REQUISITION XYZ Company 3rd Street, San Francisco CA 94132 Department: Accounting, 3rd Floor, Room No.300 Quantity 2 1

Description Office Furniture: Wood Furnish, Black Color, Saunder#68342 Photocopy Machine: Duplex, Energy Saving, Canon#401

Requisition Approval Person:Kim

Date: January 1, 201x


Figure 14-4 An Example of a Purchase Order PO #329 PURCHASE ORDER XYZ Company 3rd Street, San Francisco CA 94132 To: ABC Company 1st Street, San Francisco CA 94132 Customer Reference No. 113 Process Our Order For: Quantity 2 1


Contact Person:Mary

Date: January 3, 201x

Price $ 500 $6000

Ship Via: You delivery

Total $1000 $6000 Terms: 2/10, n/30

Figure 14-5 An example of a Receiving Report RR #761 RECEIVING REPORT XYZ Company 3rd Street, San Francisco CA 94132 Department: Receiving, BasementFloor, Room No.100 Quantity 2 1 Purchase Order #329

Description Office Furniture: Wood Furnish, Black Color, Saunder#68342 Photocopy Machine: Duplex, Energy Saving, Canon#401 Shipped Via: Deliver by Vendor

Goods Receiving Person: Lisa

Date: February 6, 201x

Figure 14-6 An Example of a Vendor Invoice SI #37561 SALES INVOICE ABC Company 1st Street, San Francisco CA 94132 Sold To: XYZ Company 3rd Street, San Francisco CA 94132 Your Purchase Order #329 Quantity 2 1


Price $ 500 $6000 Tax

Shipped: February 6, 201x

Shipped Via: Deliver by Vendor

Date: February 8, 201x.

Total $1000 $6000 560 $7560

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Figure 14-7 An Example of a Vendor Statement VS #37561 VENDOR STATEMENT ABC Company 1st Street, San Francisco CA 94132 To Customer: XYZ Company 3rd Street, San Francisco CA 94132 Date February February February February February February February

1 8 10 12 23 26 28

Amount

Beginning Balance Invoice #37561 Payment Credit #324 Invoice #37690 Payment Ending Balance

Statement Prepare Person:Jane

$7560 - $7560 - $ 140 $1000 - $ 500

Date: February 28, 201x.

Balance $3000 $7560 $3000 $2860 $3860 $3360 $3360


Figure 14-8 An Example of an Expenditure Cycle Flowchart

Functions

Documents & Records

Initiate Purchases

Purchase Requisition

Computer Process

Vendor Master File

Enter Purchase Requisition

ORDER PROGRAM Perform limit test and check authorization. Print purchase order.

Purchase Order

Receive Of Goods


Open Order File

Retrieve Authorization to Receive Shipment & Enter Goods Received Difference in Quantity Ordered & Received

RECEIVING PROGRAM Retrieve open Orders. Add receiving data. Transfer to receiving file. Print receiving report & outstanding purchase orders report.

Receiving Report

Perpetual Inventory

Receiving File

Outstanding Purchase Orders

Record Liabilities

Vendor Invoice

Enter Invoice

Voucher

Error Report

Voucher Register

General

Error Report

Ledger

ACCOUNTS PAYABLE PROGRAM Retrieve receiving data and match with vendor invoices. Perform edit checks. Enter data in purchase transaction file.

MASTER FILE UPDATE PROGRAM Update master files. Print voucher register, general ledger, weekly purchase report, and error report.

Weekly Purchases Report

Purchase Transaction File


Accounts Payable Master File

369

370


Functions Process Cash Payment

Documents & Records

Computer Process


Vendor’s Invoice

Error

CASH DISBURSEMENTS PROGRAM Match purchase, receiving, and invoice data. Print authorized disbursement listing. Print pre-signed/unsigned checks. Enter data in cash disbursement

Report

transactions file.

Enter Vendor’s Invoice Data

Authorized Disbursement Listing

Cash Disbursement Transaction File

Checks

Voucher Register MASTER FILE UPDATE PROGRAM Update master file. Print voucher register, general ledger, cash disbursements journal, and error report.

General Ledger

Cash


Accounts Payable Master File

Disbursements Journal Error Report

Vendor Master File

Consider Potential Misstatements in an Expenditure Cycle

After the auditors have obtained an understanding of the internal controls relating to the expenditure cycle and documented such an understanding; the auditors would consider potential misstatements that could occur due to weaknesses in internal control. Table 14-3 describes some of these potential misstatements in the expenditure cycle. Table 14-4 describes some potential misstatements that are specific to cash disbursements in the expenditure cycle. Table 14-3 Potential Misstatements in an Expenditure Cycle due to Weaknesses in Internal Control


Example of Fraud



Recording inaccurate purchases.





Misappropriation of purchases.





An accounting clerk colludes with a major supplier and records fictitious purchases from that supplier.

Recording a purchase for goods that have not been approved for ordering.

Goods are ordered but delivered to an

inappropriate address and stolen. Duplicate recoding of purchases

Example of Error





A purchase is recorded when an invoice is received from a vendor, and recorded again when a duplicate invoice is sent by the vendor.





Early purchases.

or

late

recording

Example of Fraud of

Example of Error



Intentionally closing purchases journal early to record this period’s purchases as having occurred in subsequent period.

Table 14-4 Potential Misstatements of Cash Disbursements in an Expenditure Cycle due to Weaknesses in Internal Control




Recording disbursements.

inaccurate

Example of Fraud cash



An accounting clerk prepares a check to himself/herself and records it as having been issued to a major supplier.

Example of Error



A disbursement is made to pay a vendor’s invoice for goods that have not been received.



Disbursements for travel and entertainment are mistakenly included with goods purchases.



Duplicate payments.



Unrecorded disbursements



A payment is made when an invoice is received from a vendor, and paid again when a duplicate invoice is sent by the vendor.



An accounting clerk writes and cashes an unrecorded check for the identical amount of an unrecorded and deposited cash receipts.


After considering potential misstatements, the auditors assess the control risk (CR) and perform TOC procedures as per the audit program for the expenditure cycle. Table 14-5 and Table 14-6 describe some common TOC procedures that the auditors perform on purchases and cash disbursements of the expenditure cycle. Table 14-5 Specific Audit Objectives, Internal Controls, and Comm on TOC Procedures for Purchases

Specific Audit Objectives Internal Controls Existence or Occurrence: Recorded purchases are for goods and Purchases are approved at the appropriate level. services actually ordered and received. No fictitious purchases or goods and services not ordered or received are recorded. Vendor invoices, receiving reports, purchase orders, and purchase requisitions are subjected to internal independent checks.

No purchases or goods and services not received are paid.

Common TOC Procedures Examine documents in voucher packet for existence. Vouch a sample of entries in the voucher register to the supporting documents in the voucher packet. Inspect a sample of vouchers for the proper authorization purchase orders. Inquiry of the management for internal verification of vendor invoices, receiving reports, purchase orders, and purchase requisitions. Vouch a sample of receiving reports to their respective vendor invoices and vouchers. Examine a sample of canceled checks to ascertain that the related receiving reports are dated no later than the checks.

Completeness: Purchases transactions are recorded. This Purchase orders, receiving reports, and vouchers Scan for numerical sequence of purchase is the most important audit objective for are prenumbered and accounted for. orders, receiving reports, and vouchers. the expenditure cycle. Trace a sample of purchase orders (or vouchers) to the purchases journal (or voucher register). Accuracy and Classification: Purchases transactions are accurately Internal independent checks on vouchers Recompute information on vouchers for prices recorded and classified.

Understandability:

preparation. A chart of accounts is used.

and discounts. Compare the classification of a sample of vouchers with the classification in the chart of accounts.

371

372



Internal Controls


Purchases transactions are properly Separation of duties between recording of Observe separation of duty procedures. recorded in the purchases journal and purchases transactions and cash disbursements accounts payable. journal. Internal independent checks on accounts payable Inquiry of management about independent subsidiary ledgers agree with accounts payable check and review of purchases records. control ledger.

Table 14-6 Specific Audit Objectives, Internal Controls, and Common TOC Procedures for Cash Disbursements


Internal Controls

Existence or Occurrence: Recorded cash disbursement are for goods Separation of duties between custody of signed and services actually received. checks and record keeping. Approvals of payment on supporting documents at the time checks are signed. Disbursement documents are defaced to prevent duplicate payments.

Completeness: Cash disbursements are recorded.

Accuracy: Cash disbursements accurately.

Classification: Cash disbursements properly classified.

are

Common TOC Procedures Observe separation of duty procedures. Inquiry of management about approval on voucher packet. Observe the official, who signs check, matches the check with the supporting disbursement documents in the voucher packet and defaces (i.e., punches a hole) the supporting documents.

Checks are prenumbered and accounted for. Scan for numerical sequence of checks. Separation of duties between monthly bank reconciliation and recording of cash Examine bank reconciliations and observe disbursement. their preparation. recorded Internal independent checks on calculations and amounts of cash disbursements. An independent person prepares the monthly bank reconciliation.

transactions

are An adequate chart of accounts is used.

Inquiry of the management about independent checks on the preparation of cash disbursements. Inspect monthly bank reconciliations. Read chart of accounts for adequacy. Compare the classification of a sample of cash disbursements with the classification in the chart of accounts.

Cutoff: Cash disbursements are recorded on the Procedures require recording of cash Compare dates on cancelled checks with the correct dates. disbursements as soon as the checks have been cash disbursements journal. signed. Compare dates on cancelled checks with the bank cancellation date.


An overview of the strategy for tests of balances in an expenditure cycle is presented in Figure 14-9.

Figure 14-9 TOB Strategy in Expenditure Cycle The Audit Process

Audit Plan

Tests of Controls

Tests of Balances


Audit Report



2. Expenditure Cycle CH 14

2. Derive DR (Detection Risk)







373

374


Apply TOB Strategy

Table 14-7 provides a brief discussion of the TOB strategy as it is applied to an expenditure cycle. Table 14-7 TOB Strategy in Expenditure Cycle

TOB Strategy – Expenditure Cycle 1. Allocate PJAM to TM

2. Derive DR




Chapter 9 discussed how the auditor allocates PJAM to TM at the individual account-balance or class of transaction level of a transaction cycle. In an expenditure cycle, the accounts payable balance is often made up of a large number of accounts and the balance is large. For these reasons, the auditor typically allocates a small TM (i.e., less tolerance) to accounts payable. The auditor derives the DR, based on a pre-specified AR, assessed IR and CR, by using the audit risk model of AR = IR x CR x DR at the individual account-balance or class of transactions level of a transaction cycle (recall Chapter 9). The derived DR drives an optimum mix of the nature, extent, and timing of the TOB procedures used by the auditor. In the expenditure cycle, inherent risk for the accounts payable is usually moderate or high. This is because it is usually made up of a large number of accounts and the balance is usually large. The auditor performssix common types of analytical procedures(recall Chapter 7): (1) Compare clientand industry data. (2) Compare client data with similar prior-period data. (3) Compare client data with clientdetermined expected results. (4) Compare client data with auditor-determined expected results. (5) Compare client data with expected results, using non-financial data. (6) Compare financial ratio analysis on client data. In the expenditure cycle, analytical procedures are used especially to uncover misstatements of accounts payable. One of the most effective analytical procedures for uncovering misstatements of accounts payable is comparing current-year expense totals with prior year. This is because expenses from year to year are typically relatively stable. Table 14-8 describes some analytical procedures and potential misstatements that may be detected by them in the expenditure cycle. The auditor performs the TOB procedures that address the nature, extent, and timing of evidence. For the nature and timing, if CR were assessed at the maximum of 100%, the auditor would not perform TOC procedures but perform only TOB procedures. In addition, the auditor would apply a variable sampling plan to determine the sample size of evidence. Table 14-9 summarizes some specific audit objectives and common TOB procedures in an expenditure cycle. The auditor is especially concerned about the specific audit objectives of completeness and cut-off in the expenditure cycle. The auditor documentsall misstatements foundby performing theTOB procedures and compares the total misstatements with the PJAM. Based on the misstatements found, the auditor may revise PJAM (RJAM) if necessary. The auditor should perform additional audit work or request the management to make adjustment for the misstatements.

Table 14-8 Analytical Procedures for the Expenditure Cycle

Analytical Procedure Purchases: Comparison of purchases-related expense account balances with prior years. Accounts Payable: Comparison of individual accounts payable with previous years.

Comparison of accounts payable turnover and days outstanding to previous years. Purchase Returns and Allowances: Comparison of purchase returns as a % of purchases to previous years. Comparison of purchase allowances as a % of purchases to previous years.

Detect Possible Misstatement of: Misstatement of purchases-related expenses. Unrecorded (understated) accounts payable. Fictitious (overstated) accounts payable. Understatement or overstatement of liabilities and expenses.

Understatement or overstatement of purchase returns and purchase allowances.


Table 14-9 Specific Audit Objectives and Common TOB Procedures for an Expenditure Cycle

Specific Audit Objectives Existence or Occurrence: Recorded accounts payable are valid.

Common TOB Procedures Confirmation of selected accounts payable by using MUS sampling approach (recall Chapter 12). Table 14-10 provides further discussion on the confirmation of accounts payable procedure. Table 14-11 provides further discussion on the use of vendor invoice and vendor statement in the TOB and confirmation of accounts payable. Vouch selected balances from the accounts payable trial balance (list) to the voucher packets and vendor invoices.

Completeness: All accounts payable are recorded Inquire the management for unrecorded liabilities. (unrecorded liabilities). This is the most Reconcile the amounts in vendor monthly statements with the amounts in the client’s accounts important audit objective for accounts payable subsidiary ledger. payable. Examine the files of unmatched purchase orders, receiving reports, and vendor invoices for any unrecorded liabilities. Trace a sample unmatched receiving report file in the current accounting period to accounts payable entries recorded in the next accounting period. All merchandise for which the client is Trace a sample of large-dollar amounts from vendor invoices to receiving reports, then to the billed is received. purchases journal and cash disbursement journal in the next accounting period to determine if the liabilities relate to the current accounting period. Confirm a sample of accounts payable including accounts with small or zero balance. Cutoff: All purchases transactions and related Examine a sample of receiving reports before year-end for recording purchases and accounts accounts payable balances are recorded in payable in proper period. the proper period. Review large purchase returns and allowances before and after the balance sheet date to determine whether they are recorded in the correct period. Table 14-11 provides further discussion on the purchases and purchases returns cutoff procedures. Rights and Obligations: Client’s is obliged to pay for liabilities As a rule of thumb, there is a very low risk for this specific audit objective because a client has no recorded in the accounts payable. incentive to record liabilities that it is not obliged to pay. Scan a small sample of the voucher packets for supporting documents such as purchase orders. Accuracy: Accounts payable in the accounts payable Foot the accounts payable trial balance (list) and agree total to accounts payable control (general) trial balance are accurate. ledger. Vouch a sample of accounts payable balances from the accounts payable trial balance to the voucher packets. Classification: Accounts payable in the accounts payable trial balance are properly classified. Long-term accounts payable and long-term notes payable are properly classified. Understandability: All related accounts in the expenditure cycle are properly presented and disclosed in the financial statements. All renewals of notes payable after the balance sheet date are properly disclosed.

Analyze accounts payable trial balance for long-term notes payable and long-term accounts payable. Inquire of management whether there are any long-term notes payable and long-term accounts payable included in the aged trial balance. Inquire management about related party payables and assure that they are properly disclosed. Read the minutes of the board of directors meetings for any long-term purchase commitments or contracts that must be adequately disclosed as a footnote in the financial statements. Review all renewals of notes payable after the balance sheet date but before the audit report issue date (referred to as subsequent events) to determine that they are properly disclosed as a footnote in the financial statements.

Confirmation of Accounts Payable

The characteristics of positive and negative confirmation described in Table 13-10 of Chapter 13 apply to the confirmation of accounts payable as well. However, there are some additional characteristics of the confirmation of accounts payable that are not shared by the confirmation of accounts receivable. These additional characteristics are summarized in Table 14-10. Table 14-11 further discusses the use of vendor invoice and vendor statement in TOB and confirmation of accounts payable.

375

376


Table 14-10 Additional Characteristics of Accounts Payable Confirmation

Additional Characteristics of Accounts Payable Confirmation



Less frequently used than accounts receivable confirmation Accounts payable confirmations are used less frequently than accounts receivable confirmations because the auditor can perform TOB on accounts payable by examining vendor invoices and vendor monthly statements. These documents srcinated from sources external to the client, so they are viewed as reliable evidence.

 Accounts payable with zero balance are confirmed to search for unrecorded liabilities. Accounts payable with zero balance are confirmed because the client may owe such vendors for purchases but the amounts may not be recorded. In addition, if the client’s internal control is weak, the auditor may also include balance with large-dollar amount for confirmation. A special form of positive confirmation is generally used.  In accounts payable confirmation, the auditor generally uses a special form of positive confirmation referred to as blank-balance confirmation. This type of positive confirmation does not state the balance owed. Instead, the confirmation requests that the recipient fill in the amount or furnish other information. It also usually requests additional information on notes payable and consigned inventory.

Table 14-11 Vendor Invoice and Vendor Statement in TOB and Confirmation of Accounts Payable

Vendor Invoice

  

Provides details of individual purchases transactions Use in performing TOC on Accounts Payable Generally not used in Accounts Payable confirmations.

Vendor Statement

  

Provides a total balance of all purchases transactions Used in performing TOB on Accounts Payable

Used instead of sending Accounts Payable confirmations. A rule of thumb: (1) When vendor statements are available, internal controls are strong, and client’s integrity is high, no need to send accounts payable confirmations. (2) When vendor statements are not available, internal controls are weak, and cli ent’s integrity is low, send accounts payable confirmations.

Table 14-12 Purchases and Purchases Returns Cut-off Procedures

Account

Cut-off Procedures

Purchases: If there is not a proper cut-off of purchase transactions; both The auditor first identifies the number of the last receiving report issued expenditure and accounts payable will be misstated for the current in the current period. Then a sample of voucher packets is selected for a and following years. In most instances, errors related to purchases few days just prior to, and subsequent to, the end of the period. The cut-off are unintentional and are due to delays in receiving goods and receiving reports contained in the voucher packets are examined to services or the recognition of the purchase. In other instances, the determine if the receipt of the goods is consistent with the recording of client may intentionally fail to record purchases transactions in the liability. Purchases representing goods received prior to year-end should current period or may record purchases from the next period in the be recorded in the current period, and purchases for goods received current period. subsequent to year-end should be recorded as purchases in the next period. Purchases Returns: Purchases returns seldom represent a material amount in the financial If the client’s internal control is strong, the auditor may use analytical statements. procedures in Table 14-8 to satisfy the cutoff objective for purchase returns.

Property, Plant, and Equipment

So far the discussion focuses on accounts payable, a liability account associated with the expenditure cycle. The following discussion focuses on property, plant, and equipment, an asset account associated with the expenditure cycle. Table 14-13 describes the application of analytical procedures to the property, plant, and equipment account. Table 14-14 summarizes some specific audit objectives and common TOB procedures in property, plant, and equipment account.


Table 14-13 Analytical Procedures for Property, Plant, and Equipment

Analytical Procedure

Detect Possible Misstatement of:

Compare the ratio of depreciation expense to the related property, plant, and equipmentMisstatement in depreciation expense and accounts and comparison to prior years’ ratio. accumulated depreciation. Compare the ratio of repairs and maintenance expense to the related property, plant, andExpensing amount that should be capitalized. equipment accounts and compari son to prior years’ ratios. Misclassification of capital expense to Compare actual maintenance expense with budgeted maintenance expense for the maintenance expense. reasonableness of the variances within a budgeting system. Compare the amounts spent on property, plant, and equipment with the amounts in the capitalPossible unauthorized overspending on plant budget. assets.

Table 14-14 Specific Audit Objectives and Common TOB Procedures in Property, Plant, and Equipment Account

Specific Audit Objective


Existence or Occurrence: Current year purchases of property, plant, Vouch additions and dispositions to vendor invoices or other supporting documents. and equipment existed. Count the plant assets to verify the physical existence of major additions and dispositions. Read lease agreement to ensure that lease transactions are accounted for properly. x records, and then tour the client’s facilities. Retired fixed assets existed. Inspect the property ledger and the insurance and ta Completeness: Existing purchases of property, plant, and Locate and inspect a sample of plant assets and trace to the property, plant, and equipment equipment are recorded. subsidiary ledger. Tour the client’s facilities, and then inspect the property ledger and the insurance and tax records. Existing retired fixed assets are recorded. Cutoff: Current year purchases are recorded in the Examine the purchases of plan assets for a few days before and after year-end. proper period. Rights and Obligations: The client has rights to current year Confirm deeds or title documents for proof of ownership. purchases of property, plant, and equipment. Accuracy: Current year purchases as recorded are Obtain a lead schedule of property, plant, and equipment; foot schedule and agree totals to the accurate.

Valuation and Allocation: Costing of plant assets is accurate.

general Obtain ledger. a detailed supporting schedule for additions and dispositions of property, plant, and equipment; agree amounts to totals shown on the lead schedule. Figure 14-10 illustrates an auditor’s work on a detailed supporting schedule for property, plant, and equipment. Vouch additions and dispositions to vendor invoices. Recompute depreciation calculations for a sample of plant assets in the detailed supporting schedule for property, plant, and equipment.

Classification: Current year purchases of plant assets are Examine vendor invoices in equipment account for items that should be classified as office properly classified. equipment or repairs. Vouch transactions included in repairs and maintenance for items that should be capitalized. Examine lease transactions for proper classification between operating and capital leases. Understandability: Plant assets are properly presented and Examine note or bond agreements to ascertain whether any capital assets are pledged as collateral disclosed in the financial statements. and require disclosure in the footnotes.

377

378


Figure 14-10 An Auditor’s Detailed Supporting Schedule for Property, Plant, and Equipment XYZ Company

Schedule: P

Detailed Supporting Schedule for Property, Plant, and Equipment

Prepared by: Tom

December 31, 20x1

Reviewed by: Fred

W/P Ref

Account No.

Account Title

Assets Additions Disposals

Balance 12/31/x0 P-1 P-2 P-3 P-4

501 502 503 504

Land Buildings Plant Equipment Totals

500,000 4,500,000 135,000 800,000 5,935,000

151,000 495,000 10,000 110,000 766,000

60,000 60,000

Balance 12/31/x1

Balance 12/31/x0

651,000 4,995,000 145,000 850,000 6,641,000

292,000 13,500 235,000 540,500

ff 

Date: 1/23/20x2 Date: 2/3/20x2

Accumulated Depreciation Provision Disposals Balance 12/31/x1 142,420r 7,000r 70,600r 220,020

50,600 50,600

434,420 255,000 20,500 709,920

ff

Agreed with general ledger and prior year working papers.

ff r

Footed and Cross-footed. Recomputed depreciation; all on straight line method; plant (5%), building (3%), and equipment (10%).

Legal Expense

This section focuses on legal expense, an expense account associated with the expenditure cycle. Table 14-15 describes some common analytical procedures for legal expense. Table 14-16 lists the common TOB procedures for legal expense. Table 14-15 Analytical Procedures for Analyzing Legal Expense

Analytical Procedure Compare individual legal expenses with previous years. Compare individual legal expenses with budgets. Look for an exponential growing trend in legal expenses over time.

Detect Possible Misstatement of: Overstatement or understatement of a balance in a legal expense account. Possible unauthorized overspending on legal services. Potential unrecorded contingent liabilities.

Table 14-16 Common TOB Procedures for Legal Expense

Common TOB Procedures for Legal Expense





Examine underlying documents TOB on legal expense usually starts with the auditor obtaining a detailed supporting schedule for legal expense from the client. This schedule typically details the name of the law firm, the legal issues involved, the duration of the engagements, and the amount of legal fees. Based on this schedule, the auditor examines the underlying documents for each transaction, such as the minutes of the board of directors meeting that authorize the hiring of a specific law firm, and the voucher packet for the payment of the legal fees. Figure 14-11 illustrates an auditor’s work on a detailed supporting schedule for legal expense. Analyze legal expense Based on the detailed supporting schedule for legal expense, the auditor usually analyses legal expense to determine whether there are potential contingent liabilities, disputes, illegal acts, or other legal issues that may affect the financial statements.


Figure 14-11 An Auditor’s Detailed Supporting Schedule for Legal Expense XYZ Company

Schedule: L

Detailed Supporting Schedule for Legal Expense

Prepared by: Sue

December 31, 20x1

Reviewed by: Fred

W/P Ref L-1

Account No. 801

Account Title Legal Expense

Paid To PPP Law Firm

Date: 1/23/20x2 Date: 2/3/20x2

Description

Date

Retainer –12 months@$1,000 – XYZ Vs ABCpatent infringement suit.

Monthly t May 3 10 Oct

QQQ Law Firm

Consultationinquiry – from Consumer Protection Bureau

RRR Law Firm

Service –assistance in collecting overdue Dec 12 accounts receivable from CDE company

June 5 Aug 23

Amount $12,000  

8,000 10,000  3,000  5,000  600  ________ 38,600 GL =========

f 

Lawyer’s letter requested. Received 1/8/20x22. All matters listed are covered therein. Letter filed in Corresponding Section of the working paper Permanent File.  Lawyer’s letter not requested. Per phone conversation with RRR Law Firm. The CDE matter was closed in Dec 20x1. 

Examined voucher packets.

t

Traced to minutes of meeting of Board of Directors 1/5/20x2. PPP Law firm reappointed general counsel with retainer.

GL f

Agreed to General Ledger. Footed.

Tests of Balances for Three Industry-Specific-Account of the Expenditure Cycle

Lastly, this section focuses on the auditor’s tests of balances on three industry-specific-accounts of the expenditure cycle are discussed. They are the intangible asset, natural resources, and leases. Table 14-17 provides a brief discussion on auditing these three industry-specific-accounts of the expenditure cycle. Table 14-17 TOB for Three Industry-Specific-Accounts of the Expenditure Cycle

A Brief Discussion on Auditing Intangible Asset, Natural Resources, and Leases



Intangible Assets



Intangible assets are the long-term resources of a client, but have no physical existence. They derive their value from intellectual or legal rights, and from the value they add to the other assets. Intangible assets are generally classified into two broad categories: (1) Limited-life intangible assets, such as patents, copyrights, and goodwill, and (2) Unlimited-life intangible assets, such as trademarks. In contrast to tangible assets, intangible assets normally cannot be used as collateral to raise loans, and some intangible assets (goodwill, for example) can be destroyed by carelessness, or as a side effect of the failure of a business. Whereas tangible assets add to an entity's current market value, intangible assets add to its future worth. An approximation of the monetary value of a firm's intangible-assets is calculated by deducting the carrying value/book value/net value of its tangible assets from its fair value/fair market value/total market capitalization. In some cases (such as the Coca Cola trademark), the value of a firm's intangible assets far outweighs the value of its tangible assets. When a client treats expenditure as creating an intangible asset, the auditor must look for objective evidence that a genuine asset has come into existence.  The auditor’s TOB on intangible assets may begin with analysis of the ledger accounts for these assets Debits to the accounts should be traced to evidence of payment having been made and to documentary evidence of the rights or benefits acquired. Credits tothe accounts should be reconciled with the client’s schedule of amortization or traced to appropriate authorization for the write-off of the asset.

379

380


A Brief Discussion on Auditing Intangible Asset, Natural Resources, and Leases



The auditor should review the reasonableness of the client’s amortization schedule. Amortization is line method over the intangible assets’ estimated useful lives. ordinarily computed by the straight-



According to FASB No.144, Accounting for the Impairment or Disposal of Long-lived Assets, long-lived intangible assets should be reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. The auditor must be alert for any changes in circumstances that may affect the recoverability of intangible assets and must continually review for their impairments.



One intangible asset that may be large in amount yet of questionable future economic benefit is goodwill. Good will arises in accounting for business combinations in which the price paid to acquire another company exceeds the fair value of the identifiable net assets acquired. When business combinations result in the recording of goodwill, the auditor should review the allocation of the lump-sum acquisition cost among tangible assets, identifiable assets, and goodwill. The auditor must also determine whether goodwill is properly allocated to all the various reporting units acquired in the acquisition. Often, the auditor will have to use the services of a business valuation specialist to assist them in evaluating the reasonableness of the valuation and allocation. Additional discussion on goodwill resulting from a business combination can be found in Chapter 19.



Once goodwill is acquired, it remains at its purchase price; it is not amortized. Instead, goodwill assigned to reporting units should be tested for impairment on an annual basis and between annual tests in certain circumstances. The auditor’s goodwill impairment tests involve determining the fair value of the reporting units for comparison to their carrying value. If the fair value of a reporting unit is less than its carrying value, and impairment loss is recognized for the difference.



Natural Resources



Natural resources are subject to depletion. Depletion is a term that describes the decrease in value of an asset that can be physically reduced over time. Unlike depreciation (for tangible assets) and amortization (for intangible assets), which describe the deduction of expenses of tangible assets and the reduction in carrying value of intangible assets, depletion is the actual physical reduction of natural resources by companies. In the audit of a client’s operating properties that are subject to depletion, such as mines, oil and gas deposits, timberlands, and other natural resources, the auditor follows a pattern similar to that used in evaluating the provision for depreciation expense and accumulated depreciation. The auditor determines whether depletion has been recorded consistently and in accordance withGAAP, and tests the mathematical accuracy of the client’s computation.



The depletion of timberlands is usually based on physical quantities established by “cruising.” Cruising means the inspection of a tract of forestland for the purpose of estimating the total lumber yield. The determination of physical quantities to use as a basis for depletion is more difficult in many mining ventures and for oil and gas deposits. The auditor often relies upon the opinions of such specialists as mining engineers and geologists about the reasonableness of the depletion rates being used for such resources. Under these Using the Work of a n Auditor’s circumstances, the auditors must comply with the provisions of AU 620 Specialist .



If the number of tons of ore in a mining property could be accurately determined in advance, an exact depletion cost per ton could be calculated by dividing the cost of the mine by the number of tons available for extraction. In reality, the contents of the mine can only be estimated, and the estimates may require significant revision as mining operations progress.



The auditor tests the ownership and the cost of mining properties (production cost) by examining deeds, leases, tax bills, vouchers, paid checks, and other records in the same manner that the auditor verifies the property, plant, and equipment of a manufacturing or trading companies. The costs of exploration and development work in a mine customarily are capitalized until such time as commercial production begins. After that date, additional development work generally is treated as an expense. Ordinarily, the large oil companies capitalize the costs of drilling oil wells only if they are found to be productive. Under this “successful efforts approach,” the costs of drilling wells that prove not to be productive are immediately written off. However, some smaller oil companies use an alternative “full-cost approach,” under which all drilling costs are capitalized and depleted over future years.



Environmental protection regulations have increased corporate responsibility to restore land used in mining to an agreed-upon natural state. In addition, many state laws require safeguards to protect the environment while the natural resource mining takes place.All costs associated with restoring the property to its srcinal state (i.e. all reclamation expenses) should be estimated and accrued. The auditor should examine the reasonableness of the procedures used by management to estimate such expenses. Reclamation expenses should be a part of the depletion expenses against the use of the natural resources.



Leases

 In the United States, there are two categories of leases: (1) Operating lease - an operating lease is a lease whose term is short compared to the useful life of the asset or piece of equipment (an aircraft, a ship leased. An operating leasehas is an commonly to 25 acquire equipment on a relatively short-term basis.etc.) Thus,being for example, an aircraft which economicused life of years may be leased to an airline for 5 years on an operating lease. An operating lease is recorded as rent expense over the lease term in the income statement by the lessee. (2) Capital (finance) lease– a capital (finance) lease is a lease that meets one or more of the following criteria: the lease term is greater than 75% of the property's estimated economic life; the lease contains an option to purchase


A Brief Discussion on Auditing Intangible Asset, Natural Resources, and Leases the property for less than fair market value; ownership of the property is transferred to the lessee at the end of the lease term; or the present value of the lease payments exceeds 90% of the fair market value of the property. A capital (finance) lease is recorded and amortized as a purchased asset in the balance sheet by the lessee. The determination of whether a lease is a capital (finance) lease or an operating lease is defined in the United States by the Statement of Financial Accounting Standards SFAS No.13. Under the current U.S. standards, an auditor client (the lessee) may improperly structure a capital (finance) lease contract as an operating lease contract thereby keeping the assets and liabilities off the balance sheet (i.e. off-balance sheet financing of asset acquisition) to make the client (the lessee) appears to be less leveraged, or to increase its return oninvestment. In 2009, the U.S. Financial Accounting Standards Board and the International Accounting Standards Board have published a joint discussion paper on the differing treatment of lease contracts under the International Financial Reporting Standards and U.S. generally accepted accounting principles. The two standards-setters have been working on converging the standards for lease towards a “principles that recognizes -based” aapproach economic of a lease contract ratheraccounting than its form in determining whether lease contract should bethe recorded as asubstance capital (finance) lease or an operating lease.

 In auditing leases, the audit procedures are as follows: (1) Obtain copies of lease agreements and carefully read the lease contracts. (2) Review the lease expense account to determine whether they are entries that are not covered by the lease contracts. (3) Review the criteria set forth in SFAS No.13 to determine whether there are improper classification of capital (finance) leases as operating leases. (4) For all capital leases, determine that (a) the assets and lease obligations (liabilities) are recorded at their present value, (b) determine the economic life of the asset, (c) recompute amortization expense and interest expenses, and (d) note any adjustments needed to correct the financial statements. (5) Test the client’s schedule of all future lease obligations to determine that it is accurate. (6) Stay alert to the possibility of management using leases for improper off-balance sheet financing of asset acquisition.

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Which of the following isan internal control that would prevent paid cash disbursement documentsfrom being presented forpayment a second time? a. Unsigned checks should be prepared by individuals who are responsible for signing checked. b. Cash disbursement documents should be approved by at least two responsible management officials. c. The date on cash disbursement documents should be within a few days of the date that the document is presented for payment. d. The official signing the check should compare the check with the documents and should deface the documents.

14-2

When goods are received, the receiving clerk should match the goods with a. The purchase order and the requisition form. b. The vendor invoice and the receiving report. c. The vendor shipping document and the purchase order. d. The receiving report and the vendor shipping document.

14-3

Internal controlis strengthened whenthe dollar amountof merchandise orderedis omitted fromthe copy of the purchase order sent to the a. Department that initiated the requisition. b. Receiving department. c. Purchasing agent. d. Accounts payable department.

14-4

Which of the following is the most effective TOC procedure to detect vouchers prepared for the payment of goods that were not received? a. Counting of goods upon receipt in storeroom. b. Matching of purchase order, receiving report, and vendor invoice for each voucher in the accounts payable department. c. Comparison of goods received with goods requisitioned in receiving department. d. Verification of vouchers for accuracy and approval in internal audit department.

14-5

For effective internal control purposes, whichof the following individuals shouldbe responsible for mailing signed checks? a. Receptionist. b. Treasurer. c. Accounts payable clerk. d. Payroll clerk.

14-6

To determine whether the recording of purchases transactionsis complete, an auditor performs a TOC procedure to verify that all merchandise received is recorded. The population of documents for this test consists of all a. vendor invoices. b. purchase orders. c. receiving reports. d. canceled checks.

14-7

Mr. A, the purchasing agent of a wholesale hardware company,has a relative who owns a retail hardware store. Mr. A arranged for hardware to be delivered by manufacturers to the retail store on a C.O.D. basis, thereby enabling his relative to buy at his hardware company’s wholesale prices. Mr. A was probably able to accomplish this because of the wholesale company’s poor internal control over a. purchase requisition. b. cash receipts. c. perpetual inventory records. d. purchase orders.


14-8

A specific audit objective isto ensure that an approved receivingreport is required to accompany everycheck request for payment of merchandise. Which of the following TOC procedures provides the greatest assurance that this control is operating effectively? a. Selection and examination of canceled checks and ascertainment that the related receiving reports are dated no later than the checks. b. Selection and examination of canceled checks and ascertainment that the related receiving reports are dated no earlier than the checks. c. Selection and examination of receiving reports and ascertainment that the related canceled checks are dated no earlier than the receiving reports. d. Selection and examination of receiving reports and ascertainment that the related canceled checks are dated no later than the receiving reports.

14-9

An auditor learnsthat his client has paid a vendor twice for the same shipment, oncebased upon the srcinal invoiceand once based upon the monthly statement. A control procedure that should have prevented this duplicate payment is a. pre-numbering of receiving reports. b. use of a limit or reasonable test of payments. c. pre-numbering of disbursement vouchers. d. attachment of the receiving report to the disbursement report.

14-10

When an acquisition ison a FOB srcin basis, the inventory andrelated accountspayable must be recorded in the current period if the goods were a. received prior to the balance sheet date. b. shipped prior to the balance sheet date. c. both shipped and received prior to the balance sheet date. d. paid for in advance.

14-11

Internal controlswhich are likely to prevent theclient fromincluding asa business expensethose transactionsthat primarily benefit management satisfy the specific audit objective of a. acquisitions are correctly valued. b. existing acquisitions are recorded. c. acquisitions are correctly classified. d. recorded acquisitions are for goods and services received.

14-12

Under which of the following circumstanceswould it be advisable forthe auditor to confirm accountspayable with creditors? a. Internal control over accounts payable is adequate, and there is sufficient evidence on hand to minimize the risk of a material misstatement. b. Confirmation response is expected to be favorable, and accounts payable balances are of immaterial amounts. c. Creditor statements are not available, and internal control over accounts payable is unsatisfactory. d. The majority of accounts payable balances are with associated companies.

14-13

Which of the following is an effective internal control over cash payments? a. Signed checks should be mailed under the supervision of the check signer. b. Spoiled checks that have been voided should be disposed of immediately. c. Checks should be prepared only by persons responsible for cash receipts and cash disbursements. d. A check-signing machine with two signatures should be utilized.

14-14

The internal control which requires that “checks are pre-numbered and accounted for” satisfies the specific objective of

a. accuracy. b. existence. c. completeness. d. cut-off. 14-15

The point at which most companies firstrecognize theacquisition andrelated liabilityon their recordsis when the a. purchase requisition is completed. b. purchase order is completed. c. receiving report is completed. d. vendor’s invoice is paid.

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14-16

A file for recording individualpurchases, cashdisbursements, andpurchase returnsand allowances foreach vendoris the a. cash disbursements transactions file. b. accounts payable master file. c. purchase transaction file. d. summary purchase report.

14-17

An auditor traceda sample of purchase ordersto the purchases journaland the cash disbursement journalfor the TOC specific objective of a. identify unusually large purchases that should be investigated further. b. verifying that cash disbursements were for goods actually received. c. determining that purchases were properly recorded. d. test whether payments were for goods actually ordered.

14-18

In auditing accounts payable, an auditor’s TOC procedures would focus primarily on management’s assertion of a. existence or occurrence. b. presentation and disclosure. c. completeness. d. valuation or allocation.

14-19

A client’s internal control requires that an approved voucher, a prenumbered purchase order, and a prenumbered receiving report accompany every check payment. To determine whether checks are being issued for unauthorized expenditures, an auditor most likely would select items for testing from the population of all

a. purchase orders. b. canceled checks. c. receiving reports. d. approved vouchers. 14-20

In assessing controlrisk for purchases, anauditor vouchesa sample of entries in the voucher registerto the supporting documents. Which assertion would this test of controls most likely support? a. Completeness. b. Existence or occurrence. c. Valuation or allocation. d. Rights and obligations.

14-21

Which of the following internalcontrol procedures mostlikely would justifya reduced assessedlevel of control risk concerning the existence or occurrence of plant and equipment acquisitions? a. Periodic physical inspection and verification of plant and equipment by the an internal independent staff. b. Comparison of current-year plant and equipment account balances with prior-year actual balances. c. The review of prenumbered purchase orders to detect unrecorded trade-ins. d. Approval of periodic depreciation entries by a supervisor independent of the accounting department.

14-22

Which of the following statements describesan important distinction betweenthe confirmation ofaccounts payablewith suppliers and confirmation of accounts receivable with debtors? a. Confirmation of accounts payable with suppliers is more widely accepted auditing procedure than is confirmation of accounts receivable with debtors. b. Statistical sampling techniques are more widely accepted in the confirmation of accounts payable than in the confirmation of account receivables. c. As compared with the confirmation of accounts payable, the confirmation of accounts receivable will tend to emphasize accounts with zero balances at the balance sheet date. d. It is less likely that the confirmation request sent to the supplier will show the amount owed him than that the request sent to the debtor will show the amount due from him.

14-23

Which of the following audit procedures is best for identifying unrecorded accounts payable? a. Examining unusual relationships between monthly accounts payable balances and recorded cash payments. b. Reconciling vendors’ statements to the file of receiving reports to identify items received just prior to the balance shee t date. c. Reviewing cash disbursements recorded subsequent to the balance sheet date to determine whether the related payables apply to the prior period. d. Investigated payables recorded just prior to and just subsequent to the balance sheet date to determine whether they are supported by receiving reports.


14-24

In auditing accounts payable, an auditor’s procedures most likely would focus primarily on management’s assertion of

a. existence or occurrence. b. presentation and disclosure. c. completeness. d. valuation or allocation. 14-25

In testing for unrecorded retirements of equipment, auditor most likely would a. select items of equipment from the accounting records and then locate them during the plant tour. b. compare depreciate journal entries with similar prior-year entries in search of fully depreciated equipment. c. inspect items of equipment observed during the plant tour and then trace them to the equipment master file. d. scan the general journal for unusual equipment additions and excessive debits to repairs and maintenance expense.

14-26

When using confirmations toprovide evidenceabout the completeness assertionfor accounts payable,the appropriate population most likely would be a. vendors with whom the client has previously done business. b. amounts recorded in the accounts payable subsidiary ledger. c. payees of checks drawn in the month after year-end. d. invoice filed in the client’s open invoice file.

14-27

Which of the following TOBprocedure is least likely to detect an unrecorded liability? a. Analysis and re-computation of interest expense. b. Analysis and re-computation of depreciation expense. c. Mailing of standard bank confirmation forms. d. Reading of the minutes of meetings of the board of directors.

14-28

Which of the following combinationsof procedures would an auditor be most likely to perform to obtain evidence about plant-asset addition? a. Inspecting documents and physically examining assets. b. Re-computing calculations and obtaining written management representations. c. Observing operating activities and comparing balances to prior-period balances. d. Confirming rights and obligations and corroborating transactions through inquiries of client personnel.

14-29

The audit procedures usedto verify accrued liabilitiesdiffer from those usedto verify accounts payablebecause a. accrued liability balances are less material than accounts payable balances. b. accrued liabilities at year-end will become accounts payable in the following year. c. evidence supporting accrued liabilities is non-existent, whereas evidence supporting accounts payable is readily available. d. accrued liabilities usually pertain to services of a continuing nature, whereas accounts payable are the result of completed transactions.

14-30

A major consideration inverifying theending balancein property, plant,and equipment accountsis the possibility of existing legal encumbrances. TOB procedures to identify possible legal encumbrances would satisfy the specific audit objective for a. b. c. d.

14-31

existence. understandability. occurrence. valuation.

The starting point for the verification ofcurrent yearacquisitions ofproperty, plant, andequipment is normally a. the property, plant, and equipment account in the general ledger. b. the acquisitions journal. c. the purchase requisitions file. d. a schedule obtained from the client of all acquisitions recorded in the general ledger during the year.

14-32

Which of the following TOB procedures would an auditor most likely perform to verify the management’s assertions of existence or occurrence and valuation or allocation of recorded accounts payable?

a. Investigating the open purchase order file to ascertain that prenumbered purchase orders are used and accounted for. b. Reviewing the client’s mail for a reasonable period of time after the year end to search for unrecordedvendor’s invoices. c. Vouching selected entries in the accounts payable subsidiary ledger to purchase orders and receiving reports. d. Confirm accounts payable balances with known suppliers who have zero balances.

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14-33

Which of the following TOBprocedures wouldan auditor mostlikely perform to search for unrecorded liabilities? a. Vouch a sample of cash disbursements recorded just after year end to next year’s receiving reports and vendor invoices. b. Scan the cash disbursements entries recorded just before year end for indications of unusual transactions. c. Compare a sample of purchase orders issued just after year end with the year-end accounts payable trial balance. d. Trace a sample unmatched receiving report file in the current accounting period to accounts payable entries recorded in the next accounting period.

14-34

The cutoff TOB proceduredesigned to detect purchasesmade beforethe end of the year that have been intentionally recorded in the subsequent year’s purchases provides assurance about management’s assertion of a. presentation and disclosure. b. completeness. c. existence or occurrence. d. valuation or allocation.

14-35

When using confirmations toprovide evidence about the completeness assertion foraccounts payable (unrecorded liabilities), the appropriate population most likely would be a. amounts recorded in the accounts payable subsidiary ledger. b. vendors with whom the client has previously done business. c. payees of checks drawn in the month after the year end. d. invoices filed in the client’s open invoice file.

14-36

In testing plantand equipment balances,an auditor may inspect new additions listedon the analysis ofplant and nce concerning management’s assertions about equipment. This procedure is designed to obtain evide Existence or Occurrence a. b. c. d.

14-37

Presentation and Disclosure

Yes Yes No No

Yes No Yes No

In performing asearch for unrecorded retirementsof fixed assets, anauditor most likely would a. inspect the property ledger and the insurance and tax records, and then tour the client’s facilities. b. tour the client’s facilities, and then inspect theproperty ledger and the insurance and tax records. c. analyze the repair and maintenance account, and then tout the client’s facilities. d. tour the client’s facilities, and then analyze the repair and maintenance account.

14-38

Determining that proper amounts of depreciation for fixed assets are expensed provides assurance about management’s assertions of valuation or allocation and a. presentation and disclosure. b. completeness. c. rights and obligations. d. existence or occurrence.

14-39

Which of the following explanationsconcerning plantassets most likely would satisfy an auditor who questions management about significant debits to the accumulated depreciation accounts? a. The estimated remaining useful lives of plant assets were revised. b. Plant assets were retired during the year. c. The prior year’s depreciation expense was erroneously understated. d. Overheads allocations were revised at year end.

14-40

When auditing prepaidinsurance, anauditor discoveredthat the srcinal insurance policyon plant equipment isnot available for inspection. The insurance policy’s absence most likely indicated the possibility of a(n) (Hint: Think of the beneficiary) a. insurance premium due but not recorded. b. deficiency in the coinsurance provision. c. lien on the plant equipment. d. understatement of insurance expense.


14-41

In TOB of property and equipment,an auditor vouches significant debitsfrom the repairs and maintenance expense account to determine a. noncapitalizable expenditure for repairs and maintenance have been recorded in the proper period. b. capitalizable expenditure for property and equipment have been properly charged to expense. c. noncapitalizable expenditure for repairs and maintenance have been properly charged to expense. d. capitalizable expenditure for property and equipment have not been charged to expense.

14-42

In performing asearch for unrecorded retirementsof fixed assets, an auditor most likely would a. inspect certain items of equipment in the plant and trace those items to the accounting records. b. review the subsidiary ledger to ascertain whether depreciation was taken on each item of equipment during the year. c. trace additions to the “other assets” account to search for equipment that is still on hand but no longer being used. d. vouch select certain items of equipment from the accounting records and locate them in the plant.

14-43

To determine whetheraccounts payableare complete, anauditor performsa test to verify that all merchandise receivedis recorded. The population of documents for this test consists of all a. payment vouchers. b. receiving reports. c. purchase requisitions. d. vendors’ invoices.

14-44

An auditor performsTOB to determine whetherall merchandise forwhich the client was billed wasreceived. The population for this test consists of all a. merchandise received. b. vendor’s invoices. c. canceled checks. d. receiving reports.

14-45

An auditor traced a sample of purchases ordersand the related receivingreports to the purchases journaland the cash disbursements journal. The purpose of this TOB procedure most likely was to a. identify unusually large purchases that should be investigated further. b. verify that cash disbursements were for goods actually received. c. determine that purchases were properly recorded. d. test whether payments were for goods actually ordered.

14-46

An auditor’s purpose in reviewing the renewal of a note payable shortly after t he balance sheet date most likely is to obtain evidence concerning management’s assertions about a. existence or occurrence. b. presentation and disclosure. c. completeness. d. valuation or allocation.

14-47

Which of the following procedureswould an auditor least likely perform before the balance sheetdate? a. confirmation of accounts payable. b. observation of physical inventory count. c. confirmation of accounts receivable. d. identification of related parties transactions.

14-48

When there are numerous propertyand equipment transactionsduring the year, an auditor who plans to assess control risk at a low level usually performs a. tests of controls and extensive tests of property and equipment balances at the end of the year. b. analytical procedures for current year property and equipment transactions. c. tests of controls and limited tests of property and equipment balances at the end of the year. d. attribute sampling tests of property and equipment balances at the end of the year.

14-49

Equipment acquisitions thatare misclassified as maintenance expense most likely would be detected by an internal control procedure that provides for a. segregation of duties for employees in the accounts payable department. b. independent verification of invoices for disbursements recorded as equipment acquisitions. c. analysis of variances with a formal budgeting system. d. authorization by the board of directors of significant equipment acquisitions.

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14-50

Which of the following TOBprocedures wouldan auditor least likely perform to search for unrecorded liabilities? a. Reconcile the amounts in vendor monthly statements with the amounts in t he client’s accoun ts payable subsidiary ledger. b. Trace a sample oflarge-dollar amounts from vendor invoices toreceiving reports, then trace to the purchases journal and cash disbursement journal in the next accounting period to determine if the liabilities relate to the current accounting period. c. Confirm a sample of accounts payable including accounts with small or zero balance. d. Vouch selected balances from the accounts payable trial balance to the voucher packets and vendor invoices.

14-51

Which of the following analytical procedures is least effective in uncovering unrecorded taxliabilities? a. Comparison of sales taxes to sales totals. b. Comparison of withholding taxes to total income. c. Comparison of payroll taxes to payroll totals. d. Comparison of income taxes to total income.

14-52

When a business combinationresulted in the recording ofgoodwill bythe client, the auditors shouldnot a. perform an annual TOB on goodwill impairment. b. review the allocation of the lump-sum acquisition cost among tangible assets, identifiable assets, and goodwill. c. determine whether goodwill is properly allocated to all the various reporting units acquired in the acquisition. d. ask the client’s management to assist them in evaluating the easonableness r of the valuation and allocation.

14-53

Natural resourcessuch as oil and gas present someunique problemsfor the auditor. Whichof the followingdoes not present an unique problem for the auditor? a. It is often difficult for the auditor to identify the costs associated with the discovery of the natural resources. b. It is often difficult for the auditor to use a geologist to determine the reasonableness of the depletion rate bring used for the natural resources. c. It is often difficult forthe auditor to estimate the amount ofcommercially available resources to be usedin determining a depletion rate. d. It is often difficult for the auditor to estimate the amount reclamation costs.

14-54

Which of the following istrue of capital (finance) leasesas compared tooperating leases? a. Only rent expense is reflected in the income statement. b. The leased asset does not appear o the balance sheet. c. Liabilities include the lease obligation. d. Future minimum lease obligations are not required to be disclosed.


14-1 d. 14-2 a. 14-3 b. 14-4 b. 14-5 a. 14-6 c. 14-7 d. 14-8 a. 14-9 d. 14-10 b. 14-11 c. 14-12 c. 14-13 a. 14-14 c. 14-15 c. 14-16 b. 14-17 c. 14-18 c. 14-19 b. 14-20 b. 14-21 a. 14-22 d. 14-23 c. 14-24 c. 14-25 c. 14-26 a. 14-27 b. 14-28 a. 14-29 d. 14-30 b. 14-31 d. 14-32 c. 14-33 d. 14-34 d. 14-35 b. 14-36 b. 14-37 b. 14-38 a. 14-39 b. 14-40 c. 14-41 d. 14-42 a. 14-43 b. 14-44 b. 14-45 c. 14-46 b. 14-47 a. 14-52 d. 14-53 b. 14-54 c.

14-48 c. 14-49 c. 14-50 d. 14-51 b.


Simulation Question 14-1 Simulation Question 14-1 is an adaptation with permission from a case by Ragothaman, S. C., W. Wilcox, and T.L. Davies in the Issues in Accounting Education , a publication of the American Accounting Association in Sarasota, Florida. This simulation question is based upon a true set of facts. However, the years during which the reported activities took place have been changed. Also, some of the names and places have been changed. As Jane Sweeny was driving south on Interstate 55 from downtown Chicago, her houghts t centered on her upcoming “end of audit” meeting with her boss, Richard Agassi, a partner of Arthur Andersen LLP (hereafter, AA), and Howard Koch, the Controller of Waste Management Incorporated (hereafter, WMI). Jane, a CPA with seven years of experience, had joined AA just three months earlier, in January 2000, soon after the previous audit manager had quit the firm. Jane was the manager on the WMI audit for the year ended December 31, 1999 and was in the process of wrapping it up. As Jane thought back over the engagement, she realized that the job had not gone as smoothly as she had expected.

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Background

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Selected Financial Information

WMI, a leading garbage hauler (trash collection business) in the U.S., experienced rapid growth in the late 1990s due to an aggressive expansion strategy and had achieved a 20 percent national market share. In just the years 1997 and 1998 alone, WMI acquired over 200 local garbage services. WMI became a Wall Street darling on the basis of a simple yet effective strategy – acquire smaller “mom and pop” operations across the nation and consolidate them into a giant business enterprise. Local garbage haulers didn’t hesitate to sell to WMI, since, by all appearances; it was a cash-rich corporation experiencing a skyrocketing stock price with no ceiling in sight. WMI had enjoyed ten years of double-digit growth in its waste disposal business, which was accompanied by a meteoric rise in its stock price. Even though WMI’s profits were soaring, there were still some concerns about the company’s business. The company began struggling to maintain the growth levels that investors had now come to expect. The situation was further exacerbated because the waste management business was being subjected to increased regulation due to public awareness and environmental concerns. Furthermore, competition was also up, as opportunistic, customer-oriented independent haulers sought to access local markets. As a result of these factors, collection fees were down, causing a general decline in the overall profitability of the waste management industry. During 1999, the company purchased 46 local haulers, a significant drop in its acquisitions pattern when compared to preceding years. However, during the year, WMI realized a $110 million gain from selling its interest in a business called SM Inc. In its 1999 preliminary financial statements, the company offset the entire gain from this transaction against unrelated operating expenses and adjus tments of prior years’ estimates. The effect on its income statement was substantial, ashet amount netted equaled 12 percent of the company’s 1999 income from operations. Company management did not believe that the disclosure of this accounting treatment was needed. Depreciable Assets. As Jane prepared to audit WMI, she knew of management’s vow to continue the company’s past success. An examination of the company’s records revealed that WMI’s property, plant, and equipment (PP&E) represented approximately 50 percent (a significant component) of the company’s assets. This was not atypical of the waste processing and disposal industry, where a typical firm would have between 45 and 60 percent of its assets in PP&E.You should access Data File 14-1 in iLearn for Table 1, which presents selected balance sheet data from PP&E. Records further indicated that the company was depreciating its vehicles and equipment (i.e., trucks and dumpsters) over useful lives

ranging from three to 20 years, usually choosing the longer period. While these recovery periods were longer than the industry average, WMI management asserted that the longer lives were reflective of the company’s actual experience.Y ou should access Data File 14-1 in iLearn for Table 2, which presents the recovery periods of the industry. Summary Income Information. In order to permit an evaluation of the financial activities of the company, you should access Data File 14-1 in iLearn for Table 3, which provides selected income statement summary data. Due to the company’s heavy capitalization, the ratio of WMI’s 1991 depreciation expense to total revenues was about 8 percent. Jane’s analysis revealed that this ratio was t ypically betwe en 10 and 14 percent

for the waste disposal industry as a whole. Because WMI is a publicly traded company, its reported earnings and earnings per share take on added significance due to their impact on Wall Street expectations and investor buy-sell decisions. Environmental Liability. A significant component of WMI’s business involves its utilization and maintenance of company-owned waste disposal sites. As part of ongoing operations, the company routinely acquires multiple sites to store and manage waste. After a site’s available space has been used, additional costs are incurred in closing the landfill. Environmental laws and regulations require that WMI monitor a closed site for potential hazards for an additional 30 years, resulting in a substantial ongoing cost to the corporation. Generally accepted accounting principles (GAAP) require that all of the costs related to the site be allocated to the operating life of the disposal sites as available space is consumed. In estimating its future financial obligation, WMI has historically inflated the cost in current dollars at 3 percent until payment was expected, and You should access Data File 14-1 in iLearn for Table 4, which discloses then discounted the cost flow to present value using a 7 percent rate. the company’s environmental liability for the closure and -closure post costs.According to management, the increase in the amount to be provided in the future related primarily to additional space having been acquired in anticipation of expected continuing expansion. After reviewing Table 4, Jane looked at the draft of the company’s financial statement notes as they related to these liabilities costs. The notes stated the following: The Company provides for closure and post-closure monitoring costs over the operating life of disposal sites as landfill space is consumed. The accrual for closure and post-closure costs relates to expenditure to be incurred after a facility ceases to accept waste. The Company’s active landfill sites have estimated remaining lives ranging from one to over 100 years based upon current siteplans and anticipated annual volumes of waste.

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Auditor’s Dilemma As the audit progressed, several issues began to concern Jane. A few years earlier, WMI had diversified into recycling, water

company’s “growth throughIn acquisitions” treatment, power,inand care.press Jane twas leery had about the ategy for itsretnew ofrecycling business, as there hadenergy, been reports thelawn financial hat WMI overpaid for these acquisitions. addition, thestrcompany’s urns lines on the business and other new endeavors were quite low. Also, as WMI became bigger and more diversified, smaller competitors began to lure away customers in the company’s core trash business, which historically was very lucrative. WDI had recently secured a multi-million dollar long-term line of credit. There were allegations that the company CEO had intimidated small garbage haulers into selling their businesses to WMI. Finally,

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cutting measures had not substantially helped WMI’s bottom line. Despite all of these conditions, recently instituted company-wide costmanagement continued to optimistically forecast double-digit earnings growth for the corporation. WMI’s top management owned significant amounts of stock in the company. Its outside directors on the audit committee also own ed WMI stock. Intense pressure to meet its own optimistic return expectations put WMI in a precarious position. If WMI wished to maintain its solid Wall Street reputation and keep investors happy, drastic action would be necessary. Management continued to implement cost-cutting plans to decrease operating expenses during 1999. In addition, the company adopted several aggressive earnings-boosting accounting procedures that involved depreciation expense, revenue recognition, and expense deferral. Through innovation maneuvering, WMI managed to achieve its lofty profit projections for 1999, but Jane continued to have her doubts about these and other happenings within the corporation. In an attempt to gain control over the accounting complexities and related issues arising from its substantial expansion activities, WMI signed a contract in 1999 with a major enterprise resource planning (ERP) software vendor to implement an integrated information system. This software was designed to integrate the company’s functional areas and permit them to maintain only one company wide database. Employees were not enthused about the new training necessitated by this complex software package, and the implementation had not been as smooth as expected. Partially due to its phenomenal growth, proper checks and balances in the management and control structure of WMI and its new information system were conspicuously absent. Jane was also troubled by the fact that the company had gone through three different CEOs in the last eight months. The compa ny’s long-time chairman and CEO, Mr. Robert Bullock, was an autocrat, and he had run the company “his way” until his involuntary departure in early 1999. An investor group that demanded corporate reforms and accountability removed Mr. Bullock, as well as his successor. The next CEO resigned after discovering accounting concerns. WMI had a few outside directors on its board. However, they possessed little knowledge about complex accounting rules. Moreover, these same directors received substantial fees and contributions from WMI. Also of interest to Jane were some aspects of the company’s hiring practices. For the previous 25 years (most of WMI’s history), every chief accounting and financial officer hired by WMI had previously worked as an auditor with Jane’s CPA firm, AA LLP. In total, 14 former AA employees held key accounting positions with WMI during the 1990s. Not surprisingly, AA considered WMI one of its most valuable clients. The accounting firm’s engagement partner for the WMI audit was Ri chard Agassi, a star “client service” partner. Soon after he took over the engagement, Richard capped the audit fee charged to WMI at the previous year’s level in exchange for contracts that enabled the firm to earn additional fees for “special work.” During the late 1990s, AA collected $7.5 million in audit fees and $11.8 million in other fees from WMI. These fees represented a substantial portion of the accounting firm’s total revenue. In addition, Andersen Consulting (a sister firm of AA) collected $6 million form WMI for completing a strategic review and other projects for the company. Richard himself served on the steering committee that conducted the strategic review. Further, Richard’s compensation at AA was based in part on the firm’s billingsto WMI for audit and non-audit services. Jane’s meeting with Richard and Howard (the Controller of WMI) did not go very well. Jane shared her concern about the company offsetting the adjustments of prior period estimates and expenses against the gain from the sale of SM Inc. The adjustments, expenses, and the gain that was netted were individually material. She did not believe this practice conformed to GAAP. While Richard agreed with Jane, he suggested that the amounts being netted were not material to the financial statements taken as a whole. Richard , to Jane’s chagrin, further agreed with Howard that the netting did not need to be disclosed in footnotes to the financial statements since the net results was not material. Richard subsequently authorized (after consultation with the firm’s regional Audit Practice Director) the issuance of an unqualified opinion for WMI’s December, 1999 financial statements.

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Epilogue

In July 1991, the SEC issued a cease and desist order alleging that management violated U.S. securities laws when they publicly forecasted results for the quarter ended June 30, 1999, despite being aware of significant adverse trends in its business which made continued public support of its announced forecasts unreasonable. In March 2002, the SEC filed suit against the founder and five other top officers of the company charging them with perpetrating a massive financial fraud lasting more than five years. “Our complaint describes one of the most egregious accounting frauds we have seen. For years, these defendants cooked the books, enriched th emselves, preserved their jobs, and duped unsuspecting shareholders.” As for the CPA firm AA, the SEC eventually settled charges with AA and four of its partners related to the 1992 through 1996 audited financial statements. AA agreed topay a penalty of $7 million, the argest l ever assessed against an accountingfirm. According to the SEC Director of Enforcement, “ Arthur Andersen and its partners failed to stand up to company management and thereby betraying their ultimate allegiance to Waste Management’s shareholders and t he investing public. Given the positions held by these partners and the duration and gravity of the misconduct, the firm i tself must be held responsible for the false and misleading audit reports.”

Required Access Data File 14-1 in iLearn for Tables 1, 2, 3 and 4 on selected financial information to answer the following questions.

1. (a) What aspects of WMI’s depreciation expense make it susceptible to earnings management? (b) Using industry averages, stateyour assumptionsand make an estimate of WMI’s depreciation expense for 1997 -1999. (c) How does WMI’s reported depreciation expense compare to your calculation for those years, on an after-tax per share basis, assuming a 30 percent tax rate? (d) Given your estimate in parts (a), (b) and (c), how would depreciation expense for 1999 change if useful lives of the assets are increased by 10 percent and if all property, plant, and equipment is assumed to have a salvage value equal to 10 percent of cost? Show your estimate on a per share basis, after taxes. (e) Given your estimate in (d), and ifWMI were to make such changes, how should the company disclose these changes in its financia l statements as per the Accounting Principles Board (APB) Opinion No.20 (APB 1971)Changes on in Accounting Estimates ? 2. (a) A significant portion of WMI’s business is waste handling and disposal. Table 1 of Data File 14-1 provides information on land for disposal sites. What events cause that account to change, and what opportunities for earnings management exist with that account? You should research Environmental Protection Agency’s regulations on land for disposal sites for this question. (b) Table 4 of Data File 14-1 summarizes the environmental liabilities for closure and post-closure costs. What events cause this liability to change, and what opportunities for earnings management exist with this account?


You should research SFAS No. 5 (FASB 1975) Accounting for Contingencies , and AU 540 Auditing Accounting Estimates, Including Fair Value Accounting Estimates and Related Disclosures for this question. (c) Describe the types of audit procedures an auditor would expect to perform in support of these environmental liability cost estimates and allocations. Also, discuss the differential reliability values of this audit evidence.

Simulation Question 14-2 Simulation Question 14-2 is an adaptation with permission from a case by P. M. Clikeman in Issues the in Accounting Education , a publication of the American Accounting Association in Sarasota, Florida. This simulation question is based on hypothetical data.

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Expense or Asset? ngs entitled, “Adapting a 1930’s Accounting Model to the 21st Century.” In June 2000 the U.S. Senate Banking committee held heari Five witnesses testified that the current accounting model is inadequate to measure the performance and resources of information-age companies. Peter Wallison, Resident Fellow at the American Enterprise Institute, told the senators: According to some estimates, about 80 percent of the value of companies listed in the S&P 500 is attributable to their intangible assets. These are familiar items such as patents, trademarks, and software, and less familiar items such as employee skills, customer satisfaction, and efficiency of product innovation. However, conventional accounting has no effective means for recording intangible assets on balance sheets, and thus corporate balance sheets-prepared in accordance with Generally Accepted Accounting Principles (GAAP)- may simply not contain most of the assets a company holds. Worse still, since the purpose of accounting is to match costs with revenues-and a major aspect of cost is the depreciation or amortization of assets-earnings may be overstated or understated because the assets that are producing the earnings are not on the balance sheet and are thus not being depreciated or amortized. Several articles in popular business magazines also have complained that the current accounting model is not appropriate for valuing information-age companies. These articles claim: (1) earnings do not properly measure the performance of information-age companies because expenses are not matched with related revenues, and (2) balance sheets do not adequately report the value of information-age companies because essential determinants of their success such as patents, brand names, customer loyalty, and employee expertise do not meet the accounting definition of assets.

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Expenses of Information-Age Companies

An important concept in measuring earnings is the Matching Principle, which states that expenses should be matched with related revenues whenever it is reasonable and practicable to do so (Statement of Financial Accounting Concepts No. 6, FASB 1986, paragraph 146). Unfortunately, it may be more difficult for industrial and knowledge-based companies than for merchandisers to match expenses with related revenues. Merchandisers (e.g., retailers and wholesalers) buy and sell physical goods. They record an asset (i.e., inventory) when goods are purchased and an expense (i.e., cost of goods sold) when goods are sold. Gross profit measures the difference between the price received from the sale of the goods and the price paid at the time of their purchase. In the financial statements, the inventory costs are matched closely with the related revenues. Industrial companies are characterized by large amounts of long-term assets (e.g., factories, production machinery). Depreciation attempts to match the costs of long-term assets with the revenues generated from their use, but the matching depend on several estimates and assumptions. Most U.S. companies record the same amount of expense every year even if the revenu e generated from the asset’s use varies among years. One study has shown that approximately 80 percent of U.S. companies record depreciation using the straight-line method; only about 5 percent use the units-ofproduction method. Unless an asset’s useful life and salvage value are estimated with perfect accuracy, depreciation expense will be misstated during each year of the asset’s life, followed by a one-time gain or loss in the year of disposal. In the present information-age economy, many knowledge-based companies earn revenue by selling intellectual property. Examples of knowledge-based companies include software producers and pharmaceutical companies. Such companies are characterized by high upfront development costs and low production costs. Pharmaceutical and software companies spend billions of dollars on research and development, but spend pennies to produce each pill or compact disc. The problem accountants facts in measuring the performance of information-age companies is how to match the expenses with the revenues. Current accounting rules require most research, product development, and marketing costs to be expensed when incurred. Only the (nominal) production costs are recognized in the same period with the revenues. Researchers such as Lev and Zarowin complain that current accounting rules do not properly measure the earnings of innovative, information-age companies: The large investments that generally drive change, such as restructuring costs and R&D expenditures, are immediately expensed, while the benefits of change are recorded later and are not matched with the previously expensed investments. Consequently, the fundamental accounting measurement processing of periodically matching costs with revenues is seriously distorted, adversely affecting the informativeness of financial information. Lev and Zarowin cite the declining association between accounting earnings and stock returns and the declining ability of earnings to explain stock prices as evidence that accounting information is losing its value relevance. In an extreme situation, Amir and Lev found that earnings and book values, on a standalone basis, are virtually irrelevant for valuing wireless communication companies.

 Merchandisers and manufacturers earn revenue through their physical and financial assets (e.g., inventory, stores and fixtures, production machinery, customer receivables). These assets are reported on their balance sheets. Information-age companies depend more heavily on intangible assets. An Internet service provider’s primary asset is its subscriber base. A pharmaceutical company’s primary assets are the patents to its drugs. A software producer’s primary assets are the copyrights to its existing products and the employee exper tise that enables the Assets of Information-Age Companies

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company to develop new programs. Most of these internally generated “assets” are not reported on corporate balance sheets or, if reported, are valued at nominal amounts. AICPA chairman Robert Elliott told the Senate Banking Committee: The current accounting model is … based on the assumption that profitability depends on physical assets, like plant and machinery; on raw materials, like coal, iron ore, sheet metal, electrical wire, and plastic; in other words, on the tangible inputs needed to produce tangible products. This is the accounting model of the industrial age. We now have information companies, companies that do research and produce findings that they hope to profit from. The role of intellectual inputs that ultimately lead to sales has multiplied enormously. The range of these inputs runs from patentable ideas to marketing, process design, computer programs, know-how, brand names, work-force expertise and training, quality controls, executive strategy, and organizational mechanisms to generate both quality improvements and innovation. All of these things can add to corporate revenues. Yet most these kinds of things are not recognized by the accounting model. In 1982, accounting book values for the S&P 500 averaged 77 percent of market capitalization. In 1998, the average book value was less than 20 percent of market capitalization. In 1998, the average book value was less than 20 percent of market capitalization. The growing gap between market and book values suggests that corporat e balance sheets fail to report many of t he “assets” that make knowledge-based companies valuable and successful.

Required

Accounting pronouncements that are helpful for answering the following questions 1-4 include: Statement Statement Statement Statement

of of of of

Financial Financial Financial Financial

Accounting Accounting Accounting Accounting

Standards No.86, Accounting for Costs of Computer Software to Be Sold, Leased, or Otherwise Marketed. Standards No.141, Business Combinations. Standards No.142, Goodwill and Other Intangible Assets. Standards, Accounting Standards Statement of Accounting Concept 1-6.

1. Expenses Expenses are recognized in accordance with the Matching Principle, which states that efforts (expenses) should be matched with accomplishments (revenues). a. A vegetable oil wholesaling company bought 10,000 gallons of olive oil on December 1, 2001 for $100,000. The company sold 7,000 gallons in December 2001 and sold the remaining 3,000 gallons in January 2002. How much expense should the company recognize in each month? b. An electric utility company commissioned a new gas-fired generating plant on January 4, 2001. The total cost of the plant was $2 billion. The plant has an estimated useful life of 20 years and no salvage value. The amount of electricity generated each year will vary depending on weather conditions in the surrounding community. How much expense should the company recognize in each of the next 20 years? c. During 2001, a software company spent $20 million writing, testing, and debugging a new computer game. The game costs only $3 per copy to manufacture and package, and can be sold for $25 per copy. The company sold one million copies of the game in 2002 and an additional one million copies in 2003. How much expense should the company recognize in 2001? 2002? 2003? d. i. In which of the situations 1a, 1b,and 1c above are expenses matched most closely with the related revenues? ii. In which of the situations 1a, 1b, and 1c above are expenses matched least closely with the related revenues? 2. Assets For this question, assets are broadly defined as “the items or qualities that make the business valuable.” Research the Internet for the following companies and for each company: i. identify the most valuable assets (i.e., primary assets) of the company (i.e., identify the things that make the company valuable and successful), ii. indicate whether the assets you identified would be reported on the company’s balance sheet, and iii. identify the market price of t he company’s common stock you expect would greatly exceed the stock’s book value (i.e., compare the company’s common stock share price with its common stock book value). Use the following format to answer: Reported on Balance Sheet? Company 1. Bank of America 2. Sears, Roebuck and Co. 3. Boise Cascade 4. The New York Times 5. Coca-Cola 6. Pfizer 7. Microsoft

Most Valuable Company Assets?

Stock Price Greatly Exceed Book Value?

3. Expense or Asset? For each of the following situations, indicate whether (under current U.S. GAAP) the expenditure should be expensed or capitalized. a. Pharmaceutical company A spends $500 million to purchase the patent to a new drug to treat arthritis. b. Pharmaceutical company B spends $500 million to research and development costs to develop a new drug to treat arthritis. c. An insurance company spends $10 million purchasing new computer equipment and software to improve its order-entry system. d. An insurance company spends $2 million training its 1,000 customer service representatives how to use the new order-entry software. e. America Online, Inc. (AOL) spends $2 million to mail CDs offering 30 days of free Internet access to 1 million households. The mailing results in 10,000 new AOL subscribers. 4. Brand Names


The Procter & Gamble Company (P&G) manufactures and distributes “more than 300 brands you know and trust.” Their products include Pingles® potato chips, Cover Girl® makeup, Tide® laundry detergent, and Pampers® diapers. a. If P&G were allowed (or required) to record its brand names as assets on its balance sheet, how would it go about estimating the values of its various brands? b. Assume P&G did record its brand names as assets on its balance sheet. Do you think P&G should also amortize the brand names? i. If so, how should they goabout calculating the amortization expense? ii. If not, do you think P&G should be required to test the values periodically for impairment? c. What challenges would P&G’s au ditors face trying to test these values?

Simulation Question 14-3 Simulation Question 14-3 is an adaptation with permission from a case by Holder-Webb, L., and M. Kohlbeck inIssues the in Accounting Education , a publication of the American Accounting Association in Sarasota, Florida. This simulation question is based upon a true set of facts.

Accounting for Intangible Assets



Overview

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The Doughnut Business

Krispy Kreme Doughnuts, Inc. (hereafter, KKD) was founded in 1937 in Winston-Salem, North Carolina . KKD’s efforts were concentrated in North Carolina and surrounding states for much of its early life. By 1996, KKD has grown to 95 units (an average of less than two stores per year). KKD developed an aggressive growth plan in the late 1990s. In the early stages, KKD financed this growth by forming alliances with “Area Developers” and retaining minority equity stakes in the developing ventures. In 2000, KKD boosted its expansion program with an injection of capital from an initial public offering (IPO), in which approximately 3.4 million shares were sold for a total of $65.7 million. Shares traded on NASDAQ, and the firm’s stock listing shifted to the NYSE in 2001. KKD increased the number of retail outletsto over 400 by 2004. In the post-IPO period, store sales posted growth of approximately 19 percent per annum, attributed partially to publicity from the IPO. Despite this growth, KKD captured less than 10 percent of t he U.S. doughnut market. The leader, Dunkin’ Donuts, had over 5,00 0 stores in 2004. Growth in store sales began to slow in 2005. KKD is a branded specialty retailer and manufacturer of premium quality doughnuts. Its principal business is to own and franchise KKD doughnut stores in the U.S. and internationally. The main product is the Hot Original Glazed, a one-of-a-kind doughnut with an established brand. Each outlet also sells over 20 other varieties of doughnuts and coffee products. Product quality and consistency has provided KKD with a very loyal customer base. Each of the retail stores is a doughnut factory with the capacity to produce between 4,000 and 10,000 dozen doughnuts daily. Each factory store contains a full doughnut-making production line. The factory store is marketed as a unique retail experience, ring featuthe store’s production process, including a doughnut-making theater. The stores also support multiple sales channels to more fully use production capacity. Stores provide KKD doughnuts to be sold in satellite locations, ballparks, and grocery stores, and under private label marketing agreements. KKD factory stores are divided into three categories. First, KKD stores are owned by Krispy Kreme. Second, KKD has an Associate program since the 1940s, where stores are owned by franchisees. Associates enter into 15-year licensing agreements to operate stores in a specific territory and are expected to concentrate on operations of existing stores. The third category is an Area Developer program, launched in the mid1990s, where franchisees have responsibilities to develop new territories in addition to operating existing stores. Development targets pertaining to territory, number of stores, and timing are specified in the Area Developer Agreement. Associates pay royalties of 3 percent on store sales and 1 percent on all other sales. Area developers have significantly higher costs: they pay royalties of 4.5 percent to 6 percent on all sales, and pay development and franchise fees of $20,000 to $50,000 per store. As of February 1, 2004, there were 141 KKD stores, 18 Associates operating 57 stores, and 26 Area Developers operating 159 stores. The Area Developers were under contract to open 250 stores over the duration of their contract periods. KKD had a controlling interest in two of the Area Developers, who operated 24 stores and a minority interest in 15 others, who operated 66 stores. KKD generates revenue from four sources: KKD stores, franchise fees and royalties from franchise stores, a vertically integrated supply chain, and offsite bakery production separate from the factory store doughnut production. The franchising program lowers capital requirements and provides a royalty stream. The vertically integrated supply chain provides franchise stores with mixes, equipment, and coffee. This arrangement permits individual stores to lower cost of goods sold and KKD to capture additional profit on these sales. You should access Data File 14-3 in iLearn for Tables 1, 2, 3 and 4 which contain financial information extracted from KKD’s 2004 annual report and other relevant information.

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Reacquired Franchise Rights

Between 2000 and 2004, KKD embarked on a franchise repurchase plan, stating that it would be easier to maintain consistency and efficiency when dealing with KKD’s suppliers and wholesalers. During this period, KKD purchased the operations of several Area Developers, including development rights for specific territories. These acquisitions may have also included existing stores owned by the Area Developer. In addition, KKD acquired operating stores from Associates. Acquisitions were accounted for as purchases. In a typical acquisition, KKD acquired accounts receivable, inventory, prepaid expenses, property, plant and equipment, and reacquired franchise rights (hereafter, The Rights) subject to certain accrued expenses. The Rights consist of the contractual responsibility to develop new territories and the right to continue operating existing stores. KKD defines The Rights in Table 3 as “the excess of the net amount assigned to identifiable assets and liabilities recorded upon the acquisition of franchise markets.” You should access Data File 14-3 in iLearn for Table 3 for selected footnotes. The Rights are stated to have an indefinite life and are reviewed at least annually for impairment or whenever events or circumstances indicate the carrying amount of the asset may be impaired in accordance with SFAS No.142 (FASB 2001b). Normally, the excess of the purchase price over the fair values of net assets acquired is assigned to goodwill. In this case, KKD followed the residual value approach to provide an initial valuation of the required franchise rights (assigning excess purchase price above the fair value of tangible acquired assets to an intangible other than goodwill). The use of the residual valuation approach was permitted during this time period when obtaining a direct valuation of the intangible was not practical.

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Required Assume you are an audit senior assigned to the engagement and have been asked to investigate KKD’s accounting for intangibleassets in preparation for a new audit. Use the following guiding questions to document your investigation: 1. Question on Industry Practice and The Rights

Search the internet or use the EDGAR website to locate at least two other companies that reported reacquired franchise rights between 2000 and 2003 and document: (a) How they rights relatedappear to a reacquired franchise? (b) Whatdo does thereport industry practice to be? (c) What reasons do different companies offer for their treatment of these rights? 2. Question on Recording The Rights

KKD asserts that the reacquired franchise asset is an intangible asset with an indefinite life. Use the Conceptual Frameworks definition of an asset (FASB 1985) and SFAS Nos. 141R and 142 (FASB 2001a, 2001b) to evaluate this assertion and document: (a) What is the economic substance of The Rights? That is, what are the economic benefits KKD expects to receive that are implied by the recognition of this asset? What characteristics of the operations give rise to these benefits? (b) What are some of factors that suggest that KKD’s Rights have an indefinite life? What factors suggest a limited life? Which set of factors is more persuasive? (c) Compare the nature and accounting of The Rights as asserted by KKD to goodwill. How do the two assets differ? How are the two assets the same? 3. Question on Impairment of The Rights

Assume that The Rights are properly reported as an indefinite-life, identifiable, intangible asset, document: ons or KKD’s business environment might cause The Rights to become impaired? (a) What changes in market conditi (b) If it is determined that the asset is impaired, how can KKD estimate the fair value of the asset in order to measure the impairment? 4. Question on Management Motivations Issues An alternative approach to the residual value approach used by KKD is to assign the excess purchase price to goodwill. Document: (a) What effect does KKD’s treatment of The Rights have on the balance sheet and earnings compared to recording the amount as goodwill? Do you consider the difference between the two accounting treatments material? Why or why not? (b) Given KKD’s history, past performance, and current performance, and other information provided in this simulation questio n (See Tables 1, 2, 3 and selected footnotes in iLearn ), document what motivations might the management have to use the residual value approach? Note: You must answer Questions 1-3 and all the subparts in order to earn the extra credit point.


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Chapter 15 Inventory Cycle – Tests of Controls and Tests of Balances Chapter Learning Outcomes (LOs) Checklist


LO15-1

Understand the accounting information system of a typical inventory cycle.

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LO15-2

Describe some common TOC procedures for inventory.

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LO15-3

Understand TOC procedures for cost accounting system.

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LO15-4

Apply the analytical procedures in an inventory cycle.

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LO15-5

Understand internal control in computerized inventory systems.

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LO15-6

Describe some common TOB procedures for inventory.

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LO15-7

Identify the procedures for observing physical inventory count.

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LO15-8

Identify the timing and extent of inventory observation.

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LO15-9

Identify some industry specific inventory count observation procedures.

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LO15-10 Distinguish between compilation and pricing.


Chapter 15 Inventory Cycle – Tests of Controls and Tests of Balances An overview of the strategy for tests of controls in an inventory cycle is presented in Figure 15-1. Figure 15-1 TOC Strategy in Inventory Cycle

The Audit Process

Audit Plan

Tests of Controls

Tests of Balances


Audit Report











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398


Understand Internal Control in an Inventory Cycle

TOC strategy in an inventory cycle starts with an understanding of internal controls relating to an inventory cycle. Table 15-1 provides a brief discussion of the various components relating to the understanding of internal controls in an inventory cycle. Table 15-1 Understanding Internal Controls in an Inventory Cycle

Understanding Internal Controls in an Inventory Cycle 1. Control environment

2. Risk assessment



5. Monitoring

Table 8-1 in Chapter 8 listed seven factors affecting the control environment. Since these factors affect all accounting cycles, understanding of the control environment is generally conducted for all the accounting cycles taken as a whole. The auditor should, however, consider any control environment factors that may have a special effect on the inventory cycle. Table 8-1 in Chapter 8 listed the five basic management assertions that must be met by the management’s risk assessment. The auditor must understand how management assesses risks that are relevant to the inventory cycle, estimates their significance, assesses the likelihood of their occurrence, and takes action to address those risks in order to meet the five basic management assertions. Table 8-1 in Chapter 8 listed the five basic control activities that must be established in an accounting cycle. If the auditor plans to conduct both TOC and TOB no the inventory cycle, then s/he needs to identify the control activities relating to specific audit objectives and for the purpose of assessing control risk (CR). The auditor usually identifies these control activities from documentations of the understanding using narrative descriptions, internal control questionnaires, or flowcharts. Figure 15-6 shows an example of an inventory cycle flowchart. The auditor must obtain sufficient knowledge of the accounting information system relating to the inventory cycle to ensure that the TOC and TOB procedures meet the eight types of specific audit objectives listed in Table 8-1 in Chapter 8. Specifically, the auditor must obtain sufficient knowledge in three areas as shown in Figure 15-2. A brief discussion of these three areas is provided in Table 15-2. The auditor must understand the management’s monitoring processes over the inventory cycle. This includes understanding how the management monitors the internal controls of the inventory cycle over time and what corrective action is initiated to improve the design and operation of controls in the inventory cycle.

Figure 15-2 Understanding of Information and Communication in an Inventory Cycle

Key Functions Understand 3 key functions of an inventory cycle




Table 15-2 Understanding of Information and Communication in an Inventory Cycle

Accounts and Classes of Transactions Key Functions


1. Receiving, storing, and issuing raw materials Receipt of the ordered raw materials is part of the purchases and payments in expenditure cycle.



Raw materials

the

2. Manufacturing goods. Accumulation of direct and indirect labor costs in producing goods is part of the payroll cycle.




Inventory


 Receiving report This receiving report srcinated from the expenditure cycle. A copy of the receiving report accompanies the raw materials received to the storing facilities and updates the raw materials perpetual inventory records.  Materials requisition This materials requisition srcinated from the production facilities. A copy of the materials requisition authorizes the release of raw materials for production and updates the raw materials perpetual inventory records. Figure 15-3 shows an example of a material requisition.

  

Labor Overhead

Work-inprocess

 Production schedule This schedule determines the quantity of goods needed and the timing that they must be produced. It is prepared based on backlog of orders, on sales forecasts, or just-in-time inventory programs.  Cost accounting record This record is in the form of worksheets that accumulate material, labor, and overhead costs by job (job cost systems) or process (process cost systems) as the costs are incurred. Figure 15-4 shows an example of a standard cost accounting record.  Cost variance report This report presents the results of the manufacturing process in terms of actual costs versus standard or budgeted costs.

3. Storing and shipping of finished goods Shipping of finished goods is part of the sales and receipts revenue cycle.

in

the

 

sold

Finished goods Cost of goods

 (Finished goods) Perpetual inventory record (master file) Finished goods perpetual inventory records maintain detailed unit cost of goods produced based on a copy of the cost accounting record that accompanies the finished goods to the storing facilities. Figure 15-5 shows an example of a perpetual inventory record.  Inventory status report This report summarizes the perpetual inventory records showing the type and amount of goods on hand. It can also be used to determine the status of the work-in-progress goods.  Shipping document The shipping document srcinated from the revenue cycle. A copy of the shipping document authorizes the release of finished goods for shipment and updates the finished goods perpetual inventory records.

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Figure 15-3 An example of A Material Requisition MR#3990 MATERIAL REQUISITION MNO Company 5th Street, San Francisco CA 94132 Department: Assembling, 2nd Floor, Room No. 200 Quantity 100 tubes

Description 17 feet, 3/8 inch thick, 1 inch square, silver finished,

Unit Cost $0.49

Total Cost $833.00

aluminum tubing. Requisition Approval Person:David

Date: August 10, 201x

Date Required: August 15, 201x

Figure 15-4 An Example of a Standard Cost Accounting Record SC#4875689 STANDARD COST ACCOUNTING RECORD MNO Company 5th Street, San Francisco CA 94132 Department: Cost AccountingDepartment, 5th Floor, Room No. 500 Product: B20SS Product Description: B20SS is the finished product Bicycle Frame Assembly (silver unit) with brass customization for the U.S. market. Product Process: Frame is assembled from raw material stock in the bent frame assembly unit. Frames are shaped and cut to precision with the two Cougar framing machines. The frames are polished and customized according to specific designs. Finished products are sent to final assembly to be packaged with other frame components. The cost and the basis for the standard costs are calculated as follows: Rate

Standard Cost

Raw Material: 16 feet, 3/8 inch thick, 1 inch square, silver finished, aluminum tubing.

Description

16 feet used, plus 1 feet scrap

Product or Cost Used

$0.49

$8.33

Direct Labor: For bending and finishing.

Bending – 1/30 hour Finishing – 1/12 hour

$5.50 $7.50

$0.91

Factory Overhead: Predetermined formula

Applied at 250% of standard labor cost

$0.91

Total

$2.28 $11.52 =====

Note: Costs were accumulated 9/11/201x by engineering department based on time study of production and current cost of raw material. Factory overhead formula reviewed by cost accounting manager. Record Reviewed and Approved by: Ken Cost Accounting Manager

Date: September 21, 201x.


Figure 15-5 An Example of a Perpetual Inventory Record PIR#003 PERPETUAL INVENTORY RECORD MNO Company 5th Street, San Francisco CA 94132 Department: Inventory ControlDepartment, 7th Floor, Room No. 700 Product: B20SS Date

Document Reference Balance RR#403 SI#37662 RR#482 SI#38941

10/1/200x 10/3/200x 10/5/200x 10/16/200x 10/23/200x

UnitInCost

Unit Cost Out

$11.52

Number In

Number Out

100 $11.48

$11.49

10 50

$11.50

80

Balance Units in 100 200 180 230 150

Balance in Cost

Figure 15-6 An Example of an Inventory Cycle Flowchart

Functions

Documents & Records

Issuing Raw Materials

Computer Process


Materials Requisition Raw Materials Inventory Master File Enter Material Requisition

RAW MATERIALS UPDATE ROGRAM Update raw materials inventory master file. Print materials requisition report.

Materials Requisition Report

Manufacturing Goods

Standard Costs Master File

Job Time Ticket WORK IN PROCESS UPDATE PROGRAM Update work in process inventory and general ledger master file. Print cost accounting record, cost variance report, and general ledger.

Enter Time & Move Tickets

Goods Move Ticket

Cost Accounting Record Cost Variance Report

General Ledger

Work In Process Inventory Master File


$ 1,280.00 2,432.00 2,317.20 2,891.70 1,971.70

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Functions Storing Finished Goods

Documents & Records Finished Goods Move Ticket

Computer Process


FINISHED GOODS UPDATE PROGRAM Update finished goods inventory master file and general ledger master file. Print perpetual inventory record, inventory status report, and general ledger.

Enter Finished Goods Data

Perpetual Inventory Record

Finished Goods Inventory Master File


Inventory Status Report

General Ledger

Consider Potential Misstatements in an Inventory Cycle

After the auditors have obtained an understanding of the internal controls relating to the inventory cycle and documented such an understanding; the auditors would consider potential misstatements that could occur due to weaknesses in internal control. Table 15-3 describes some of these potential misstatements in the inventory cycle. Table 15-3 Potential Misstatements in an Inventory Cycle due to Weakness in Internal Control




Example of Fraud



Misstatement of inventory costs

Intentional misstatement of production costs assigned to inventory items.



Intentional misstatement of inventory prices.



Misstatement quantities.

of

inventory



Inventory is stolen with no journal entry reflecting the theft.

Example of Error



Unintentional mistake in assigning labor costs, material costs, or factory overhead to inventory items.



Unintentional mistake in pricing of inventory.



Miscounting of inventory physical inventory count.

during



Intentional overstatement of inventory in certain locations.



Overstatement of inventory at locations that are not observed by the auditors.



Early inventory.

or

late

recognition

of



Intentional recording of purchases of raw materials in the subsequent period.



Intentional recording of sales of finished goods from the subsequent period.



Unintentional mistake in recording of purchases of raw materials in the subsequent period.



Unintentional mistake in recording of finished goods from the subsequent period.



After considering potential misstatements, the auditors assess the control risk (CR) and perform the TOC procedures as per the audit program for the inventory cycle. Table 15-4 describes some common TOC procedures that the auditors perform on inventory of the inventory cycle. Table 15-4 Specific Audit Objectives, Internal Controls, and Comm on TOC Procedures for Inventory


Internal Controls


Existence or Occurrence: No fictitious inventory is recorded.

Proper separation between the inventory managementofandduties inventory recording functions. Proper authorization for inventory transferred from the raw materials storing facilities to the production facilities. Proper authorization for production.

Inventory recorded but not on hand Physical safeguards over inventory. (stolen). Completeness: Inventory transactions are recorded.

Observe and evaluate proper separation of duties. Examine materials requisitions for proper approval. Inspect a sample of materials requisitions for numeric sequence. Examine authorized production schedules. Observe physical controls over inventory such as the existence of a locked storeroom or the hiring of a competent custodian.

Materials requisitions and receiving reports are prenumbered and accounted for.

Scan for numerical sequence of materials requisitions and receiving reports. Trace a sample of receiving reports to the updated perpetual inventory records.

Valuation and Allocation: Inventory quantities recorded correctly.

Adequate cost accounting records.

Inventory costs recorded correctly.

Adequate cost accounting records.

Compare inventory on hand with amounts shown in perpetual inventory records. Analyze cost accounting records and cost variance reports for allocation of materials, labor, and overhead. Table 15-12 provides further discussion on TOC for cost accounting system. Inspect perpetual inventory records for

Inventory obsolescence recorded correctly. Adequate cost accounting records.

Classification: Inventory transactions are properly classified among raw materials, work-inprogress, and finished goods. Understandability: Inventory transactions are properly recorded in perpetual inventory records.

obsolete, slow-moving, or excess quantities. Internal independent checks on the preparation Compare the classification of a sample of of production schedule, cost accounting records, inventory into raw materials, work-inand cost variance report. progress, and finished goods. Separation of duties between physical handling/transferring of the inventory transactions and the recording of the inventory transactions in the perpetual inventory records.

Observe separation of duty procedures. Observe the reconciliation of perpetual inventory records to inventory control account in the general ledger.

Internal Controls in Computerized Inventory Systems

 The Perpetual Inventory System Perpetual inventory records in a computerized perpetual inventory system constitute an important part of internal control. These records, by showing at all times the quantity of inventory on hand, provide information essential to efficient purchasing, sales, and production-planning policies. With such a record, it is possible to guide procurement by establishing points of minimum and maximum quantities for each standard item stocked. The use of a computerized perpetual inventory system allows clients to control the high costs of holding excessive inventory, while minimizing the risk of running out of stock. The client can control inventories through reorder points and economic order quantities, including just-in-time ordering systems in which inventory levels are kept to a minimum. In addition, the system discourages inventory theft and waste, since storekeepers and other employees are aware of the accountability over inventory established by the continuous record of inventory received, issued, and on hand. For good internal control over a computerized perpetual inventory system: 1. The subsidiary records should be maintained in both quantities and dollars for all stock. 2. The subsidiary records should be controlled by the

403

404


general ledger. 3. Trial balances should be prepared at reasonable intervals. 4. Both the detailed records and the general ledger control accounts should be adjusted to agree with physical counts that are taken periodically.

 IT-Based Inventory System An IT-based inventory system makes it much easier for the client to maintain control over inventories, purchasing, and the manufacturing process. The IT system can automatically generate purchase requisitions and orders when inventory levels reach predetermined reorder points. The client’s IT-based inventory system may even be linked to the system of its suppliers, allowing electronic data interchange (EDI) to completely coordinate production and purchasing. The IT system also maintains records of inventories as they are routed through the production process. Details of direct labor and materials usage are entered, and the computer allocates these direct costs to jobs or processes, applies manufacturing overhead costs based on predetermined rates, and maintains perpetual records of the costs of goods in process, finished, and sold. The system also generates various financial reports that indicate actual costs, standard costs, and the related variances. Good internal control over an IT-based inventory system requires the usual segregation of the purchasing, receiving, storing, processing, and shipping functions. In addition, the client should establish appropriate controls that ensure the accuracy of cost data as they are entered into the system and maintain the integrity of the cost data after they are entered into the system.


An overview of the strategy for tests of balances in an inventory cycle is presented in Figure 15-7. Figure 15-7 TOB strategy in Inventory Cycle

The Audit Process

Audit Plan

Tests of Controls

Tests of Balances


Audit Report





3. Perform Analytical Procedures






405

406


Apply TOB Strategy

Table 15-5 provides a brief discussion of the TOB strategy as it is applied to an inventory cycle. Table 15-5 TOB Strategy in Inventory Cycle

TOB Strategy – Inventory Cycle 1. Allocate PJAM to TM

2. Derive DR




Chapter 9 discussed how the auditor allocates PJAM to TM at the individual account-balance or class of transaction level of a transaction cycle. In an inventory cycle, the inventory account is typically the most material items in the financial statements for manufacturing, wholesale, and retail companies. For these reasons, the auditor typically allocates a small TM (i.e., less tolerance) to inventory account. The auditor derives the DR, based on a pre-specified AR, assessed IR and CR, by using the audit risk model of AR = IR x CR x DR at the individual account-balance or class of transactions level of a transaction cycle (recall Chapter 9). The derived DR drives an optimum mix of the nature, extent, and timing of the TOB procedures used by the auditor. In the inventory cycle, inherent risk is often assessed at a relatively high level for companies with significant inventory. The auditor performssix common types of analytical procedures(recall Chapter 7): (1) Compare clientand industry data. (2) Compare client data with similar prior-period data. (3) Compare client data with clientdetermined expected results. (4) Compare client data with auditor-determined expected results. (5) Compare client data with expected results, using non-financial data. (6) Compare financial ratio analysis on client data. In the inventory cycle, analytical procedures are used especially to uncover misstatement of inventory account. One of the most effective analytical procedures for uncovering misstatement of inventory and cost of goods sold accounts is comparing gross margin percentage with that of previous years. This is because expenses from year to year are typically relatively stable. Table 15-6 describes some analytical procedures and potential misstatements that may be detected by them in the inventory cycle. The auditor performs the TOB procedures that address the nature, extent, and timing of evidence. For the nature and timing, if CR were assessed at the maximum of 100%, the auditor would not perform TOC procedures but perform only TOB procedures. In addition, the auditor would apply a variable sampling plan to determine the sample size of evidence. Table 15-7 summarizes some specific audit objectives and common TOB procedures in an inventory cycle. The auditor is especially concerned with the specific audit objective of existence or occurrence that tests the management’s assertion of existence and occurrence in the inventory cycle. The auditor documentsall misstatements foundby performing theTOB procedures and compares the total misstatements with the PJAM. Based on the misstatements found, the auditor may revise PJAM (RJAM) if necessary. The auditor should perform additional audit work or request the management to make an adjustment for the misstatements.

Table 15-6 Analytical Procedures for the Inventory Cycle



Inventory: – cost of goods sold)/net sales] with that of Unrecorded or fictitious inventory. Comparison of gross margin percentage [(net sales previous years. Overstatement and understatement of cost of goods sold. Comparison of inventory turnover [cost of goods sold/average inventory] with that of previousObsolete, slow-moving, or excess inventory. years and industry averages. Comparison of days outstanding in inventory with that of previous years and industry averages. Obsolete, slow-moving, or excess inventory. Pricing of inventory: Comparison of unit costs of inventory with that of previous years. Overstatement and understatement of unit costs. Comparison of current-year standard costs with that of previous years after considering currentOverstatement and understatement of unit conditions. costs. Comparison of actual manufacturing overhead costs with budgeted or standard manufacturingInclusion or exclusion of overhead costs. overhead costs.


Table 15-7 Specific Audit Objectives and Common TOB Procedures for an Inventory Cycle

Specific Audit Objectives Existence or Occurrence: Recorded inventory actually existed.

Completeness: All inventories are recorded.

Common TOB Procedures AU 501 Audit Evidence – Specific Considerations for Selected Items requires the auditor to observe the client’s physical inventory count in order to establish the existence of the inventory. Table 15-8 provides further discussion on the audit procedures for observing physical inventory count. Vouch inventory items listed in the inventory listing/sheet/schedule to the inventory tags, and to the auditor’s test count sheet during the physical inventory observation. Trace inventory tags noted during the auditor’s physical inventory observation to inventory items listed in the inventory listing/sheet/schedule. Trace a sample of the auditor’ test counts during the physical inventory observation to the perpetual inventory records. Confirm any inventory held on consignment by others or is stored in public warehouses.

Cutoff: All sales of finished goods and purchases Examine a sample of shipping documents for a few days before and after year-end for recording of raw materials are recorded in the proper inventory in the proper period (see Chapter 13 for sales cutoff procedures). period. Examine a sample of receiving reports for a few days before and after the year-end for recording of inventory purchases in the proper period (see Chapter 14 for purchases cutoff procedures). Rights and Obligations: Recorded inventory actually belongs to the Confirm that inventory held on consignment for others is not included in inventory. Confirm that “bill-and-hold” goods are not included in the inventory. The “bill-and-hold” goods client. are treated as a sale but the client holds the goods until the customer needs them. Inspect agreements to determine whether any inventory is pledged as collateral or subject to any liens. Accuracy: Inventory account balance is accurate. Select and test a sample of inventory accounts by using MUS sampling approach (recall Chapter 12) and generalize from the sample results to the accuracy of the inventory account balance (population). Valuation and Allocation: Inventories are valued (priced) properly. If the client uses a standard cost system (job or process cost systems), the output of the standard cost system (the cost accounting records and cost variance report) should show standard costs approximate actual costs of inventory valuation. The auditor can test this by selecting a sample of inventory and determining the unit cost of the sample by re-computing the material costs, labor costs, and overhead. Examine pricing ofselected inventory performing the lower-of-cost-or-market test on large-dollar inventory the or inventory frombydifferent production lines. Inquiry of the management about obsolete, slow-moving, or excess inventory. Table 15-11 provides further discussion on the audit procedures for compilation and pricing. Classification: Inventory is properly classified as raw materials, work-in-progress, and finished goods. Understandability: All inventory related accounts are properly presented and disclosed in the financial statements.

Trace a sample of the auditor’ test counts during the physical inventory observation to the classification in the cost accounting record and the inventory status report.

Read the minutes of the board of directors meetings for any pledged inventory that must be adequately disclosed as a footnote in the financial statements. – raw materials, Inquiry of management about (1) adequate disclosure of the three components work-in-progress, and finished goods in the balance sheet, (2) adequate disclosure of the cost method, such as LIFO or FIFO, to value inventory, and (3) if LIFO is used to value inventory and there is a material LIFO liquidation, footnote disclosure is provided.

Observing Physical Inventory Count

AU 501 requires the auditor to be present at the time of the client’s inventory count (also known as inventorytaking) so as to observe and to do test counts of the client’s inventory. Therefore, it is important to note the distinction between the observation of the inventory count and the responsibility for taking the count. The client’s management has the responsibility for taking the inventory count. The auditor’s responsibility is to observe the inventory count and draw conclusions about the reliability of the client’s inventory count. Table 15-8 describes the audit procedures for observing the inventory count.

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408


Table 15-8 Procedures for Observing Physical Inventory Count

Procedures for Observing Physical Inventory Count



Prior to the physical inventory count. (1) The auditor familiarizes with the inventory locations and the client’s instruction for counting inventory. Figure 15-8 shows an example of a client’s instruction for physical inventory count. (2) The auditor plans the timing of the observation, the extent of the test counts, and the use of specific inventory observation procedures. The plans should be in writing and should ensure that all auditors understand their assignments concerning the physical inventory count; but the plan 9 shows an example of the auditor’s plan for observing physical inventory count. Table 15-9 should not be made available to the client. Figure 15summarizes the auditor’s consideration concerning the timing and extent of inventory observation.

 During the observation of the physical inventory count. The auditor should do the following: (1) Ensure that no production is scheduled to prevent double counting. (2) Ensure that there is no movement of goods during the inventory count to prevent double counting. (3) Ensure that the client’s count teams are following the inventory count instructions. (4) Ensure that inventory tags are issued sequentially. (5) Perform test counts and record a sample of counts in the working papers. (6) Perform industry specific inventory count observation procedures whenever practical and reasonable. See Table 15-10. (7) Observe the condition of the inventory for obsolete, slow-moving, or excess quantity items. (8) Inquire about inventories held on cons ignment for others or held on a “bill-and –hold” basis and ensure that they are not included in the client’s inventory.  After the observation of the physical inventory count. (1) Each auditor participating in the observation of the inventory count should prepare audit working papers that indicate the extent of test counts, describe any deficiencies noted, and express a conclusion as to whether the physical inventory were properly taken in accordance with the client’s instructions. (2) The auditor-in-charge should prepare a summary memorandum that indicates the overall extent of observation and the percentage of inventory value covered by quantity tests. The memorandum should also include comments on the consideration given to the factors of quality and condition of stock, the treatment of consigned goods on hand, and the control of shipments and receipts during the counting process. Figure charge’s memorandum on the observation of physical inventory count. 15-10 shows an example of the auditor-in-

Figure 15-8 An Example of a Client’s Instruction for Physical Inventory Count

INSTRUCTION FOR PHYSICAL INVENTORY COUNT MNO Company 5th Street, San Francisco CA 94132 Department: Accounting Department,3rd Floor, Room No. 300 To All Supervisors: A complete physical inventory count of all departments will be taken Sunday, December 7, 201x, beginning at 8:30 a.m. and continuing until completed. Employees are to report at 8:15 a.m. to receive their final briefing on their instructions, which are appended hereto. Within one week prior to Dec 7, supervisors should make sure that merchandise in departments is well organized. All merchandise with the same stock number should be located together. Merchandise that is damaged should be segregated for separate listing on inventory sheets. Each count team should be formed and started by a supervisor, and should be periodically observed by that supervisor to assure that instructions are being complied with in the counting and listing processes. A block of sequential prenumbered inventory sheets will be issued to each supervisor at 8:00 a.m. December 7, for later issuance to count teams. Each supervisor is to account for all sheets– used, unused, or voided. In addition, each supervisor will be furnished at that time with a listing of count teams under his or her supervision. When a count team reports completion of a department, that team’s supervisor should accompany a representative of the independent auditors, ’ test counts. When the independent auditors have “cleared” a department, the supervisor XYZ CPA, LLP, in performing the independent auditors responsible should take possession of the inventory count sheets and sign each inventory count sheet. All completed count sheets are to be placed in numerical sequence and turned over to me when the entire inventory has been completed. Before supervisors and employees leave the stores Saturday evening, December 6, 201 x, they are to make certain that “housekeeping” is in order in each department, and that all merchandise bears a price ticket. If you have any questions about these instructions or any other aspect of the physical inventory, please see me.

Jehan CFO November, 25, 201x.


Figure 15-9 An Example of the Auditor’s Plan for Observing Physical Inventory Count

XYZ CPA, LLP P.O.Box 888, San Francisco CA 94132

W/P Ref : IO#1-1

Instructions For Audit Staff on Inventory Observation th We will observe physical inventory taking at the following departments of MNO Company, Street, 5 San Francisco, on December 7, 201x.

Department

Department Manager

Our Staff

San Francisco San Jose Oakland

G. Bush B. Clinton J. Carter

J. Huang, J. McWilliam R. Wagner, A. Yuan J. Kang, D.Frantz

Report to assigned department promptly at 8:00 a.m. Attached are copies of the MNO company’s detailed instructions to employe es who are to take the physical inventories and to supervisors who are to be in charge. These instructions appear to be complete and adequate; we should satisfy ourselves by observation that the instructions are being followed. All merchandise counted will be listed on prenumbered inventory sheets. We should make test counts of approximately 5% of the inventory items to ascertain the accuracy of the physical counts. A majority of the counts should be performed on the high-value inventory, as described on the enclosed listing. Test counts are to be recorded in audit working papers, with the following information include:

     

Department number Inventory sheet number Inventory number Description of item Quantity Selling price per price tag

We should ascertain that adequate control is maintained over the prenumbered inventory sheets issued. Also, we should prepare a listing of the last numbersuntil used transfers, and not markups in the various departments. Inventory sheets are not to be removed from the departments wefor have “cleared”markdowns, them; we should delay this operation. Each staff member’s audit working papers should include an opinion on the adequacy of the inventory taking. The working papers should also include a summary of time incurred in the observation. No cash or other cutoff procedures are to be performed as an adjunct to the inventory observation.

Ezen Auditor-In-Charge December 1, 201x

Table 15-9 Auditor’s Consideration of the Timing and Extent of Inventory Observation

Situation a. Client maintains a periodic inventory system and all inventory counts are done at or near balance sheet date. b. Client with a perpetual inventory system and– i. all inventory counts are at or near balance sheet date.

ii. inventory is counted on a cycle inventory count basis throughout the financial year.

Timing and Extent

     

Auditor must be present on the specific date of inventory counts. Auditor must perform extensive test count. Auditor must be present on the specific date of inventory counts. Auditor must perform extensive test count.

Auditor must be present at some of the inventory counts. Auditor must perform limited test count.

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iii. inventory is counted on a statistical sampling basis throughout the financial year.

  

Auditor must be present at some of the inventory counts. Auditor must perform limited test count.

Auditor must understand the client’s sampling plan and evaluate its appropriateness.

c. Client performs inventory count at a time when it is impossible or impractical for the auditor to observe the count.



d. Client requests auditor not to observe the inventory count.

 

e. Client stored inventory in a public warehouse.

Auditor must perform alternative procedures, such as a direct confirmation with major vendors. Auditor must issue either a qualified or disclaimer opinion. Auditor confirms in writing with the manager of the public

warehouse.  If the inventory represents a significant amount of the current assets, the auditor must perform supplemental inquiries as follows: (1) Discussion with the owner of the warehouse about his/her control of the warehouse personnel. (2) Review with the owner of the warehouse about his/her control of the performance of the warehouse personnel. (3) Observation of physical counts of the inventory whenever practical and reasonable. (4) Confirm with lenders about their warehouse receipts that are pledged as collateral.

Table 15-10 Some Industry Specific Inventory Count Observation Procedures

Inventory Type

  

Audit Procedure

Outdoor inventories such as lumber, steel coils, and tubes. Pile inventories such as sugar, coal, and rice.

Check for chalk marking with the help of a specialist or experience client personnel. Use engineering estimates or geometric computation.

Check scales for accuracy before and during counts. Check rebalancing procedures. Check conversion factors. tanks with dipping or measuring sticks.  Bulk inventories such as liquids, storage tanks, and Check Collect samples for analysis. chemicals. Inventory items weighed on scales.



Precious inventories such as jewelries, works of art, and collectibles.

Check for the quality with the help of a specialist such as an appraiser. More discussion on using the work of a specialist in Chapter 20.



Use aerial photographs for existence. Perform test count whenever practical and reasonable.

Livestock such as cows, sheep, and chickens.

Figure 15-10 An Example of the Auditor-InCharge’s Memorandum on the Observation of Physical Inventory Count

XYZ CPA, LLP P.O.Box 888, San Francisco CA 94132

W/P Ref : IO#1-2

Comments on Physical Inventory Observation

 Advance Planning of Physical Inventory. A physical inventory was taken by the client, MNO Company, on December 7, 201x. One week in advance of this date we reviewed the written inventory instructions prepared by Jehan, CFO. These instructions were adequate and reflected the experience gained during the physical inventory count of previous years. The instruction called for a complete closing down of all the departments on December 7, since the preceding year’s count had been handicapped by movements of merchandise during the counting process. Training meetings were conducted by Jehan for all employees assigned to participate in the inventory count; at these meetings the written instructions were explained and discussed.  Observation of Physical Inventory. We were present throughout the taking of physical inventory on December 7, 201x. Prior to the count, all merchandise had been neatly arranged, labeled, and separated by type. Two-employee inventory teams were used: one employee counting and calling quantities and descriptions; the other employee filling in data on the serially numbered inventory tags. As the goods were counted, the counting team tore off the “first count” portion of the inventory tag. A second count was made later by another team working independently of the first; this second team recorded the quantity of its count on the “second count” portion of the tag.


We made test counts of the numerous items, covering approximately 5% of the total inventory value. These test counts were recorded on our audit working papers. Our observation throughout the inventory counts indicated that both the first and second counts required by the inventory instructions were being performed in a systematic and conscientious manner. The careful and alert attitude of employees indicated that the training meetings preceding the count had been quite effective in creating an understanding of the importance of an accurate count. Before the “second count” portions of the tags were removed, we visited all departments in the company with Jehan and satisfied ourselves that all merchandises had been tagged and counted. No goods were shipped on December 7. We ascertained that receiving reports were prepared on all goods taken into the receiving department on December 7. We recorded the serial numbers of the last receiving report and the last shipping advice for the year 201x (see W/P Reference RR#07). We compared the quantities per the count with perpetual inventory records and found no significant discrepancies.

 Quality and Condition of Materials. Certain obsolete items had been removed from inventory prior to the count and reduced to a scrap carrying value. On the basis of our personal observation and questions addressed to the supervisors, we have no reason to believe that any obsolete or defective items remained in the inventory. During the course of inventory observation, we tested the reasonableness of quantities of 40 items, representing 30% of the value of the inventory, by comparing the quantity on hand with the quantity used in recent months; in no case did we find that the quantity in inventory exceeded three months’ normal usage.

Ezen Auditor-In-Charge January 5, 201x

Compilation and Pricing

After observing physical inventory count, the auditor performs compilation and pricing procedures to test for the specific audit objectives of accuracy and valuation and allocation. Table 15-11 describes the auditor’s procedures for compilation and pricing. Table 15-11 Procedures for Compilation and Pricing

Procedures for Compilation and Pricing



Auditor’s observation of physical inventory count procedures are designed to test for the specific audit objectives of existence and completeness.



After the inventory count observation is completed, test count items taken by the auditor at the observation are traced to the inventory listing and then to the perpetual inventory records to test for the specific audit objective of completeness.



The auditor then performs compilation and pricing procedures that are designed to meet the specific audit objectives of accuracy and valuation and allocation.



The auditor performs compilation procedures to test for the specific audit objective of mathematical accuracy. First, the auditor performs footing and cross-footing of the inventory listing for accuracy. Next, the auditor tests the following compilation for accuracy: (1) Items in the perpetual records but not owned are excluded from the inventory compilation. (2) Items on handare counted and included inthe inventory compilation. (3) Items consigned-out or stored in outside warehouses (items owned but not on hand) are included in the nventory i compilation. (4) Items in transit (items purchased and recorded butnot received) are added to the inventory count and included in the inventory compilation. (5) Items on hand already sold (but notdelivered) are not counted and are excluded from the inventory compilation. For example, bill-and hold items. (6) Items consigned-in (items on hand but not owned) are excluded from the inventory compilation.



The auditor performs pricing procedures to test for the specific audit objective of valuation and allocation. First, the pricing for each item (i.e., the unit-price) is tested by multiplying its quantity with price. Next, the unit-price of each item is tested for lower-of-cost-or-market valuation. Cost of each item is tested by comparing its unit-price to the purchase price for raw materials and to standard cost for in-progress and finished goods. Themarket price of each item is tested by examining the client’s catalogue and actual sales price i n the subsequent period. In addition, obsolete or slow-moving items (e.g., old expiration date, dust, or rust items) noted by the auditor at the inventory count observation or through inquiry of warehouse personnel are priced at their residual value, if any.



The auditor can perform the above tests automatically by using computer-assisted-audit-tests techniques (CAATs).

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412


Table 15-12 Further Discussion on TOC for Cost Accounting System

Further Discussion on TOC for Cost Accounting System









 

Ordinarily, the auditor encounters a wide variety of a client’s cost accounting system. The cost accounting records may be controlled by general ledger accounts or operated independently of the general accounting system. Since the cost accounting systems vary widely, even in the same industry, the auditor’s procedures for a cost accounting system must be designed to fit the specific circumstances encountered.

In any cost accounting system, the three elements of manufacturing cost are direct materials costs, direct labor costs, and manufacturing overhead. Cost accounting systems may accumulate either actual costs or standard (expected) costs according to processes or jobs (job or process cost systems). The auditor’s TOC of the client’s cost accounting system are designed to determine that costs are appropriately valuated and allocated to specific jobs or processes. To achieve this specific audit objective, the auditor tests the propriety of direct materials quantities and unit costs, direct labor-hours and hourly rates, and overheard rates and allocation bases. Quantities of direct materials charged to jobs or processes are vouched to materials requisitions, and unit materials costs are traced to the raw materials perpetual inventory records or purchase invoices. The auditors also examine job time tickets or time summaries supporting direct labor-hour accumulations and trace direct labor hourly rates to union contracts or individual employee personnel files. The auditor should recognize that a variety of methods are generally accepted for the application of manufacturing (factory) overhead to inventories. A predetermined rate of factory overhead applied on the basis of machine-hours, direct labor dollars, direct laborhours, or some similar basis is used by a variety of manufacturing clients. FAEB No.151, Inventory Costs – An Amendment to ARB No. 43, clarifies that variable manufacturing costs should be allocated to products on the basis of the actual level of activity. Fixed manufacturing overhead, on the other hand, should be allocated based on the normal capacity of the production facility. In addition, a distinction between manufacturing overhead and overhead costs pertaining to selling or general administration must be made under the GAAP because selling expenses and general administrative expenses are written off in the period incurred. Typically, the auditor analyses a number of the manufacturing overhead subsidiary ledger accounts and verifies the propriety of the charges thereto. If standard (expected) costs are in use, the auditor should compare them with actual costs for representative items and to ascertain whether the standards reflect current materials and labor usage and unit costs. The composition of factory overhead, the basis for its distribution by department and product, and the effect of any change in basis during the year should be reviewed. The standard costs of selected products should be verified by testing computations, extensions, and footings and by tracing charges for labor, materials, and overhead to srcinal sources. The auditor’s should pay attention to any changes in cost methods of the client’s cost accounting system during the year, and the effect of such changes on the cost of sales. Close attention should also be given to the methods of summarizing costs of completed products and to the procedures for recording the cost of partial shipments.

If the client has supply contracts with the U.S. government agencies, the auditors should determine whether standards issued by the Cost Accounting Standards Board were complied with. Cost accounting standards issued to date have dealt with such matters as consistency in estimating, accumulating, allocating, and reporting costs and depreciation of plant assets.



For control purposes,the quantities ofraw materials orderedmay be omitted fromthe copy of the purchase orderthat is a. forwarded to the accounting department. b. retain in the purchasing department file. c. return to the requisitioners. d. forwarded to the receiving department.

15-2

The objectives ofinternal control for an inventory cycle are to provide assurance that transactions are properly executed and recorded and that a. Independent internal verification of activity reports is established. b. Transfers to the finished goods department are documented by a completed production report and a quality control report. c. Production orders are prenumbered and signed by a supervisor. d. Custody of work in process and finished goods is properly maintained.

15-3

Which of the following wouldmost likely be an internal controlprocedure designedto detect errors and fraud concerning thecustody of inventory? a. Periodic reconciliation of work in process with job cost sheets. b. Segregation of functions between general accounting and cost accounting. c. Independent comparisons of finished goods records with counts of goods on hand. d. Approval of inventory journal entries by the storekeeper.

15-4

Which of the following control procedures would be most likely to assist in reducing the control risk related to the existence or occurrence of manufacturing transactions? a. Perpetual inventory records are independently compared with goods on hand. b. Forms used for direct materials requisitions are prenumbered and accounted for. c. Finished goods are stored in locked limited-access warehouse. d. Subsidiary ledgers are periodically reconciled with inventory control accounts.

15-5

An auditor’s tests of controls over the i ssuance of raw materials to production would most likely i nclude?

a. Reconciliation of raw materials and work in process perpetual inventory records to general ledger balance. b. Inquiry of the custodian about the procedures followed when defective materials are received from vendors. c. Observation that raw materials are stored in secure areas and that storeroom security is supervised by a responsible individual. d. Examination of materials requisitions and reperformance of client controls designed to process and record issuances. 15-6

Which of the following internalcontrol procedures ismost likely to address the completeness assertion forinventory? a. The work in process account is periodically reconciled with subsidiary records. b. Employees responsible for custody of finished goods do not perform the receiving function. c. Receiving reports are prenumbered and periodically reconciled. d. There is a separation of duties between payroll department and inventory accounting personnel.

15-7

In tests of controls for management’s assertion of valuation or allocation, an auditor would be most likely to learn of slow-moving or obsolete inventory through

a. inquiry of sales personnel. b. inquiry of store personnel. c. physical observation of inventory. d. review of perpetual inventory master file. 15-8

Which of the following controlprocedures wouldmost likely be used to maintain accurate perpetual inventory records? a. Independent storeroom count of goods received. b. Periodic independent comparison of records with goods on hand. c. Periodic independent reconciliation of control and subsidiary records. d. Independent matching of purchase orders, receiving reports, and vendors’ invoices.

413

414


15-9

The auditor tests the quantity of materials charged to work-in-progress by tracing thesequantities to (Hint: Tracing in general sense, not for specific objective of completeness) a. material requisitions. b. receiving reports. c. perpetual inventory records. d. cost ledgers.

15-10

A useful starting point for understanding the audit client’s inventory is for the auditor to a. read the AICPA’s Industry Audit Guide. b. review accounting procedures covering special problems, such as gas and oil accounting, or lease-purchase agreements. c. read the client’s Accounting Manual on inventory. d. tour the client’s facility.

15-11

Master files, worksheets, andreports that accumulate material, labor,and overhead asthe costs are incurred are a. operation records. b. perpetual inventory records. c. cost accounting records. d. financial accounting records.

15-12

In obtaining an understanding of a manufacturing client’s internal control concerning inventory balances, an auditor most lik ely would

a. analyze the liquidity and turnover ratios of the inventory. b. perform analytical procedures designed to identify cost variances. c. review the client’s descriptions of inventory policies and procedures. d. perform test counts of inventory during the client’s physical count. 15-13

Which of the following internalcontrol procedures mostlikely would be used by a client to maintain accurateinventory records? a. Perpetual inventory records are periodically compared with the current cost of individual inventory items (i.e. check for lower of cost or market) b. A just-in-time inventory ordering system keeps inventory levels to a desired minimum. c. Requisitions, receiving reports, and purchase orders are independently matched before payment is approved. d. Periodic inventory counts are used to adjust the perpetual inventory records.

15-14

When auditing merchandiseinventory atyear-end, theauditor performs a purchase cutofftest to obtain evidence that a. All goods purchased before year-end are received before the physical inventory count. b. No goods held on consignment for customers are included in the inventory balance. c. No goods observed during the physical count are pledged or sold. d. All goods owned at year-end are included in the inventory balance.

15-15

In tests of balances, inquiriesof warehouse personnelconcerning obsoleteor slow-moving inventory items provide assuranceabout management’s assertion of a. completeness. b. existence or occurrence. c. presentation and disclosure. d. valuation or allocation.

15-16

Which of the following audit procedures would probably provide the most reliable evidence concerning the entity’s assertion of rights and obligations related to inventory? a. Tracing of test counts noted during the entity’s physical count to the entity’s summarization of quantities. b. Inspection of agreements to determine whether any inventory is pledged as collateral or subject to any liens. c. Selection of the last few shipping advices used before the physical count and determination of whether the shipments were recorded as sales. d. Inspection of the open-purchase-order file for significant commitments that should be considered for disclosure.

15-17

Periodic or cycle counts of selected inventory itemsare made at various times during the year rather than via a single inventorycount at year-end. Which of the following is necessary if the auditor plans to observe inventory at interim dates? a. Completer recounts are performed by independent teams. b. Perpetual inventory records are maintained. c. Unit cost records are integrated with production-accounting records. d. Inventory balances are rarely at low levels.


15-18

After accounting for a sequence of inventory tags, an auditor traces a sample of tags to the physical inventory listing(or inventory sheet) to obtain evidence that all items a. included in the inventory listing/sheet have been counted. b. represented by inventory tags are included in the inventory listing/sheet. c. included in the inventory listing/sheet are represented by inventory tags. d. represented by inventory tags are bona fide.

15-19

When an auditor tests a client’s cost accounting records, the auditor’s tests are primarily designed to determine that

a. quantities on hand have been computed based on acceptable cost accounting techniques that reasonable approximate actual quantities on hand. b. physical inventories are in substantial agreement with book inventories. c. the internal controls are in accordance with generally accepted accounting principles and are functioning as planned. d. costs have been properly assigned to finished goods, work-in-process, and cost of goods sold. 15-20

When auditing a public warehouse, whichof the following TOBprocedures isthe most important auditprocedure with respect to disclosing unrecorded liabilities? a. Observation of inventory. b. Review of outstanding receipts. c. Inspection of receiving and issuing procedures. d. Confirmation of negotiable receipts with holders.

15-21

Which of the following istrue regarding the taking of physical inventory (physical inventorycount)? a. Client has the responsibility for setting up the procedures for taking an accurate physical inventory and actually making and recording the counts. b. Client has the responsibility for setting up the procedures and auditor has the responsibility for making and recording the counts. c. Auditor has the responsibility for setting up the procedures for taking an accurate physical inventory and actually making and recording the counts. d. Auditor has the responsibility for setting up the procedures and client has the responsibility for following the procedures when actually making and recording the counts.

15-22

Which of the following inventorysituations wouldmost likely require specialaudit planning bythe auditor? a. Some inventory items do not bear identification numbers. b. Depreciation methods used for some inventory items differ from those used on the books. c. Inventory items are comprised of precious stone. d. Inventory items costing less than $500 are expensed even though their expected life exceeds one year.

15-23

The primary objective of an auditor’s observation of a client’s physical inventory count is to

a. discover whether a client has counted a particular inventory item or group of items. b. obtain direct knowledge that the inventory exists and has been properly counted. c. provide an appraisal of the quality of the merchandise on hand on the day of the physical count. d. allow the auditor to supervise the conduct of the count so as to obtain assurance that inventory quantities are accurate. 15-24

A common inventoryobservation procedure isto be alert for items that are damaged, rust- or dust-covered,or located in inappropriate places. The specific audit objective being achieved by this procedure is a. classification. b. rights and obligations. c. valuation and allocation. d. right.

15-25

When there are no perpetual inventory files and the inventory is material, a. a complete physical inventory must be taken by the client near year-end. b. the auditor will have to perform the inventory count and determine valuation instead of the client. c. the auditor is relieved of responsibility for observing inventory counts but still must perform test count. d. inventory count cannot be observed, so the auditor must issue a disclaimer.

15-26

A major difficulty in the verification of inventory cost records is determining the reasonableness of a. direct labor’s hourly rate. b. raw materials per unit cost. c. cost allocations. d. all three of the above.

415

416


15-27

Which of the followinganalytical procedures wouldbe most helpfulin alerting the auditor to the possibilityof obsolete inventory? a. Compare gross margin percentage with previous years’. b. Compare unit costs of inventory with previous years’. c. Compare inventory turnover ratio with previous years’. d. Compare current yearmanufacturing costs with previous years’.

15-28

Finished goodsperpetual inventorymaster files include thesame type of information asraw materials perpetualbut are a. considerably more complex if costs are included along with units. b. simpler since materials, labor, and overhead have been combined into one total value. c. considerably more complex because of the paper trail that is needed in addition to the computer records. d. simpler because the cost accounting system is in effect and well defined.

15-29

Audit test results of which other cycle, in addition to the audit test results of inventory cyclewill affect the TOB procedures for inventory? a. The revenue cycle. b. The expenditure cycle. c. The payroll cycle. d. All three of the above.

15-30

While observing a client’s annual physical inventory, an auditor recorded test counts for several items and noticedthat certain test counts were higher than the recorded quantities in the client’s perpetual inventory records. Thissituation could be the result of the client’s failure to record

a. purchase discounts. b. purchase returns. c. sales. d. sales returns. 15-31

When auditing inventories, an auditor would least likely verify that a. the financial statement presentation of inventory is appropriate. b. damaged goods and obsolete items have been properly accounted for. c. all inventory owned by the client is on hand at the time of the count. d. the client has used proper inventory pricing.

15-32

Which of the following TOB procedures most likely would provide assurance about a manufacturing client’s inventory Valuation and allocation? a. Testing the client’s computation of standard material costs, labor costs, and overhead. b. Obtaining confirmation of inventories pledged under loan agreements. c. Reviewing shipping and receiving cutoff procedures for inventories. d. Tracing test counts to the client’s inventory listing.

15-33

A client maintainsperpetual inventoryrecords in both quantitiesand dollars. If the assessed level of control risk is extremely high, an auditor would probably a. decrease the extent of tests of controls of the inventory cycle. b. request the client to schedule the physical inventory count at the end of the year. c. request the client to schedule the physical inventory counts several times during the year. d. apply gross profit tests to ascertain the reasonableness of the physical counts.

15-34

Which of the following TOB procedures would provide the most reliable evidence concerning the management’s assertion of rights and obligations relating to inventories? a. Inspect the open purchases order file for significant commitments that should be considered for disclosure. b. Inspect agreements to determine whether any inventory is pledged as collateral or subject to any liens. c. Select the last few shipping advices used before the physical count and determine whether the shipments were recorded as sales. d. Trace test counts noted during th e client’s physical count to the client’s summarization of quantities.


15-35

An auditor selected items for test counts while observing a client’s physical inventory. The auditor then tracedhe t test counts to the client’s inventory listing. This procedure would most likely obtain evidence concerning management assertion of

a. rights and obligations. b. existence or occurrence. c. completeness. d. valuation or allocation. 15-36

An auditor would make inquiries ofproduction andsales personnel concerningpossible obsoleteor slow-moving inventory to support management’s financial statement assertion of a. valuation or allocation. b. rights and obligations. c. existence or occurrence. d. presentation and disclosure.

15-37

To gain assurance that all i nventory items in a client’s inventory listing schedule are valid, an auditor most likely would a. trace inventory tags noted during the auditor’s observation to items listed in theinventory listing schedule. b. inventory tags noted during the auditor’s observation to items listed in receiving reports and vendor’s invoices. c. vouch items listed i n the inventory listing schedule to inventory tags and the auditor’s recorded count sh eets. d. trace items listed in receiving reports and vendors’ invoices to the inventory listing schedule.

15-38

An auditor concludedthat no excessive costsfor an idle plant werecharged to inventory. Thisconclusion mostlikely related to the auditor’s objective to obtain evidence about the financial statement assertions regarding inventory, including presentation and disclosure and a. valuation and allocation. b. completeness. c. existence or occurrence. d. right and obligations.

15-39

Which of the following auditing procedures most likely would provide assurance about a manufacturing client’s inventory valuation and allocation? a. Testing the client’s computation of standard overhead rates. b. Obtaining confirmation of inventories pledged under loan agreement. c. Reviewing shipping and receiving cutoff procedures for inventories. d. Tracing test counts to the client’s inventory listing.

15-40

An auditor performs the inventory compilationand pricing procedures toprimarily test the specific audit objective of: a. existence and completeness b. valuation and allocation, and understandability. c. accuracy and valuation. d. completeness and rights and obligations.

15-41

Which of the following is not a correct statement pertaining to the auditor’s compilation tests on inventory?

a. Items on hand are counted and included in the inventory compilation. b. Items in transit (items purchased and recorded but not received) are added to the inventory count and included in the inventory compilation. c. Items in the perpetual records but not owned are included in the inventory compilation. d. Items consigned-out or stored in outside warehouses (items owned but not on hand) are included in the inventory compilation.

417

418



15-1 d. 15-2 d. 15-3 c. 15-4 c. 15-5 d. 15-6 c. 15-7 d. 15-8 b. 15-9 a. 15-10 d. 15-11 c. 15-12 c. 15-13 d. 15-14 b. 15-15 d. 15-16 b. 15-17 b. 15-18 b. 15-19 d. 15-20 d. 15-21 a. 15-22 c. 15-23 b. 15-24 c. 15-25 a. 15-26 c. 15-27 c. 15-28 a. 15-29 d. 15-30 d. 15-31 c. 15-32 a. 15-33 b. 15-34 b. 15-35 c. 15-36 a. 15-37 c. 15-38 a. 15-39 a. 15-40 c. 15-41 c.


Simulation Question 15-1 Simulation Question 15-1 is an adaptation with permission from a case by Knapp, M.C. and C.A. Knapp inIssues the in Accounting Education , a publication of the American Accounting Association in Sarasota, Florida. This simulation question is based upon a true set of facts.

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Background

In 1957, a 27-year-old pharmacist, Jack Robinson, founded Perry Drug Stores (hereafter, PDS) in Detroit, Michigan. PDS grew rapidly under Robinson’s leadership. Robinson incorporated his business in 1980 and later took the company public, listing ist stock on the New York Stock Exchange. By 1994, PDS operated more than 200 retail outlets, had a workforce of approximately 5,000 employees, and boasted annual revenues of $700 million. Although the 14th largest drug retailer in the United States by the early 1990s, PDS could not compete with the much larger nationwide drug competitors store chains.invested Walgreen, Rite Aid, and other nationwide retailers benefited from economies of scale unavailable to to PDS. example, PDS’s millions of dollars in state -of-the-artdrug inventory management systems that linked these companies theirFor major suppliers via electronic data interchange (EDI) networks. These systems allowed the nationwide chains to maximize sales while minimizing inventory-related carrying costs, including losses due to inventory obsolescence. BY comparison, PDS relied largely upon utdated o inventory management and control systems. For example, PDS’s retail stored did not have point-of-scale scanning devices at sales terminals. Unlike major competitors, PDS had not installed computer-based logistics systems to ensure timely and accurate deliveries to retail stores from the company’s merchandise distribution centers. PDS’s inability to monitor precisely the daily inventory movements and balance complicated the efforts of company executives to evaluate the results of chain-wide sales promotions and other special programs. At the store level, the absence of detailed inventory data forced the company’s store managers torely heavily upon their own intuition in making critical decisions, such as which products to stock in their individual stores. PDS’s inventory control problems were magnified greatly in the early 1990s. To compete more effectively with the national drug store chains, PDS rapidly expanded its product line in the “front end” of its stores to include a wide array of cosmetics, personal beauty treatment products, and home office supplies. One company executive noted that by 1991, PDS retail outlets stocked approximately 200 shampoos, more than 100 hair sprays, and two dozen mousses. In 1992, PDS inventory problems contributedthe to company’s loss of position as the number-one drug store chain in the metropolitan Detroit area, which easily ranked as PDS’s largest sales region. In that year, Arbor Drugs, Inc. replaced PDS as the drug store chain with the largest total sales in Detroit. A former PDS executive who accepted a position with one of the large nationwide drug store chains in the early 1990 commented on the stark differences between the nationwide chain and PDS. The executive noted that PDS lacked sufficient funds to invest in technology needed to effectively and efficiently manage a large retail business. He also observed that leaving PDS and accepting a position with the nationwide chain was comparable to going “from the Dark Ages to the st21 Century”. In 1992, PDS’s financial fortunes took a sharp turn for the worse when company executives discovered an inventory shortage of approximately $20 million, a shortage that went unreported in the company’s 1992 financial statements. The following year, PDS wrote off the inventory shortage, which contributed to the company suffering a huge loss. Late in 1994, Rite Aid, the nation’s largest drug retailer with 2,500 stores and $4 billion in annual revenues, purchased PDS for $132 million.



You should access Data File 15-1 in iLearn for Table 1, which presents selected key financial data of PDS for the period 1989-

1993.



PDS’s Inventory Problems

PDS used a periodic inventory system and both the LIFO and FIFO costing methods. In a typical year, PDS applied the LIFO method to approximately 70 percent of its total inventory and the FIFO method to the remainder. Throughout the early 1990s, PDS retained an outside firm to count the inventory of each of its stores. The firm performed these counts in regular cycles, meaning it counted the same group of PDS stores at approximately the same point each year. Following the completion of each cycle count, PDS adjusted the given stores ’ recorded inventory balances to agree with t he physical inventory results and recorded a collective “book-to-physical inventory adjustment” for the general ledger inventory account at corporate headquarters. Between the annual physical inventory counts, PDS used the gross profit method to estimate each store’s inventory and to arrive at a collective inventoryfigure (estimate) for the company as a whole as follows: PDS would add to the amount of the [recorded] beginning inventory the actual cost of its goods purchased through its accounts payable system (cost of goods acquired for sale). PDS would then reduce the inventory by an estimate of the cost of goods sold calculated using the estimated gross profit margin. PDS included the estimated inventory balance on its general ledger, until the actual inventory was verified through a new physical count. Arriving at a reasonable estimated gross profit margin is the most critical step in applying the gross profit method. If an entity’s estimated gross profit margin varies significantly from actual, the resulting estimates of cost of sales and inventory will be unreliable. The estimates yielded by the gross profit method can be made more reliable by applying an estimated gross profit margin to each major inventory group. However, PDS used an overall estimated gross profit margin in applying this method. PDS’s management regularly reviewed the estimated gross profit margin used in applying the gross profit method. Among other factors, the company’s management considered changes in merchandising plans and the year-to-date results of its cycle inventory counts during these reviews. PDS typically revised its estimated gross profit margin more than once per year. PDS’s cycle counts in early fiscal 1992 revealed much larger differences than usual between the book inventories and inventory values determined by physical inventory counts. (Recognize that the book inventories reflected estimates resulting from yearlong application of the gross profit method.) By the end of thesecond quarter of of fiscal 1992, these differences totaled $7.6 million. Follow ing the completion of all cycle counts for fiscal 1992, the collective difference amounted to more than $20 million. This figure alarmed PDS’s management since it represented approximately 14 percent of the company’s collective book inventory of $140.2 million. Unlike in previous years, as fiscal 1992 progressed, PDS did not immediately adjust the corporate inventory account to recognize the book-to-physical differences uncovered by the cycle inventory counts. PDS’s management believed the large discrepancies between stores’ bo ok and physical inventories were not “reasonable.” Management therefore created a “suspense account” to which it transferred thedifferences between given stores’ book and physical inventories. That is, after adjusting a store’s book inventory to agree wit h its physical inventory results, PDS transferred the difference to a general ledger account referred to as the “Store 100” inventory account. (Store 100 was a fictitious store.)

419

420


PDS’s management included Store 100’s inventory balance in the total inventory figure reported for the company in its interim financial statements for 1992. Again, by the end of fiscal 1992, the balance of the Store 100 inventory account exceeded 20 million. shortages, PDS’s CFO, Jerry Stone, initiated a company-wide Shortly after the 1992 cycle counts began revealing large inventory investigation to uncover the source of the shortages. Stone retained Arthur Andersen & Co., PDS’s independent audit firm, toperform a study to “determine whether systems problems were the cause of the discrepancy.” This study was carried out by members of Arthur Andersen’s computer-risk-management group, none of whom were involved in the annual audits of PDS. When that study suggested that computer shortages, Stone hired private detectives. These detectives, along with PDS’s internal auditors, breakdowns were not responsible for the inventory searched for evidence of large-scale inventory thefts. These efforts also failed to reveal the source of the inventory shortage. Finally, Stone’s sale system. The data collected by that store’s subordinates performed an intensive study of a PDS store that had recently installed a point-ofpoint-of-sales system allowed Stone to more accurately assess the company’s actual gross profit margins on the products it sold. Although PDS did not publicly reveal the data, they apparently failed to convince Stone that the estimated gross profit margin being applied by the company was unreasonable.1

 Before becoming PDS’s CFO, Stone served for12 years as an audit partner with Arthur Andersen & CO (hereafter, AA). Quite naturally, then, Stone relied heavily on his contacts at this firm in deciding how to resolve PDS’s 1992 inventory crisis. Richard Valade, an AA audit partner, supervised the annual audits of PDS from 1984 through 1987 and again from 1991 through 1993. Stone notified Valade of the inventory shortage before AA began its audit of PDS’s 1992 financial statements. In September 1992, shortly after learning of the inventory shortage, Valade and a subordinate prepared a General Risk Analysis (GRA) memorandum for the 1992 PDS audit. AA prepared this document for audit engagements to identify the financial statement items requiring particular attention during each engagement. A GRA memo also identified the apparent overall audit risk (AR) posed by the engagement and the planned materiality level for the engagement. The GRA memo for the 1992 PDS audit indicated that AA expected an overall “moderate” audit risk for that engagement. This assessment reflected that auditor expected misstatements but had reason to believe they were not likely to be material in relation to the financial statements.” AA established an overall materiality level of $700,000 for the engagement. Specifically, total misstatements that reduced PDS net income by $700,000 or more would be considered material. During the 1992 PDS audit, AA applied a wide range of audit tests to the client’s inventory, tests more extensive than thosenormally performed on PDS’s inventory. AA applied many of these tests expressly to determine the source of the large inventory shortage revealed by PDS’s 1992 cycle inventory counts. You should access Data File 15-1 in iLearn for Table 2, which lists the key inventory audit procedures completed by AA during the 1992 PDS audit. AA’s 1992 inventory audit procedures failed to uncover the source of the large inventory shortage. Before AA completed the 92 19 PDS audit, PDS’s management decided not to write off the $20.3 million balance of the Store 100inventory account. Instead, it chose to include the $20.3 million in the dollar amount reported for inventory in the company’s 1992 balance sheet. PDS executives presented his t decision to the company’s board of directors during a meeting that Valade attended. Before the December 1992 meeting with Perry’s Board of Directors, Valade discussed the large inventory shortage with severalfellow AA partners, including the Regional Practice Director. Valade asked two of these partners to attend the meeting withS’s PDBoard. During the meeting, Valade did not object t o the Board’s decision to ignore the apparent inventory shortage in preparing the company’sinancial f statements. The minutes of that meeting showed that Valade did not object to include the Store 100 nventory i as an asset on PDS’s balance sheet and that he would sign an unqualified opinion. The minutes also reflect that Valade recommended that PDS conduct a simultaneous chain-wide Input from Arthur Andersen & Co

physical inventory count as soon as possible to discover the reasons for the discrepancy. PDS filed its fiscal 1992 10-K with the SEC in late 1992. PDS’s income statement included in the 10-K reported a net income of $8.3 million. Your should access Data File 15-1 in iLearn for Table 1, which presents selected PDS fi nancial data from 1989 to Had 1993. PDS written off the $20.3 million balance of the Store 100 inventory account, the company would have reported a net loss of approximately $6 million for the fiscal year of 1992. Also included in the 10k was AA’s unqualified audit opinion on PDS’s 1992 financial statements, an opinion signed by Valade on December 15, 1992.



SEC investigate PDS

The management of PDS followed the recommendation of Valade and took a companywide physical inventory in the spring of 1993. That physical inventory confirmed the large inventory shortage discovered by the company infiscal 1992. Near the end of fiscal 1993, PDS’s management decided to write off the balance of the Store 100 inventory account. PD included this write-off in a $33.4 million fourth-quarter adjustment. Since management deemed that the $20.3 inventory writeoff resulted from a “change in estimate,” it did not report the write-off separately in its fiscal 1993 income statement, nor did the company restate its 1992 financial statements for the item. Valade did not object to PDS’s financial statement treatment of the large inventory adjustment.



You should access Data File 151 in iLearn for Table 3, which presents a paragraph from the Management’s Discussion & Analysis (MD&A) section of PDS’s 1993 annual report that disclosed the inventory adjustment. While reviewing the MD&A section of PDS’s 1993 10-K, the SEC discovered the $33.4 million adjustment recorded by the company this matter with PDS’s management, the SEC insisted that the company during the fourth quarter of fiscal 1993. In July 1994, afteriscussing d

restate its 1992 and 1993 financial statements. The SEC required PDS to treat the $20.3 million write-off of the Store 100 inventory account as a correction of an error. This tr eatment increased PDS’s cost of sales for fiscal 1992 by that amount, while decreasing 1993’s cost of sales by the 1 in iLearn for Table 4, which presents the key financial data affected by PDS’s restatement same amount. You should access Data File 15of its 1992 and 1993 financial statements, and Table 5, which contains a portion of the financial statement footnote PDS included in its 1994 10-K to disclose the restatement of its 1992 and 1993 financial statements. 1

During late 1992, PDS began installing a chain-wide, electronic perpetual inventory system. Such a system allows a business to update its

inventory records instantaneously when employees enter on a computer terminal a sale, sales return, purchase, or other transaction affecting inventory. This installation was completed in late 1993. Since PDS’s major competitors had previously installed such systems,PDS’s executives realized that to compete effectively with those firms, they had to obtain the cost savings and strategic benefits yielded by an electronic inventory system. The new inventory system included point-of-sale terminals, electronic surveillance technology to detect theft, and a computer-based distribution network to provide for timely and accurate shipments from PDS’s warehouses to its retail outlets. Most important, the new electronic inventory system allowed PDS’s store managers to monitor closely the sales volume of individual products.


Following PDS’s restatement of its 1992 and 1993 financial statements, the SEC launched an investigation of the company. The investigation centered on the circumstances surrounding PDS’s decision not to write off the balance of the Store 100 inventory account in fiscal 1992. In 1998, the SEC issued two enforcement releases reporting the results of that investigation. The SEC’s firsts enforcement release (SEC 1998a) focused on Stone, the former AA audit partner who served as PDS’s CFO during e for signing PDS’s 1992 Form 10-K: “ by signing PDS’s 1992 Form 10-K, Stone caused the early 1990s. In this release, the SEC chastised Ston PDS to file with the commission financial statements that did not accurately reflect the value of PDS’s inventory” (SEC 1998a). The SEC g to correct PDS’s 1992 financial statements. This sanction ordered Stone to “cease and desist from causing publicly sanctioned Stone for failin any violation and future violation” of federal securities laws. The SEC’s second enforcement release (SEC 1998b) focused on Valade, PDS’s audit engagement partner during the early 1990s. This release criticized Valade for allowing PDS’s management to include the balance of the Store 100 inventory account in the company’s year -end inventory for fiscal 1992. According to the SEC, Valade overlooked a key auditing precept during the 1992 audit. Auditing standards AU 500 explicitly state that evidence obtained by physical examination is more persuasive than evidence produced by indirect tests. During the 1992 audit, Valade collected and reviewed significant physical evidence indicated that the company’s inventory was overstated. Nevertheless, Valade eventually chose to rely on the results of analytical tests that suggested the data produced by the physical inventory counts were unreliable. These analytical procedures consisted principally of AA’s tests of the gross profit margins actually realized by a small sample of stores, tests that suggested that the estimated gross profit margin used by PDS in applying the gross profit method was reasonable. Despite Valade’s consultations with his partners and the additional audit procedures he performed, he nevertheless failed to obtain sufficient appropriate evidential matter to resolve the inventory discrepancy issue. Valade failed to either: (a) require PDS to reconcile the recorded inventory and the physical inventory, and record the proper adjustment to the books and records; (b) discredit either the recorded inventory or the physical inventory and require PDS to adjust the books and records accordingly; (c) issue a qualified opinion; or (d) refrain from issuing an audit opinion until the matter was resolved. The SEC publicly censured Valade for his conduct during the 1992 PDS audit. This censure simply required Valade to comply in the future with all applicable practice requirements for auditors of SEC registrants. Both Valade and Stone “consented” to the SEC sanctions imposed n the “without admitting or denying” the federal agency’s reported findings.

Required Assess Data File 15-1 in iLearn for Tables 1 through to 5 on financial information to answer the following questions.

1. Develop an example to illustrate how using an improper gross profit margin in applying the gross profit method can significantly distort a company’s reported inventory and cost of goods sold. Use the framework below to develop your example. Beginning Inventory Purchase Goods Available for Sale Sales Gross Profit ($ xxx X number of %) Cost of Goods Sold ( ? %) Estimated Ending Inventory

$ xxx xxx xxx $ xxx xxx

xxx $ xxx ===== 2. Identify specific misrepresentations in PDS’s 1992 financial statement data and related financial ratios that resulted from the company’s failure to write off the Store 100 inventory balance. Were these misrepresentations material? Explain. Use the frameworks below to identify specific misrepresentations. i. PDS’s five-year trend in net income: 1993

1992

1991

1990

1989

Reported Net Income Actual Net Income ii. The effect of the inventory error had on PDS’s other key financial statement items: 1993

1992

Cost of Sales Inventory Current Assets Total Assets Stockholders’ Equity PDS’s key financial ratios for the five-year period 1989-1993. iii. The effect of the misstated inventory and cost of sales on

1993 Current Ratio Reported: Actual: Age of Inventory Reported:

1992

1991

1990

1989

421

422


Actual: Gross Profit Percentage Reported: Actual: Profit Margin Percentage Reported: Actual: Return on Assets Reported: Actual: Return on Equity Reported: Actual: 3. Access Table 2 of Data File 15-1 in iLearn and critically evaluate the TOB inventory audit procedures completed by AA during the 1992 PDS audit. Would those procedures assure sufficient appropriate evidence concerning PDS’s inventory balance? What additional TOB procedure should AA perform concerning PDS’s inventory balance?

Simulation Question 15-2 Simulation Question 15-2 is an adaptation with permission from a case by Cohen, J. R., G. Krishnamoorthy, and A. M. Wright in Issues the in Accounting Education , a publication of the American Accounting Association in Sarasota, Florida. This simulation question is based upon a true set of facts; however, the names and places have been changed.



Data Data, Inc

Data Data, Inc. (hereafter, DD) is a global high-technology, publicly traded corporation in the data networking industry. The Company, founded in 1990, is headquartered in the Silicon Valley, San Jose and employs approximately 2,000 people, maintaining operations in ten countries. DD creates hardware and software solutions that link computer networks. In the last few years, the Internet has spurred the growth of the data networking industry into a multibillion dollar global business. DD’s primary customers are computer equipment manufa cturers, Internet service providers, public and private corporations, educational institutions, and long-distance companies. The segments of the computer industry in which DD operates continue to be very competitive,. Primary competitive factors are product performance, technology, customer service, product availability, and price.

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Prior and Current Year’s Audits

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Board of Directors

DD is a medium-sized client in your CPA firm with significant billable hours and audit fees. David Driver, the partner-in-charge of the audit of DD, has audited DD for the past eight years andhas issued standard unqualified reports in each of those years. A review of prior years’ work papers indicated that a few, but not an excessive number of, material adjusting entries were required. The client has always been cooperative in handling these adjusting entries. A review of current standards revealed that there were no significant changes in any accounting or auditing standards that would affect this year’s audit. Management has a positive attitude about developing a reliable control environment and relies on the information generated from the ysts’ earnings accounting system to make management decisions. As with most public companies, there is pressure for management to meet anal forecast and this pressure is greater for companies in the technology industry due to the high growth expectation from the investing public. Further, as is common, management bonuses are tied to earnings. The company’s board of directors has taken the view that it is management’s job to set the direction for the company and to formulate strategies. Although the board formally approves major strategic decisions of management, they do not actively participate in helping the company cope with environment environ mental uncertainties or provide strategic direction and vision to the company’s business. The Board has taken a “hands-off” approach with management decisions and about the strategic fits of new products and markets. For instance, the company hired an outside consulting firm that recommended that a Balanced Scorecard approach be implemented to help improve corporate performance. This approach emphasizes the need to look at multiple perspectives when evaluating performance. The four perspectives (Financial, Customer, Internal Operations, and Innovation and Learning) include both a financial and nonfinancial strategic viewpoint. The Board however, viewed the Balance Scorecard approach as an operational issue and delegated the decision to adopt and implement the approach to the senior management of the company. The company has a tradition of having a majority of outside (nonexecutive) Board of Directors that oversees management’s activities closely. For example, the Board has the power to conduct independent investigations of unethical behavior. There are large institutional holdings of the company’s stock including CALPERS (California Public Employees’ Retirement System) and TIAA-CREF (Teachers Insurance and Annuity Association-College Retirement Equities Fund). Both of these funds have a tradition of being at the forefront of monitoring the governance of corporations in which they have a significant investment. This has resulted in an explicit focus on ensuring at management’s th decisions are aligned with protecting shareholder interests and rights. For example, the chair of the Board is an independent outsider and all members of the Compensation Committee are independent outsiders. The Board has also invested significant power in the Audit Committee to

fulfill its charter. It is very supportive of the Audit Committee’s role in ensuring sound financial reporting policies and a strong control environment for the company.

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Audit Committee

Based on changes implemented in light of the report issued by the Blue Ribbon Committee (1999) and the regulations enacted in the Sarbanes-Oxley Act (U.S. House of Representatives 2002), audit committees must now meet a number of requirements that more clearly define


their objectives as well as the composition of the committee. In light of these changes, the Audit Committee (hereafter, AC) of the company has adopted a formal written charter that is similar to other firms in the industry. Further in accordance with the Sarbanes-Oxley Act, the AC also ppointment of the company’s outside auditors and determines the appropriateness of their fees. The AC recommends the appointment/rea currently consists of Ms. Zheng, Mr. Kumar, and Mr. Taylor. Their background is presented to demonstrated that audit the committee meets at least the minimum requirements as far as financial literacy and expertise is concerned. Ms. Zheng, a Certified Management Accountant (CMA), has served on the AC of the company’s Board for the last 4 years. She was recently appointed the Chair of the Board and the Chief Executive Officer of RMA Corporation, a telecommunications company that offers local, long distance, Internet, and advanced telecommunications services directly to business customers. Prior to her current position, she was the Chief Information Officer (CIO) of Mandeel International, Fortune a 500 company engaged n the manufacture and marketing of semiconductor capital equipment. She worked first five years of hercareer as a budget analyst and as an internal auditor, but after earning her CMA 15 years ago, she Ms. Zheng’s soon thereafter switched to a career in information technology and obtained an M.B.A., concentrating in Information Sciences. background qualifies her as the required individual on the AC with financial expertise. Mr. Kumar was elected to the Board three years ago and has been a member of the AC ever since. He is President of EdenCal Consulting, Inc., a firm he founded in 1987. EdenCal provides marketing consulting services to companies in the automobile industry. Mr. Kumar’s personal expertise is in the area of brand management. His prior experience includes faculty positions where he taught courses in marketing and advertising. Mr. Kumar recently audited an introductory accounting course. He holds a Ph.D. in Psychology. Mr. Taylor has served on the AC for the last three years. He is the chief project manager at Relief for Children, a charitable organization providing education and healthcare assistance to children in developing countries. Prior to joining Relief for Children, he was head of the Department of Social Work for the State of New York. Mr. Taylor holds a B.A. in English Literature and an M.A. in Social Work. In preparation for service as an audit committee member, Mr. Taylor went through a two-day company-sponsored training program, which provided an exposure to the fundamentals of financial statements and financial reporting.

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The Inventory Cycle

Roughly 20 percent of the company’s current assets are in inventory, and cost of goods sold represents 57 percent of sales. Hence, the inventory cycle represents a critical audit area for DD. DD has implemented an information system that ensures that raw materials are tracked from the time they are shipped by the supplier until the company receives them. Upon receipt of materials, they are stored in the warehouse until needed for production. Materials are issued to production only upon a properly approved materials requisition that indicates the type and quantity of materials needed. The perpetual inventory system monitors and updates the inventory and cost of goods sold records on a real time basis. The company undertakes an extensive physical verification of inventory each year and material discrepancies between actual counts and book records are properly authorized and reconciled on a timely basis. Given the rapid technological changes in the data networking industry, the potential for product obsolescence is high. Constant and fierce competition from start-up companies further exacerbates the need to ensure that the technology on which products are based keeps pace with the developments in the industry and the demands of the customers. Financial information relevant to the inventory cycle is presented in Table You 1. should access Data File 15-2 in iLearn for Table After reviewing last year’s financial statements and the current year’s unaudited financial 1, which presents the key financial data of DD. statements, materiality has been set at $6 million.

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Inventory Valuation The major remaining issue in the current year’s audit relates to whether approximately $11.4 million of inventory for two products

(discussed below) should be writtenfacts down as proposed Valuer, the Chief Financial Officer (CFO), continued to be carried on the balance sheet at cost. The following areor, available about by theMr. products. Product History

The history of the data networking industry parallels that of the Internet, with much of the commercial and consumer applications emerging only in the last decades. A characteristic of any emerging technology is that competing standards and protocols are constantly proposed by participants in the industry, who strive to make their proprietary technology the de facto industry standard. The router segment of the data networking industry is one such segment where industry rivals including DD are competing and lobbying vigorously to make their technology the de facto industry standard. Routers consist of hardware devices and software programs that help direct and route data, voice, and video traffic through the Internet. In the router market, DD competes with other companies that are similar in size and market share. As explain later, none of the companies currently have a technological lead in the market for the specific class of routers that address the needs of lower-to mid-level enterprise and Internet service provider (ISP) customers. In late 2000, the company’s management identified a significant market opportunity for this market, butthe major challenge in exploring this opportunity related to the technology on which the routers will be based. DD’s routers are based on a proprietary technology, codenamed XP, which uses the time-division-multiplexing-based (TDM) technology to transmit signals. Other industry participants have proposed a competing standard, code-named Optixx (OP), which is based on the fiber optic technology. The fiber optic technology is being successfully deployed by regional telecom carriers. However, the technology faces significant engineering and marketing challenges for adoption in the enterprise (business) router market covering the metropolitan areas where the routers need to work with the existing infrastructure already in place. DD’s senior management and the technical team felt that the t echnology on which DD’s routers are based is compatible with the existing copper-based telecom infrastructure where signals are transmitted as electrical, rather than as light waves, as is the case with the optical-based routers. If the XP protocols based on the TDM technology become the industry standard, then DD will have an enormous competitive advantage in an industry where “early movers” typically gain an unsurpassable lead over competition. In June 2002, the board approved plans for the manufacture of two models, the XP3000 and XP2000, and commercial production of the routers began in October 2002. The products were introduced into the market later that month. Although the quantity of sales has not made the projected forecasts, management has maintained production levels in anticipation if their perception that demand will be strong. Until now, management has not engaged in any price cuts. See the comparison of actual to budgeted sales in TableYou 2. should access Data File 15-2 in iLearn for Table 2, which presents the comparison of sales forecast and actual sales (units). Inventory Observation and Costing

The inventory as of June 30, 2003 totaling $287 million included $11.4 million relating to XP3000 and XP2000 (valued at cost). Details are as follows: XP3000: 415 units @ $15,000 = $ 6.25 million (approx.) XP2000: 605 units @ $8,500 = $ 5.15 million(approx.) Total = $ 11.4 million

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As part of the current year audit, inventory quantities have been verified through observation at the year-end physical inventory counts. Further, the relevant job cost sheets have been verified against unit cost values attached to both the XP3000 and XP2000. The remaining $276 million (approx.) inventory items have also been audited by various offices of you CPA firms with no proposed audit adjustments. The only remaining substantive inventory issue is the carrying value of XP3000 and XP2000. Lower of Cost or Market

Because of the short history of the newer XP3000 and XP2000 products and their special purpose nature, a negative change in demand potentially could drastically affect product pricing. In such an event, the products will need to be severely discounted or worse yet, disposed as scrap as any decline in value will likely extend to the raw materials component as well. Currently, management has no specific obsolescence reserve set up. They have a policy of only writing down inventory when specific products are viewed as obsolete. Industry Publication

Two articles fromDataNet Review magazine are relevant with respect to the valuation of XP3000 and XP2000. The first article, which appeared in January 2003, gives a glowing review of both products. The article concludes by indicating that these routers will significantly increase the bandwidth capacity with enterprise (business) customers located in the densely populated metro areas, thus increasing the number of simultaneous users from areas where these routers are deployed. The second article, which appeared in June 2003, talks about a competitor’s product. The article states that XP3000 and XP2000 are based on the TDM technology that uses the existing copper-line telecommunication infrastructure for data transmission. Although TDM has supported the recent growth of the Internet traffic using existing telephone lines, the article stated that it is not capable of scaling up to meet future traffic as well as additional service needs of the consumer (e.g., streaming video and audio). A ompetitor’s c product, released in May 2003, is based on the fiber optic Internet working technology that uses light waves to transmit data, voice, and video. The article claims that relative to TDM, the fiber optic technology offers significantly higher bandwidth and speed for network traffic and the fiber optic technology will increase compatibility with the newer fiber optic equipment currently being deployed by telecommunications companies. However, as discussed earlier, the article concludes by stating that the fiber optic technology for routers that are largely deployed by enterprise and Internet service providers in the metro areas is still in its infancy and the ability to execute the mass deployment of products based on this technology faces significant customer acceptance and marketing challenges. Discussion with the CFO On inquiry, Mr. Valuer, DD’s CFO explains the reasons for the slowdown in sales of XP3000 and XP2000 and justifies their valuation

on the balance sheet at cost. Mr. Valuer says that he is bullish on these products and attributes the slowdown in new orders to the general sluggishness of the economy. Further, he states that enterprise and ISP capital expenditures are lower during the traditionally slow summer months. He also believesthat the competitor’s products will be less reliable than XP3000 and XP2000 since the new technology (fiber optic) is deemed less mature and established. Finally, Mr. Valuer stated the board concurred with management’s assessments of the market potential for the XP class router products and approved the introduction of these products. The company’s management is convinced of the su periority of its products and plans to continue production as suggested by their budget. Given this discussion with the CFO, David Driver plans to raise the issue of salability of the products in the upcoming meeting with the audit committee of DD.

Required The efficiency of capital markets rests on the free flow of unbiased, objective information from the stewards of capital to its providers. Research as well as corporate malfeasance scandals provides ample evidence regarding the importance of high-quality financial information to the efficient functioning of the capital markets. Indeed, good governance is crucial not only in preventing major financial reporting disasters, but also in ensuring that significant issues impacting the financial reporting process (e.g., inventory valuation) are appropriately accounted for by the corporation. However, ensuring high-quality financial reports requires that all stakeholders, and not just the management, take an active role in the governance process. The questions that follow are designed to help you carefully consider all aspects of the governance framework and to evaluate the role of each of the major players (e.g., auditors, management, audit committee, board of directors) who must work together to ensure that the highest quality of financial information is provided to the stakeholders who make important decisions based on that information. Fully answer the following questions: 1. What impact will the valuation of inventory at cost versus a write-down from cost have on the following financial statements reported to the stockholders: (ignore any income tax implications) a. Income Statement, b. Balance Sheet, and c. Statement of Cash Flows 2. Discuss the factors that may be driving Mr. Valuer’s desire to value the inventory at cost. List each factor and explain your answers as follows: a. Factor one …. Reasons are … b. Factor two … Reasons are … Continue …

3. Assume you are the senior auditor-incharge of DD’s audit, write a memo to David Driver, the audit partner, which fully explains whether the inventory relating to XP3000 and XP2000 should be valued at cost or be written down. 4. Irrespective of your answer in 3. above, assume you believe that the inventory should be written down while Mr. Valuer, the CFO, believes that it should be carried at cost. Fully explain what steps you would take to resolve your disagreement with Mr. Valuer.


Simulation Question 15-3 Simulation Question 15-3 is an adaptation with permission from a case by Long, J. H., L. Mertins, and D. L. Searcy in the in Accounting Issues Education , a publication of the American Accounting Association in Sarasota, Florida. This simulation question is based upon a true set of facts; however, the names and places have been changed.

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Introduction

Lisa Martin, CMA, CPA, was recently promoted to the position of controller at International Retail Computer Solutions (IRCS). Her promotion resulted from eight years of hard work as a corporate accountant. Martin has been with IRCS since graduating from Big State University and was thrilled to have an opportunity to move up within the organization. She has a fantastic relationship with the other members of IRCS's management team (all of whom are also Big State alumni) and enjoys tailgating with them before Big State sporting events. Although Martin has enjoyed the opportunity to get involved with the bigger financial picture at IRCS and is excited about the challenges presented by her new position, she has recently been struggling with an unexpected dilemma: in her professional judgment, some of the company's accounting practices may be inappropriate and unethical.

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The Company

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The Management Team

IRCS is a privately held company headquartered in the southeastern United States. IRCS's primary business activities involve buying and selling used point-of-sale (POS) computer systems. When a U.S. retailer upgrades its POS computer systems, IRCS purchases the used equipment (including handheld scanners, receipt printers, monitors, keyboards, CPUs, and servers) and resells it to retailers in developing countries, where it is considered to be top of the line (see Figure 1). You should access Data File 15-3 in iLearn for FigureIn1.addition, IRCS provides replacement parts to U.S. retailers that continue to use older POS computer systems. Ernesto Rodriguez founded IRCS in 1984. He retired last year to engage in other pursuits and is no longer involved with the day-today operations of the business. However, he still retains a majority ownership interest in the company and serves as the chairman of the board. The president and chief executive officer, Harvey Lang, has been with IRCS since the founding of the company. He worked his way up to become Rodriguez's right-hand man and the vice president of sales. Upon Rodriguez's retirement, Lang was promoted and given a small ownership interest in the company. Besides Harvey Lang and Lisa Martin, IRCS's management team includes Chief Financial Officer Christina Edmonds, Chief Information Officer Carl Miller, Vice President of Sales Ryan Scott, and Vice President of Logistics Elizabeth Conner. Edmonds and Scott are recent additions to the management team. Lang hired Edmonds from IRCS's largest competitor, where she had previously worked as the controller. She replaced the old CFO, Adam Stone, who left the company soon after Rodriguez retired. Scott worked in sales at IRCS for ten years and was Lang's handpicked successor as the vice president of sales. Miller and Conner have been with IRCS in their current positions for more than a decade. The members of the management team all have an excellent working relationship with one another and frequently spend time together outside of work, often at Big State University sporting events. Management's compensation consists of a base salary and a bonus. Each manager's bonus is calculated as a percentage of Earnings before Bonuses, Interest, and Taxes (EBBIT). In total, management receives bonuses equal to 10 percent of IRCS's EBBIT, with Lang receiving the lion's share. At the end of each year, management makes a presentation to Rodriguez that summarizes the company's financial performance and management's plans for the future. Once the presentation is complete and he is satisfied with management's report, Rodriguez and the board members authorize the payment of managerial bonuses.

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Changing Circumstances

During the current year (2012), the continued downturn in the U.S. economy prolonged the havoc being wrought on the financial prospects of many national retail chains. Several large chains, which had expanded aggressively during the boom years preceding 2008, succumbed to the ongoing financial hardship and were forced into bankruptcy. IRCS's management saw an opportunity to acquire a significant number of used, but relatively up-to-date POS systems at a significant discount from traditional market prices. However, IRCS lacked sufficient capital to complete the acquisitions on its own. Therefore, the company obtained a $10 million loan from First National Bank (FNB) to help finance the purchase. In order to obtain the financing from FNB, IRCS agreed to several loan covenants, the most restrictive of which involves the interest coverage ratio (Earnings before Interest and Taxes ÷ Interest Expense). Specifically, IRCS is required to maintain a minimum interest coverage ratio of 3. Failure to do so violates the loan covenant and allows FNB to demand immediate repayment of the loan. To verify compliance with the debt covenants, FNB requires IRCS to provide monthly and annual financial statements prepared in accordance with U.S. Generally Accepted Accounting Principles (GAAP), and to engage a CPA firm to provide a review of the annual financial statements to be completed no later than 90 days after the end of the fiscal year. In addition, both Rodriguez and Lang are required to personally guarantee the loan.

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IRCS’s Inventory Costing Procedures

One of the most difficult management accounting issues facing IRCS relates to inventory costing and valuation. Typically, IRCS pays a lump sum to acquire used POS equipment. This payment must be allocated to the individual pieces of equipment. Although the typical costing approach for this scenario involves assigning costs based on the relative fair market values of the acquired items, the unique nature of IRCS's business often precludes this approach. Many of the items the company acquires do not have readily determinable market values, and might be considered obsolete in the U.S. and by the manufacturer. However, given IRCS's sales contacts around the world, it can usually sell these “obsolete” inventory items in other countries at a profit, with normal gross margins ranging from 25–75 percent. For traditional inventory acquisitions, management begins the costing process by identifying the pieces of equipment they believe to be the mostthat marketable. They assign for the an majority of period the acquisition cost to these items, which sell at prices above allocated cost. Equipment remains in inventory extended of time typically has very little cost usually assigned to quickly it.

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Costing the New Inventory

In June 2012, IRCS paid more than $12 million to acquire used POS systems from a bankrupt retail chain. Although IRCS frequently purchases and sells used POS equipment, this latest purchase is by far the largest the company has ever made, thus the need for the $10 million loan. In addition, the equipment acquired is much more up to date than their usual inventory, and management does not have the expertise to cost these particular inventory items in the traditional manner. However, because the latest purchase primarily consists of newer equipment, the relative fair market value of each inventory item is more easily determinable. Lang (CEO), Edmonds (CFO), and Scott (VP Sales) met to decide how costs should be assigned to the newly acquired inventory. After careful consideration of the authoritative guidance in FASB ASC 330-10-30, they determined that costs would be assigned based on the relative fair values of the inventory items. This approach is consistent with the individual circumstances surrounding this acquisition of inventory, as well as with methods that have been adopted by the majority of the other companies in the industry that deal with this type of equipment (ASC 330-10-30-14). They asked Martin (Controller) to perform the necessary calculations and allocate the cost to the individual items, using the latest sales price from an industry-wide database as an approximate measure of each type of equipment's relative fair market value. You should access Data File 15-3 in iLearn for Table 1, which provides a detailed list of the purchased items, along with the last confirmed sales price from the industry-wide database, and the date on which the item was last sold.

Martin was excited about the opportunity to lead such an important project, her first major assignment as controller. When the project was completed, Edmonds praised her efforts, and Lang rewarded her with exclusive use of his luxury box for a Big State game. One day in late November, over lunch with the management team, Martin listened attentively as Lang, Edmonds, and Scott discussed the success of IRCS's latest venture. She was delighted to hear that sales of the newly acquired inventory were proceeding briskly, and that the company's profit margins were substantially higher than normal. Scott mentioned that the sales team had been able to sell the complete inventories of three types of monitors, two types of printers, three types of scanners, and one type of CPU. The remaining monitors, printers, and scanners were also moving relatively well. The only items that were cause for concern were the three remaining types of CPUs. Scott noted that there just did not seem to be much demand for these items, even when IRCS offered relatively deep discounts. However, he mentioned that his sales team had several promising leads, and that he was confident that they would be able to find buyers for these items, even if they had to offer even larger discounts.

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Inventory Impairment Testing

Shortly after year-end, Martin was instructed to prepare the first draft of ICRS's financial statements. As part of the preparation process, she conducted an inventory impairment test to determine whether inventories were appropriately recorded on IRCS's books at the lower of cost or market, as required by ASC 330-10-35. This impairment test had not resulted in significant impairment losses in prior years because prior-year ending inventory levels were generally small. Based on her research into the technical standards and consistent with the impairment tests that had been conducted in prior periods, Martin determined that she should compare each inventory item's cost to its market value at an individual item level (see Table 2).Y ou should access Data File 15-3 in iLearn for TableConsistent 2. with ASC 330-10-35-4, Martin used the current cost of replacement as the proxy for “market value.” This cost of replacement was obtained from the industry-wide database used to assign costs to inventory initially. When she had completed the impairment test, she was surprised to see that her calculation indicated that there was an impairment loss of $538,005. Upon further examination, Martin determined that the impairment loss was attributable to the decline in market value of the three slow-moving CPU items. Concerned, she sought out Ryan Scott to determine whether the sales force had had any luck finding buyers for the three CPU items: Martin: “Hey, Ryan. Do you have a minute to chat about those three slow-moving CPU items from the June purchase?” Scott: “Sure, Lisa. What can I do for you?” Martin: “I need to know if you still think that we might be able to sell those items at any amount close to the cost we have on the books. In other words, is it reasonable to hope that we can sell them for a normal profit?” Scott: “Well, Lisa, that's a tough question. You know, we have a great sales team here at IRCS, and we are generally able to move our used inventory pretty quickly. We did have several promising leads, but unfortunately, those customers bought CPUs from our competition at a deeply discounted price relative to our carrying amount. Given the market, I think a more realistic expectation is that we will have to offer them at a significant discount ifwe want to sell them.” Martin: “I see. Okay, Ryan, thanks for taking the time to talk things over with me.” Scott: “Of course! Any time.” Given her discussion with Scott, and the lack of evidence that the CPU items assigned cost could be recovered with an approximately normal profit upon sale in the ordinary course of business (see ASC 330-10-35-5), Martin recorded the loss, which directly reduced income before taxes and interest, and significantly reduced net income. She then sent the financial statements and impairment test documentation to Edmonds for review and approval. The next day, Lang called Martin into his office: Lang: “Thanks for dropping by, Lisa.” Martin: “No problem, Harvey. What's up?” Lang: “I wanted to talk about the draft of the financial statements that you sent to Christina yesterday. I see that you've indicated that we should recognize an impairment loss in excess of $500,000 associated with our inventory. You do realize that amount would reduce our bonuses by more than $50,000? I use my bonus to pay for my Big State luxury box and provide scholarships for deserving student athletes. In addition, these financial statements are going to our bankers. The impairment loss you booked will cause us to violate the interest coverage ratio debt of our loan!” covenant. In fact, any impairment adjustment above $72,000 will place us in violation of our debt covenants in the first year Martin: “I definitely don't want us to violate our debt covenants. But do you really think the bankers would call our loan on our first violation?” Lang: “Look, the bank wasn't really excited about extending us the loan to begin with; however, Ernesto was a friend of the bank president and that was what got us the loan. Unfortunately, that bank president retired within weeks of our loan approval and the bank has become much more conservative under its new leadership. As a matter of fact, Dean, our new loan officer, has called me twice already this month about the financial statements. He mentioned that it is imperative that we get the financials ready for the review so that the bank can have them as soon as


possible. He has also mentioned the importance of not violating our debt covenants. The down economy has really hurt the bank and they are in no position to have risky loans outstanding. So, to answer your question, yes, I believe the bank will call our loan if we violate our debt covenants this year. Doing so will probably send us to bankruptcy and put 25 people out of work, and Ernesto and I would be on the hook for the remaining loan balance. Do you want that to happen?” Martin: “Of course not, especially since I am one of those people that could be out of work! Look Harvey, I didn't make up the accounting rules, but we have to follow them, especially since a CPA firm will review t hese financial statements before we send them to the bank.” Lang: “The bankers are not interested in the nuts and bolts of our accounting, particularly an issue that doesn't affect our cash flows. An impairment loss isn't a real loss anyway; it's just a paper write-down. Besides, when it comes time to sell our inventory items, we've never had any trouble recovering our costs before. The bank just needs to get a big picture of our financial situation, and I am telling you, we are in good shape! Now, I need you to find a way to lower that adjustment, so that we don't violate our debt covenants.” Martin: “Harvey, based on my reading of the authoritative guidance, I don't think we have an option here. And I don't feel comfortable with you pressuring me …” Lang: “Okay, okay. I'm sorry I got so riled up. Tell you what, why don't you walk me through the impairment calculation, and we will see what we can figure out.” Martin: “Okay. Essentially, the impairment is t ied to those slow-moving CPU items. The last sales price according the industry-wide database for each item was far below our carrying amount, and that leads to a large impairment associated with those items. If we had evidence that the cost was recoverable with a normal profit in the ordinary course of business, we could argue that we shouldn't recognize an impairment loss for be able to sell them without offering deep discounts.” these items. However, I talked with Ryan yesterday, and he doesn't think we will Lang: “Wait a minute. You're saying that if we can provide some evidence that the cost is recoverable, we won't have to recognize the impairment?” Martin: “Essentially, we would be able to argue that impairment is unnecessary.” Lang: “I tell you what. I think I can see our way out of this. Let me have a few days to get things lined up, and I will touch base with you soon.” Two days later, Martin received a note from Lang that read, “This should take care of our impairment problem! Once you've reversed the impairment loss and updated the financial statements, just send them on to Christina for final review.” Underneath was acopy of Lang's impairment test (see Table 3), a purchase order from one of IRCS's largest Indian customers, along with IRCS's corresponding invoice (see Figure 2) and shipping documentation.You should access Data File 15-3 in iLearn for Table 3 and Figure Martin 2. noticed that three items included in the order were the slow-moving CPU items. Martin considered whether this documentation provided sufficient evidence that the cost assigned to the slow-moving CPU items was recoverable with a normal profit in the ordinary course of business. She noted that the sales price for each of the CPU items exceeded the carrying amount. However, she also noted that the sales prices for the other items were substantially below their market values, even though she knew that these items continued to sell for prices that approximated the current replacement cost she had used in her impairment test. Concerned that there might have been a mistake in the pricing, she decided to check with Ryan Scott:

Martin: “Ryan, can I ask you about Invoice Number 2011 -00295? The latest sale we made toNational Computers?” Scott: “Sure, Lisa. What do you need to know?” Martin: “First, great job selling some of those CPU units. I know we were all worried they would be tough to sell, but it looks like we were actually able to recover our cost. I dohave a question about the other items on the invoice though. I think there might be a mistake on the prices?” Scott: “That's no mistake. Just between you and me, Harvey said that for financial reasons, we needed to show that we could sell the CPU items above our carrying cost, so I was able to convince National Computers to ‘pay' a substantial premium for the CPU items by giving them great prices on the other items. But Harvey said to make sure to keep that information confidential. He specifically asked that we not discuss it with the auditorscoming to review the books in a few weeks.” Martin: “Whoa! That's news to me. So you don't think we could sell those CPU items, even at cost, without giving the customer ‘special' pricing on the other item?” Scott: “No way. Those CPU items are pretty obsolete, even for our overseas customers. We'll be lucky if we can sell them for half of the carrying value.” Martin's head was spinning as she returned to her office. She was very uncomfortable with what she had learned about the sale to National Computers. She definitely did not think that it provided evidence that IRCS could recover the cost assigned to the computers, and strongly believed that IRCS needed to record an impairment loss related to those items. She was also concerned about the implications of Harvey's under-the-table dealings with National Computer, and his request that they keep information about that true economics of the deal from the CPA firm that was reviewing the financial statements. However, she knew that there could be real consequences if IRCS recorded the impairment loss and violated its debt covenants. Unsure how she should proceed, she decided to request a meeting with Christina Edmonds to talk through the issue. At the meeting the next day, Martin began by describing the issues around the impairment loss, and her concerns about Harvey's “solution” to the problem. She then asked Edmonds what she should do: Edmonds: “Well, Lisa, this is a tough situation. Harvey just wants to do what is best for the company, and violating our debt covenants could have serious consequences. However, I agree with you that Harvey's solution doesn't meet the requirements laid out in the authoritative guidance to avoid an impairment loss. But have you considered other possible alternatives? For instance, when you conducted the impairment test, it looks like you applied the lower-of-cost-or-market rule directly to each item. However, ASC 330-10-35-8 also allows us to apply the lower-of-cost-ormarket rule to the total inventory. I took a quick look at the calculation, and I bet that if we used this method to conduct the impairment test, we won't have a significant impairment loss.” “That's a great point, Christina. Butthat ASC Martin:ASC -10-35-8 that method we use should rule be that which most clearly reflects periodic income. 330-10-35-10 goes on to say we330 should onlysays apply thethe lower-of-cost-or-market to the entire inventory when there is only one end-product category and when the inventory items are in balanced quantities. When we sell our inventory, it is typically on an item-by-item basis, rather than as a complete POS computer system. Additionally, the method I used initially was consistent with prior years, and ASC 330-1035-10 says that our impairment test methodology must be applied consistently from year to year. Do you think we can justify applying the lowerof-cost-or-market rule to the entire inventory?”

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Edmonds: “It's true that the vast majority of our sales are on an item-by-item basis, but we do sell complete POS computer systems from time to time. For instance, our recent sale to National Computers included monitors, printers, scanners, and CPUs.” Martin: “But Ryan said the only reason National Computer was willing to buy the CPUs was because we gave them deep discounts on the other items.” Edmonds: “This is definitely a gray area, and we must use our professional judgment to determine the appropriate course of action. I've been an accounting professional for a long time, and in my professional judgment, we can apply the lower-of-cost-or-market rule to the entire inventory. I will take full responsibility for the decision. Why don't you recalculate the impairment applying lower-of-cost-or-market to the inventory as a whole, book any entries required to adjust the impairment loss, and then send me the updated financial statements? I will let the accounting firm know that they will be ready to review by the end of the week.” Martin: “Do you think we will have any problems with the i mpairment issue during the review?” Edmonds: “Probably not. The auditors who conduct the review of our financial statements won't be required to examine source documents as part of their review. But if they push on the issue and want additional support for our position, we can show them the National Computers invoice as evidence that we do sell the component items as a system. Just make sure you don't mention Harvey's side deal to them. We both know Harvey only wanted to protect the company, but the auditors who are reviewing our financials might misinterpret his actions. All right, Lisa, thanks for being a team player on this one. I talked with Harvey, and just to show you how much we value your loyalty to the company, he'd like to offer you the use of his luxury box for next week's game. It should be a good one; both teams are undefeated!” Still somewhat uncomfortable with Edmond's arguments, Martin nevertheless returned to her office to rework the inventory impairment calculations. Using Edmonds' methodology, she determined that the inventory was not impaired (see Table 4) and that IRCS did not need to record an impairment loss.Y ou should access Data File 15-3 in iLearn for TableAfter 4. she reversed her initial impairment loss, the updated financial statements met the covenants required by the FNB loan agreement. Lisa was amazed at the effect that changing a simple methodological assumption could have on the financial statements! That night, Martin struggled to fall asleep. Her thoughts kept drifting back to her discussions with Lang and Edmonds about the inventory impairment test. She wanted to be a good team player, but she continued to be uncomfortable about upper management's accounting choices. In her professional judgment, management's choice of accounting methodology was inconsistent, inappropriate, and motivated more by the effect each method had on the company's loan covenants and managerial bonuses than by objective accounting and reporting. She worried that the company's updated financial statements misrepresented IRCS's financial performance to both First National Bank and Mr. Rodriguez. She was also concerned about Harvey's under-the-table dealings with National Computer, and the implications for management's integrity with respect to financial reporting. As a CPA, she knew she had a duty to behave ethically, but how did that apply in this situation?

Required 1.

2.

3. 4.

5.

6. 7.

8. 9. 10. 11. 12.

Given the guidance in ASC 330 “Inventory,” which of the three impairment tests do you believe is allowable (Martin's in Table 2, Lang's in Table 3, or Edmonds' in Table 4)? Why? Which of the three impairment tests do you believe is most the appropriate (Martin's in Table 2, Lang's in Table 3, or Edmonds' in Table 4)? Why? Based on the discussion inthe case and the AICPA's Code of Professional Conduct, how did Martin adhere to the principle of “due care” (Article V)? What concerns related to “due care” might she have about management's accounting methodology?(Refer to Chapter 3). What implications does the principle of “integrity” (Article III) from the AICPA's Code of Professional Conduct have for Martin in this situation? Does this principle also have implications for Harvey's “under-the-table dealings” with National Computers? (Refer to Chapter 3). As part of the standard of the principle of “objectivity and independence” (Article IV), the AICPA's Code of Professional Conduct requires Martin to be “intellectually honest and free of conflicts of interest.” Do you believe that Martin acts in accordance with this principle? In addition, the AICPA's Code of Professional Conduct defines six threat categories that jeopardize compliance with the rules of conduct, especially the principle of “objectivity and independence” (Rules of Compliance Guides, para. 13). Which of these threats are applicable to Martin's situation? (Refer to Chapter 3). Article II (“the public interest”) in AICPA's Code of Professional Conduct states that financial accountants should serve the public interest and honor the public trust. Who are the intended users of Martin's reports? How should Martin apply this principle, given her current situation? Does Edmonds' statement taking full responsibility for the accounting decisions absolve Martin of her ethical responsibilities? Why or why not? Lang requested that Martin keep her concerns about the company's accounting methods confidential. However, Martin believes that the application of the company's newly introduced accounting methods is unethical. What options does Martin have to resolve this ethical dilemma? How should the potential consequences of recording the more conservative impairment loss factor into Martin's decision (e.g., lost jobs if the bank calls the loan, smaller management bonuses, and fewer scholarships for Big State athletes)? Discuss the positive and negative factors associated with the “beyond-work” relationships that exist among the management team. Which individual (Martin, Edmonds, or Lang) do you believe is ethically correct? Defend that person's position. Defend the position of the two individuals (Martin, Edmonds, or Lang) that you did not select for Question 10. What would you do if you were Martin?


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Chapter 16 Payroll Cycle – Tests of Controls and Tests of Balances Chapter Learning Outcomes (LOs) Checklist


LO16-1 Understand the accounting information system of a typical payroll cycle.



LO16-2 Describe some common TOC procedures for payroll.



LO16-3 Identify internal controls in computerized payroll systems.



LO16-4 Apply the analytical procedures in a payroll cycle.



LO16-5 Understand internal control in computerized payroll system.



LO16-6 Describe some common TOB procedures for payroll.



LO16-7 Describe some common audit procedures for share-based compensation.


Chapter 16 Payroll Cycle – Tests of Controls and Tests of Balances An overview of the strategy for tests of controls in a payroll cycle is presented in Figure 16-1. Figure 16-1 TOC Strategy in Payroll Cycle

The Audit Process

Audit Plan

Tests of Controls

Tests of Balances


Audit Report











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432


Understand Internal Controls in a Payroll Cycle

TOC strategy in a payroll cycle starts with an understanding of internal controls relating to a payroll cycle. Table 161 provides a brief discussion of the various components relating to the understanding of internal controls in a payroll cycle. Table 16-1 Understanding Internal Controls in a Payroll Cycle

Understanding Internal Controls in a Payroll Cycle 1. Control environment

2. Risk assessment


4. Information andcommunication

5. Monitoring

Table 8-1 in Chapter 8 listed seven factors affecting the control environment. Since these factors affect all accounting cycles, understanding of the control environment is generally conducted for all the accounting cycles taken as a whole. The auditor should, however, consider any control environment factors that may have a special effect on the payroll cycle. Table 8-1 in Chapter 8 listed the five basic management assertions that must be met by the management’s risk assessment. The auditor must understand how management assesses risks that are relevant to the payroll cycle, estimates their significance, assesses the likelihood of their occurrence, and takes action to address those risks in order to meet the five basic management assertions. Table 8-1 in Chapter 8 listed the five basic control activities that must be established in an accounting cycle. If the auditor plans to conduct both TOC and TOBon the payroll cycle, then s/he needs to identify the control activities relating to specific audit objectives and for the purpose of assessing control risk (CR). The auditor usually identifies these control activities from documentations of the understanding using narrative descriptions, internal control questionnaires, or flowcharts. Figure 16-5 shows an example of a payroll cycle flowchart. The auditor mustobtain sufficient knowledge ofthe accounting information systemrelating to thepayroll cycle to ensure that the TOC and TOB procedures meet the eight types of specific audit objectives listed in Table 8-1 in Chapter 8. Specifically, the auditor must obtain sufficient knowledge in three areas as shown in Figure 16-2. A brief discussion of these three areas is provided in Table 16-2. The auditor must understand the management’s monitoring processes over t he payroll cycle. This includes understanding how the management monitors the internal controls of the payroll cycle over time and what corrective action is initiated to improve the design and operation of controls in the payroll cycle.

Figure 16-2 Understanding of Information and Communication in a Payroll Cycle

Key Functions Understand 4 key functions of a payroll cycle




Table 16-2 Understanding of Information and Communication in a Payroll Cycle





1. Personnel Managing human resources that include hiring and terminating employees, setting wage

 Personnel file This file contains each employee’s hiring date, wage rate or salary, payroll deduction authorization forms, wage-rate and salary adjustment authorizations, performance evaluations and

rates and salaries, and establishing and monitoring employee benefit programs. Note: Personnel function = Human resources function. Ordinarily, a payroll department refers to a department that combines the personnel and accounting/recordkeeping departments.

termination notice, if applicable.  Deduction authorization form A form authorizing payroll deductions including withholding of income taxes, 401(k) and other retirement savings plans, U.S. savings bonds, and union dues.

2. Payroll processing Preparing and reviewing employees’ time card and coding payroll costs to appropriate accounts. Computing gross pay, deductions, and net pay, and recording and summarizing payments. Note: Controllership function = Accounting/recordkeeping function. Ordinarily, the production department provides the hours worked, and the accounting/recordkeeping department calculates and records the payroll.

3. Payroll disbursement Preparing and distributing payroll checks. Note: Administrative function = Internal accounting function. Ordinarily, the treasurer in the administration department has custody of payroll checks and distributes payroll checks.

 Rate authorization form A form authorizing the rate of pay.  W-4 form A form authorizing the withholding of federal and state income taxes.



Accrued payroll accounts (liabilities) (e.g., accrued wages and salaries, accrual payroll tax expense)



Payroll expense accounts (expenses) (e.g., bonuses, commissions, direct labor, payroll tax expense)



Payroll withholding/deducti on accounts (liabilities) (e.g., income taxes withholding, FICA taxes withholding, union due deductions)

 

Payroll Cash Cash in Bank



Payroll

   

Form 1120 - Corporate income tax returns Form 1040 -Personal income tax returns ST 140 –Sales tax returns

Time card (Clock card) This document records the time the employee started and stopped working each day and the number of hours the employee worked. The employee fills in the time worked or a time clock records the time. Figure 16-3 shows an example of a time card.

 Job time ticket (Job card) This document indicates specific jobs on which a factory employee worked during a given time period, such as overtime work. Figure 16-4 shows an example of a job time ticket.  Payroll register (Payroll journal) This document records payroll checks showing the employees’ gross pay, deductions, and net pay. The details in the journal are also included in the payroll master file.  Payroll master file This computer file records each payroll transaction for each employee and maintains total employee wages paid for the year to date. The record for each employee includes social security number, gross pay for each payroll period, deductions from gross pay, net pay, check number, and date.  Periodic payroll reports This report is prepared at the end of each week or month depending on the client’s organization. A manufacturing company usually prepares a payroll expense report that shows the allocation of direct labor to various job or unit in a standard cost accounting system.  Payroll check A check written to the employee for services performed. The amount of the check is the gross pay less taxes and other deductions withheld. The payroll check may be in the form of a direct deposit into the employee’s bank account. Imprest payroll “account” Animprest payroll “account” is a separate payroll account in which a small balance is maintained. A check for the exact amount of each net payroll is transferred from the general payroll account to the imprest payroll accounting immediately

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Documents and Records (form, list, schedule, report, book, subsidiary ledger, file) before the distribution of the payroll. The advantages of an imprest account are (1) it limits the client’s exposure to payroll fraud, (2) it allows the delegation of payroll checksigning duties, (3) it separates routine payroll expenditures from irregular expenditures, and (4) it facilitates cash management.

4. Payroll tax returns processing Preparing and submitting payroll tax returns.

 W-2 form This form issued to each employee showing the earnings record for the calendar year. The information includes gross pay, income taxes withheld, and FICA withheld. The same information is also submitted to the Internal Revenue Services and state and local tax commissions when applicable. The W2 form is prepared from the information on the payroll master file.  Form 941 These payroll tax forms are submitted to local, state, and federal units of government for the payment of withheld taxes and the employer’s tax. The due dates of the forms vary depending on the type of taxes. For example, federal withholding and social security payments are due weekly, monthly, or quarterly depending on the amount of withholding, and most state unemployment taxes are due quarterly. These tax forms are prepared from the information on the payroll master file.


Figure 16-3 An Example of a Time Card TM#58359 TIME CARD MNO Company 5th Street, San Francisco CA 94132 Department: Assembling, 2nd Floor, Room No. 200 Employee Name:

Barry Bond

Employee Number:

8645

Date 10/14/201x

Day Mon

Time In 8:00

Time Out 18:00

10/15/201x 10/16/201x

Tues

8:10

18:10

Wed

8:00

18:00

Supervisor Signature

S.F. Giants S.F. Giants S.F. Giants

Thurs Fri Sat Sun

Figure 16-4 An Example of a Job Time Ticket JTT#67352 JOB TIME TICKET MNO Company 5th Street, San Francisco CA 94132 Department: Assembling, 2nd Floor, Room No. 200 Employee Name: Employee Number: Date 11/12/200x

Jeff Garcia 4949

Start Time 6:00 a.m.

End time 10:30 a.m.

Special Production Order #68341 Specific Job Description: Assemble Bicycle Frame Quantity Completed: 49 Bicycle Frames Supervisor Signature:

F. Niners

Date: 11/12/201x

Hourly Rate $25.50

Total Hours 4.5

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Figure 16-5 An Example of a Payroll Cycle Flowchart

Functions Personnel

Documents & Records

Computer Process


Rate Authorization Form

PERSONNEL PROGRAM Controls changes to personnel data master file.

Enter Personnel Data

Personnel Data Master File

Report of Master File Changes

Payroll Processing

Time Card

Supervisory Approval

Personnel Data Master File

Enter Time Card

PAYROLL PROGRAM Calculate payroll. Update employee earnings master file. Update general ledger master file. Print payroll expense report Print paychecks

Payroll Register

General Ledger

Employee Earnings Master . File

General Ledger File Master Payroll Expense Report

Payroll Disbursement

Paycheck

Direct Deposit Report

Consider Potential Misstatements in a Payroll Cycle

After the auditors have obtained an understanding of the internal controls relating to the payroll cycle and documented such an understanding; the auditors would consider potential misstatements that could occur due to weaknesses in internal control. Table 16-3 describes some of these potential misstatements in the payroll cycle.


Table 16-3 Potential Misstatements in a Payroll Cycle due to Weakness in Internal Control




Creation of fictitious employee.

Example of Fraud

Example of error









Insertion of phantom employees on the personnel data master file and paychecks made out to the perpetrators. Creation of phantom part-time employees at remote locations and paychecks made out to the perpetrators.



Unintentional entering of personnel information of individuals who are not hired by the client. Double recording of female employees who changed their maiden names.

Not notifying payroll department on

terminated employees and the perpetrators collect the paychecks.



Misstatement of work hours.



Fraudulent recording of overtime work that was never performed.



Use a buddy system to clock in time cards for one another.



Misstatement earned.

of

commission



Fraudulent increase of sales commission by creating fictitious sales, falsifying the value of sales, or overstating sales by claiming sales from another period.



Mistake made in entering the time card or job time ticket to the employee earning master file.



Mistake made in calculating commission earned by employees.


After considering potential misstatements, the auditors assess control risk (CR) and perform TOC procedures as per the audit program for the payroll cycle. Table 16-4 describes some common TOC procedures that the auditors perform in the payroll cycle . Table 16-4 Specific Audit Objectives, Internal Controls, and Common TOC Procedures for Payroll


Internal Controls


Existence or Occurrence: Recorded payroll payments for work Proper separation of duties among personnel, actually performed by existingareemployees. timekeeping, and payroll disbursement. Adequate personnel files (documentation) are maintained. Time clock is used to record time. Time cards are approved by supervisor.

Read organization chart, employees, and observe performed. Inspect personnel files.

inquiry being with duties

Observe employees’ use of time clock. Inspect time cards for indication of approvals. Only employees with valid employee number Examine client’s procedures for entering and (social security number) are paid. removing employee numbers from the payroll master file.

Completeness: Payroll transactions are recorded.

Payroll checks are prenumbered and accounted for.

Cutoff: Payroll transactions are recorded in the Notices of additions, terminations, and changes correct period. to salaries, wages, and deductions reported promptly to the payroll department, and the changes are updated promptly in the payroll master file. All time cards forwarded timely to the payroll department.

Scan for numerical sequence of payroll checks. Scan for numerical sequence of time cards. Inspect the client’s procedures for accepting and updating the payroll master file in the correct dates.

Observe the gathering and forwarding of the time cards to the payroll department in timely manner.

Valuation and Allocation: Employee compensation and payroll Proper authorization procedures for (1) hiring Examine authorization procedures for each deduction are properly authorized. and terminating of employees, (2) time worked, point of authorization in the payroll cycle. (3) wages, salary, and commission rates, (4) withholdings, (5) benefits, and (6) issuing payroll checks. Accuracy: Employee

compensation

and

payroll

Internal independent checks on payroll amounts

Scan for indication of internal independent

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Specific Audit Objectives deduction are computed correctly.

Internal Controls


and benefit calculations. verification. Use of payroll budget to control payroll Inspect the client’s budgeting procedures and expenses. scan payroll register for unusual amounts.

Classification: Payroll transactions are properly classified An adequate chart of accounts is used. Analyze chart of accounts for adequacy. among the payroll accounts, such as Compare the classification of a sample of payroll expense is classified appropriately payroll expenses into the appropriate payroll into direct and indirect labor accounts. accounts. Internal independent check on payroll accounts Scan for indication of internal independent classifications. verification.

Internal Controls in Computerized Payroll Systems

Computerized payroll systems use computer software to produce checks and record transactions. Record keeping function is paperless, and even a W-4 Form can be submitted online directly to the payroll systems. Fraud prevention in the computerized payroll systems covers several areas:

 The Payroll Department The job duties of each payroll staff should be reviewed to determine the highest computer access needed. Not all staff members need complete access to all computer files and programs. For example, the supervisor/manager of the payroll department should only submit payroll to the computerized payroll systems. This duty could even be limited to only one computer that is kept in the manager/supervisor's locked office. If the payroll staff only inputs timecards or Forms W-4 to the payroll systems, then their total access to report writers or check writing program would not be necessary. Generally, hard or paper copies of payroll records should always be kept locked in the payroll department. However, if an off-site facility is used to store old payroll data, the payroll department should make sure that this area is secure as well. Garnishment records and court related documents should be kept in a separate locked cabinet in the payroll department. Access to this cabinet should be given only to those payroll staff members who deal directly with garnishments. The general employee population should not know the name of the payroll staff who handles garnishments. Emails concerning garnishments should go to a separate email address and then forwarded to the payroll staff who handles garnishments. 

Human Resources or Benefits Department

Access to the computerized payroll systems by the human resources or benefits departments depends on how new hires and benefit deductions are processed. If the computerized payroll systems are not integrated and these two departments do not handle any of the input for the payroll systems then they should have a read only access to the payroll computer screens. If the human resources or benefits departments do handle the input for these areas for the payroll systems, then full access to the screens would be necessary. Generally, employees have access to their personal files in the computerized payroll systems with appropriate access codes. For example, an employee may want to check what s/he is claiming on the latest Form W-4 or what benefits s/he may have. However, proper identification should always be required when an employee requests information in writing or copies of information to be printed by the human resources or benefits department. Moreover, the employee should pick up such information in person and present proper identification.

 Information System or Information Technology Department Programmers or IT personnel would need access to payroll software to handle upgrades and software adjustments. However, their access should be limited to software upgrades and adjustments and not allow making changes to benefits or payroll screens that affect data such as hourly wage or Form W-4 information. Programmers or IT personnel who do not interact with the payroll software but handle other software functions should not have access to the computerized payroll systems. For example, an IT personnel who maintains the websites or email does not need payroll computer access.


An overview of the strategy for tests of balances in a payroll cycle is presented in Figure 16-6. Figure 16-6 TOB Strategy in Payroll Cycle

The Audit Process

Audit Plan

Tests of Controls

Tests of Balances


Audit Report










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Apply TOB Strategy

Table 16-5 provides a brief discussion of the TOB strategy as it is applied to a payroll cycle. Table 16-5 TOB Strategy in Payroll Cycle

TOB Strategy – Payroll Cycle 1. Allocate PJAM to TM

2. Derive DR




Chapter 9 discussed how the auditor allocates PJAM to TM at the individual account-balance or class of transactions level of a transaction cycle. In a payroll cycle, the payroll expense accounts are normally significant in the payroll accounts are normally insignificant in the balance sheet. Theincome auditorstatement, typically whereas allocates the TMaccrual to accrual payroll accounts in the balance sheet (recall allocation to balance sheet verses income statement items in Chapter 9), and allocates a large TM (i.e., more tolerance) to the accrual payroll accounts. The auditor derives the DR, based on a pre-specified AR, assessed IR and CR, by using the audit risk model of AR = IR x CR x DR at the individual account-balance or class of transactions level of a transaction cycle (recall Chapter 9). The derived DR drives an optimum mix of the nature, extent, and timing of the TOB procedures used by the auditor. In the payroll cycle, inherent risk is typically assessed at a low level because misstatement in payroll accounts is unlikely due to employees’ self-interests in making sure that they are properly compensated for and the external government agencies’ demand for accurate submission of payroll-related tax returns. The auditor performssix common types of analytical procedures(recall Chapter 7): (1) Compare clientand industry data. (2) Compare client data with similar prior-period data. (3) Compare client data with clientdetermined expected results. (4) Compare client data with auditor-determined expected results. (5) Compare client data with expected results, using non-financial data. (6) Compare financial ratio analysis on client data. In the payroll cycle, analytical procedures are used especially to examine the reasonableness of payroll expense accounts and accrued payroll accounts. Table 16-6 describes some analytical procedures and potential misstatements that may be detected by them in the payroll cycle. The auditor performs the TOB procedures that address the nature, extent, and timing of evidence. For the nature and timing, if CR were assessed at the maximum of 100%, the auditor would not perform TOC procedures but perform only TOB procedures. In a payroll cycle, the CR (as well as IR) is typically set at a low level. Therefore, the derived DR is normally high resulting in fewer TOB procedures being performed in a payroll cycle. Table 16-7 summarizes some specific audit objectives and common TOB procedures in a payroll cycle. The auditor is especially concerned about the specific audit objective of existence or occurrence that tests for fictitious employee and fraudulent work hours. The auditor documentsall misstatements foundby performing theTOB procedures andcompares thetotal misstatements with the PJAM. Based on the misstatements found, the auditor may revise PJAM (RJAM) if necessary. The auditor should perform additional audit work or request the management to make adjustment for the misstatements.

Table 16-6 Analytical Procedures for the Payroll Cycle



Payroll expense accounts: Comparison of payroll expense account balances with prior years’ balances after adjusting for Overstatement and understatement of payroll pay changes and number of employees. expense. Comparison of budgeted payroll expenses with actual payroll expenses. Overstatement and understatement of payroll expense. Comparison of payroll costs as a percentage of sales with prior years’ and industry data. Overstatement and understatement of payroll expense. Comparison of direct labor as a percentage of sales with prior years. Misstatements of direct labor and inventory. Comparison of commission expense as a percentage of sales with prior years. Misstatement of commission expense. Estimate sales commissions by applying commission formulas to recorded sales totals. Misstatement of sales commission. Comparison of payroll tax expense as a percentage of salaries and wages with prior years afterMisstatement of payroll tax expense. adjusting for changes in the tax rates. Analyze the overall reasonableness of the payroll expense accounts. Misstatement of payroll expense. Accrued payroll accounts: Accrued withholding/deduction accounts: Comparison of accrued payroll account balances with prior years’ balances after adjusting or Overstatement and understatement of accrued changes in payroll conditions. liabilities. Analyze the overall reasonableness of the accrued payroll accounts. Misstatement of accrued payroll liabilities.


Table 16-7 Specific Audit Objectives and Common TOB Procedures for a Payroll Cycle

Specific Audit Objectives Existence or Occurrence: Recorded payroll actually existed.

Common TOB Procedures Conduct tests for non-existent payroll (fictitious employee) as follows:



Compare employee names on cancelled checks (endorsed signatures) with time cards and other records for authorized signatures.



Trace selected payroll transactions recorded in the payroll register (payroll journal) to the personnel department to determine whether the employees (personnel files) were actually employed. Select personnel files for employees who were terminated to determine whether each  received his/her termination pay according to company policy.



Observe an employee collecting a paycheck on behalf of another employee who is sick on payday.

 No fraudulent work hours recorded.

Conduct a surprise payroll payoff check (spot check).

Conduct tests for fraudulent work hours as follows:



Reconcile the total hours paid according to the payroll master file with an independent record, such as time cards for the hours worked.

 

Observe an employee clocking in more than one time card under a buddy approach.

Vouch data for a sample of employees in the payroll register to approved time card data. Completeness: All payroll expenses and payroll accruals Trace a sample of the payroll expenses and accrued payroll balances to the payroll master file. are recorded. Inspect preparation of the monthly payroll account bank reconciliation. Cutoff: All payroll expenses and payroll accruals Examine a sample of time cards or paychecks for a few days before and after a pay period for are recorded in the proper period. recording payroll expenses in the proper period. Examine a sample of balances in the periodic payroll reports for a few days before and after the year-end for recording of accrued payroll accounts in the proper period. Accuracy: Accrued payroll account balances are Vouch a sample of accrued payroll account balances from the payroll master file for the supporting recorded correctly. documents such as payroll tax returns and corporate benefit policies. Compare pay rates with union contract or approval by board of directors. Compare withholdings by reference to tax tables and authorization forms in personnel files. Recompute hours worked form time cards. Recompute gross pay. Recompute net pay. Recompute payroll deductions. Compare cancelled checks with payroll register (journal) for correct amount. Reconcile the disbursements in the payroll register (journal) with the disbursements on the payroll bank statement. Classification: Accrued payroll accounts are properly Analyze accrued payroll accounts for proper classification between short-term and long- term classified in the balance sheet. liabilities. Understandability: All payroll-related accounts are properly Read the client’s financial statements and inquiry of the management to ensure that all the presented and disclosed in the financial necessary disclosures for the payroll cycle are made according to GAAP. These items include: statements.  Pension disclosure required by FASB No.87.

   

Postretirement benefit disclosures required by FASB No.106. Profit sharing plans disclosure in the footnotes. Deferred compensation arrangements disclosure in the footnotes. Stock options either as expenses or disclosure in the footnotes.

Auditing Share-Based (Stock Options) Compensation

In 1995 the FASBcompensation issued Statement No.123, encouraged did not mandate the use of the fair value method to determine expense on thewhich income statement. but Initially, nearly all companies continued to use the intrinsic value method to report compensation expense, which typically resulted in zero compensation expense. After the accounting scandals of the early 2000s, some companies (e.g., Amazon, Coca-Cola) decided voluntarily to use the fair value method to determine share-based compensation expense as a way of signaling the

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high quality of their financial reporting to the capital markets. Within a few years, over 700 companies in the United States voluntarily applied the fair value method. The FASB revisited the issue of share-based compensation, and in December 2004 the FASB issued Statement No.123R Share-Based Payment , requiring the expensing of the fair value of stock options granted and other share-based payments as compensation. Statement No.123R became effective in 2006 for most public companies. The determination of the fair value for share-based payments will require the use of an option-pricing model for most companies. The most common models are the Black-Scholes-Merton model and the binomial model. These models incorporate a variety of factors, including: 1. The exercise price of the option. 2. The term of the option. 3. The current market price of the underlying stock. 4. Expected volatility. 5. Expected dividends. 6. Expected risk-free rate. Many of these factors are complex and involve forward-looking information. As such auditing share-based compensation often presents high inherent risk because of the complexity of the accounting rules and the degree of judgment and estimation that must go into the fair value determination. In addition to FASB statement No. 123 there are a number of other sources of technical literature that clients and auditors should consider in this area, for example, FIN28, FIN38, FIN44, EITF90-7, EITF00-18, EITF00-23. In addition, CPA firms develop extensive audit programs to help audit teams ensure that a client is appropriately accounting for share-based compensation. Table 16-8 discusses some common procedures that the auditor performs on share-based compensation. Table 16-8 Common Audit Procedures for Share-based Compensation

Common Audit Procedures for Share-based Compensation

       



Read all applicable share-based plans and inquire of management whether other documents, for example, employment agreements contain relevant information. Understand policies, processes, and controls around share-based compensation. Test design and operating effectiveness of controls, including a determination that the transactions have been properly authorized. Obtain and test the accuracy of schedule supporting the granting of share-based compensation awards. Review board of directors’ minutes to ensure completeness of the supporting schedules and to identify modifications to the terms of outstanding awards or existing plans, for example, exercise price or date.

Perform analytical procedures to identify unusual fluctuations in compensation expense as well as related income/expense accounts. Determine if any awards were exercised for other than cash, for example, loan or if employees were offered the opportunity to replace an out-of-the-money award for another award. Test the fair value measurements of option pricing. If the client is using an approved model, for example, Black-Scholes-Merton or binomial model, verify the mathematical accura cy of the client’s calculations, tie the output of the model to the financial statements, and tie the known inputs, for example, term, stock price to relevant source documents. For forward-looking inputs, for example, expected volatility, dividends, interest rate, test the reasonableness of these inputs. Consider using the work of a valuation specialist to obtain evidence regarding fair value measurements. When specialists are used the auditor is required to evaluate the specialist’s qualifications and objectivity. The auditor also must determine if the valuation model used by the specialist is appropriate and consistent with GAAP. Finally, the auditor must understand and agree with the reasonableness of the underlying assumptions.



A factory supervisor at XYZ Company terminated an hourly worker but did not notify the payroll department. The supervisor then forged the workers’ signature on time cards and, when giving out the payroll checks, diverted the payroll checks drawn from the terminated worker to his own use. The most effective procedure for preventing this payroll fraud is to a. require written authorization for all employees added to or removed from the payroll. b. have a paymaster who has no other payroll responsibility distribute the payroll checks. c. have someone other than persons who prepare or distribute the payroll obtain custody of unclaimed payroll checks. d. from time to time, rotate persons distributing the payroll.

16-2

Which of the followingis an example of a weak internal controlweakness whena supervisor inthe payroll departmentis assigned the responsibility for a. distributing payroll checks to subordinate employees. b. reviewing and approving time reports for subordinates. c. interviewing applicants for subordinate positions before hiring is done by the personnel department. d. initiating requests for salary adjustments for subordinate employees.

16-3

For good internal control, distributing payroll checks to employees is best handled by the a. accounting department. b. personnel department. c. t reasurer’s department. d. employee’s department supervisor.

16-4

The purpose of segregating the duties of hiring personnel and distributing payroll checks is to separate the a. Human resources function from the controllership function. b. Administrative controls from the internal accounting controls. c. Authorization transactions from the custody-related assets. d. Operational responsibility from the record-keeping responsibility.

16-5

Tracing selected items from the payroll register (journal) to employee time cards that have been approved by supervisory personnel provides evidence that a. internal control relating to payroll disbursement were operating effectively. b. payroll checks were signed by an appropriate officer independent of the payroll preparation process. c. only bona fide employees worked and their pay was properly computed. d. employees worked the number of hours for which their pay was computed.

16-6

Effective control procedures over the payroll function may include a. reconciliation of totals on job time cards with job reports by employees responsible for those specific jobs. b. verification of agreement of job time cards with employee clock card hours by a payroll department employee. c. preparation of payroll transaction journal entries by an employee who reports to the supervisor of the personnel department. d. custody of the rate authorization records by the supervisor of the payroll department.

16-7

Which of the following procedures would most likely be considered aweakness in a client’s internal controls over payroll? a. A voucher for the amount of the payroll is prepared in the general accounting department based on the payroll department’s payroll summary. b. Payroll checks are prepared by the payroll department and signed by the treasurer. c. The employee who distributes payroll checks returns unclaimed payroll checks to the payroll department. d. The personnel department sends employees’ termination notices t o the payroll department.

16-8

An auditor is most likely to perform TOB on payroll transactions and balances when a. cutoff tests indicate a substantial amount of accrued payroll expense. b. the assessed level of control risk, CR, relative to payroll transactions is low. c. analytical procedures indicate unusual fluctuations in recurring payroll entries. d. accrued payroll expense consists primarily of unpaid commissions.

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16-9

The auditor may observe the distribution of paychecks (spot check) to ascertain whether a. pay rate authorization is properly separated from the operating function. b. deductions from gross pay are calculated correctly and are properly authorized. c. paychecks agree with the payroll register and the time cards. d. recorded employees actually exist and are employed by the client.

16-10

A computer operator perpetrated a theft by preparing erroneous W-2 forms. The operator’s FICA withheld was overstated by $10,000, and the FICA withheld from all other employees was understated. Which of the following audit procedures would detect such a fraud? a. Multiplication of the applicable rate by the individual’s gross taxable earnings. b. Using form W-4 and withholding charts to determine whether deductions authorized per pay period agree with amounts deducted per pay period. c. Footing and cross footing of the payroll register followed by tracing postings to the general ledger. d. Vouching cancelled checks to federal tax form 941.

16-11

In the audit of which of the following types business organizations would the auditor be most likely to place special emphasis on TOC for proper classifications of payroll transactions? a. A manufacturing organization. b. A retailing organization. c. A wholesaling organization. d. A service organization.

16-12

Which of the following conditions wouldnot alert the auditor to the possibility oferrors or frauds on the payrolltax forms which the client must file? a. The existence of serious liquidity problems. b. An ongoing IRS audit of client’s Form 1120. c. The payment of penalties and interest in the prior period for improper payments. d. New personnel in the payroll department who are responsible for preparation of the forms.

16-13

From an audit point of view, which of the following wouldnot be an important internalcontrol in the payrollcycle? a. Formal methods of informing payroll personnel of new employees. b. Authorization of changes in pay rates. c. Notice of the termination date of employees no longer working for the company. d. Reconciliation of total payroll expense in the general ledger with the payroll tax returns and the W-2 forms.

16-14

Weak internalcontrol allowsa foreman to clock in daily for a fictitious employeeand to approve the time card at the end of the payroll period. This fraud would be detected if other controls were in place, such as having an independent party a. recomputed hours worked from time cards. b. foot the payroll journal and trace postings to the general ledger and the payroll master file. c. distribute paychecks. d. compare the date of the recorded check in the payroll journal with the date on the canceled checks and time cards.

16-15

Which of the following best describes proper internal control over payroll? a. The preparation of the payroll must be under the control of the personnel department. b. The confidentiality of employee payroll data should be protected to prevent fraud. c. The duties of hiring, payroll computation, and payment to employees should be separated. d. The payment of cash to employees should be replaced with payment by checks.

16-16

Verification ofthe legitimacy of year-end unpaid bonuses to officers and employees can be accomplished bycomparing the recorded accrual to the amount a. in the expense account. b. used in the prior period. c. paid in the subsequent period. d. authorized in the minutes of the board.


16 -17

Which of the following is the best TOB procedure for an auditor to determine that every name on a company’s payroll is that of a bona fide employee presently on the job?

a. Examine personnel records for accuracy and completeness. b. Examine employees’ names listed on payroll tax returns for agreement with payroll accounting records. c. Make a surprise observation of the compa ny’s regular distribution of paychecks. d. Visit the working areas and confirm with employees their badge or identification numbers. 16-18

“Recorded payroll transactions are for the amount of time actually worked and at the proper pay rate; withholdingsare properly calculated” relates to which specific audit objective?

a. Accuracy. b. Existence. c. Valuation and allocation. d. Completeness. 16-19

Which of the following isa test of control (TOC) procedure inthe payroll cycle? a. Review the payroll journal, general ledger, and payroll earnings records for large or unusual amounts. b. Examine time cards for indication of supervisor approval. c. Compare canceled check with payroll journal for name, amount, and date. d. Examine canceled checks for proper endorsement.

16-20

To minimize the opportunity for fraud, unclaimed salary checks should be a. held for the employee in the personnel department. b. left with employee’s supervisor. c. kept in the payroll department. d. deposited in a special bank account.

16-21

When controlrisk (CR) is assessed to be very low, tests of balances (TOB) forthe payroll cycle would most likely limited to applying analytical procedures and a. observing the distribution of paychecks. b. examining time cards for fraudulent work hours. c. inspecting payroll tax returns. d. re-computing payroll accruals.

16-22

An auditor most likely would extend TOB of payroll when a. payroll is extensively audited by the state government. b. payroll expense is higher than in the prior year. c. overstatement of work hours is discovered in performing TOC procedures. d. employees complain to management about too much overtime.

16-23

An auditor voucheddata for a sample of employees ina payroll registerto approved clock card data to provide assurance that a. payments to employees are computed at authorized rates. b. employees work the number of hours for which they are paid. c. segregation of duties exists between the preparation and distribution of the payroll. d. internal controls relating to unclaimed payroll checks are operating effectively.

16-24

Which of the following circumstancesmost likely would causean auditor to suspect an employee payrollfraud scheme? a. There are significant unexplained variances between standard and actual labor cost. b. Payroll checks are disbursed by the same employee each payday. c. Employee time cards are approved by individual departmental supervisors. d. A separate payroll bank account is maintained on an imprest basis.

16-25

In a computerized payrollsystem environment, anauditor wouldbe least likely to use test data approach to test controls related to a. missing employee numbers. b. proper approval overtime by supervisors. c. time tickets with of invalid job numbers. d. agreement of hours per clock cards with hours on time tickets.

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16-26

In a computerizedpayroll systemenvironment, anauditor wouldbe most likely to use a test data approach thatcontains conditions such as a. deductions not authorized by employees. b. overtime not approved by supervisors. c. time tickets with invalid job numbers. d. payroll checks with unauthorized signature.

16-27

In determining the effectiveness of a client’s policies and procedures relating to the existence or occurrence assertion for payroll transactions, an auditor most likely would inquire about and

a. observe the segregation of duties concerning personnel responsibilities and payroll disbursement. b. inspect evidence of accounting for prenumbered payroll checks. c. re-compute the payroll deductions for employee fringe benefits d. verify the preparation of the monthly payroll account bank reconciliation. 16-28

The sampling unitin a test of controls (i.e.,using attribute samplingplan) pertainingto the existence ofpayroll transactions ordinarily is a(n) a. clock card or time ticket. b. employee Form W-2. c. employee personnel record. d. payroll register entry.

16-29

Which of the following internalcontrol procedures mostlikely would preventdirect laborhours from being chargedto manufacturing overhead? a. Periodic independent counts of work in process for comparison to recorded amount. b. Comparison of daily journal entries with approved production orders. c. Use of time tickets to record actual direct labor worked on production orders. d. Reconciliation of work-in-process inventory with periodic cost budgets.

16-30

In meeting the specific audit objectiveof safeguarding ofassets, which department should be responsible for

a. b. c. d. 16-31

Distribution of Paychecks Treasurer Payroll Treasurer Payroll

Custody of Unclaimed Paychecks Treasurer Treasurer Payroll Payroll

An auditor mostlikely would assess control risk (CR) at the maximum (100%) if the payroll departmentsupervisor is responsible for a. examining authorization forms for new employees. b. comparing payroll registers with srcinal batch transmittal data. c. authorizing payroll rate changes for all employees. d. hiring all subordinate payroll department employees.

16-32

Which of the following departmentsmost likely would approve changesin pay rates and deductions fromemployee salaries? a. Personnel. b. Treasurer. c. Controller. d. Payroll.

16-33

Which of the following isan internal controlprocedure thatmost likely could help prevent employeepayroll fraud? a. The personnel department promptly sends employee termination notices to the payroll supervisor. b. Employees who distribute payroll checks forward unclaimed payroll checks to the absent employees’ supervisors. c. Salary rates resulting from new hires are approved by the payroll supervisor. d. Total hours used for determination of gross pay are calculated by the payroll supervisor.


16-34

An audit client has changed from a system of recording time worked on clock cardsto a computerized payrollsystem in which employees record time in and out with magnetic cards. The computer system automatically updates all payroll records. Because of this change a. a generalized computer audit program must be used. b. part of the audit trail is altered. c. the potential for payroll-related fraud is diminished. d. transactions must be processed in batches.

16-35

An auditor mostlikely would introducetest data into a computerized payrollsystem to test internal controlsrelated to the a. existence of unclaimed payroll checks held by supervisors. b. Early cashing of payroll checks by employees. c. discovery of invalid employee I.D. number. d. proper approval of overtime by supervisors.

16-36

An auditor is gathering evidence regarding a client’s share-based compensation. Ifthe auditor’s specific audit objective is accuracy of the client’s presentation- and disclosure-related information, which of the following is the most appropriate audit procedure to use?

a. b. c. d. 16-37

Use the work ofa valuation specialist to obtain evidence regarding fair value measurements Understand policies, processes, andcontrols around share-based compensation. Determine if the valuation model used bythe client is appropriate and consistent with GAAP. Obtain and test theaccuracy of schedule supporting the granting of share-based compensation awards.

In auditing a client’s share-based compensation, which of the following risk assessments would an auditor typically make?

a. Audit risk (AR) is typically set at moderate level. b. Inherent risk (IR) is typically assessed at high level. c. Control risk (CR) is typically assessed at low level. d. Detection risk (DR) is typically derived at moderate level.


16-1 b. 16-2 a. 16-3 c. 16-4 c. 16-5 d. 16-6 b. 16-7 b. 16-8 c. 16-9 d. 16-10 a. 16-11 a. 16-12 b. 16-13 d. 16-14 c. 16-15 c. 16-16 d. 16-17 c. 16-18 a. 16-19 b. 16-20 d. 16-21 d. 16-22 c. 16-23 b. 16-24 a. 16-25 b. 16-26 c. 16-27 a. 16-28 d. 16-29 c. 16-30 a. 16-31 c. 16-32 a. 16-33 a. 16-34 b. 16-35 c. 16-36 d. 16-37 b.

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Simulation Question 16-1 Simulation Question 16-1 is an adaptation with permission from a case by Keim, M.T. and C.T. Grant inIssues the in Accounting Education , a publication of the American Accounting Association in Sarasota, Florida. This simulation question is based upon a fictitious yet realistic set of facts.



To Tell or Not to Tell

Digital Manufacturing, Inc. is a publicly traded company that produces consumer goods for sale, primarily to wholesalers. The company hired your accounting firm, San CPA, more than three years ago under both auditing and consulting engagements to assist with its initial public offering (IPO) of common stock under the 1933 Securities Act. San CPA is among the 12 largest accounting firms in the United States. It has developed a respectable reputation regarding its ability to help growing companies go public. You are currently an audit manager for San CPA, having been promoted to this position from senior auditor in the last year, due in large part to your successful handling of the Digital Manufacturing accounts. You have just returned from lunch with Jay Hoffman, the new chief financial officer (CFO) for Digital Manufacturing, Inc. The purpose of the meeting was to congratulate Hoffman on his recent promotion. You have known Hoffman since you were assigned to this engagement, during which time he has progressed from accounting manager to chief accountant and now to his current position. When you expressed how pleased you were about his promotion, Hoffman explained how proud he was of the accomplishments he has achieved since entering the country as an illegal alien. He then told you that he entered the U.S. illegally because, at the time, that was the only way he could get into this country. He was quick to explain that he has been a U.S. citizen for almost three years and asked that you keep this in confidence. In connection with your audit of executive payroll, you pulled Hoffman’s personnel file, along with those of all senior executives of Digital Manufacturing. After the lunch meeting with Hoffman, you reviewed the contents of his personnel file. As required by federal law, a Form I-9, Employment Eligibility Verification, from the U.S. Immigration and Naturalization Service, was included in his personnel record. Hoffman completed and signed the form in 1992 at the commencement of his initial employment with Digital Manufacturing. He checked the box indicating he was a citizen of the United States and signed the form; attesting under the penalty of perjury that he had made no false statements or used false documents in connection with the completion of the form. You should access Data File 161 in iLearn for Attachment 1, which presents Hoffman’s -9 Form, I along with the official instructions for completion.

Since 1986, federal law has required all newly hired employees (citizens and non-citizens) to complete and sign Section 1 of Form I-9. Federal law also establishes that “the employer is responsible for ensuring that Section 1 is timely and properly completed.”Employers must then complete and sign Section 2 of the form. This process requires employers to examine evidence of employee identity and employment eligibility within three business days of the date employment begins. The employee must present specific acceptable documentation to verify identity and You should access Data File 16-1 in iLearn for page employment eligibility, for example, a U.S. Passport or Certificate of U.S. Citizenship. three of Form I-9, which provides a complete list of acceptable documentation. To your surprise, Digital Manufacturing never completed Section 2 of Hoffman’s form. Note: If you encounter difficulty opening the scanned documents – I-9 Form in iLearn, simply proceed to answer this simulation questions

without viewing those scanned documents.

Required t committee about the CFO’s illegal act? Support your answers by researching 1. As part of your duties as the auditor, should you contact the audi and discussing specific guidance provided by the following authorities:

i. The AICPA Code of Professional Conduct (CPC) 1997. The AICPA Code of Professional Conduct (CPC) is availablet http://www.aicpa.org/about/code/index.htm a ii. The AICPA Statement on Auditing standards No.54 “Illegal Acts.” The AICPA Statements on Auditing Standards are available on Lexis-Nexis http://web.lexis-nexis.com/universe at . If online access to AUs is not available, you may use AICPA printed versions of the AUs available in the university libraries. In addition, the AICPA prints AUs in Journal the of Accountancy as they are released in the “Official Releases” section of the journal.

iii. The Private Securities Litigation Reform Act of 1995. Specifically, Discovering Illegal Acts by the Client is available http://www.nysscpa.org/prof%5Flibrary/lrm/ii%5F13c.htm at iv. The Sabanes-Oxley Act of 2002 Articles and discussions on Sabanes-Oxley Act are available http://www.imaknowledge.org/sox/ at v. Refer back to Chapter 3 about auditor and confidential information on illegal acts. 2. Based on your research and discussing in 1, write a memo to Sue Pincus, the audit partner-in-charge, informing her of your recommendation regarding San CPA’s resolution of this issue. Be sure to fully explain your reasoning and provide authoritative support for your proposed handling of this matter, including any extended TOC and TOB procedures for Digital Manufacturing’s payroll cycle.


Simulation Question 16-2 This simulation question is based upon a true set of facts. The information contained in the simulation question was obtained from publicly available sources. The simulation question is developed by F. Choo Financial in a nd Integrated Audit s, a publication of the CSU AcademicPub in San Francisco, California.



Phantom Employees

In 1890, the Brooklyn Trolley Dodgers professional baseball team joined the National League. Over the following years, the Dodgers would have considerable difficulty competing with the other baseball teams in the New York City area. Those teams, principal among them the New York Yankees, were much better financed and generally stocked with players of higher caliber. In 1958, after nearly seven decades of mostly frustration on and off the baseball field, the Dodgers shocked the sport world by moving to Los Angeles. Walter O’Malley, the flamboyant owner of the Dodgers, saw an opportunity to introduce professional baseball to the rapidly growing population of the West Coast. Furthermore, O’Malley saw an opportunity to make his t eam more profitable. As an inducement to the Dodgers, Los Angeles Count y purchased a ty to O’Malley for the site of hi s goat farm located in Chavez Ravine, an area two miles northwest of downtown Los Angeles, and gave the proper new baseball stadium. ”In everything from profit to stadium Since moving to Los Angeles, the Dodgers have been the envy of the baseball world: maintenance … the Dodgers are the prototype of how a franchise should be run” (The Wall Street J ournal , August 31, 1990). During the 1980s and 1990s, the Dodgers reigned as the most profitable franchise in baseball with a pretax profit margin approaching 25 percent in many years. In late 1997, Peter O’Malley, Walter O’Malley’s son and the Dodgers’ principal owner, sold the franchise for $350 million to media mogul Rupert Murdoch. A spokesman for Murdoch complimented the O’Malley family for the longstanding success of the Dodgers organization. “The O’Malley’s have set a gold standard for franchise ownership” Los ( Angeles Times,September 5, 1997) During an interview before he sold the Dodgers, Peter O’Malley attributed the success of his organization to the experts he had retained in all functional areas: “I don’t have to be an expert on taxes, split-fingered fastballs, or labor relations with our users., That talent is all available” (The Wall Street Jour nal , August 31, 1990). Edward Campos, a longtime accountant for the Dodgers, was seemingly a perfect example of one of those accepts in the Dodgers organization. Campos, accepted an entry-level position with the Dodgers, as young man. By 1986, after almost two decades with the club, he had worked his way up the employment hierarchy to become the operations payroll chief. After taking charges of the Dodgers’ payroll department, Campos designed and implemented a new payroll system, a system that reportedly only he fully understood. In fact, Campos controlled the system so completely that he personally filled out the weekly payroll cards for each of the four hundred employees of the Dodgers. Campos was known not only for his work ethic but also for his loyalty to the club and its owners: “The Dodgers trusted him, and when he was on vacation, he even came back and did the payroll” (Los Angeles Times, September 17, 1986). Unfortunately, the Dodgers’ trust in Campos was misplaced. Over a period of several years, Campos embezzled several hundred thousand dollars from his employer. According to court records, Campos padded the Dodgers’ pay roll by adding fictitious employees to various departments in the organization. In addition, Campos routinely inflated the number of hours worked by several employees and then split the resulting overpayments fifty-fifty with those individuals. The fraudulent scheme came unraveled when appendicitis struck down Campos, forcing the Dodgers’ controller to temporarily assume his While completing theunusually payroll one week, the controller that severalearning employees, including ushers, security guards, and responsibilities. ticket salespeople, were being paid large amounts. In some noticed cases, employees $47 an hour received weekly paychecks approaching $2,000. Following a criminal investigation and the filing of charges against Campos and his cohorts, all the individuals involved in the payroll fraud confessed. A state court sentenced Campos to eight years in prison and required him to make restitution of approximately $132,000 to the Dodgers. Another of the conspirators also received a prison sentence. The remaining individuals involved in the payroll scheme make restitution were placed on probation.

Required 1. Refer to Table 6-2 in Chapter 6 and identify the risk factors pertaining to Campos’s payroll fraudulent scheme under three separate headings as follows: (a) Incentives/Pressure Risk factor 1 . . . Risk factor 2 . . . (b) Opportunities Risk factor 1 . . . Risk factor 2 . . . (c) Rationalization Risk factor 1 . . . Risk factor 2 . . . 2. Based on the risk factors identified in 1. above,plan your test of control procedures that might led to the discovery of the fraudulent sch eme masterminded by Campos using the following format: Specific audit objective #1 . . . Planned test of control procedure #1 . . . Planned test of control procedure #2 . . . Specific audit objective #2 . . . Planned test of control procedure #1 . . . Planned test of control procedure #2 . . .

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3. Based on the risk factors identified in 1. above, plan your test of balance procedures that might led to the discovery of the fraudulent scheme masterminded by Campos using the following format: Specific audit objective #1 . . . Planned test of balance procedure #1 . . . Planned test of balance procedure #2 . . . Specific audit objective #2 . . . Planned test of balance procedures #1 . . . Planned test of balance procedures #2 . . . 4. Assume when you were conducting the planned audit tests in 2. and 3. above, Campos and his cohorts fled from the U.S. to México. (a) Explain whether a federal prosecutor in the U.S. would likely or unlikely get a warrant to extradite them from México. You should search the Internet for information on any extradition or law-enforcement cooperation agreements between the U.S. and México. Cite all relevant cases and sources of information from the Internet, and your search of the Internet should be reasonably exhaustive. (b) Explain whether a federal prosecutor in the U.S. would likely or unlikely get the México government to cooperate in the criminal/civil investigation of Campos and his cohorts who fled to México. You should search the Internet for information regarding the diplomatic track record between the U.S. Embassy in México City and the México government. Cite all relevant cases and sources of information from the Internet, and your search of the Internet should be reasonably exhaustive.

Simulation Question 16-3 This simulation question is based upon a true set of facts. The information contained in the simulation question was obtained from publicly available sources. The simulation question is developed by F. Choo Financial in a nd Integrated Aud its , a publication of the CSU AcademicPub in San Francisco, California.



The Executive Compensation Issues

Executive compensation ballooned in the 1990s. There were notable compensation abuses. The most popular form of executive compensation the 1990s was company stock (or options to purchase stock). Designers of these compensation plans argue that by compensating officers with stock, the officers will take actions in the best interest of the shareholders. Critics claim executive compensation is often too high in proportion to average salaries at companies and that the compensation levels motivate officers to take selfish actions.



An example of Executive Compensation Abuses

Tyco International Ltd.’s Dennis Kozlowski looms large as a rogue CEO for the ages. His $6,000shower curtain and vodka-spewing, full-size ice replica of Michelangelo’s David will not be soon forgotten. In essence, prosecutors accused Kozlowski and former Chief Financial Officer Mark Swartz ofrunning a criminal enterprise within Tyco’s executive suite. The two were hit with 38 felony counts for pilfering $170 million directly from the company and for pocketing an additional $430 million through tainted sales of stock. Ironically, both Kozlowski and Swartz were former auditors; Kozlowski has become the personification of the widespread irrational exuberance of the late 1990s. Kozlowski

handpicked sometoof$67 themillion members of thetocompensation and changes to his benefitthat as his total compensation rose from $8.8 million in 1997 in 1998 $170 millioncommittee, in 1999. But it the appears that worked Kozlowski believed he deserved more money that he was making. The more he was paid as a reward for Tyco’s soaring stock price, the more he spent on luxuries – and the more he stole. During these years, Kozlowski was secretly selling lots of stock$280 million worth, according to the Manhattan DA’s indictment of Kozlowski . Kozlowski also ran up a $242 million tab at Tyco under a loan program designed to finance the purchase of company stock. Rather than use the money to buy Tyco stock, he used it to purchase fine art and antiques, a yacht, and a Nantucket estate. The loans were forms of compensation, but characterizing the compensation as a loan provided significant tax and accounting benefits to the executive and the corporation. Tyco’s board approved some, but not all, of the forms of compensation Kozlowski had tapped into. When Congress learned of the level of abuse in corporate loans, it was shocked. In the Sarbanes-Oxley Act of 2002, Congress forbids public companies to make or even arrange new loans to executives or to modify or renew old ones. The penalties for a violation are up to 20 years in jail and fines reaching $ 5 million for executives and $25 million for companies. In June 2005, Kozlowski and Swartz were each convicted on 22 criminal charges relating to their misdeeds at Tyco. Both were sentenced to serve up to 25 years in prison and pay fines and restitution totaling $240 million. In May of 206 Kozlowski agreed to pay $21.2 million dollars to New York State to settle tax-evasion charges that included millions in sales taxes, fines, and penalties relating to his purchases of fine art.

Required 1. (a) Research executive compensation of at least three well-known companies. You can find executive compensation in SEC filings on EDGAR at www.sec.gov or on a variety of Internet sites, such as eComp at www.ecomponline.com. (b) Use your best judgment to compute the proportion of executive compensation to average salary (i.e., are executives earning 5 times, or 10 times, or 100 times the average employee). (c) In your opinion, are the executives in (a) and (b) above worth it? Please explain. 2. In your opinion, what are the costs and benefits associated with compensating executives with stock options to purchase stock? 3. What do you believe are the most effective audit procedures to use to identify executive compensation abuse or fraud? Please explain.


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Chapter 17 Capital Cycle – Tests of Controls and Tests of Balances Chapter Learning Outcomes (LOs) Checklist

After reading this chapter, you should be able to: 

LO17-1 Understand the accounting information system for notes payable.



LO17-2 Describe some common TOC procedures for notes payable.



LO17-3 Apply the analytical procedures for notes payable.



LO17-4 Describe some common TOB procedures for notes payable.



LO17-5 Understand the accounting information system for stockholders’ equity.



LO17-6 Describe some common TOC procedures for stockholders’ equity.



LO17-7 Describe some common TOB procedures for stockholders’ equity.


Chapter 17 Capital Cycle – Tests of Controls and Tests of Balances An overview of the strategy for tests of controls for notes payable in a capital cycle is presented in Figure 17-1. Figure 17-1 TOC Strategy for Notes Payable in Capital Cycle

The Audit Process

Audit Plan

Tests of Controls

Tests of Balances


Audit Report











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In capital cycle, the auditor focuses on auditing of long-term liabilities and stockholders’ equity. Long-term debt accounts consist of notes payable, bonds payable, and mortgages payable. Auditing of notes payable, a representative long-term debt account is discussed here. Stockholders’ equity consists of capital stock - common, capital stock - preferred, paid-in capital in excess of par, dividends, retained earnings, and treasury stock. Auditing of common stock, dividends and retained earnings as representative stockholders’ equity are discussed here. Understanding Internal Controls for Notes Payable in a Capital Cycle

TOC methodology for notes payable (a long-term liabilities in the capital cycle) starts with an understanding of internal controls relating to notes payable. Table 17-1 provides a brief discussion of the various components relating to the understanding of internal controls of notes payable. Table 17-1 Understanding Internal Controls of Notes Payable

Understanding Internal Controls of Notes Payable (a Long -Term Liabilities in the Capital Cycle) 1. Control environment

2. Risk assessment



5. Monitoring

Table 8-1 in Chapter 8 listed seven factors affecting the control environment. Since these factors affect all accounting cycles, understanding of the control environment is generally conducted for all the accounting cycles taken as a whole. The auditor should, however, consider any control environment factors that may have a special effect on notes payable. Notes that are issued longer than a year are long-term notes payable. Long-term notes are usually audited in the capital cycle whereas short-term notes are usually audited in the revenue cycle (issuance) and expenditure cycle (payment of principal and interests). Table 8-1 in Chapter 8 listed the five basic management assertions that must be met by the management’s risk assessment. The auditor must understand how management assesses risks that are relevant to notes payable, estimates their significance, assesses the likelihood of their occurrence, and takes action to address those risks in order to meet the five basic management assertions. Table 8-1 in Chapter 8 listed the five basic control activities that must be established in an accounting cycle. If the auditor plans to conduct both TOC and TOB on notes payable, then s/he needs to identify the control activities relating to specific audit objectives and for the purpose of assessing control risk (CR). The auditor usually identifies these control activities from documentations of the understanding using narrative descriptions, internal control questionnaires, or flowcharts. Figure 17-3 shows an example of a notes payable internal control questionnaires. The auditor must obtain sufficient knowledge of theaccounting information system relating to notes payable to ensure that the TOC and TOB procedures meet the eight types of specific audit objectives listed in Table 8-1 in Chapter 8. Specifically, the auditor must obtain sufficient knowledge in three areas as shown in Figure A briefthe discussion of thesemonitoring three areasprocesses is provided in Table 17-2. The auditor must17-2. understand management’s over notes payable. This includes understanding how the management monitors the internal controls of notes payable over time and what corrective action is initiated to improve the design and operation of controls in the capital cycle.

Figure 17-2 Understanding of Information and Communication for Notes Payable

Key Functions Understand 1 key function of notes payable

Accounts and Classes of Transactions Understand how the 1 key function is recorded in accounts and grouped in classes of transactions



Table 17-2 Understanding of Information and Communication for Notes Payable

Accounts and Classes of Transactions Key Functions 1. Financing Financing activities are infrequent: Approval of common financing instruments such as notes, bonds, and mortgages. Financing activities are frequent: Approval of other sophisticated financing instruments such as collateralized mortgage obligations, repurchase and reverse repurchase agreements, interest-rate swaps, and derivatives.


 

Notes payable

Interest payable



Long-term liabilities



 Minutes The board of directors is responsible for the issuance of notes payable. The board’s approval for the issuance is recorded in the minutes of its meetings. 

Interest expense





Notesdocument payable states the type of notes payable This legal (unsecured or secured), the amount of loan (principal), and the term of repayment (principal and interest).

Cash in bank

 Schedule of notes payable and accrued interest This schedule details each note transaction showing the name/entity of the note holders, the principal amount borrowed, the type of security, the term of the notes, the amount of repayment in principal and interests, and the accrued interest payable.

Figure 17-3 An Example of a Notes Payable Internal Control Questionnaires W/P Ref: ICQ -7 Internal Control Questionnaire– Notes Payable Client: ABC Company

Completed by: Reviewed by:

Helen Mary

Date: 8.12.201x Date: 10.30.201x

Yes, No, N/A

Comments

1. Are investment (marketable notes payable, and equity)transactions made in accordance with securities, management’s authorization? 2. Are sources of capital funds (marketable securities, notes payable and equity) authorized in accordance with management’s criteria? 3. Are adjustments of marketable securities (e.g., adjustment of carrying value), notes payable (e.g., adjustment of debt obligations after renegotiation), and equity (e.g., changes to par or stated value of stock) authorized in accordance with management’s criteria? 4. Are marketable securities, notes payable, and equity transactions recorded at the correct amounts, in the proper period, and properly classified?

Yes

The management has investment establishedtransactions. policies for selecting and approving

Yes

The management has established policies for obtaining capital funds.

Yes

5. Is access to securities restricted to personnel authorized by management? 6. Are access to marketable securities, notes payable, and equity-related records and forms restricted to personnel authorized by management?

Yes

The management has established policies for approving marketable securities, debt, and equity adjustments. Adjustment forms are prenumbered. Adjustments exceeding pre-established dollar amounts required specific authorization. The management reviews board minutes regularly for directives related to dividend, long-term debt, and treasury transactions. The management also regularly prepares schedules of interest and loan payment due dates. Securities are kept in a locked safe. Files of authorized signatures are maintained. Forms and records are kept in a secured locker room. All un-issued, issued, and retired securities are accounted for by an officer who is independent of physically controlling securities, accounting, and cash activities.

Yes

Yes

Conclusion: Internal controls for notes payable are adequate. Specifically, the control activities of authorization, independent check, and safe guarding of assets are present and strong.

455

456


Consider Potential Misstatements of Notes Payable in a Capital Cycle

After the auditors have obtained an understanding of the internal controls relating to notes payable and documented such an understanding; the auditors would consider potential misstatements that could occur due to weaknesses in internal control. Table 17-3 describes some of the potential misstatements of notes payable in a capital cycle. Table 17-3 Potential Misstatements of Notes Payable in a Capital Cycle due to Weakness in Internal Control




Unauthorized marketable securities, notes payable, and equity transactions.

Example of Fraud







Make investment in marketable securities, notes payable, and equity by including more debt instruments than allowed by the board of directors. Make unauthorized adjustments of investments in marketable securities, notes payable, and equity that violate established policies for the adjustments.



No physical safeguarding of marketable securities, notes payable, and equity – related forms and records.

Obtain capital funds in marketable securities, notes payable, and equity at unfavorable terms/cost or with overly restrictive covenants. Incorrect adjustments of the carrying value of marketable securities, debt obligations of notes payable, and stated value of equity.



Improper recording of marketable securities, notes payable, and equity transactions.



Example of Error



Inaccurate recording of detailed schedules and records of marketable securities, notes payable, and equity transactions.



Make unauthorized access to investment to steal un-issued or issued forms and records relating to marketable securities, notes payable, and equity.


After considering potential misstatements, the auditors assess control risk (CR) and perform TOC procedures as per the audit program for notes payable in the capital cycle. Table 17-4 describes some common TOC procedures that the auditors perform on notes payable in the capital cycle. Table 17-4 Specific Audit Objectives, Internal Controls, and Common TOC Procedures for Notes Payable


Internal Controls


Existence or Occurrence: Issuance and renewal of notes payable is Proper authorization for issuing and renewing of If the CFO is responsible for both the properly approved. notes payable. executing and accounting of notes payable, observe independent check on the CFO by a member (finance committee) of the board of directors. Examine copies of new note or bond agreements. Read board of directors’ minutes for approval of new and existing notes. Review the renewal of notes payable shortly after the balance sheet date. Completeness: Notes payable transactions are recorded. Blank and paid notes are accounted for. Observe the control over blank notes by a responsible person. Inspect paid notes to ensure that they are cancelled and retained by a responsible person. Valuation and Allocation: Notes payable are recorded correctly. Adequate accounting records for issuing and Inquiry of the management that at the time of repaying long-term liabilities. issuance of notes, the borrowed sum is properly recorded in the revenue cycle. Inquiry of the management that at the time of repayment of principal and interest; the checks are properly prepared in the expenditure cycle. Observe internal independent check on periodic reconciliation of the detailed notes payable schedule with the notes payable



Internal Controls

Common TOC Procedures account. Observe periodic comparison with the notes payable account withnote holders’ records by an employee who is not responsible for maintaining the detailed notes payable schedule.

457

458


An overview of the strategy for tests of balances of notes payable in a capital c ycle is presented in Figure 17 -4. Figure 17-4 TOB Strategy for Notes Payable in Capital Cycle

The Audit Process

Audit Plan

Tests of Controls

Tests of Balances


Audit Report











Apply TOB Strategy to Notes Payable in Capital Cycle

Table 17-5 provides a brief discussion of the TOB strategy as it is applied to notes payable in a capital cycle. Table 17-5 TOB Strategy for Notes Payable

TOB Strategy – Notes Payable 1. Allocate PJAM to TM

2. Derive DR




Chapter 9 discussed how the auditor allocates PJAM to TM at the individual account-balance or class of transactions level of a transaction cycle. In a capital cycle, the audit focuses on examining any new debt agreement and determining the status of prior debt agreements. Thus, if the frequency of issuing new longterm notes payable is low, and adequate records are kept for prior debt agreements, the auditor typically allocates a large TM (i.e., more tolerance) to notes payable. The auditor derives the DR, based on a pre-specified AR, assessed IR and CR, by using the audit risk model of AR = IR x CR x DR at the individual account-balance or class of transactions level of a transaction cycle (recall Chapter 9). The derived DR drives an optimum mix of the nature, extent, and timing of the TOB procedures used by the auditor. In the capital cycle, inherent risk is often assessed at a relatively low level for companies with a few notes payable transactions. The auditor performssix common types of analytical procedures(recall Chapter 7): (1) Compare clientand industry data. (2) Compare client data with similar prior-period data. (3) Compare client data with clientdetermined expected results. (4) Compare client data with auditor-determined expected results. (5) Compare client data with expected results, using non-financial data. (6) Compare financial ratio analysis on client data. In the capital cycle, the application of analytical procedures on notes payable is especially efficient because if the results were favorable, the auditor might eliminate the TOB procedures on notes payable. Table 17-6 describes some analytical procedures for notes payable and potential misstatements that may be detected by them. Figure 17-5 shows an example of the application of analytical procedures that might eliminate the TOB procedures for notes payable. The auditor performs the TOB procedures that address the nature, extent, and timing of evidence. For the nature and timing, if CR were assessed at a very low level and the occurrence of notes payable transactions is rare; the auditor would focus more on TOC procedures than TOB procedures for notes payable. TOB on notes payable usually starts with the auditor obtaining a schedule of notes payable and accrued interest from the client. The auditor then uses this schedule as a basis for performing the TOB procedures on notes payable. Table 17-6 summarizes some specific audit objectives and common TOB procedures for notes payable. The auditor is especially concerned about the specific audit objectives of existence or occurrence, completeness, accuracy, and understandability for notes payable. Figure 17-6 shows an example of the auditor’s TOB procedures performed on the schedule of notes payable. The auditor documentsall misstatements foundby performing theTOB procedures and compares the total misstatements with the PJAM. Based on the misstatements found, the auditor may revise PJAM (RJAM) if necessary. The auditor should perform additional audit work or request the management to make adjustment for the misstatements.

Table 17-6 Analytical Procedures for Notes Payable



Compute approximate interest expense on the basis of average interest rates and overall monthlyMisstatement of interest expense and accrued notes payable. Compare this approximated interest expense with the interest expense recorded ininterest, or omission of an outstanding note the client’s record (notes payable account). See Figure 17 -5 for an example. payable. Compare individual notes outstanding with those of the prior year. Omission or misstatement of a note payable. Compare total balance in notes payable, interest expense, and accrued interest with prior yearMisstatement of interest expense and accrued balances. interest or notes payable.

459

460


Figure 17-5 An Example of the Application of Analytical Procedures that Might Eliminate the TOB Procedures for Notes Payable W/P Ref: NP-5 Analytical Procedure on Interest Expense– Notes Payable Client: ABC Company

Prepared by:

Helen Mary

Reviewed by:

Date: 8.18.201x Date: 10.30.201x

$ 2,571,000 

Interest expense per general ledger 1. Compute approximate interest expense for short-term notes payable: Balance outstanding at the end of month: January $ 2,000,000 February 2,500,000 March 3,000,000 April 2,000,000 May 3,000,000 June 2,500,000 July 3,000,000 August 2,500,000 September 2,000,000 October 3,000,000 November 2,500,000 December 2,000,000 Total

30,000,000

Average outstanding balance at the end of month $ 30,000,000/12 = $ 2,500,000 Average interest expense for the 12 months $ 2,500,000 @ 10% = $ 250,000  2. Compute approximate interest expense for long-term notes payable: Beginning balance Ending balance Total

$ 28,000,000  30,000,000  58,000,000

Average outstanding balance for the 12 months $ 58,000,000/2 = $ 29,000,000 Average interest expense for the 12 months $ 29,000,000 @ 8% = $ 2,320,000  3. Compute approximate total interest expense for short- and long-term notes payable: Approximate short-term interest expense Approximate long-term interest expense Total

$

250,000 2,320,000 2,570,000

2,570,000 Difference

    

1,000 ========

Agrees with general ledgerand working trial balance. Obtained from general ledger. Estimated by examining several notes throughout the year with rates ranging from 9% to 11%. Agrees with 8% rate forthe 12 months in the permanent fileschedule of long-term notes payable. Difference is 1,000/2,570,000 = 0.04% of the approximate total interest expense.

Conclusion: The difference between the computed approximate interest expense and the client’s interest expense per general ledger is not significant because the difference is less than 5% of the approximate total interest expense. Therefore, the interest expense for notes payable per books is acceptable.


Table 17-7 Specific Audit Objectives and Common TOB Procedures for Notes Payable

Specific Audit Objectives Existence or Occurrence: Notes payable in the schedule of notes payable and accrued interest exist. Completeness: Existing notes payable are included in the schedule of notes payable and accrued interest.

Common TOB Procedures Confirm notes payable with creditors (usually creditors are banks, insurance companies, or trustees representing the creditors). Obtain a standard bank confirmation that requests specific information on the existence of notes payable from all banks with which the client does business (see Chapter 18 for more discussion on bank confirmation). Examine the bank reconciliation for new notes credited to the bank account by the bank (see Chapter 18 for more discussion on bank reconciliation). Examine notes paid after year-end to determine whether they were liabilities at the balance sheet date. Compare interest expense with the notes payable amount for reasonableness.

Existing notes payable are recorded. Accuracy: Notes payable and accrued interests on the Obtain a schedule of notes payable. See Figure 17-6 for an example. schedule of notes payable and accrued Foot and cross-foot the schedule of notes payable and accrued interest and agree totals to the interests are accurate. balances in notes payable account, interest payable account, and interest expense account. Confirm balances of notes payable, interest rates, and last date for which interest has been paid with holders of notes. Recompute accrued interest. Classification: Short and long term liabilities are properly Examine due dates of notes for proper classification between current and long-term liabilities. classified. Examine notes to determine whether there are related-party transactions or borrowings from major shareholders. Cutoff: Notes payable are included in the proper Examine notes payable activities for a few days before and after year-end to determine if the accounting period. transactions are included in the proper accounting period. Rights and Obligations: The client has an obligation to pay the Scan notes to determine whether the client has obligations for payment. notes payable (rights and obligations assertions) Understandability: Notes payable, interest expense, and Examine balance sheet for proper presentation and disclosure of short and long term liabilities, accrued interest are properly presented and related parties, assets pledged as security for notes, and restrictions on notes payable. disclosed in the financial statements. Read note agreement for any restrictions that should be disclosed in the footnotes of the financial statements.

461

462


Figure 17-6 An Example of the Auditor’s TOB Procedures Performed on the Schedule of Notes Payable W/P Ref: NP-12 TOB Procedure on Schedule of Notes Payable Client: ABC Company

Prepared by:

Notes Acct Payable 301 – Acct 302 – Interest Payable Acct 305 – Interest Expense

Description 10 % Notes  Payable to Bank of America, due $100,000 per year to 7/1/2013 9% Notes  Payable to Wells Fargo Bank, due 9/1/2013

 

Balance 1/1/2001

Reviewed by:

Notes Payable Additions Payments

300,000 t

100,000 ^

Balance 1/1/2001

200,000 #

15,000 t

Date: 8.22.2002 Date: 10.30.2002

Interest Payable Expense Payments

25,000 r

30,000 ^

Balance 12/31/2002 10,000



250,000

250,000 #

^ 300,000

250,000

100,000

f

f

f

7,500

7,500 r

450,000

x

15,000

32,500

30,000

f

f

f

17,500 #

x

Long-term investmentsin stock pledged as security; agreedto confirmationreceived frombank. Land and building pledgedas security;agreed to confirmation received frombank.

t # ^

Traced to general ledger at 12/31/2002.



Examined copy of notes included inpermanent file. Recomputed interest expense; no difference noted.

r f x

Balance 12/31/2002

Helen Mary

Traced to prior year schedule of notes payable.

Traced to cash journal and examined cancelled notesand/or check.

Footed. Cross-footed.

TOC Strategyfor Stockholders’ Equity in Capital Cycle

The rest of this chapter focuses on auditing stockholders’ equity in the capital cycle. The strategy for TOC for notes payable in capital cycle in Figure 17-1 applies the same to stockholders’ equity. Accordingly, the understanding of information and communication in Figure 17-2 also applies to the stockholders’ equity. Table 17-9 provides specific details concerning the auditor’s understanding of information and communication for stockholders’ equity. It should be noted that inherent risk for stockholders’ equity is often assessed at a relatively low lever because transactions in stockholders’ equity are normally few in number. However, control risk for stockholders’ equity is often assessed at a low or moderate level depending on the responsibilities of the high level management who handle the transactions. Table 17-8 provides a brief description of the responsibilities of high level management for transactions in stockholders’ equity. Table 17-8 Responsibilities of High Level Management for Transactions in Stockholders’ Equity

Responsibilities



Financial planning

Brief Description Financial planning starts with the CFO’s cash flow forecast. This forecast informs the board of directors and management of the business plans, the prospects for cash flows, and the needs for cash flows. The cash flow forecast usually is integrated with the capital budget, which contains the plans for asset purchases and business acquisitions. A capital budget approved by the board of directors constitutes the authorization for major capital


Responsibilities



Raising capital



Record keeping

Brief Description asset acquisitions and investments. The board of directors usually authorizes sales of capital stock and debt financing transactions. All the directors must sign registration documents for public securities offerings. Authority for recurring transactions, such as periodic renewals of notes payable, is normally delegated to the CFO or Treasurer to complete such transactions without specific board approval of each transaction. Company bonds and stocks are normally handled by an external intermediary calledtransfer a agent, generally a bank or trust company. The transfer agent keeps track of securities owners for payment of interest or dividends. The certificate records are kept by aregistrar who updates the records based on information from the transfer agent. Often the registrar and transfer agent are the same company. It should be noted that for “off balance sheet” financing, clients may enter into obligations and commitments that are not required to be recorded in the accounts. Examples of such transactions include: operating leases, endorsements discounted notes, letters of credit,to guarantees, repurchase or remarketing agreements, commitments toonpurchase at fixed prices, commitments sell at fixed prices, and certain type of stock options. Records of notes and bonds payable are maintained by the Accounting Department and the CFO or controller. The record keeping procedures are the same as for accounts payable, that is, interest payments are set up in vouchers for payment, and accruals for unpaid interest are made on financial reporting dates. Clients that have a few bonds and notes outstanding usually do not keep subsidiary accounts. All information is recorded in the general ledger accounts (control ledger). At year end, the CFO or controller is responsible for properly classifying them into short or long term liabilities. For small private companies, CFOs periodically inspect the stock certificate book to verify the bona fide existence of stockholders. The CFOs may also confirm the ownership of shares with the stockholders. For large public companies, The CFOs periodically obtain reports from the registrars and transfer agents to verify the company records of outstanding shares. For some large public companies,t rusteeshandle the ownership of bonds. The trustees have the same duties and responsibilities as that of registrars and transfer agents. In this case, the CFOs confirm with the bond trustees to verify the company records of bonds payable.

Table 17-9 Understanding of Information and Communication for Stockholders’ Equity

Key Functions

Accounts and Classes of Transactions Accounts (control ledger)

1. Financing Non-publicly held company: Approval of a few, if any, changes in the stockholders’ equity (owner’s equity and dividend) Publicly held company: Approval of frequent and complex changes in the stockholders’ equity (common stock, preferred stock, paid-in capital in excess of par, retained earnings and dividends)



Capital stock common



Capital stock prefer



Paid-in capital in excess of par



Dividends payable



Retained earnings



Cash in bank





 Minutes The board of directors is responsible for the issuance of capital stock, repurchasing of treasury stock, and declaration

stock. (2) Repurchasing of treasury stock. (3) Payment of dividend.

of dividends or of stock). The board’s decisions are recorded in the(cash minutes its meetings. The SEC requires all publicly held company to engage an independent stock registrarwho is responsible for (1) ensuring that all stock is issued in accordance with the authorized capital stock provision in the corporate charter and the authorization of the board of directors and (2) signing all newly issued stock certificates and making sure that old certificates are received and cancelled before a replacement certificate is issued.

Stockholders’ equity including: (1) Issuance of capital

 Capital stock certificate book This book records the issuance and repurchase of capital stock for the life of the company. It records such information as the certificate number, the number of shares issued, the name of the person to whom it was issued, and the issue date. When shares are repurchased and later retired or reissued, it records the cancelled certificates and replacement certificates and the date of their cancellation and replacement.  Shareholders’ capital stock master file This file records the total outstanding stock at any given time. It is used as a check on the accuracy of the capital – stock certificate book and the balance of the Capital Stock Common account in the general ledger. It is also used as a basis for the payment of dividends. Most publicly held company also engage astock transfer agent who is responsible for (1) preparing stock certificates, (2) maintaining the capital stock certificate book and shareholders’ capital stock master file, and (3) preparation and disbursement of dividends.

463

464



After understanding and documenting internal controls relating to the stockholders’ equity, the auditors assess control risk (CR) and perform TOC procedures as per the audit program for the stockholders’ equity. Table 17-10 summarizes some specific audit objectives for TOC, internal controls, and common TOC procedures for stockholders’ equity. Table 17-10 Specific Audit Objectives, Internal Controls, and Common TOC edures Proc for Stockholders’ Equity


Internal Controls


Existence or Occurrence: Issuance of capital stock (and stock Proper authorization for issuing and Read board of directors’ minutes for options), repurchase of capital stock, and repurchasing of stock, and payment of authorization on (1) the type and number of payment of dividends are properly dividends. stock to issue, par value of stock, and the date approved. of the issue, (2) the type and number of stock to repurchase, the amount to pay for repurchasing, and the timing of the buy back, and (3) the form of dividend (cash or stock), the amount of the dividend per share, the declaration, recording, and payment dates. Vouch corporate stock (and stock options) issuances and treasury stock transactions to the minutes of the board of directors. If the client does not engage a transfer agent, observe proper segregation of duties is maintained as follows:



The person responsible for issuing, transferring, and canceling certificates should not have any accounting responsibilities.



The person responsible for maintaining the detailed stockholders’ records should be independent of the accounts maintenance the capital stock related in the of general ledger.



The person responsible for maintaining the detailed stockholders’ records should not also process cash receipts (issued shares) or disbursement (dividends).



Appropriate separation of duties among the preparation, recording, signing, and mailing of dividend checks. Completeness: Existing capital stock transactions are Adequate stockholders’ recorded. maintained.

equity

records

are Confirm with the stock transfer agent that all capital stock transactions are recorded. If the client does not engage a transfer agent:



Read the minutes of the board of directors’ meeting to identify approved capital stock transactions.



Examine the client-held capital stock records to ensure all approved capital stock transactions in the minutes are recorded.



Trace capital stock transactions to cash receipts (for issuance of stock) in the revenue cycle and or cash payment (repurchase of capital stock cash dividend) in the expenditure cycle.


Apply TOB Strategy to Stockholders’ Equity

The strategy for TOB of Notes payable in Figure 17- 4 applies the same to stockholders’ equity. It should be noted that since there are usually a few transactions occurring in the stockholders’ equity within a particular accounting period (but each transaction is usually very significant if it occurs), the auditor does not use analytical procedures in the TOB of the stockholders’ equity. Instead, the auditor focuses on the TOB procedures and conducts 100% testing of the few but material transactions taking place in the stockholders’ equity. Table 17-11 summarizes some specific audit objectives and common TOB procedures for stockh olders’ equity. The auditor is especially concerned about the specific audit objectives of existence or occurrence, completeness, accuracy, and understandability. Table 17-11 Specific Audit Objectives and Common TOB Procedures for Stockholders’ Equity



Existence or Occurrence: The existence of recorded capital stock Confirm with the independent stock registrar and the stock transfer agent for the existence of the transactions, such as issuance of new capital stock transactions. capital stock, the merger with another If the client does not engage a stock transfer agent: company through an exchange of stock,  Inquiry of the board of directors that capital stocks are issued in conformity with the donated shares, and the purchase of company charter. treasury stock.  Confirm the existence of the capital stock transaction in the minutes of the board of directors’ meetings.

 Trace a sample of the cancelled dividend payment checks to the authenticity of the payees (stockholders) in the stock certificate book. Completeness: All capital stock transactions are recorded Confirm with the stock transfer agent that all capital stock transactions are recorded in the capital in the capital stock related accounts. stock certificate book and the stockholders’ capital stock master file. . If the client does not engage a transfer agent: 

Foot the shares outstanding in the client-held capital stock records and agree them to total shares outstanding in the client-held capital stock related accounts in the general ledger.

 

Inspect that cancelled stock certificates are defaced to prevent re-issuance.

Inspect and account for any un-issued stock certificates in the capital stock certificate book. Accuracy: All capital stock related accounts are Confirm with the stock transfer agent the ending balances of the capital-stock related accounts. recorded correctly. If the client does not engage a stock transfer agent: (1) Capital stock accounts

 

Obtain a schedule of stockholders’ equity. See Figure 17-7 for an example.

Recompute the amount of the paid-in capital for all the outstanding shares and verify to the ending balances in the capital stock accounts.

 Recompute the amount of the paid-in capital in excess of par or stated value and verify to the ending balance in the paid-in-capital in excess of par accounts. (2) Dividends 

Recompute amount of dividends (number of shares outstanding x amount of per share dividend approved) and verify to the ending-balance of the dividend payable account.

 Read the minutes for dividends declared but not recorded, and for any restrictions on the payment of dividends in bond indenture agreements or preferred stock provisions. (3) Retained earnings 

Trace the net income/loss entry to the retained earnings account to the earnings/loss in the income statement.



Recompute and verify any transactions entered to the retained earnings account, such as cash dividends declared, market value of stock dividends or splits declared (debit to retained earnings), prior-period adjustments, foreign currency translation, and appropriation of retained earnings. Trace the ending balance of the retained earnings account to the stockholders’ equity in the balance sheet. 

Understandability: Stockholders’ equity is properly presented and disclosed in the financial statements.

Examine balance sheet for proper presentation and disclosure in the stockholders’ equity:



Number of shares authorized, issued, and outstanding for each class of stock.

465

466




     

Call privileges, prices, and dates for preferred stock. Preferred stock sinking funds. Stock option or purchase plans. Stock option re-pricing program. Restrictions on retained earnings and dividends.

Market value of stock dividends or splits is capitalized (credit to capital stock) in stockholders’ equity.

Figure 17-7 An Example of the Auditor’s TOB Procedures Performed on the Schedule of Stockholders’ Equity W/P Ref: SEA-1 TOB Procedure on Schedule of Stockholders’ Equity

Client: ABC Company

Prepared by:

Acct 501 – Stockholders’ Equity Accounts

Reviewed by:

Helen Mary

Date: 8.31.20x2 Date: 10.30.20x2 Additional Paid-In Capital

Authorized Balance, 12/31/20x1, $5 par. Issued 6/1/20x2 at par.

15,000 Shares  ____________

Balance, 12/31/20x2

  

t f

15,000 Shares ===========

Issued & Outstanding

Amount At Par

12,000 Shares t 2,000 Shares  ______________

$ 60,000 t 10,000  ______________

____________

14,000 Shares ===========

$ 70,000 ============

$ 5,000 ===========

f

f

Agreedwith withauthorization the client’s corporate charter. Agreed in the minutes of the board of directors. Agreed with cash receipts records.

Traced to general ledger and prior- year’s audit working papers. Footed.

Conclusion: Stockholders’ equity accounts in the balance sheet are recorded correctly.

$ 5,000 t



The audit program for long-term liabilities should include which one of the following additional procedures? a. Verification of the existence of the bondholders. b. Examination of any bond trust indenture (an additional agreement to a bond issue that defines the risk of bondholders). c. Inspection of the notes payable master file. d. Investigation of credits to the bond interest income account.

17-2

An audit clienthas completed aprivate placementof a substantial amountof bonds. Whichof the following is the most important TOB procedures for the audit of bonds payable? a. Confirming the amount issued with the bond trustee. b. Tracing the cash received from the issue to the accounting records. c. Examining the bond records maintained by the bond transfer agent. d. Re-computing the annual interest cost and the effective yield.

17-3

An audit client has a conventional realestate mortgage loan. Which of the following audit procedures isleast likely to be performed in auditing the mortgage balance? a. Examine the current year’s cancelled checks. b. Analyze the mortgage amortization schedule. c. Inspect public records of lien (the legal right to keep or sell someone else’s property as security for a debt) balance. d. Recompute interest expense.

17-4

When auditing a publicly held company, the auditor should obtain written confirmation regarding debenture (unsecured bond) transactions from the a. debenture holders. b. client’s attorney. c. internal auditors. d. debenture trustee.

17-5

Which of the followings is a TOC procedure for the audit of the retained earnings? a. Examining market value used to charge retained earnings to account for a 2-for-1 stock split. b. Examining prior period adjustment entry to retained earnings. c. Authorization for both cash and stock dividends. d. Gain or loss entry to retained earnings resulting from disposition of treasury shares.

17-6

When an audit client does not engage an independent stocktransfer agent, and the client issues its own stocks and maintains stock records, cancelled stock certificates should a. be defaced to prevent re-issuance and attached to their corresponding stubs. b. not be defaced, but segregated from other stock certificates and retained in a cancelled certificate file. c. be destroyed to prevent fraudulent re-issuance. d. be defaced and sent to the secretary of state.

17-7

Which of the following questionswould an auditor most likely include on an internal control questionnaire fornotes payable? a. Are assets thatcollateralize notes payable critically needed for the entity’s continued existence? b. Are two or more authorized signatures required on checks that repay notes payable? c. Are the proceeds from notes payable used to purchase non-current assets? d. Are direct borrowings on notes payable authorized by the board of directors?

17-8

An auditor’s purpose in reviewing the renewal of a note payable shortly after the balance sheet date is most likely to obtain evidence concerning management’s assertions about

a. existence or occurrence. b. presentation and disclosure. c. completeness. d. valuation and allocation.

467

468


17-9

When a client does not maintain its own stock records, theauditor should obtain written confirmation fromthe transfer agent and registrar concerning a. restrictions on the payment of dividends. b. the number of shares issued and outstanding. c. guarantees of preferred stock liquidation value. d. the number of shares subject to agreements to repurchase.

17-10

An auditor should trace corporate stock issuances and treasury stock transactions to the a. numbered stock certificates. b. articles of incorporation. c. transfer agent’s records. d. minutes of the board of directors.

17-11

The primary responsibility of a bank acting as a registrar ofcapital stockis to a. ascertain that dividends declared do not exceed the statutory amount allowance in the state of incorporation. b. account for stock certificates by comparing the total shares outstanding to the total in the shareholders’ subsidiary ledger. c. act as an independent third party between the board of directors and outside investors concerning mergers, acquisitions, and the sale of treasury stock. d. verify that stock has been issued in accordance with the authorization of the board of directors and the articles of incorporation.

17-12

It is normal practice to verify all capital stock transactions a. only when the client is a small company. b. that are in excess of a material amount. c. if there aren’t very many such transactions during the year. d. regardless of the controls in existence, because of their materiality and permanence in the accounting records.

17-13

Analytical procedures are essential for notes payable because a. of the paucity of documentations in this area. b. there are few internal controls in this area which the auditor can rely upon to reduce substantive testing. c. tests of details for interest expense and accrued interest can frequently be eliminated when results are favorable. d. the large quantity of transactions would make this an expensive area to audit by other test procedures.

17-14

The record of the issuanceand repurchaseof capitalstock for the life of the corporationis maintainedin the a. capital stock certificate books. b. shareholders’ capital stock master file. c. schedule of stock owners. d. common stock account in the general ledger.

17-15

When there are not numerous transactionsinvolving notesduring theyear, the normalstarting pointfor the audit of notes payable is a. a schedule of notes payable and accrued interest prepared by the audit team. b. a schedule of notes payable and accrued interest obtained from the client. c. a schedule of only those notes with unpaid balances at the end of the year prepared by client. d. the notes payable account in the general ledger.

17-16

When auditing a client’s retained earnings account, an auditor should determine whether there are any restrictions on agreements, or state law. This procedure is designed to attest management’s retained earnings that result from oans, l financial statement assertion of

a. valuation or allocation. b. existence or occurrence. c. presentation and disclosure. d. rights and obligations.


17-17

In performing TOC concerning the granting of stock options, an auditor should a. confirm the transaction with the Secretary of State in the state of incorporation. b. verify the existence of option holders in the client’s payroll records. c. determine that sufficient treasury stock is available to cover any new stock issued. d. trace the authorization for the transaction to a vote of the board of directors.

17-18

In auditing for unrecorded long-term bonds payable, an auditor most likely will a. perform analytical procedures on the bond premium and discount accounts. b. examine documentation of assets purchased with bond proceeds for liens. c. compare interest expense with the bond payable amount for reasonableness. d. confirm the existence of individual bondholders at year-end.

17-19

In auditing a typical capital cycle, an auditor would most likely a. assess inherent risk (IR) at a high level. b. assess control risk (CR) at a low or moderate level. c. assess both inherent risk (IR) and control risk (CR) at a high level. d. set detection risk (DR) at a low level.


17-1 b. 17-2 a. 17-3 c. 17-4 d. 17-5 c. 17-6. a. 17-7 d. 17-8 b. 17-9 b. 17-10 d. 17-11 d. 17-12 c. 17-13 c. 17-14 a. 17-15 b. 17-16 c. 17-17 d. 17-18 c. 17-19 b.

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Simulation Question 17-1 Simulation Question 17-1 is an adaptation with permission from a case by T.J. Vogel in Issues the in Accounting Education , a publication of the American Accounting Association in Sarasota, Florida. This simulation question is based upon a true set of facts.



Introduction

Stock options are usually issued to corporate executives in an attempt to align the interests of those individuals with the interests of the company’s shareholders. The options are designed to provide a large payoff to the executives when the company’s stock price increases substantially above the exercise price of the options. However, in those periods when a company performs poorly, its stock price may decrease to a level below the exercise price of outstanding options. When this occurs, the options are aids to be “underwater.” Because options provide a benefit only as the stock price increases, underwater options will often lack the motivational incentive that they were designed to create. This – i.e., modify creates a dilemma the compensation committee the company the compensation agreements of the individuals charge during in the period of poor to stock price performance or riskoflosing hose executives to other companies. One such modification that is in often considered these circumstances is a stock-option repricing program. Here, underwater stock options are exchanged for new options containing a lower exercise price. These programs experienced increased popularity during the 1990s despite the opposition that arose from critics who claimed that repricing programs “reward” executives for poor performance. You are the independent auditor of Cendant Corp. (hereafter, CC). In auditing its capital cycle, you are to evaluate the appropriateness of a stock-option repricing program for the executives and other employees of CC. This audit client experienced a severe decrease in its stock price during 1998 as a result of many factors including an accounting scandal, failed expansion efforts, and poor market conditions.



The Formation of CC and the Subsequent Accounting Scandal

On May 27, 1997, the Boards of Directors for HFS, Inc. and CUC International Inc. approved a merger agreement that formed CC., a conglomerate that specialized in travel and shopping-club memberships and Internet marketing. Its divisions include Avis rental cars; the Howard Johnson, Days Inn, and Ramada Hotel chains; the Coldwell Banker and Century 21 real-estate franchises, and Sierra On-Line software. The combination was billed as a merger of equals. Henry Silerman, CEO of HFS, Inc. was elected s ad CC’s president and CEO, while Walter Forbes, CEO of CUC international Inc., was selected as the company’s Chairman of the Board. You should access Data File 17-1 in iLearn for Table 1, which contains a summary of the merger events as described in the proxy statement filed with the SEC by HFS, Inc. on August 28, 1997. The merger was finalized in December, and CC’s stock started trading on December 17, 1997, closing that day at $32.62. Following

the merger, the company enjoyed immediate success and on April 6, 1998, its share price rose to a high of $41.69. The company was in the midst of many acquisitions, including the recently negotiated stock-and-cash acquisition of American Bankers Insurance Group. Unfortunately, the company was not progressing as well as the market believed. On April 9, 1998, the company announced that three former CUC executives were leaving the company, including Cosmo Csrcliano, CUC’s chief financial officer, and Amy Lipton, CUC’s general counsel. As rep orted in the Wall Street Journa l: Rumors of changes at the top of the company had sent the stock plunging earlier in the day. The stock closed at $37, down $2.0625, or 5.3% in composite trading on the New York Stock Exchange … The company tried to reassure investors in a conference call, saying that first-quarter earnings met or exceeded analysts’ expectations of 25 cents per diluted share, according to First Call … In an interview, Mr. Silverman called the impending resignations ‘inevitable when large companies merge’ … He added that Ms. Lipton’s and Mr. Csrcliano’s “jobs went away” with the merger. A week later, on April 15, 1998, CC released a shocking message after the markets had closed for the day. Company officials had “discovered ‘potential accounting irregularities’ in its core membership-club operations that will require it to reduce reported 1997 operating income by $100 million or more and that it will hurt this year earnings.” The primary issue at hand was the method employed yb the CUC unit in recognizing revenue in its club-membership sales. It was discovered that too much of the revenue was booked up front, while the recording of expenses associated with the memberships was deferred until future periods. The following day, CC’s stock price plunged from Wednesday’s close of $36.00 to $19.06 as an astounding 108 million shares traded hands. The average trading volume for CC had been about 4 million shares per day. On July 14, 1998, the company sent a second shocking announcement to the market: to meet Wall Street’s earnings expectations. CUC had recorded nonexistent revenue of $300 million over a threeyear period. In evaluating the situation, Mr. Silverman observed, “We merged with a company and 50% to 60% of the earnings were without substance. It should be called a terrible transaction … A layman would call it fraud.” The auditor for CUC, Ernst & Young, LLP, had issued unqualified audit opinions for the period involved. In defending its position, Ernst & Young claimed, “Revenue recognition is a complex issue … accounting is an art. Accounting principles are subject to interpretation.” After announcing the expanded losses involved in the investigation, CC’s stock price dropped to $15.69, a 52-week low. Subsequently, on July 29, 1998, mounting pressure from irate investors forced Walter Forbes to resign as CC’s Chairman, along with t en other members of CC’s Board of Directors formerly associated with CUC. Mr. Forbes received severance pay of $47.5 million, and Mr. Silverman was elected to succeed him as the company’s new Chairman. Over the next few months, many factors forced the stock price even lower. First, the SEC had instituted its own investigation into the company’s accounting policies. The strict requirements mandated by the SEC from its investigation forced the company to downgrade its projected earnings for 1998. Second, as thestock price continued to decline, it became apparent that the company’s planned acquisitions would be difficult to complete. Eventually, CC called off its planned acquisition of Providian Auto & Home Insurance Co. and American Bankers Insurance Group, Inc. Third, the allegations of fraud created many lawsuits against the company. An investigation by Arthur Andersen LLP focused the responsibility for the fraud on Walter Forbes and the other dismissed CUC employees. Finally, the overall market experienced a th decline in the third quarter of 1998. The Dow Jones Industrial Average fell from its 1998 high of 9338 on July to 17 its low for the year of 7539 on August 31st (a 19 percent decrease in less than two months). In September 1998, CC’s Stock price had impounded the aggregate effect of these factors and was trading in the range of $10 to $14 per share.



CC’s Compensation Policy

Like most publicly traded companies, CC established a compensation committee, composed of four non-employee directors of the company, to oversee the company’s compensation policies. The compensation packages of executives and key employees contained three or maj components: salary, bonus, and stock options. Primary emphasis was given to equity-based compensation (stock options). The compensation


committee believed that it was essential to align the interests of management with those of shareholders. Stock options were issued with an exercise price of equal to the company’s stock price on the date of issuance. They were designed to provide a substantial payoff to employees when CC’s stock price increased above this exercise price. In addition to stock options, employees were highly encouraged (but not mandated) to maintain stock ownership in the company. Unfortunately, the stock price decline experienced by CC in 1998 was so severe that the exercise price of many outstanding employee stock options was now higher than CC’s stock price (i.e., the options were “underwater”). Furthermore, even the options thatwere still in-themoney (i.e., hadexercise prices below CC’s stock price) had lost a t remendous amount of value. Company morale was extremely low. Employees realized that the stock options they once hoped would provide a substantial payoff now seemed to be of little value. In September 1998, the compensation committee held a special meeting to discuss potential modifications that could be made to the company’s compensation plans in an attempt to re-motivate and re-energize valuable company employees. The information available to committee members at this meeting is summarized in Tables 2 through to You 5. should access Data File 17-1 in iLearn for Tables 2 through to 5. Table 2 provides the job tiles and stockholdings in September 1998 of CC’s five named 1executives, and Table 3 provides information on the outstanding stock options f or each of the named executives. Many of the options were issued by the predecessor company 2 When the merger was completed (December 1997), a significant option (HFS or CUC) and exchanged for CC options at the time of the merger. grant was made to further align the interests of the employees involved. In addition, CC did not require a vesting period for option grants. All of the options presented in Table 3 were therefore fully vested and currently exercisable. After examining the information on the outstanding options, the magnitude of the loss of wealth to the employees became apparent. However, the committee also noted that some employees (including Silverman, Holmes, and Buckman) held other options with extremely low exercise prices (see Table 3). Perhaps there was really no need to modify the compensation packages currently in effect. Alternatively, committee members acknowledged that these low exercise prices also demonstrated the value of the employees involved. They realized that it was the policy of CC and its predecessor companies to set an option’s exercise price at the market price of the underlying stock on the date of issuance. be the case that the company’s market value has increased Therefore, when a low exercise price is observed on lower options, it must significantly during the employees’ term of employment. The annual compensation levels of the named executives are presented in Table 4. The compensation received in 1997, primarily from the predecessor companies, is presented in Panel A. The importance of stock options was obvious to committee members. When CC’s stockprice was rising, the compensation received from the exercise of stock options would often dwarf that received from salary and bonus. Panel B presents similar information for 1998 (through September). The salary listed for each executive represented the scheduled annual amount. The bonus column had zero for each executive, as this had not yet been determined as of this meeting date of the committee. Finally, Table 5 provides the footnote disclosure from CC’s 1997 financial statements summarizing the information on outstanding employee stock options for the company as a whole. At December 31, 1997, there was a total of 172 million employee options outstanding, of which 123.1 million had exercise prices of $10 or higher. Certainly, the stock price decline experienced by CC affected the financial fortunes of all employees, not just the named executives.



The Repricing Decision

From the information available, the Compensation Committee concluded that CC’s recent misfortunes had caused financial distress for virtually every employee. Recognizing the value of these employees, the committee was anxious to modify the compensation packages currently in place to reduce some of the financial hardship experienced. It was suggested that CC adopt a stock-option repricing program whereby employees would have the opportunity to exchange “underwater” options for new options with a lower exercise price. Option repricing programs had become popular with other companies experiencing a severe stock price decline. Their purpose is to re-motivate all employees by restoring the inherent values of the options involved. It seemed like a plausible solution, but as the meeting progressed a number of questions arose regarding the proposed repricing program: How would the external investors who suffered significant losses with CC’s stock price decline react to a repricing decision? Should an employee be allowed to have all of his/her underwater stock options be repriced, or should only a portion of these options be eligible in the program? Should the new exercise price in the repricing program be lowered all the way down to the current market price, or would a “substantial decrease” in the exercise price to a new level that was still above the current market price (say$15) be sufficient to achieve the desired goals of the program? Also unclear was whether all employees should be eligible to participate in the program or whether specific individuals should be excluded. These issues and others were under consideration by the committee at its September 1998 meeting.

Required In auditing CC’s capital cycle, you are to evaluate the appropriateness of its stock-option repricing program for the executives and other employees by answering the following questions. 1. a. When the accounting scandal was announced, CC’s stock price dropped to $19.06. Afterward, the highest price obtained through September 1998 was $25.37. Panel B of Table 4 Access ( Data File 17-1 in iLearn ) states that Mr. Silverman and Mr. Buckman exercised options during the first nine months of 1998. What must the stock price have been when the options were exercised? What does this tell you about the timing of the option exercises? b. During the period of this simulated question, CC’s stock price decreased from a high of $41.69 in April 1998, to a low of$10 in September 1998. How much did the intrinsic value of the options held by Mr. Silverman and the other executives decrease during this period? Note: The per share intrinsic value is computed by subtracting the exercise price from the market price ($41.69 on April 6, 1998 and $10 estimated on September 23, 1998), but may not be less than zero.

1

The named executives refer to those individuals for whom specific compensation information is provided in proxy statements filed with the SEC. 2 Information on the options existing prior to the merger was obtained from individual Forms S-3 filed with the SEC at the time of the merger in December 1997.

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c. What are the major pros and cons that CC’s compensation committee will need to consider when deciding whether to reprice m e ployee stock options, especially those of senior management and executives? Note: Disregard any taxation issues that may result. 2. a. CC uses APB No.25 to report compensation expense (recorded at intrinsic value). How would this be different if FASB’s Interpretation No.44, Accounting for Certain Transactions Involving Stock Compensation: An Interpretation of APB Opinion No.25 (issued in March 2000), was in effect when the repricing occurred?

For question 2.a., you should research the following documents: i. Financial Accounting Standards Board (FASB). 2002. Accounting for Certain Transactions Involving Stock Compensation: An Interpretation of APB Opinion No.25 is available at: http://www.fasb.org/ ii. Journal of Accountancy . 2000. FASB offers more guidance on stock options. (July): 18-19. iii. Cocco, A.F., and G. Vent.2000. FASB Interpretation No.44: Accounting for certain transactions involving stock compensation. The CPA Journal (July): 22-27. iv. Hall, B.J. 2000. Whatyou need to know about stock options.Harvard Business Review (March-April): 121-129. b. What impact do you believe that Interpretation No.44 will have on companies considering a stock-option repricing program in the future? Note: Compare the impact of the Interpretation No.44 of APB No.25 and FASB Statement No.123 on CC’s earnings.

Simulation Question 17-2 Simulation Question 17-2 is an adaptation with permission from a case by P. D. Kimmel and T. D. Warfield in Issues the in Accounting Education , a publication of the American Accounting Association in Sarasota, Florida. This simulation question is based upon a true set of facts; however, the names and places have been changed.



Stock Buybacks Decision

It is December 15, 2006. Phillip Buyback, CFO, and Carver Smith, Controller, both employees of Oracle International, are seated in a conference room with Hank Wiseman, an investment banker for the firm of Wiseman and Wisdom. Wiseman requested the meeting to discuss a proposal for Oracle’s stock buyback program. Oracle has engaged in a number of previous large stock buybacks to make shares available for its employee stock option plan and for use as currency in acquisitions of other companies. Oracle has a large number of employee stock options that will most likely be exercised in the near future. Therefore, Wiseman is anticipating that Oracle will soon initiate a large stock buyback to minimize outstanding shares and thus avoid diluting its earnings per share. Because Wiseman believes that he can structureacle’s Or stock buyback in a more beneficial fashion, he scheduled a meeting with Buyback and Smith. Onyour the date the meeting, Wiseman began his presentation brief exchange of pleasantries: Wiseman: In pastof stock repurchases you have typically announcedafter youraintentions to repurchase anywhere from 500,000 to 1,000,000 shares over the subsequent 12-month period. You then repurchased the shares in two to four open-market repurchases scattered throughout the year. This approach enabled you to repurchases the shares when you thought the price was advantageous. However, this approach has the disadvantage of delaying some of the stock buyback’s beneficial aspects. Buyback: What do you mean by that? Wiseman: One of the primary benefits of a stock buyback is that it reduces the number of outstanding shares, and thus increases reported earnings per share. Suppose that you plan to purchase 1,000,000 shares in the coming year. Under your usual approach, your stock repurchases are scattered throughout the year; therefore, the beneficial impact on earnings per share that results from reducing shares is much reduced. Using our approach, you would instead record a 1,000,000-share reduction in the number of outstanding shares immediately after executing the buyback plan, all at a pre-agree price. Buyback: That does sound good. Wiseman: An additional benefit of a stock buyback is that, by executing the transaction at the beginning of the buyback period, you send a more creditable signal to the market by actually acting on your stated intentions. Otherwise, in some past instances, due to either cash shortfalls or increases in the cost of shares, you have only partially executed your announced share repurchase plan. For example, two years ago you only repurchased half as many shares as you had srcinally stated that you would . By not fulfilling your srcinally stated plan, you potentially left some investors skeptical about your real intentions. Buyback: How does your plan work? Wiseman: Out approach, a fairly common one, is called an “accelerated share repurchase.” Let me explain the steps. After you announce your agreed price from our firm. For example, Oracle’s stock is currently selling for $45 share repurchase plan, you buy all of the shares at a predollars. If we arranged for a repurchase of 1,000,000 shares today, then you would give us $45,000,000, and we would give you 1,000,000 shares. Buyback: I didn’t realize that you are holding so many of our shares. Wiseman: We aren’t, but our institutional clients are. We simply borrow the shares from them, and then sell them to you . This process enables you to purchase more shares than are currently available in the market, and you do so without driving the price up. However, as a result of borrowing shares from our clients, we are in a short position on your shares. So, to protect us against loss on this short position, we require that you agree to a forward sale contract. Under this forward contract, you agree to buy our firm shares at a price equal to the price at the initiation of the orshares, in thisatcase, Any difference between the market price price at the date of settlement payable cashtransaction, or additional your$45. discretion. Throughout the buyback period, we and closethe outagreed our short position by buying shares inisthe marketintoeither replace the shares we borrowed from our clients. For example, suppose that we purchase 1,000,000 shares at an average price of $60. You would either pay us $15,000,000 [($60 - $45) x 1,000,000] or 250,000 additional shares ($15,000,000/$60). On the other hand, if we only pay $30 for the shares, then we would pay you $15,000,000 [$45 - $30) x 1,000,000].


Smith: What about the accounting? What is the accounting treatment for this transaction? It would seem that Oracle’s forward sale contract would be treated as a derivative. If that’s case, then the gains and losses on the contract that result from changes in Oracle’s stock price would flow directly into net income, negating much of the earnings per share benefit. Wiseman: That’s beauty of it. By using an accelerated share repurchase plan, you get an immediate boost to EPS because of the immediate reduction in shares outstanding. Furthermore, under an Emerging Issues Task Force (EITF) ruling issued in the late 1990s, the forward sale contract does not get derivative treatment because the contract is an instr ument indexed to Oracle’s own stock. In fact, Oracle has the option of settling in shares. As a result, gains or losses on the contract are recorded as adjustments to equity, rather than as a component of income. In other words, if the gain or loss is paid in cash, then the amount directly increases or decreases stockholders’ equity. Just so you know, for diluted EPS calculations, if your intent is to pay the difference in cash, then the numerator of EPS is adjusted for the gain or loss. On the other hand, if you intend to settle by issuing additional shares, then the additional shares increase the shares outstanding. Thus, if your share price changes, then the initial EPS improvement gained at the inception of the deal may change to some extent. I have prepared the following example for a hypothetical company to illustrate the accounting treatment. Suppose that XYZ Company engages in an accelerated share repurchase (hereafter, ASR) on January 2, 2007 for 20,000 shares at an initial price of $20 per share. XYZ makes the following entry to record the ASR:

Treasury Stock Cash

400,000 400,000

Assume XYZ had 2006 net income of $360,000 and that earning per share for 2006 was $1.80 ($360,000 net income / 200,000 shares outstanding). If XYZ estimates that 2007 net income will also be $360,000, then its EPS for 2007 will increase to $2 [$360,000/ (200,000 – 20,000) shares outstanding]. If XYZ’s share price decreases to $15 during the settlement period, ending June 30, 2007, then the company will receive a $100,000 [($20 - $15) x 20,000 shares] cash payment from Wiseman and Wisdom on settlement of the forward sale agreement. This payment reduces the net cost of the share repurchase program to XYZ and is reported a s a direct increases to stockholders’ q e uity. Buyback: Thank you for your presentation. We would like to do some additional analysis before we make a decision. I will call you within a week.

Required Smith approaches you, the external auditor, for help regarding the accounting treatment for the buybacks decision. Based on the projected 2007 comparative financial statements, you are to prepare responses to the following questions for Smith. These responses will form the basis of Smith’s report to Buyback. You should access Data File 17-2 in iLearn for Exhibit 1, which presents the projected 2007 comparative financial statements.

1. Using the financial statement data presented in Exhibit 1 of Date File 17-2, compute the following for 2007 and 2006 (You may assume that the December 31, 2006 balance sheet balances are representative for December 31, 2005): a. Basic Earnings per Share b. Debt-Equity Ratio c. Return on Assets 2. Assume that Oracle buys back 250,000 shares on March 31, 2007, and 750,000 shares on September 30, 2007, at a price of $45 on each date, using a traditional repurchase program. a. What entry is made on each of the dates that treasury stock is repurchased? b. What is the total amount paid to execute share repurchase program? c. Repeat the analysis for Requirement 1. above and discuss the impact of a traditional share repurchase on Basic Earnings per Share, the DebtEquity Ratio, and Return on Assets. 3. Assume that Oracle enters into an ASR agreement to repurchase 1,000,000 shares on January 2, 2007 at a price of $45, and settles the forward contract on September 30, 2007. a. Prepare the journal entries at January 2, 2007 and September 30, 2007. Assume that Oracle share price holds steady such that the average settlement price at September 30, 2007 is $45 per share. b. What is the total amount paid to execute the share repurchasing program? c. Repeat the analysis for Requirement 1. above and discuss how the results differ among the base case, the traditional repurchase, and the ASR with respect to Basic Earnings per Share, the Debt-Equity Ratio, and Return on Assets 4. Repeat the analysis for Requirement 3. above, assuming the difference is paid in cash at an average settlement price of $50. 5. Assuming the ASR in Requirement 3. above: ed in Oracle’s financial a. If Oracle prepares financial statements on June 30, 2007, when its share price is $50, is the value of the ASR reflect statements on that date? Explain. b. i. What risk does the ASR create for Oracle that it would not face under a traditional plan? ii. Are the potential consequences of this risk adequately reported under the current standards? 6. Prepare a management letter (also known as a client’s advisory comments letter) to Smith that: a. Explains i. the accounting for the basic earnings per share treatment for the ASR, and ii. the accounting for the forward sale contract. b. Discusses i. the pros and cons of usingthe ASR to avoid the dilution ofearnings per share that results from stock option exercises. ii. the implications that the ASR transaction could be both legal and in accordance with GAAP, but not be considered ethical. c. Explains your opinion on whether Oracle should/should not execute the share repurchase using the ASR arrangement.

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Resources available on the Internet that are helpful for answering the above questions include: a. EITF No. 99-7, Accounting for a n Accelerated Shar e Repurchase Pr ogram (http: //www.fasb.org/pdf/abs99-7.pdf). b. FASB (and IASB) have projects whose resolution could affect the classification of the ASR forward contract as debt (asset) or equity (see http: //www.fasb.org/project/liabeq.shtml), as well as the EPS effects of these arrangements (see http://www.fasb.org/project/short-term intl convergence.shtml).

Simulation Question 17-3 Simulation question 17-3 is developed by F. Choo in Financial and Integrated Audits , a publication of the CSU AcademicPub in San Francisco, California.

Part 1  Internal Controls of Stockholders’ Equity

Auditors typically use internal control questionnaires to obtain an understanding of a client’s internal control of stockholders’ equity. Items 1 through 6 below are common questions found in the internal control questionnaires used by the auditors. A “yes” to these questions indicates the presence of an internal control, whereas a “no” indicates an absence of an int ernal control. 1. Are all entries i n the stockholders’ equity accounts authorized at the proper level in the organization? 2. Are issues and retirements of stock authorized by the board of directors? 3. Does the company use the services of an independent registrar or transfer agent? 4. If an independent registrar and transfer agent are not used: (a) Are unissued certificates properly controlled? (b) Are cancelled certificates mutilated to prevent their reuse? 5. Are common stock master files and stock certificate books periodically reconciled with the general ledger by an independent person? 6. Is an independent transfer agent used for disbursing dividend? If not, is an imprest dividend account maintained?

Required 1. For each of the common internal control questions 1 through 6 above, state the purpose of the control. 2. For each of the common internal control questions 1 through 6 above, identify the type of potential financial statements if the control is absence. 3. For each of the potential misstatements in 2. list an audit TOC procedure that the auditor would use to determine whether a material misstatement exists.

Part 2



Tests of Controls and Tests of Balances of Stockholders’ Equity

Auditors typically perform TOC and TOB procedures to verify a client’s stockholders’ equity. Items 1 through 7 below are common TOC and TOB procedures used by the auditors. 1. Review the articles of incorporation and bylaws for provisions about stockholde rs’ equity. 2. Analyze all stockholders’ equity accounts for the year and document the nature of any recorded change in each account. 3. Account for all certificate numbers in the capital stock book for all shares outstanding. 4. Examine the sock certificate book for any stock that was cancelled. 5. Review the minutes of the board of directors’ meeting for the year for approvals related to stockholders’ equity. 6. Recompute earnings per share. 7. Review debt provisions and senior securities with respect to liquidation preferences, dividends in arrears, and restrictions on the payment of dividends or the issue of stock.

Required 1. For each of the testing procedures 1 through 7 above, identify whether it is a TOC or a TOB procedures of stockholders’equity. 2. For each of the testing procedures 1 through 7 above, state the specific audit objective for each of the testing procedures. 3. For each of the testing procedures 1 through 7 above, list the type of misstatements the auditor would uncover by the use of each of the testing procedures.

Part 3



Testing a Special Case of Stockholders’ Equity

You, the continuing auditor of Yesman, Inc., are beginning to test the common stock and treasury stock accounts. You have decided to design TOB (testsof balances) procedures without relying on the company’s internal controls (i.e., the company’s CR (control risk) is assessed at the maximum of 100%). Yesman, Inc. has no par and no stated-value common stock, and it acts as its own registrar and transfer agent. During the past year Yesman, Inc. both issued and reacquired shares of its own common stock, some of which the company still owned at year-end. Additional common stock transactions occurred among the shareholders during the year. Common stock transactions can be traced to individual shareholders’ accounts in a subsidiary ledger and to a stock certificate book. The company has not paid any cash or stock dividends. There are no other classes of stock, stock rights, warrants, or option plans.


Required 1. List the TOB procedures you would use to test Yesman, Inc.’s common stock and t reasury stock accounts. 2. How should Yesman, Inc.stockholders’ equity be properly presented and disclosed in the financial statements?

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Chapter 18 General Cash and Investments – Tests of Controls and Tests of Balances Chapter Learning Outcomes (LOs) Checklist

After reading this chapter, you should be able to: 

LO18-1 Differential among accounts and documents in general cash.

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LO18-2 Apply the analytical procedures for general cash.

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LO18-3 Describe some common TOB procedures for general cash.

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LO18-4 Understand the auditor’s procedures for tests of bank reconciliation (existence or occurrence).

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LO18-5 Understand the auditor’s procedures on bank cutoff statements (completeness).

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LO18-6 Understand the auditor’s procedures for extended tests of bank reconciliation (accuracy).

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LO18-7 Understand the auditor’s procedures for proof of cash (accuracy).

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LO18-8 Understand the auditor’s procedures for tests for kiting/tests of inter-bank transfers (accuracy).

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LO18-9 Understand the auditor’s procedures for tests of lapping (accuracy).

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LO18-10 Describe some common TOC procedures for investments.

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LO18-11 Apply the analytical procedures for investments.

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LO18-12 Describe some common TOB procedures for investments.


Chapter 18 General Cash and Investments – Tests of Controls and Tests of Balances Auditing General Cash

The audit of general cash is divided into two categories: 1. Verifying whether recorded cash in the general ledger correctly reflects all cash transactions that took place during the year. 2. Verifying the audit client’s reconciliation of the balance on the bank statement to the cash account balance in the general ledger. The first category of verification is primarily a TOC procedure, which is typically performed as part of the TOC procedures in other cycles. This is because general cash is part of every cycle except the inventory cycle; and a majority of transactions in the general cash account is closely related to accounts receivable in the revenue cycle and accounts payable in the expenditure cycles. For example, recall Table 13-6 for the revenue cycle in Chapter 13. Thus, the TOC strategy and procedures for general cash will not be discussed here. Figure 18-1 shows the relationships of general cash with other transaction cycles. The second category of verification is essentially a TOB procedure, which the auditor performs two distinctive types of verification: 1. Verification of the client’s bank reconciliation. 2. Application of fraud-related audit procedures: extended tests of bank reconciliation, proof of cash, tests for kiting (tests of inter-bank transfers), and cash count (tests of lapping). Figure 18-1 The Relationships of General Cash with Other Transaction Cycles

Revenue Cycle Sales

Expenditure Cycle Purchases

Cash Sales

Cash Purchases

Accounts Receivable

Accounts Payable

Receipts of Account

Capital Cycle Capital Stock Retire Stock

Issue Stock

Bonds Payable

Payments of Account

General Cash Cash Revenue Cycle

Expenditure Cycle

Capital Cycle

Capital Cycle

Investments

Investments

Investments Investments Purchase Securities

Sell Securities

Interest & Dividend Revenue Redeem Bonds

Issue Bonds

Payroll Cycle Interest & Dividends Payable Pay Interest & Dividends

Payroll Cycle Accrued Wages & Salaries Payroll Cash

Receipts of Interest & Dividends

477

478


General Cash Accounts and Documents

Common general cash accounts and documents are described in Table 18-1 to facilitate the discussion of the TOB strategy for general cash. Table 18-1 Accounts and Documents in General Cash

Accounts and Documents in General Cash Accounts:

 General cash account/balance (cash on hand) This is the principal cash account representing cash on hand for most clients. The major source of cash receipts for this account is the revenue cycle; and the major source of cash payments are the expenditure and payroll cycles.  Imprest cash account (petty cash) This is a fixed amount of cash, usually very small, such as $10, set aside in a strong box for incidental expenses. Periodically, a check is drawn from the general cash account to deposit the amount of cash required to restore the balance of the imprest cash account to $10.  General bank account/balance (cash in bank) This is the principal bank account representing cash in bank for most clients.  Imprest payroll bank account This is a fixed balance, such as $1,000, maintained in a separate bank account. Immediately before each pay period, one check is drawn on the general cash account to deposit the total amount of the net payroll into the imprest payroll bank account. After all payroll checks have cleared the imprest payroll bank account, this bank account should have a $1,000 balance.  Branch bank account Audit clients that operate branches in multiple locations often maintain separate bank accounts at local banks.  Cash equivalents These are short-term investments such as saving account, certificates of deposit, and money market funds that are readily convertible to known amounts of cash within a short time. Documents:

 Bank reconciliation working paper A copy of the bank reconciliation prepared by the client. The working paper reconciles the balance per the bank (balance on the bank statement) with the balance per the books (cash account balance in the general ledger). The major reconciliation items are deposits in transit, outstanding checks, and other adjustments, such as bank service charges and any none-sufficient fund (NSF) check returned. Ordinarily, this document is used to meet the specific audit objective of accuracy.  Standard bank confirmation form A standard form titled, Standard Form to Confirm Account Balance Information with Financial Institutions , agreed upon by the AICPA, American Bankers Association, and Bank Administration Institute and used by the auditor to confirm cash deposit balances and loan balances (also referred to as direct liabilities) with every bank or financial institute that maintains an account for the audit client. This form is also used to e with the bank. The form confirms a direct liability’s account number and description, obtain information about any loans the client may hav balance, due date, interest rate, and description of collateral. But the form does not request information about principal amount already paid on a direct liability. A bundle of 100 formscan be purchased and downloaded from the AICPA website. This standard bank confirmation form does not require bank personnel to conduct a comprehensive, detailed search of the bank’ s records beyond the account information requested on the confirmation. However, it does request that bank personnel indicate any other deposits or loans that come to their attention while completing the confirmation. As a result, this confirmation request cannot be relied upon to identify all information about a client’s bank deposits or loans. If the auditor believes that additional information is needed, a separate confirmationletter signed by the client should be sent to the bank. Ordinarily, this document is used to meet the specific audit objective of existence or occurrence.  Bank cutoff statement A partial-period bank statement that the auditor requested from the client’s bank and sent directly to the auditor to verify reconcilin g items such as deposits in transit and outstanding checks for a 7- to 10-day period after the balance sheet date/after the date on which the bank account is reconciled. Ordinarily, this document is used to meet the specific audit objective of completeness.


An overview of the strategy for tests of balances of general cash is presented in Figure 18-2. Figure 18-2 TOB Strategy in General Cash

The Audit Process

Audit Plan

Tests of Controls

Tests of Balances


Audit Report










479

480


Apply TOB Strategy to General Cash

Table 18-2 provides a brief discussion of the TOB Strategy as it is applied to general cash. Table 18-2 TOB Strategy in General Cash

TOB Strategy – General Cash 1. Allocate PJAM to TM

Chapter 9 discussed how the auditor allocates PJAM to TM at the individual account-balance or class of transaction level of a transaction cycle. General cash balance is immaterial in most audits, therefore, the auditor typically allocates a large TM (i.e., more tolerance) to general cash. The auditor derives the DR, based on a pre-specified AR, assessed IR and CR, by using the audit risk model of AR = IR x CR x DR at the individual account-balance or class of transactions level of a transaction cycle (recall Chapter 9). The derived DR drives an optimum mix of the nature, extent, and timing of the TOB procedures used by the auditor. Since general cash is more susceptible to theft than other assets, the auditor typically sets inherent risk, IR, relatively high for the specific audit objectives of existence or occurrence, completeness, and accuracy. The auditor’s assessment of CR depends on the results of the TOC in other cycles, especially the revenue and expenditure cycles. The auditor performssix common types of analytical procedures(recall Chapter 7): (1) Compare clientand industry data. (2) Compare client data with similar prior-period data. (3) Compare client data with clientdetermined expected results. (4) Compare client data with auditor-determined expected results. (5) Compare client data with expected results, using non-financial data. 6. Compare financial ratio analysis on client data. Since general cash balance is a residual balance in nature, general cash does not have a predictable relationship with other financial statement accounts. As a result, the auditor’s use of analytical procedures for general cash is limit ed to comparisons with prior year’s general cash balance. Table 18-3 describes the very limited use of analytical procedures in general cash. The auditor performs the TOB procedures that address the nature, extent, and timing of evidence. In general, TOB on general cash starts with the auditor obtaining bank reconciliation from the client for inclusion in the auditor’s working papers. Note that: (1) TOB specifically for accuracy of cash in bank starts with the auditor obtaining a bank reconciliation working paper from the client. (2) TOB specifically for existence or occurrence of cash in bank starts with the auditor obtaining a standard bank confirmation form directly from the bank. (3) TOB specifically for completeness of cash in bank starts with the auditor obtaining a bank cut-off statement directly from the bank. The auditor also performs specific fraud-related TOB procedures. Table 18-4 summarizes some specific

2. Derive DR



audit objectives commonofTOB procedures for general cash. The auditor is especially concerned about the specific auditand objectives existence or occurrence, completeness, and accuracy. The auditor documentsall misstatements foundby performing theTOB procedures andcompares the total misstatements with the PJAM. Based on the misstatements found, the auditor may revise PJAM (RJAM) if necessary. The auditor should perform additional audit work or request the management to make adjustment for the misstatements.


Table 18-3 Analytical Procedures for General Cash



Compare the ending balance of general cash account with prior year ending balances.

Misstatement in cash

Table 18-4 Specific Audit Objectives and Common TOB Procedures for General Cash



Existence or Occurrence: Items stated in the bank reconciliation Obtain a standard bank confirmation that requests specific information on the existence of cash exist. deposit balances and loan balances with every bank that maintains an account for the audit client. Tests of bank reconciliation. Table 18-5 provides more discu ssions on the auditor’s procedures for testing bank reconciliation. Completeness: Existing cash in the bank recorded. Obtain a bank cutoff statement that covers a 7-to 10-day period after the balance sheet date. Trace deposits in transit, outstanding checks, and other reconciling items to cutoff bank statement. Table 18-6 provides more discussions on the auditor’s procedures for obtaining and using bank 4 for an example of the auditor’s procedures relating to the bank cutoff statements. See Figure 18cutoff statement. Accuracy: Cash in the bank as stated on the Tests of bank reconciliation. Table 185 provides more discussions on the auditor’s procedures for reconciliation is accurate. testing bank reconciliation.



Common TOB Procedures If the auditor suspects that some type of fraud involving cash has occurred: (1) Extended tests of bank reconciliation. See Table 18-7 for further discussion on this audit procedure. (2) Proof of cash. See Table 18-8 for further discussion on this audit procedure. (3) Tests for Kiting (for fraud), also known as Tests of Inter-Bank Transfers (for unintentional mistake). See Table 18-9 for further discussion on this audit procedure. (4) Tests for Lapping. See Table 18-10 for further discussion on this audit procedure.

Cutoff: Cash receipts and cash disbursements transactions are recorded in the proper accounting period.

Cash receipts:



Count the cash on hand (cash counts) on the last day of the year/accounting period and subsequently trace to deposits in transit and the cash receipts journal. In performing cash counts, the auditor should: (1) Take control of all cash/cash registers held by the client until they have been counted. (2) Insist that the custodian/cashier of the cash be present throughout the count. (3) Obtain a signed receipt from the custodian/cashier on return of the cash to the client.

 Trace deposits in transit to subsequent period cutoff bank statement. Cash disbursements: 

Record the last check number used on the last day of the year/accounting period and subsequently trace to the outstanding checks and the cash disbursements journal. Understandability: Cash in bank is properly presented and disclosed in the financial statements.



Trace outstanding checks to subsequent period cutoff bank statement.

Read board of director’s minutes, line-of-credit arrangements, loan agreements, or other documents for any restrictions on cash such as compensating balances or sinking fund requirements. Review financial statements to make sure: (1) Material savings accounts and certificates of deposit are disclosed separately from cash in the bank. (2) Cash restricted to certain uses and compensating balances are adequately disclosed. (3) Bank overdrafts are included as current liabilities.

Table 18-5 Auditor’s Procedures for Tests of Bank Reconciliation

Auditor’s Procedures for Tests of Bank Reconciliation The auditor’s procedures for tests of bank reconciliation:

  

Foot the bank reconciliation working paper for mathematical accuracy. Agree the bank balance on the bank reconciliation working paper with the balance shown on the standard bank confirmation.

Trace the deposits in transit on the bank reconciliation working paper to the cutoff bank statement. Any deposit in transit shown on the bank reconciliation should be listed as a deposit shortly after the balance sheet date.



Compare the outstanding checks on the bank reconciliation working paper with the canceled checks contained in the cutoff bank statement for proper payee, amount, and endorsement. Any outstanding check shown on the bank reconciliation should clear the bank shortly after the balance sheet date.



Agree any charges (bank service charges, bank errors and corrections, and unrecorded note transactions debited or credited directly to the bank account by the bank) included on the bank statement to the bank reconciliation.

 Agree the adjusted book balance to the cash account lead schedule. This adjusted book balance should be part of the amount included in the financial statement for cash. See Figure 5-6 in Chapter 5 for an example of the auditor’s procedures for tests of bank reconciliation. Table 18-6 Auditor’s Procedures on Bank Cutoff Statements

Auditor’s Procedures on Bank Cutoff Statements



The client must request a bank cutoff statement from the bank and instruct that it be sent directly to the auditor. See Figure 18-4 for an example of auditor’s procedures relating to the bank cutoff statement.




This is to prevent the client from intercepting the bank cutoff statement and to provide appropriate corroborative evidence about the existence or occurrence of the year-end bank reconciliation.

On receipt of the cutoff statement, trace all prior-year dated If a prior-period check not on the list of outstanding checks has   checks to the outstanding checks listed on the bank reconciliation. cleared the bank, there may be a “kiting” fraud (see Table 18-9 for more discussion).



If a prior-period check on the list of outstanding checks has not cleared the bank, there may be delays in (1) mailing the check by the

481

482


Auditor’s Procedures on Bank Cutoff Statements

Potential Misstatements client, (2) depositing the check by the payees, and (3) processing the check by the bank.



If there are a large number of outstanding checks remaining uncleared, there may be a “window dressing” fraud, which is a deliberate attempt to overstate a company’s short-term liquidity. For example, if the client’s current assets are $900,000 and current liabilities are $500,000, the current ratio is 1.8:1. But if $100,000 of checks are deliberately paid prematurely, the current assets are now $800,000 and the current liabilities are $400,000, which results in a stronger current ratio of 2.0:1. On receipt of the cutoff statement, trace deposits in transit on  bank the reconciliation to deposits on the cutoff statement.

The first deposit on the cutoff statement should be the first deposit in transit shown on the bank reconciliation. If this is not the  case, the auditor should investigate the reason for the time lag.





On receipt of the cutoff statement, scan the cutoff statement for unusual items.

The auditor should be alert for such items as unrecorded bank debits and credits, and bank errors and corrections; and seek explanations for the unusual items.

Table 18-7 Auditor’s Procedures for Extended Tests of Bank Reconciliation

Auditor’s Procedures in Extended Tests of Bank Reconciliation When the auditor suspects that the year-end bank reconciliation may be intentionally misstated, s/he performs extended tests of the year-end reconciliation. The purpose of the extended procedures is to verify whether all transactions included in the journals for the last month of the year were correctly included in or excluded from the bank reconciliation and to verify whether all items in the bank reconciliation were correctly included. The audit procedures for extended tests of bank reconciliation include:



Assume the client’s year-end is December 31. Start with the bank reconciliation for November and compare all reconciling items with cancelled checks and other documents in the December bank statement.



Compare all remaining cancelled checks and deposit slips in the December bank statement with the December cash disbursements and receipts journals.



Inspect that all un-cleared items in the November bank reconciliation and the December cash disbursements and receipts journals are included in the December 31 bank reconciliation.



Inspect that all reconciling items in the December 31 bank reconciliation are items from the November bank reconciliation and December’s journals that have not yet cleared the bank.

Table 18-8 Auditor’s Procedures for Proof of Cash

Auditor’s Procedures for Proof of Cash When the client’s has material internal control weaknesses in cash,the auditor prepares a proof of cash to determine:

   

All recorded cash receipts were deposited. All deposits in the bank were recorded in the accounting records. All recorded cash disbursements were paid by the bank.

All amounts that were paid by the bank were recorded. The auditor prepares a proof of cash by reconciling the cash receipts and disbursement recorded on the client’s books with the cash deposited into and disbursed from the client’s bank account for a specific time period, such as a month, although it may also be prepared for the entire accounting period under audit. Because the proof contains four columns, a proof of cash is commonly referred to as a four-column proof of cash. The four columns include:

   

A bank reconciliation for the beginning of the period. A reconciliation of the cash deposited in the bank with the cash receipts recorded in the cash receipts journal. A reconciliation of the cash disbursed through the bank account with the cash disbursements recorded in the cash disbursements journal.

A bank reconciliation for the end of the period. Note: A proof of cash will not detect a theft of cash when the cash was stolen before being recorded in the client’s book, orthe recording and deposit of an improper amount of cash. See Figure 18-5 for an example of a proof of cash prepared by the auditor for an interim month.


Table 18-9 Auditor’s Procedures for Tests for Kiting (Tests of -bank Inter Transfers)

Auditor’s Procedures for Tests for Kiting (Tests of Inter -bank Transfers) A client’s employee may steal cash and cover the cash shortage by a fraud scheme known as kiting. In kiting, an employee coversthe cash shortage by transferring money from one bank account to another and recording the transactions improperly on the client’s books. Specifically, the employee conceals the cash shortage by preparing a check on one bank account before year-end but not recording it as a cash disbursement in the book account until the next period. The check is deposited in a second bank account before year-end and recorded as a cash receipt in the current period. The deposit occurs close enough to year-end that it will not clear the first bank account before the year-end. See Figure 18-3 for an example of kiting. Auditor’s procedures for tests for kiting (tests of inter-bank transfer) include:



Prepare an inter-bank transfer schedule that is used to list all inter-bank transfers made a few days before and after the balance sheet date

and to trace each transfer to the accounting records for proper recording.  Verify the accuracy of the information on the inter-bank transfer schedule.

  

Verify that inter-bank transfers are recorded in both the receiving and disbursing banks. Verify the date of the recording of the disbursements and receipts for each transfer is in the same fiscal year.

Verify that disbursements on the inter-bank transfer schedule are correctly included in or excluded from year-end reconciliations as outstanding checks.

 Verify that receipts on the inter-bank transfer schedule are correctly included in or excluded from year-end reconciliations as deposits in transit. When an audit client has many bank transfers, the auditor prepares an inter-bank transfer schedule even though no fraud is suspected. This schedule helps the auditor to detect unintentional mistakes and to account for proper cutoff of cash transactions. Figure 18-4 shows an example of an inter-bank transfers schedule prepared by the auditor and the procedures relating to the bank cutoff statement. Figure 18-3 An Example of Kiting Bank A records the $20 cash withdrawal that decreases the balance of ABC Co. from $100 to $80. Bank A is not aware of the $20 check transfers to Bank B just before the end of the accounting period. Therefore, Bank A’s record shows a balance of $80 instead of $60 on its bank statement to the ABC Co. at the end of the accounting period.

Bank A’s Record ABC Co. Account $100 - 20 80

2.

Bank B’s Record

ABC Co. Account $100 + 20 120

Bank B records the $20 check deposit, but will not clear the check with Bank A until after the accounting period. Therefore, Bank B’s record shows an increase in ABC Co.’s balance from $100 to $120 on its bank statement to the ABC Co. at the end of the accounting period.

1. 3.

ABC Co.’s Record

Bank A Account $ 80 Bank B Account 120 200

1. The employee first withdraws $20 cash from its Bank A account just before the end of an accounting period. 2. The employee immediately deposits a check of $20 drawn from its Bank A account to its Bank B account knowing the check

will not clear Bank A account until after the end of the accounting period. 3. The records on receipt of the $20 check in Bank ABC Co.’s Cash book to show a balance of $120, matches with employee the $120 balance the bank statement from B at the endReceipt of the accounting period. Meanwhile, thewhich employee intentionally fails to record disbursement of the $20 check in ABC Co.’s Cash Disbursement book so that its balance remains

at $80, which matches with the $80 balance on the bank statement from Bank A at the end of the accounting period. In sum, the employee has covered up the $20 cash embezzlement just before the end of an accounting period by taking advantage of the time lag in clearing the inter-bank transfer.

483

484


Figure 18-4 Auditor’s Preparation of an Inter -Bank Transfers Schedule and Procedures Relating to the Bank Cutoff Statement W/P Ref: SIT-1 Schedule of Inter-bank Transfers Schedule as at 12.31.2001 and Procedures Relating to Bank Cutoff Statement as at 01.07.2002 Client: ABC Company

Prepared by:

Document Bank Reconciliation BR – Document BS – Bank Statement Document BCS– Bank Cutoff Statement Acct 508 – Cash Disbursement Account Acct 509 – Cash Receipts Account Disbursements (Transfer TO) 3. Amount 4. Date Recorded in

5. Date Paid by Bank

$20,000

Acct 508 * 12.26.2001

12.28.2001

t

cno

<

Bank - Head Office

$30,000

12.28.2001

01.02.2002

t

cio

>

#3767

Bank - Head Office

$10,000

12.30.2001

01.04.2002

t

cio

>

#3798

Bank - Head Office

$40,000

01.02.2002

01.04.2002

t

cno

>

1. Check No.

2. Bank

#3703

Bank - Head Office

#3736

t ^ <

Reviewed by:

6. Bank

*

Mark Chris

Date: 1.10.2002 Date: 2.12.2002

Receipts (Transfer From) 7. Date 8. Date Received by Recorded in Bank Acct 509

Bank – Branch

12.28.2001

^ cnd

<

Bank – Branch

12.29.2001

12.29.2001

BankBranch

12.30.2001

^ cid

>

Bank Branch

01.03.2002

01.04.2002

^ cnd

>

^ cnd

12-29.2001

< 01.03.2002

Traced to cash disbursements journal. Traced to cash receipts journal. Traced to bank statement as at 12.31.2001.

Traced to bank cutoff statement as at 01.07.2002. > cno Comparing the dates in columns 4 and 5, check is not included as outstanding check on bank reconciliation, which is correct. cio Comparing thedates in columns 4 and 5, check is included as outstanding check onbank reconciliation, whichis correct. cnd Comparing the dates in columns 7 and 8, receipt is not included as deposit in transit on bank reconciliation, which is correct. cid Comparing thedates in columns7 and 8, receipt isincluded as depositin transit on bank reconciliation, which is correct. * Vouched cash disbursements journalfor the existence or occurrence ofprior-period checks that were not included as outstanding checks on the bank reconciliation as at 12.31.2001, but were paid in subsequent-period by the bank on the bank cut-off statement as at 01.07.2002. Since no such prior-period checks was found, the existence or occurrence of a kiting fraud is veryunlikely. Conclusion: After preparing and testing the inter-bank transfers schedule, no intentional kiting fraud is discovered, and no unintentional mistake in recording inter-bank transfers is detected.


Figure 18-5 Auditor’s Preparation of a Four -Column Proof of Cash for an Interim Month W/P Ref: POC-4 Interim Proof of Cash Client: ABC Company

Prepared by:

Document Bank Statement BS – Record CDJ – Cash Disbursements Journal Record CRJ – Cash Receipts Journal Acct100 – General Cash Account

Reviewed by:

Balance per Bank: Deposits in Transit: 5.31.201x  6.30.201x  Outstanding Checks: 5.31.201x  6.30.201x  NSF Checks  Adjust the effect of a cash disbursement recorded as a credit item in cash receipts journal Balance per Bank, Adjusted:

Balance per books, unadjusted: Bank debit memos: Payroll checks erroneously entered General Disbursements Journal: Balance per Books, Adjusted:

5.31.201x $10,000.00

Receipts $200.00

700.00

(700.00) 800.00

Joe Date: 07.01.201x Don Date: 07.12.201x

Disbursements $100.00

(300.00)

800.00

(50.00)

(300.00) 600.00 (50.00)

10,400.00 =======

(6.00) 244.00 =====

(6.00) 344.00 =====

10,300.00 =======

10,400.00

244.00

374.00 80

10,270.00 (80)

10,400.00 =======

244.00 =====

(50) 344.00 =====

50.00 10,300.00 =======

(600.00)

in

  

Obtained as per 6.30.201x bankstatement. Compiled the detailsof deposits intransit in the attached list;traced to subsequent bank statement. Compiled thedetails of outstanding check inthe attachedlist; examinedcancelled checks.



Compiled the details ofNSF item in the attached list; allNSF items werere-deposited in June and hadall cleared asof 6.30.201x. Safety depositrentals; tracedrental feeto cash disbursement journal. Traced to journal entrycorrecting theerror.

 

6.30.201x $10,100.00

Conclusion: The interim proof of cash indicates that internal control on cash is adequate.

Table 18-10 Auditor’s Procedures for Tests of Lapping

Auditor’s Procedures for Tests of Lapping A client’s employee may steal cash and cover the cash shortage by a fraud scheme known aslapping. In lapping, an employee deliberately defers recording cash receipts from one customer and covers the cash shortage with receipts from another customer. These in turn are covered from the receipts of a third customer a few days later. The employee must continue to cover the shortage through repeated lapping. Thus, this lapping fraud can best be prevented by segregation of duties in handling cash receipts and postings of the collections to the account s receivable ledger. If segregation of duties is not practical, a mandatory vacation policy should be imposed on the employee who both handles cash and records cash receipts. The employee will not be ableto continue covering the cash shortage through repeated lapping while on vacation.See Figure 18- 6 for an example of lapping. Auditor’s procedures for tests of lapping include:

 Confirm accounts receivable. Recall confirmation of accounts receivable in Chapter 13. This procedure will be more effective if it is performed on a surprise basis at the interim audit date. Confirmation at this interim date will prevent the employee engaged in lapping from bringing the “lapped” accounts up to date. Confirmation at the balance sheet date will be less effective because the employee may anticipate the auditor ’s confirmation procedure and adjust the “lapped” accounts to their correct balance at that date. 

Make a surprise cash count. Recall cash count procedures for the specific audit objective of cutoff in Table 18-4 above.

The cash count will include coin, currency, and customer checks on hand. The auditor should oversee the deposit of these funds. Subsequently, the details of the deposit shown on the duplicate copy of deposit slip should be compared with cash receipts journal entries and postings to the customers’ accounts.

 Compare details of cash receipts journal entries with the details of corresponding daily deposit slips. This procedure should discover discrepancies caused by the employee’s lapping of customers’ accounts.

485

486


Figure 18-6 An Example of Lapping Lapping in day one …

Assume on day one, the cash register tapes totaled $600 and the mail receipts opened by the employee consisted of one payment on account by check for $200 from customer A. The employee would steal $200 in cash and destroy all evidence pertaining to the mail receipt except for the customer’s check. The cash receipts journal entry would agree with the register tape of $600, and the deposit slip would showcash $400 and A’s check for $200. Day one of lapping is shown as follows: Actual Receipts: Documents: Cash Receipts Journal Entry: Bank Deposit Slip: Cash $ 600 Cash Tape $ 600 Cash sales $ 600 Cash $ 400 Customer A Check 200 ____ _____ Customer A check 200 800 ==== Lapping in two or three days later …

600 ====

600 =====

600 =====

In order to conceal the cash shortage, the employee would (1) keep daily bank balance and book balance in agreement so that a bank reconciliation would not detect the lapping, (2) correct customer A’s account by a j ournal entry within two or three days, and (3) shift lapping to customer B’s account a few days later. The total cash stolen would now be $300, $200 in day one of lapping and $100 in day two or three of lapping. Day two or three of lapping is shown as follows: Actual Receipts: Documents: Cash Receipts Journal Entry: Bank Deposit Slip: Cash $ 500 Cash Tape $ 500 Cash sales $ 500 Cash $ 400 Customer B Check 300 Customer A Check 200 Customer A Check 200 Customer A check 300 800 700 700 700 ==== ==== ===== =====

Auditing Investments

AU 501, Audit Evidence- Specific Consideration for Selected Items, provides guidance for conducting TOC and TOB for investments. A client’s investments might include equity securities such as common and preferred stock, debt securities such as notes and bonds, and hybrid securities such as convertible bonds and stocks. The strategy for auditing investment is not different from auditing current assets, such as inventory (in Chapter 15), for short-term investments; and long-term assets, such as property, plant and equipment (in Chapter 14), for long-term investments. Thus, the TOC and TOB strategy pertaining to investments are not discussed here. should be for noted that inherent riskfinance for investments is often assessed at a relatively level and due to: 1. Loan Itcovenants, example, clients their investments by borrowing from high the bank the loan agreement requires the client to maintain strict debt to equity ratio. 2. Related party transactions, for example, parent companies finance their investments by borrowing from subsidiary companies without repayment term. 3. Complex transactions, for example, clients create complex investment transactions, such as Special Purpose Entities (SPE), that are structured to bypass GAAP. 4. Investment impairment, for example, clients understate large losses of investments value by writing off assets and building up reserves to reduce in future year. Assess Control Risk and Perform TOC Procedures

After understanding and documenting internal controls relating to investments, the auditors assess control risk and perform TOC procedures as per the audit program for the investments. Table 18-11 summarizes some specific audit objectives for TOC, internal controls, and common TOC procedures for investments. Table 18-11 Specific Audit Objectives, Internal Controls, and Co mmon TOC Procedures for Investments

Specific Audit Objectives Existence or Occurrence: Investments are properly approved.

Internal Controls


Proper authorization for the purchase or sales of

Read board of directors’ minutes for approval

any investment.

for the purchase or saleofofdirectors investments. Inquiry of the board for general policies to guide the client’s investment activities, and specific policies to delegate investment activities to individual finance executive, investment committee, or outside



Internal Controls

Common TOC Procedures investment advisers.

Completeness: All securities transactions are recorded.

Adequate records are maintained for securities transactions.

all

Inquiry of management that a securities ledger that records all detailed securities transactions is maintained. Observe periodic independent check of the securities ledger to ensure that all dividends and interest have been received and recorded in the client’s records. Observe that the internal auditor compares the securities held in bank safe-deposit box with the client’s records.

Rights and Obligations: Investments are indeed owned by the Physical safeguarding of assets. client and safeguard against theft.

When securities are held by the client, they should be stored in a safe or safe-deposit box, and access to the safe-deposit box must require the presence of two authorized officials. If an independent custodian such as a broker maintains securities, observe that the client has established proper procedures for authorizing the transfer of securities. Examine brokers’ advice for a sample of securities purchased during the year.

Apply TOB Strategy to Investments

The auditor primarily uses analytical procedures to determine the overall reasonableness of investments as shown in Table 18-12. Table 18-13 summarizes some specific audit objectives and common TOB procedures for investments. Table 18-12 Analytical Procedures for Investments



Comparison of the balances in the current year’s investment accounts with prior years’ balances Overall reasonableness of investments after consideration of the effects of current-year operating and financing activities on cash andaccount balances. investments. Comparison of current-year interest and dividend income with the reported income for priorOverall reasonableness of return on years and with the expected return on investment. investments. Compute the amount of dividend income that should have been received by referring to The reasonableness of dividend income from dividend record books (contain dividend amount and payment dates) for publicly held investments. companies that are published by investment advisory services, such as Dun & Bradstreet.

Table 18-13 Specific Audit Objectives and Common TOB Procedures for Investments

Specific Audit Objectives Existence or Occurrence: Investments exist.

Common TOB Procedures AU 501 states the auditor should gather evidence for existence or occurrence as follows:



Physical examination of investments. (1) The client maintains custody of the investments. During the physical examination, the auditor should note the name, class and description, serial number, maturity date, registration in the name of the client, interest rates or dividend payment dates, and other relevant information about the investments. Note: If the client’s investment portfolio is kept in a bank safe-deposit box, and if the auditor is unable to count the securities at the balance sheet date, the auditor most likely will request the client’s bank to seal the safe-deposit box until the auditor can count the securities at a subsequent date. (2) The investments are held by an issuer or a custodian such as a broker or investment adviser. The auditor should confirm the details of the client’s investments with the issuer or custodian of the investments.

   

Confirmation with the issuer of investments. Confirmation with the custodian of investments. Confirmation of unsettled transactions with the broker-dealer. Confirmation with the counter-party.

487

488






Read executed partnership or similar agreements.

Completeness: Existing notes payable are included in the Obtain a standard bank confirmation that requests specific information on the existence of notes schedule of notes payable and accrued payable from all banks with which the client does business (see Table 18-4 for more discussion on interest. bank confirmation). Examine the bank reconciliation for new notes credited to the bank account by the bank (see Table 18-5 for more discussion on bank reconciliation). Examine notes paid after year-end to determine whether they were liabilities at the balance sheet date. Accuracy: Investments are recorded accurately. Obtain schedules of investments by category (held-to-maturity, trading, and available-for-sale); foot schedules and agree totals to securities register and general ledger. Figure 18-7 shows an example of auditor’s procedures on a schedule of available-for-sale investment. Classification: Short and long term investments are Inquire of management’s intent concerning investments to determine proper classification of properly classified. investments into:



Held-to-maturity investments– debt securities that the client intends to hold to maturity – should be classified as current or long-term assets based on whether management expects to be converted to cash within 12 months (current assets) or longer than 12 months (long-term assets).



Trading investments –debt and equity securities that the client bought and held primarily for the purpose of selling them in the near term– all should be classified as trading as current assets.



Available-for-sale investments– debt or equity securities not classified as either held-tomaturity or trading securities - should be classified as current or long-term assets based on whether management expects to be converted to cash within 12 months (current assets) or longer than 12 months (long-term assets). Examine investment activities to determine whether they corroborate or conflict with the management’s intent concerning investments. The auditor should examine investment activities such as written and approved records of investment strategies, records of investment activities, instructions to portfolio managers, and minutes of meetings of the board of directors or investment committee. See Figure 18-8 for a summary of accounting for investments under SFAS No.115, Accounting for Certain Investments in Debt and Equity Securities. Cutoff: Investments are included in the proper Examine purchases and sales of securities for a few days before and after year-end to determine if accounting period. the transactions are included in the proper accounting period. Valuation and Allocation: Investments recorded in the financial AU 540, Auditing Accounting Estimates, Including Fair Value Accounting Estimates and Related statements are properly valued. Disclosures , provides guidance for fair value measurements of investments:



When securities are initiallypurchased, they should be recorded atacquisition cost. The auditor verifies the purchase price of a security by examining a broker’s advice or similar documents.



Held-to-maturity investments should be valued at their amortized cost. The auditor verifies the purchase price and use the effective interest rate to recognize the interest income and to computer the amortization.



Trading investment should be valued at fair value (market value/market price). The auditor verifies the fair value with securities exchanges registered with the SEC or on the over-thecounter market. The auditor can also verify the fair value by tracing it to sources such as brokers, The Wall Street Journal, or other reliable financial literature.

 Available-for-sale investments should be valued at fair value (market value/market price). The auditor verifies the fair value as that for the trading investments above. The auditor should determine whether there has been any permanent decline (or other-thantemporary impairment) in the value of an investment security. In other words, an investment security has a non-temporary decline in value below amortized cost. In such a case, the security should be written down and a new carrying amount established. AU 540 gave examples of factors that may indicate an other-than-temporary impairment condition as follows: (1) Fair value is significantly below cost. (2) The decline in fair value is attributable to specific adverse conditions affecting a particular investment. (3) The decline in fair value is attributable to specific conditions, such as conditions in an industry or in a geographic area. (4) Management does not possess both the intent and the ability to hold the investment for a period of time sufficient to allow for any anticipated recovery in fair value.



Common TOB Procedures (5) The decline in fair value has existed for an extended period of time. (6) A debt security has been downgraded by a rating agency. (7) The financial condition of the issuer has deteriorated. (8) Dividends have been reduced or eliminated, or scheduled interest payment on debt securities has not been made. The auditor should examine the sale of any securities to ensure that proper values were used to record the sale and any realized gain or loss. Table 18-14 provides more discussion on auditing fair value measurements of investments in accordance with AU 540. For complex investments such as derivative investments and hedging activities, the auditor should verify them based on the guidelines in AU 501 and AU 540. Derivative investments are those that derive their from another index. For example, an option bonds, to purchase another client’sand stock is a value derivative. Interestasset rateorswaps, options, convertible futures contracts convertible preferred stock are all derivatives. For example, an energy company might buy futures contracts on oil and gas to lock the price of its raw ingredients so that it can predict future cost of goods sold. Likewise, an export company might buy currency futures contracts to lock in the currency exchange rate for their sales.

Understandability: Investments are properly presented and Examine financial statements for proper presentation and disclosure investments in conformity disclosed in the financial statements. with SFAS No.115, Accounting for Certain Investments in Debt and Equity Securities :



Held-to-maturity investments– reported at amortized cost under current assets (within 12 months) or long-term assets (longer than 12 months) on the balance sheet.



Trading investments – reported at fair (market) value under current assets on the balance sheet. Unrealized gains andlosses on short-term investment are reported under “Other revenue, gains, and losses” and above “Net Income” on the income statement.



Available-for-sale investments – reported at fair (market) value under current assets (within 12 months) or long-term assets (longer than 12 months) on the balance sheet. Unrealized gains and losses are reported in two places: (1) Under “Other Comprehensive Income” and below “Net Income” on the income statement, and (2) Under “Accumulated Other Comprehensive Income” and below “Retained Earnings” on the balance sheet. Examine any securities have been pledged as collateral by inquiry of management and reading board of directors’ minutes, loan agreements, and other documents. This information should be disclosed in footnotes of the financial statements.

Auditing Fair Value Measurements of Investments (AU 540 )

Financial Accounting Standards Board (FASB) issued SFAS No.157 (Fair Value Measurements), which defines fair value, establishes a framework for measuring fair value, and expands disclosures. SFAS No.157 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. However, it also introduces concepts such as the fair value hierarchy of inputs and the principal and most advantageous markets. The fair value hierarchy in SFAS No.157 prioritizes the inputs, which refer broadly to assumptions market participants would use in pricing an asset or liability, into three levels. It gives the highest priority to quoted prices (unadjusted) in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. The level in the fair value hierarchy within which a fair value measurement falls is determined based on the lowest level input that is significant to the fair value measurement as follows: Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities that the management has the ability to access at the measurement date. Level 2 inputs are inputs other than quoted prices within Level 1that are observable for the asset or liability, either directly or indirectly. A significant adjustment to a Level 2 input could result in the Level 2 measurement becoming a Level 3 measurement. Level 3 inputs are unobservable inputs for the asset or liability. Unobservable inputs are those that reflect the management’s own assumptions about the assumptions market participants would use in pricing the asset or liability developed based on the best information available in the circumstances. Under SFAS No.157, a fair value measurement assumes that the transaction occurs in the principal market for the asset or liability or, in the absence of a principal market, the most advantageous market. The principal market is one in which the reporting entity would sell the asset or transfer the liability with the greatest volume and level of activity. If there is a principal market, under SFAS No.157, the fair value measurement represents the price in that market even if the price in a different market is potentially more advantageous.

489

490


Auditing Standards AU 540, Auditing Accounting Estimates, Including Fair Value Accounting Estimates and Related Disclosures , provide guidance for auditing fair value measurements of investment. Table 18-14 summarizes auditing fair value measurements of investments in accordance with AU 540. Table 18-14 Auditing Fair Value Measurements of Investments in Accordance with AU 540

Auditing Fair Value Measurements of Investments (AU 540)

   

 



 



Obtain an understanding of the management's process for determining fair value measurements and disclosures, including relevant controls. Evaluate whether management’s assumptions are reasonable and reflect, or are not inconsistent with, market information. For example, the fact that transaction volume in a particular market is lower than in previous periods may not necessarily support an assumption that transactions in that market constituted forced or distressed sales.

If management relies on historical financial information in the development of an assumption, consider the extent to which such reliance is justified. However, historical information might not be representative of future conditions or events. For example, an auditor should evaluate whether management’s use of historical default rates, in an environment in which default rates are increasing, is justifi ed. Evaluate whether the management’s method for determining fair value measurements is applied consistently and if so, whether he t consistency is appropriate considering possible changes in the environment or circumstances affecting the company. For example, the relative weightings in the management’s model may not be reasonable in situations where there has been a change in market conditions.In such cases, the auditor should consider whether compliance with applicable accounting standards might require a change in the model. Inputs based on a company’s own data may be more susceptible to preparer bias because they may not be based on observable market inputs. In such cases, the auditor should be aware of the increased risk of management bias and address the related risk of material misstatement (Recall Chapter 9 on Risk and Materiality).

With regard to the fair value hierarchy in SFAS No.157, because there are different consequences associated with each of the three levels of the hierarchy, the auditor should be alert for circumstances in which management may have an incentive to inappropriately classify fair value measurements within the hierarchy. For example, an asset or liability with Level 1inputs generally must be measured using unadjusted quoted prices in an active market, while an asset or liability with Level 2 inputs is measured using observable market inputs other than quoted prices included in Level 1. Accordingly, a Level 2 measurement might allow for more discretion or judgment on the part of management than a Level 1 measurement. As another example, the required disclosures associated with Level 3 measurements are more extensive than those associated with Level 1 and Level 2 measurements. The auditor’s opinion is based on, among other things, his or her judgment as to whether the financial statements and related notes are informative of matters that may affect their use, understanding, and interpretation. In evaluating whether management’s discl osures are complete, accurate, and in conformity with SFAS No.157, the auditor should be aware that a financial statement disclosure that is not in accordance with GAAP could be a misstatement of the financial statements.

The auditor should consider whether to engage a valuation specialist and use the work of that specialist as evidential matter in performing audit procedures related to the fair value measurement. Factors to consider include (1) significant use of unobservable inputs, (2) complexity of the valuation technique, and (3) materiality of the fair value measurement. If management uses a pricing service for its fair value measurements, the auditor should determine the nature of the information provided by the pricing service. For example, the auditor should understand whether the fair value measurement was determined using quoted prices from an active market, observable inputs (such as prices for similar assets), or fair value measurements based on a model, and adjust his or her audit procedures based on the nature of the information provided by the pricing service. In addition, if the price is not based on quoted prices from an active market or observable inputs (such as prices for similar assets), the auditor should obtain an understanding of the model and evaluate whether the assumptions are reasonable. When management uses a pricing service, the auditor should also evaluate whether the assumptions used by the pricing service reflect the price to sell the asset or paid to transfer the liability in the principal market (or most advantageous market if the company has no principal market). If the pricing service valuation is based on actual trades or quotes, the auditor should evaluate whether those traded or quoted prices would be available to the company in the company’s principal market (or most advantageous market, if the company has no principal market). For example, a pricing service might provide an amount for which a large financial institution could sell the financial instrument. However, a company that owns that financial instrument might not be able to transact in the same market as a large financial institution. If the price available to a large financial institution would not be available to the company, then that price may not be an appropriate measure of fair value.


Figure 18-7 Auditor’s Procedures on a Schedule of Available -For-Sale Investment W/P Ref: AFSI-9 Schedule of Available-For-Sales Investment Client: ABC Company

Prepared by:

Stock Document Certificate SC – Record CDJ – Cash Disbursements Journal Record CRJ – Cash Receipts Journal Acct801 – Market Adjustment - Available-For-Sales Investment Acct802 - Unrealized Gain (Loss) in Available-For-Sale Investment Acct803 – Dividend Account Investee

Certificate No. #

FF Co. GG Co. HH Co. II Co.

F569 G9982 H342 I0085

e t ^ f ff  v q 

a

Date Acquired

No. of Shares

Cost per Share

Balance 01.01.2001

Reviewed by:

Purchases

Sales

Balance 12.31.2001

Pat Kay

Market price at 12.31.2001 Per Share 24.50 q

Date: 01.10.2002

v $19,800^  16,600 3,700 ^ 3,700 v 17.00 q 10,900 ^ 10,900 t _____ _____ 29.25 q 34,400 t 47,300 t 3,700 16,600 ====== ===== ===== ====== ff f f f Fair value over (under) cost at 12/31.2001: Balance in Market Adjustment– Available-For-Sales Investment (Acct801) before current adjustment: Current adjustment required– Increase (Decrease): e e e e

3.2.2000 8.3.2000 3.1.2001 6.2.2000

900 500 200 400

22.00 33.20 18.50 27.25

$19,800 t 16,600 t

Date: 01.25.2002

Market price at 12.31.2001 Total $22,050

Dividend Income

3,400 11,700 37,150 ====== f $2,750 1,250 1,500 a ====

675  127  120  922  === f

Examined stock certificates at Stock Trust Co. Traced to prior year’s audit working papers. Traced to general ledger balance. Footed. Footed and Cross-footed. Extension checked. Vouched to brokers’ advice and minutes of broad of directors’ authorization. Per market quotation in 1.2.2002 Wall Street Journal. Dividend rateschecked to Standard andPoors; Dividendreceived tracedto Cash Receipts Journaland Dividend Account(Acct803). Adjusting entry-posted to W/P AJE-3: Dr. Market Adjustment– Available-For-Sale Investment (Acct801). Cr. Unrealized Gain (Loss) in Available-For-Sale Investment (Acct802).

Conclusion: Requested the accountant to make the adjusting entry. Follow-up to the adjusting entry request indicated that the accountant has made the adjustment as at 1.3.2002.

491

492


Figure 18-8 A Summary of SFAS No.115, Accounting for Certain Investments in Debt and Equity Securities

Question Does the investor influence or control?

have

Presentation on Financial Statements

Change in Fair Value Other-ThanTemporary Temporary Loss

substantial

(1) Investor owns 20% to 50% of stock and has significant influence but not control of the corporation Use Equity Method

On BS at historical cost plus share of earnings since acquisition less dividends received (amortization may also be required)

NA

Realized loss on IS, new basis on BS

NA

NA

NA

Realized loss on IS, new basis on BS

NA

Realized loss on IS, new cost basis on BS

Recognized on IS and included in RE

No additional entries needed

Reported on SCI and included in AOCI

Realized loss on IS, new cost basis on BS

(2) Investor owns over 50% of stock or otherwise controls the corporation Consolidation Required Consolidated financial statements Does a readily determinable fair value exist? On BS at historical cost If Not, Use Cost Method For debt securities, does the enterprise have the positive intent and ability to hold to maturity? On BS at amortized cost Classify as Held-to-Maturity

IS includes amortization of premiums and discounts Disclose fair value in notes Is the investment objective to generate profits on short-term differences in price? On BS at fair value Classify as Trading Securities

IS reports unrealized gain/loss for period All other debt and equity securities are classified as Available-for-Sale Securities

On BS at fair value SCI reports hold gain/loss for period

AOCI = accumulated other comprehensive income (owners. equity account); BS = balance sheet; IS = income statement; RE = retained earnings; SCI = statement of comprehensive income; and NA = not applicable (since investments are not carried at fair value).



An auditor obtainsa January 10 cutoff bank statementfor his client directly fromthe bank. Few of the outstanding checkslisted on his client’s December 31 bank reconciliation cleared during the cutoff period. A probable cause of this is that the client a. is engage in kiting. b. is engaged in lapping. c. transmitted the checks to the payees after year-end. d. has overstated its year-end bank balance.

18-2

The auditor shouldmail a standard bank confirmation formto all banks with which the client has conducted any business during the year, regardless of the year-end balance, because a. the conformation form also seeks information about indebtedness to the bank. b. this procedure will detect kiting activities that would otherwise not be detected. c. this procedure is required by generally accepted auditing standards. d. this procedure relieves the auditor of any responsibility with respect to non-detection of forged checks.

18-3

The usefulness ofthe standard bank confirmation request may be limited because the bank employee who completes the form may a. not believe the bank is obligated to verify confidential information to a third party. b. sign and return the form without inspecting the accuracy of the client’s bank reconciliation. c. not have access to the client’s bank statement. d. be unaware of all the financial relationships that the bank has with the client.

18-4

Which of the following is a better audit procedure to detect kiting? a. Review composition of authenticated deposit slips. b. Review subsequent bank statements and cancelled checks received directly from the bank. c. Prepare a schedule of bank transfers from the client’s books. d. Prepare year-end bank reconciliation.

18-5

The cashier of a company covered a shortage inhis cash working fund with cash obtainedon December 31from a local bank A by cashing an unrecorded check drawn on the company’s head quarter bank B. The auditor would discover this manipulation by a. preparing independent bank reconciliation as of December 31. b. counting the cash working fund at the close of business on December 31. c. investigating items returned (cancelled checks) with the bank cutoff statements. d. confirming the December 31 bank balances

18-6

On receiving the cutoff bank statement, the auditor should trace a. deposits in transit on the year-end bank reconciliation to deposits in the cash receipts journal. b. checks dated before year-end to outstanding checks listed on the year-end bank reconciliation. c. deposits in transit on the cutoff statement to deposits in the cash receipts journal. d. checks dated after year-end to outstanding checks listed on the year-end bank reconciliation.

18-7

Which of the following controls would most effectively ensure that the proper custody of assets in investments is maintained? a. Direct access to securities in the safe-deposit box is limited to one corporate officer. b. Personnel who post investment transactions to the general ledger are not permitted to update the investment subsidiary ledger. c. Purchase and sale of investments are executed on the specific authorization of the board of directors. d. The recorded balances in the investment subsidiary ledger are periodically compared with the contents of the safedeposit box by independent personnel.

18-8

When an auditor is unable to inspect and count a client’s investment securities until after the balance sheet date, the bank where the securities are held in a safe-deposit box should be asked to a. verify any differences between the contents of the box and t he balances in the client’s subsidiary ledger. b. provide a list of securities added and removed from the box between the balance sheet date and the security-count date. c. confirm that there has been no access to the box between the balance sheet date and the security-count date. d. count the securities in the box so that the auditor will have an independent direct verification.

493

494


18-9

Which of the following is the most effective audit procedure forverifying dividends earnedon investments in equity securities? a. Trace deposits of dividend checks to the cash receipts book. b. Reconcile amounts received with published dividend records. c. Compare the amounts received with prior-year dividends received. d. Recompute selected extensions and footings of dividend schedules and compare totals to the general ledger.

18-10

The standard bank confirmation form has been agreed upon by the a. SEC and FASB. b. AICPA and the SEC. c. SEC and the American Bankers’ Association. d. AICPA and the American Bankers’ Association.

18-11

Which of the following errorswould be least likely to be discovered duringthe tests of the bank reconciliation? a. Payment to an employee for more hours than s/she worked. b. Cash received by the client subsequent to the balance sheet date was recorded as cash receipts in the current year. c. The existence of payments on notes payable that were debited directly to the bank balance by the bank but were not entered in the client’s records. d. Deposits recorded in the cash receipts records near the end of the year, deposited in the bank, and included in the bank reconciliation as a deposit in transit.

18-12

The audit procedure whichrequires theauditor to record thelast check number usedon the last day of the year and subsequently trace to the outstanding checks and the cash disbursements records is performed to satisfy the specific audit objective of a. occurrence. b. existence. c. completeness. d. cut-off.

18-13

The starting pointfor the verification ofthe balancein the general bankaccount is to obtain a. a bank reconciliation from the client. b. client’s cash account from the general ledger. c. a cutoff bank statement directly from the bank. d. the client’s year-end bank statement and reconcile it.

18-14

In establishing theexistence oroccurrence ofa long-term investmentin the form of publicly tradedstock, an auditor should a. correspond with the investee company to verify the number of shares owned. b. inspect the audited financial statement of the investee company. c. confirm number and details of stocks owned that are held by an independent custodian. d. determine that the investment is carried at the fair market value.

18-15

The primarypurpose of sending a standard bankconfirmation requestto banks with which the client has done business during the year is to a. detect kiting activities that may otherwise not be discovered. b. corroborate information regarding deposit and loan balances. c. provide the data necessary to prepare a proof of cash. d. request information about contingent liabilities.

18-16

An auditor usuallytests the reasonableness ofdividend incomefrom investments bycomputing theamounts thatshould have been received by referring to a. dividend record books published by investment advisory services. b. stock indentures published by stock transfer agents. c. stock ledgers maintained by independent registrars. d. annual audited financial statements issued by the investee company.

18-17

An unrecorded checkissued duringthe last week of the year would most likely be discovered bythe auditor when a. the check register for the last month of the year is reviewed. b. the cutoff bank statement is reviewed as part of the year-end bank reconciliation. c. the bank confirmation is reviewed. d. the search for unrecorded liabilities is performed.


18-18

Internal control overcash receiptsis weakened whenan employee who receives customermail receipts also a. prepares initial cash receipt records. b. prepares bank deposit slips for all mail receipts. c. maintains a petty cash fund. d. records credits to individual accounts receivable.

18-19

An auditor shouldtrace bank transfers forthe last part of the audit period and first part of the subsequentperiod to detect whether a. the cash receipts journal was held open for a few days after the year-end. b. the last checks recorded before the year-end were actually mailed by the year-end. c. cash balances were overstated because of kiting. d. any unusual payments to or receipts from related parties occurred.

18-20

Which of the following frauds is least likelyto be detected by a schedule of four-columnproofs of cash preparedby the auditor? a. A theft of cash when the cash was stolen before being recorded in the client’s book. b. A theft of cash which is concealed by lapping customers’ accounts. c. A theft of cash by inter-bank transfers just before the end of an accounting period. d. A theft of cash by preparing erroneous bank reconciliation.

18-21

Which of the following pairsof accounts wouldan auditor mostlikely analyze on the same audit working paper? a. Notes receivable and interest income. b. Accrued interest receivable and accrued interest payable. c. Notes payable and notes receivable. d. Interest income and interest expense.

18-22

An auditor would most likely verify the interest earned on bond investments by a. vouching the receipt and deposit of interest checks. b. confirming the bond interest rate with the issuer of the bonds. c. recomputing the interest earned on the basis of face amount, interest rate, and period held. d. testing internal controls relevant to cash receipts.

18-23

A client has a large and active investmentportfolio thatis kept in a bank safe-deposit box. fI the auditor is unable to count the securities at the balance sheet date, the auditor most likely will a. request the bank to confirm to the auditor the contents of the safe-deposit box at the balance sheet date. b. examine supporting evidence for transactions occurring during the year. c. count the securities at a subsequent date and confirm with the bank whether securities were added or removed since the balance sheet date. d. request the client to have the bank seal the safe-deposit box until the auditor can count the securities at a subsequent date.

18-24

An auditor performing TOB on long-term investments wouldordinarily use analytical procedures toascertain the reasonableness of a. existence of unrealized gains or losses. b. completeness of recorded investment income. c. classification as available-for-sale or trading securities. d. valuation of trading securities.

18-25

In confirming withan outside agent,such as a financial institution,that the agent is holding investmentsecurities in the client’s name, an auditor most likely gathers evidence in support of management’s assertions of existence or occurrence and (Hint: Think about ‘in the cli ent’s name’) a. valuation or allocation. b. rights and obligations. c. completeness. d. presentation and disclosure.

495

496


18-26

To satisfy the valuation assertion concerning undistributed income when auditing an investor client’s investment accounted for yb the equity method, an auditor most likely would a. inspect the stock certificates evidencing the investment. b. examine the audited financial statements of the investee company. c. review the broker’s advice or canceled check for the investment’s acquisition. d. obtain market quotations from financial newspapers or periodicals.

18-27

An auditor suspects that a cli ent’s cashier is misappropriating cash receipts for personal use by lapping customer checks received in the mail. In attempting to uncover this embezzlement scheme, the auditor most likely would compare the

a. dates checks are deposited per bank statements with the dates remittance credits are recorded. b. daily cash summaries with the sums of the cash receipts journal entries. c. individual bank deposit slips with the details of the monthly bank statements. d. dates uncollectible accounts are authorizes to be written off with the dates the write-offs are actually recorded. 18-28

The best evidence regarding an audit client’s year-end bank balances is documented in the

a. cutoff bank statement. b. bank reconciliations. c. interbank transfer. d. bank deposit lead schedule. 18-29

Which of the following setsof information doesan auditor usually confirmon one form (i.e., a same piece of document)? a. Accounts payable and purchase commitments. b. Cash in bank and collateral for loans. c. Inventory on consignment and contingent liabilities. d. Accounts receivable and accrued interest receivable.

18-30

The standard AICPA form directed to financial institutions requestsall of the following except a. due date of a direct liability. b. the principal amount paid on a direct liability. c. description of collateral for a direct liability. d. the interest rate of a direct liability.

18-31

Which of the following cashtransfers resultsin a misstatement ofcash at December 31,2000? (Hint:Think of kiting)

Transfer a. b. c. d. 18-32

Bank Transfer Disbursement Recorded in Books Paid by Bank 12.31.2000 01.04.2001 01.04.2001 01.05.2001 12.31.2000 01.05.2001 01.04.2001 01.11.2001

Schedule Receipt Recorded in Books Received by Bank 12.31.2000 12.31.2000 12.31.2000 01.04.2001 12.31.2000 01.04.2001 01.04.2001 01.04.2001

Which of the following internalcontrol procedures would a client most likely use in safeguardingagainst the loss (theft) of trading securities? a. An independent trust company that has no direct contact with the employees who have record-keeping responsibilities has possession of the securities. in the client’s safe each year on the balance sheet date. b. The internal auditor verifies the trading activities c. The external auditor traces all purchases and sales of trading securities through the subsidiary ledgers to the general ledger. d. One designated member of the board of directors controls the securities in a bank safe-deposit box.

18-33

Which of the following internalcontrol procedures woulda client mostlikely use to safeguard marketablesecurities when an independent trust agent is not employed? a. The investment committee of the board of directors periodically reviews the investment decisions delegated to the treasurer. b. Two company officials have joint control of marketable securities, which are kept in a bank safe-deposit box. c. The internal auditor and the controller independently trace all purchases and sales of marketable securities from the ledgers to board the general ledger. d. subsidiary The chairman of the verifies the marketable securities, which are kept in a bank safe-deposit box, each year on the balance sheet date.


18-34

Which of the following internalcontrol procedureswould a client mostlikely use to assist in satisfying thecompleteness assertion related to long-term investments? a. Senior management verifies that securities in the bank safedeposit box are registered in the client’s name. b. The internal auditor compares the securities in the bank safe-deposit box with recorded investments. c. The t reasurer vouches the acquisition of securities by comparing brokers’ advices with canceled checks. d. The controller compares the current market prices of recorded investments with the brokers’ advices on file.

18-35

Auditing investmentis no different fromauditing currentassets (e.g.,inventory), forshort-term investments andlong-term assets (e.g., property, plant and equipment) for long-term investments. However, auditor should note a distinctive feature when auditing investment, which is: a. The level of preliminary judgment about material (PJAM) is relatively high. b. The level of control risk (CR) is relatively low. c. The level of materiality threshold (MT) is relatively low. d. The level of inherent risk (IR) is relatively high.

18-36

For the specific auditobjective ofvaluation aboutpresentation anddisclosure, whichof the following isnot an example of factors that may indicate an other-thantemporary impairment condition of a client’s investments? a. The decline in fair value is attributable to specific conditions, such as conditions in an industry or in a geographic area. b. Management does not possess both the intent and the ability to hold the investment for a period of time sufficient to allow for any anticipated recovery in fair value. c. A debt security has been upgraded by a rating agency. d. The decline in fair value has existed for an extended period of time.

18-37

Which of the following available-for-sale investments (within12 months) meets the specific audit objective of understandability? a. Reported at fair value under currentassets on the balance sheet. Unrealized gains and losses are reported under “Other revenue, gains, and losses” and above “Net Income” on the income statement. b. Reported at amortized cost under current assets on the balance sheet. c. Reported at fair value under longterm assets on the balance sheet. Unrealized gains and losses are reported in “Other Comprehensive Income” and below “Net Income” on the income statement. d. Reported at fair value under current assets on the balance sheet. Unreali zed gains and losses are reported in “Other Comprehensive Income” and below “Net Income” on the income statement, and in “Accumulated Other Comprehensive Income” and below “Retained Earnings” on the balance sheet.

18-38

According to the concept of the fair value hierarchyof inputs, a fair valuemeasurement isnot determined bywhich of the following level of inputs? a. Level 1 inputs, which are quoted prices (unadjusted) in active markets for identical assets or liabilities that the management has the ability to access at the measurement date. b. Level 2 inputs, which are inputs other than quoted prices within Level 1 that are observable for the asset or liability, either directly or indirectly. c. A significant adjustment to a Level 2 input could result in the Level 2 measurement becoming a Level 1 measurement. d. Level 3 inputs, which are unobservable inputs for the asset or liability.

18-39

Which of the following isnot a guidance tothe auditor in Auditing StandardsAU 540,Auditing Accounting Estimates, Including Fair Value Accounting Estimates and Related Disclosures ? a. The auditor should consider whether to engage a specialist and use the work of that specialist as evidential matter in performing audit procedures related to the fair value measurement. b. The auditor should determine the nature of the information provided by a pricing service used by management for its fair value measurements. c. The auditor should be alert for circumstances in which management may have an incentive to inappropriately classify fair value measurements within the three levels of the fair value hierarchy of inputs. d. The auditor should be aware of the decreased risk of management bias when it uses unobservable market inputs in a fair value measurement.

497

498



18-1 c. 18-2 a. 18-3 d. 18-4 c. 18-5 c. 18-6 b. 18-7 d. 18-8 c. 18-9 b. 18-10 d. 18-11 a. 18-12 d. 18-13 a. 18-14 c. 18-15 b. 18-16 a. 18-17 b. 18-18 d. 18-19 c. 18-20 a. 18-21 a. 18-22 c. 18-23 d. 18-24 b. 18-25 b. 18-26 b. 18-27 a. 18-28 b. 18-29 b. 18-30 b. 18-31 b. 18-32 a. 18-33 b. 18-34 b. 18-35 d. 18-36 c. 18-37 d. 18-38 c. 18-39 d.


Simulation Question 18-1 Simulation Question 18-1 is an adaptation with permission from a case by Hogan, T.J., J.L. Bierstaker, and E.S. William inIssues the in Accounting Education , a publication of the American Accounting Association in Sarasota, Florida. This simulation question is based upon a true set of facts; however, the names and places have been changed.



Audit Planning Meeting

Barbara Jeffrey, a partner with Cote & Company, CPAs, is responsible for the audit of Local 829. Barbara assigned to the audit several members of her staff; each of whom had varying levels of experience related to audits of health and welfare plans. She called a meeting to introduce the members of the audit team. would like to startcompanies. by int roducing ourtonewest firm, Emily O’Donnell. She worked onestart yearthe forintone of the Big 5 irms f and focused“Ion manufacturing I’d like take a member moment of to the introduce ourselves to her. Bill, would you roductions?” “Hi. I’m Bill West. I started with Cote & Company last year after leaving a CPA firm in upstate New York to relocate to Boston. I’ve worked many nonprofits in the past, in audits of pension plans as well as health and welfare.” “Hi, Emily, I’m Tom Myers. I started here in ’95 and was promoted to senior accountant in ’98. If you have any questions, Emily, feel free to ask.” “Thanks, I will,” Emily replied, “I’m looking forward to working with all of you.” “Emily,” said Barbara, “we may do things a little differently compared to your experience. Tom will be the ‘in-charge’ staff accountant, but there will be times when he will defer in particular areas to others with more experience. I will be both partner and manager on this job. As a company, wedon’t have much experience on health and welfare plans, but we want to build our business in this market. We’ll all be learning together. Do your homework. A copy of Audits of Employee Benefit Plans,1 the AICPA’s industry audit guide, is in the firm’s library (hereafter, Audit Guide). We’ll be using PPC audit programs,2 so scan ahead on the areas you’ll be assigned, Tom…” Tom readied his pad and pencil to take notes. “I’m most concerned with the asset areas of Investments and Receivables. This is yours to review, Tom. You’ll be putting the financial statements together and drafting the auditors’ report.” “Emily, you’ll be helpful in testing asset balances and performing transaction tests.” “I can do that,” said Emily. “Here is a general Background Memorandum of the company for all of you to look over, OK? I’ve given you plenty to chew on. I’ll see you at the client’s office in a few days.”



Background Memorandum

Local 829 Laborers Union Health Benefit Fund and Employee Activity Fund are multi-employer plans financed by employer contributions. The two funds provide skilled union construction laborers and their dependents and beneficiaries the following benefits: Health Benefit Fund: Medical Dental Pharmaceutical Employee Activity Fund: Sick-leave benefit Ms. Catherine Joshua has been Plan Administrator of the Funds for the last 15 years. Her overall management duties include responsibility for the Plan’s financial statements. As the Union Plan Administrator, she has the responsibility to manage the plans and provide plan participants with the Fund’s financial information. She supervises people who maintain the accounting records, process benefit claims, bill contractors, and process cash payments and receipts. The various contractor-employers make Health Benefit Fund contributions to the central union office. For the Health Benefit Fund, employer contributions are based on a negotiated hourly charge times the number of hours a union member works on a construction job per week. The contractor-employers pay salaries directly to employees; the union office pays for medical, dental, and pharmaceutical costs of union members from the Health Benefit Fund. Last year, employers paid $6 per hour into the Health Benefit Fund. Payroll records indicate that there were approximately 400,000 hours worked. Previously, funding of the Employee Activity Fund came from contractors-employers, who withheld a small part of member salaries, and paid it to the Fund. The Fund used the money to give to members when they were sick and not receiving salaries. Funding of the Activity Fund has been dropped in favor of a new contract increasing salaries. As long as resources permit, the Employee Activity Fund will continue to make payments to ill members for sick time. Once the Activity Fund for ill members is depleted, individuals will no longer receive pay for sick time and the Activity Fund will be eliminated. Then, only the Health Benefit Fund will remain. The audit for 1998 was performed yb BSH, a local CPA firm. This year’s audit, for 1999, was appointed to Cote & Company. Upon acceptance, Cote & Company requested and received permission from fund management to communicate with BSH for work papers relating to the previous year’s audit. You should access Data File 181 in iLearn for Tables 1 and 2, which present BSH’s work on Health Benefit Plan in 1997.

Local 829’s Plan management changed auditors because they felt that the previous year’s audit had been poorly planned and supervised. In addition, audit personnel testing investments seemed inexperienced.



Discussing Financial Statements

At the Local 829, Emily leaned over Tom’s desk with the 1998 Financial Report in hand and asked, “Why wasn’t a balance sheet presented in last year’s financial statements? I’m also missing an income statement.” 1 2

American Institute of Certified Public Accountants (AICPA) 2000, Audits of Employee Benefit Pla ns. New York, NY: AICPA. Practitioners Publishing Company (PPC), “Guides to Audits of Employee Benefit Plans” available at http://PPCnet.com/

499

500


“You won’t see the same reports as in a manufacturing company, or in any publicly held company, for that matter. There’s a difference in the format and account types utilized. Instead of a balan ce sheet there’s aStatement of Net Assets Availa ble for Benefits.” [Note: Not provided in this simulation question.] “What do those data reveal?” “All assets available for benefits, less normal liabilities for accounts payable and accruals. There’s a separate Schedule of the Plan’s Benefit Obligations.” [Note: Not provided in this simulation question.] “So it is more a focus on net assets and current benefit obligations?” “Exactly.” “And the income statement is …” “Essentially the Schedule of Changes in Net Assets Available for Benefits.” [Note: Not provided in this simulation question.]



Testing Investments “That’s interesting,” Emily said, “but I really need to talk to you about investments. I looked at the client’s investment schedule of

1].” should access common stock for last year [1998] and this year [1999] [Tables 3 and 5] and compared it to the schedule for 1997 [Table You

Data File 18-1 in iLearn for Tables 1, 3 and 5, which present the investment schedules for 1997, 1998 and 1999. “I think more tests could have been performed in 1998 than were completed. For example, there is no indication that extensions of the

number of shares and price per share were tested [see Table 6 for stock-price data]. Purchase and sale transactions should have been agreed to the schedules. Tom, take a look at the list of 1998 and 1999 stock investment transaction [Table3 I‘ve 4] got here.” Emily continued, “CVS had a two-for-one stock split in 1998, but the number of shares for CVS on last year’s 1998 schedule wasn’t changed from the 1997 amount. I checked, and they didn’t sell any of the CVS stock. I’m concerned that a number of possible errors might be imbedded in the 1998 and 1999 working papers, including the number of shares, price per share, and the extensions and footings determining total market values of the stocks.” After completing work on the investment schedules, Emily presented her work to Tom for review and then began her next task.



Testing Receivables



Receivables in the Employee Sick-Leave Activity Fund

“Tom?” Emily asked. “Receivables are due from contra ctors who employ union members on construction projects. For each hour of employment $6 is paid to the Health Benefit Fund per Union laborer. Who determines that amount?” “It was a collective bargaining agreement between the Union and a consortium of regional contractors,” Tom said. “Weekly payroll information is sent to the Union office by each contractor. Expect a few weeks’ delay in transmission.” “What if the services of the Union member are no longer required?” “The member has to contact the Union Halland get on-the-job referral listing within one week.” “And if the person isn’t working after two weeks, who pays?” asked Emily. “The Union member has to make self-payments to the Health Benefit Fund, or health benefits would be terminated.”

While reviewing the Employee Sick-Leave Activity Fund used to pay union members for sick time, Tom noted a large balance ($3,597,000) in the “Contributions Receivable from Contractors” account. Extracts of the partialbalances of the two funds are shown below: Extract from the Laborers Local 829 Trial Balance Employee Health Benefit Fund Account Description

Cash Checking Account Cash Lowell Savings Bank Petty Cash Contributions Receivable from Contractors Members Self-Payments Accrued Interest and Dividends U.S. Gvt Security @ fair value (FV) Corp. bonds and debentures @ FV Common Stocks @ FV Certificate of Deposit Equipment Total

3

Assume the information was agreed to source documents.

1997

1998

1999 Unadjusted

$ 205,941 89,900 500

$ 279,702 97,829 500

$ 265,000 77,650 500

2,400,600 92,829 630,500 420,000 36,000,000 29,434,308 1,000,000 750,000

2,387,560 85,230 650,300 450,000 38,000,000 42,877,638 1,000,000 720,000

2,233,829 92,800 646,500 350,000 41,000,000 38,048,650 1,000,000

$71,024,578 ========

$86,548,759 ========

720,000 $84,434,929 =========


Extract from the Laborers Local 829 Trial Balance Employee Sick-Leave Activity Fund Account Description

Cash Checking Account Contributions Receivable from Contractors Certificate of Deposit Total

1997

1998

1999 Unadjusted

$ 295,000

$ 455,000

$ 165,000

3,650,000 1,700,000 $5,645,000 =======

3,600,000 800,000 $4,855,000 =======

3,597,000 50,000 $3,812,000 ========

Tom spoke with the Plan Administrator, Ms. Joshua. “I’mchanged concerned about the years.” large balance in the Contribution Receivable from Contractors account in the Employee Activity Fund.The balance hasn’t much in two “As you know,” began Ms. Joshua, “the sick-leave benefit was removed in the collective bargaining agreement. When the Employee Activity Fund is exhausted, members will not receive any monies when they’re sick. Only a few contractors are making paymentsto this fund.” Ms. Joshua continued, “There’s no way, Tom, that contractors could owe that amount. We might collect a few thousand dollars,but nothing more. I do recall, though, a Union meeting about ten years ago when some contractors were requested to reimburse the Sick-Leave Fund.” “Any follow-up on that?” asked Tom. “Not that I’m aware of.” “It would seem that more than three and a half million dollars would be considered significant,” thought Tom.

Required 1. a. Assume you are Emily, answer theollowing f questions relating to the analysis of Local 829’s Investment Schedules: i. ii. iii.

What management assertions regarding investments should be tested? What specific audit objectives should be met? What type of audit evidence, external or internal, should be gathered?

b. Based on your answers to 1.a.i, ii, and iii, apply appropriate audit tests to the 1998 and 1999 Local 829’s Investment Schedules. From iLearn, download Tables 3 and 5 from Data File 18-1 and perform audit tests directly on the schedules . Use standard audit symbols to mark the audit tests performed, for example,ff for footed and cross-footed. Your working papers should be in proper form. Include a heading, the

purpose of the analysis, preparer initials and date, and a discussion of the work performed as well as the results of such work. Assume that the schedule for 1997 (Table 1) and the list of transactions and events for 1998 and 1999 presented in Table 4 are correct. c. Include auditofworking papers a schedule,(i.e., for both 1998 1999, of anyprice stocks errors to the value) marketand value of the set stock. Provide a set in of your columns the srcinal information number of and shares, market perwith share, andrelating total market another of columns for the proper amounts. For Health and Welfare Plans, all investments are reported in the financial statements at fair value (Audit Guide, para.4.85). Your audit working paper schedule would be used to support suggested adjusting entry to the accounts. It is not necessary to propose adjusting entries for this simulation question. Note: Table 6 in Data File 18-1 provides you the stock price information . However, you can also obtain the stock price information from the Internet, such as from theWall Street Journal online version of Market Browserhttp://www.marketbrowser.com/mbwsjin.html , a free software application available for download. 2. Tom would like your assistance regarding the issue of Employee Sick-Leave Activity Fund. He would like you to prepare a memo to Barbara Jeffrey presenting her with options for addressing the apparent overstatement of $3,597,000 in “Contributions Receivable fromContractors” in the Employee Sick-Leave Activity Fund. In the memo, you should comment on whether this amount would be considered material, and the basis for your judgment. Note: Table 1 in Statement of Financial Accounting Concepts No.2 (para.166) provides examples of quantitative materiality guidelines (FASB 1986). It refers to SEC Accounting Series Release No.41, which requires separate disclosure of balance sheet items “ if 10 pe rcent or more of their immediate category or more than 5 percent of total assets.”

Simulation Question 18-2 Simulation Question 18-2 is an adaptation with permission from a case by Gordon T. P., and M.S. Niles inIssues the in Accounting Education , a publication of the American Accounting Association in Sarasota, Florida. This simulation question is based upon a true set of facts; however, the names and places have been changed.



Auditing Marketable Securities

On a chilly Monday morning in late February, Fred Braddock sipped coffee from a paper cup and stared at his laptop computer screen. Fred was in the coffee room of his audit client, Selden Systems (hereafter, SS), which was being used by his audit team from Sand and Rock, CPA LLP. Because SS was a publicly traded company that had a December 31, 2000 year-end, its financial statements needed to be filed with the

501

502


SEC by March 15, just 17 days after today’s date of February 26. Grey was in his third year with the CPA firm and had just been promoted to senior. This morning he was reviewing the work of his staff auditor, Mary Jensen. Mary had prepared a schedule supporting the presentation of SS’s marketable securities. Her audit working papers, labeled A-2asand A2a, are displayed in Exhibit 1. Additional relevant information from SS’s preliminary financial statements is included in Ex hibit 2. You should access Data File 182 in iLearn for Exhibit 1, which presents Mary’s audit working papers -2 and A A-2a, and Exhibit 2, which presents selected financial statement information for SS. Fred’s attention was particularly draw to the nearly 80 percent decline in accumulated other comprehensive income (AOCI) in stockholders’ equity. The account had gone from nearly $1 million on January 1 to just $212,110.63 at December 31. Since SS had no foreign –sale securities; this was confirmed by a quick subsidiaries and no defined benefit pension plan, Fred knew AOCI must be related to available-for look at working paper A-2 (Exhibit 1). Clearly, the market value of the investment portfolio had dropped significantly with the biggest declines attributable to Lucent Technologies and Microsoft. As he was reflecting on the numbers, Mary walk in, dropped her computer case and headed for the coffee machine. “Hi, Mary! I was looking at your analysis of the securities portfolio. I knew that the market was down and that the market downturn had hit the technology sector pretty hard, but, wow! I had no idea that Lucent had gone down so much during the last year. Microsoft really took a hit as well.” “Yeah, Selden [SS] is lucky. If its year-end were later, it would be even sores,” responded Mary. “What do you mean?” asked Fred. “Well, on January 1, 2000, Lucent’s stock price was $75. On December 31, 2000, the price was $13.50. Last Friday [February 23], it closed at $12.40,” said Mary. “Of course, the loss would have been partially offset by Microsoft, which seems to be recovering. Its stock is up 30 percent from around $43 to over $56 sincethe beginning of the year.” “Is some of this million-dollar decline in the portfolio caused by the sale of Caterpillar and CocaCola? “ asked Fred. “Um,” said Mary. “I don’t think so. They essentially took the proceeds and reinvested the money from Coca-Cola into Pepsico and from Caterpillar into Pfizer. So the decline in value is marketrelated.” Fred returned to his work, but the size of the marketable securities adjustment continued to nag him. He visited a financial information web page and verified Mary’s statement about the Lucent and Microsoft stocks. He also logged onto LexisNexis, read several articles, and made some notes as to ongoing problems at Lucent and Microsoft (see Exhibits 3 and You 4). should access Data File 18-2 in iLearn for Exhibits 3 and 4, which presents Fred’s Research on Lucent and Microsoft). The news wasn’t encouraging: the price of the Lucentstock had declined in value by 82 percent in 2000 alone. Microsoft was hardly better with a 63 percent decline. He inserted the CD-ROM containing FASB pronouncements and reviewed SFAS No.115 (FASB 1993). What he learned there increased his distress. He telephoned the audit manager on the SS engagement, Kathy Caldwell. She share his concerns and said she’d set up a meeting with the senior manager and the partner. “What I need you to do, Fred, is document your understanding of the situation and work up a preliminary position statement. Don’t talk to the client personnel yet. We want to make sure that our ducks are all in a row before they get alarmed- you know how excitable their CFO is. We need to get moving on this since we’re only two weeks away from our printing deadline.” Fred gathered the information he had located, and tried to outline the memo he needed to write. Different ideas about how the Lucent and Microsoft stocks should be valued and presented in the financial statements swirled in his head.

Required Kathy, the audit manager, would like your assistance regarding the issue of SS’s marketable securities. She would like you to prepare her a memo that addresses the following issues: 1. Although Lucent and Microsoft have, in the past, been included in SS’ portfolio of available-for-sale securities, at least five accounting alternatives are available now that the market values of these shares have declined significantly. Discuss the appropriateness of each of the following five accounting alternatives with reference to/citation of authoritative accounting and auditing literature: i. Leave Lucent and/or Microsoft in the available-for-sale portfolio on the basis that the decline in value was temporary. ii. Recognize in net income a realized loss on the basis that the decline in value was other than temporary. iii. Transfer Lucent and/or Microsoft to the trading portfolio. iv. Transfer Lucent and/or Microsoft to the held-to-maturity portfolio. v. Reclassify Lucent and/or Microsoft as an equity method investment. You should refer to/cite the following authoritative accounting and auditing literature: (a) AICPA. 2000. Audit Evidence – Specific Considerations for Selected Items. Statement on Auditing Standards AU 501. (b) FASB. 1997. Reporting Comprehensive Income. Statement of Financial Accounting Standards (SFAS) No. 130 (FARS abbreviation: FAS130). (c) FASB. 1993. Accounting for Certain Investments in Debt and Equity Securities. Statement of Financial Accounting Standards (SFAS) No. 115 (FARS abbreviation: FAS115). (d) FASB. 1995c. A Guide to Implementation of Statement 115 on Accounting for Certain Investments in Debt and Equity Securities (FARS abbreviation: Q&A115). FASB. 1995b. Emerging Issues Task Force (EITF) Appendix D-44: Recognition of Other-Than-Temporary Impairment upon the Planned Sale of a Security Whose Cost Exceeds Fair Value (FARS abbreviation: EITF D-44). SEC. 2004. Accounting for Noncurrent Marketable Equity Securities. Staff Accounting Bulletin (SAB) No. 59. 2. It is anticipated that SS’s CFO would strongly disagree with your recommendation of the five accounting alternatives to Kathy. i. Discuss from your (the auditor’s) perspective, which of the five accounting alternatives you would most likely recommend to Kathy? Support your argument with reference to/citation of authoritative accounting and auditing literature. ii. Discuss from CFO’s (the management’s) perspective, which of the five accounting alternatives the CFO would most likely ask you to recommend to Kathy? Support your argument with reference to/citation of authoritative accounting and auditing literature.


Simulation Question 18-3 Simulation Question 18-3 is an adaptation with permission from a case by Phillips, F. C., and B. Mackintosh inIssues the in Accounting Education , a publication of the American Accounting Association in Sarasota, Florida. This simulation question is based upon a true set of facts. However, the years during which the reported activities took place have been changed. Also, some of the names and places have been changed.



The Setting



Background Information

Wiki Art Gallery, Inc. (WAG) is a privately owned business started in 2006 by two students. Rob Wilco combined his entrepreneurial business interests with Stephen Conley's knowledge of artwork to create an online art gallery, which they named WAG. WAG's start-up years were challenging. The owners contributed their savings to the company, but initially earned little return on their significant investments of money and time. Propelled by a belief that their work would pay off, they persevered. Now, it appears their luck is changing. WAG became profitable in late 2009 and has reported a sizable net income for the year ended September 30, 2011. Both owners are excited by this turn of events. In the summer of 2010, Stephen had indicated he would like to buy-out Rob, which coincided with Rob's interest in leaving WAG and embarking on a new career. Realizing that he has limited accounting knowledge, Stephen has approached you, a close friend and an experienced auditor, for advice. As a private company, WAG's shares do not have a readily available price. Consequently, Stephen and Rob have agreed to calculate the buy-out price using an “earnings multiplier” equal to five times WAG's GAAP-based net income for the year ended September 30, 2011. Although Rob has been a reliable friend and business partner in the past, Stephen is concerned that WAG's fiscal 2011 results could be misstated or biased because WAG does not obtain an annual audit. Stephen would like you to advise him whether WAG's fiscal 2011 net income fairly reports the company's financial success, given that the purchase price he will pay Rob is to be based on WAG's 2011 net income. Stephen explained that WAG obtains revenues from two sources. First, WAG purchases art from promising artists and sells it to individuals and traditional art galleries. Second, WAG charges annual artist fees in exchange for displaying their work in its online galleries. WAG's expenses relate to salaries, the cost WAG incurs to buy the artwork it sells, depreciation on WAG's computer equipment, website maintenance, and other administrative costs (e.g., bad debts, interest, income taxes). WAG has many transactions with artists and customers throughout the year. Stephen described some of the particularly significant events that happened during the year ended September 30, 2011, which you summarized in Exhibit 1.You should access Data File 18-3 in iLearn for ExhibitHe 1. also provided you comparative income statements for the years ended September 30, 2011 and 2010 (see Exhibit 2), and excerpts from WAG's notes to the financial statements (see Exhibit 3). You should access Data File 18-3 in iLearn for Exhibits 2 and 3.

Required Stephen has asked you, a close friend and an experienced auditor, to prepare a memo that identifies and evaluates financial reporting choices that Rob has made that may have resulted in a biased measure of WAG's 2011 financial success. Specifically, for each accounting judgment or method that Rob has applied that might not fairly measure WAG's 2011 net income, you should: (1) Describe the choice, (2) Evaluate whether it is allowed under U.S. GAAP, (3) WAG's specific information how it with leadsU.S. to anGAAP unfair and measure WAG's 2011measure net income, (4) Use Propose an alternative choice thatto is explain in accordance wouldofyield a fairer of netand income. Stephen would like you to focus on accounting choices rather than investment decisions (i.e., buy-out Rob), given his primary focus on the fairness of WAG's 2011 net income. He indicated that he would consult with you about investment decisions later, but for now he wants you to focus on providing the accounting advice he currently needs.

503

504


Chapter 19 Completing the Audit Chapter Learning Outcomes (LOs) Checklist


LO19-1 Describe the audit procedures for identifying contingent liabilities; including inquiry of a client’s lawyer concerning contingent liabilities.



LO19-2 Discuss the auditor’s responsibilities for reviewing subsequent events; including audit procedures for testing subsequent events.



LO19-3 Discuss the auditor’s responsibilities for evaluating accounting estimates; including audit procedures for testing specific accrued liabilities.



LO19-4 Discuss the auditor’s responsibilities for reviewing related-party transactions; including audit procedures for identifying and examining related-party transactions.



LO19-5 Discuss the auditor’s responsibilities for reviewing the work of a specialist; including audit procedures on using the work of a specialist.



LO19-6 Understand the auditor’s considerations for subsequently discovered facts.


Chapter 19 Completing the Audit Figure 19-1 provides an overview of the audit work performed by the auditor at the completing the audit of the audit process. Figure 19-1 Completing the Audit

The Audit Process

Audit Plan

Tests of Controls

Tests of Balances


Financial Audit

Audit Report

Integrated Audit

Review of Contingent Liabilities (LCAs)

Review of Subsequent Events (SEs)

Final Evidence Evaluation Processes

Communications with the Audit Committee and Management

Consider Subsequently Discovered Facts (SDFs)

505

506


Review of Contingent Liabilities (LCAs)

The auditor’s objectives in verifying contingent liabilities are to evaluate the accounting treatment of known contingent liabilities and to identify any contingencies not already identified by management. Examples of contingent liabilities and their accounting treatment are described in Table 19-1. Audi tor’s procedures for identifying contingent liabilities are divided into two categories: 1. Audit procedures related to tests done in other accounting cycles, and 2. Audit procedures conducted specifically in completing the audit phase of the audit process. Examples of these two categories of procedures are described in Table 19-2. Table 19-1 Contingent Liabilities and Accounting Treatments

Contingent Liabilities

Accounting Treatment (FASB No.5 Accounting for Contingencies )

Examples:

 

Probability

Quantifiability

Remote  Not estimated The chance of the contingent Amount of the contingent Actual or possible claims and event occurring is slight. event is not a factor. assessments.  Reasonably possible  Not estimated  Income tax disputes. The chance of the contingent Amount of the contingent event occurring is more than event is not a factor.  Product warranties or defects. remote but less than probable.  Guarantees of obligations to  Probable  Amount others. of the The chance of the contingent contingent event can be  Agreement to repurchase event occurring is likely to reasonably estimated. receivables that have been sold. occur.  Amount of the contingent event cannot be reasonably estimated. Pending or threatened litigation.



Reporting



Not reported



Disclose as footnotes in the financial statements.



Accrued as contingent liabilities in the income statement.



Disclose as footnotes in the financial statements.

Table 19-2 Audit Procedures for Identifying Contingent Liabilities

Procedures Related to Tests



in other Accounting Cycles

Read the minutes of meetings of the board of directors, committees of the board, and stockholders.



Review contracts, loan agreements, leases, and correspondence from government agencies.

Procedures Conducted Specifically



in Completing the Audit

Inquiry of and discussion with management about its policies and procedures for identifying, evaluating, and accounting for contingent liabilities.



Confirm guarantees and letters of credit of obtained from financial institutions or other lending agencies.

Examine documents in the client’s records such as correspondence and invoices from lawyers for pending or threatened lawsuits. Recall analysis of legal expenses in Chapter 14 on TOB in expenditure cycle. The results of that analysis may result in further examination for the existence of contingent liabilities relating to lawsuits.







Review income tax liability, tax returns, and IRS agents’ reports.



Inspect other documents for possible guarantees.

Obtain a lawyer’s representation letter (also known as legal letter) that describes and evaluates any litigation, claims, or assessments (LCAs). Figure 19-2, Table 19-3, and Figure 19-4 provide further discussion and examples on obtaining the lawyer’s representation letter according to AU 501Audit Evidence – Specific Considerations for Selected Items.



Obtain a management representation letter indicating that all litigation, asserted and unasserted claims, and assessments (LCAs) have been disclosed in accordance with FASB No.5. Figure 19-3 and Table 19-3 provide further discussion and examples on the management representation furnished by the client according to AU 580 Written Representation.


Figure 19-2 Inquiry of a Client’s Lawyer Concerni ng LCAs according to AU 501

Lawyer

7. Lawyers prepare and sign a

lawyer representation letter 1. about InformLCAs client

6. Send client’s inquiry letter

to the lawyer. Client

2. Inform auditor

about LCAs

5. Send both letters to client

Auditor

3. Prepare Management Representation letter Specifically: Auditor a. prepares a management representation letter b. Use the client’s letterhead c. Signed by TWO client officials (CEO & another officer) If refuses to sign, auditor issues qualified audit report based on limitation on audit scope. d. Dated to coincide with the audit report date. See Figure 20-3 for an example.

Prepare letter + Client’s Inquiry of Lawyer letter to obtainCover corroborative LCAs information given by the management. Specifically: a. Auditor prepares an auditor’s cover letter b. Auditor prepares a client’s inquiry of lawyer letter on the client’s letterhead c. Sign by ONE client official. d. Dated to coincide with the audit report date. 4.

8. Send lawyer’s representation letter to auditor

Note in Step No.7 above: 1. If a client’s lawyer were unable to form a conclusion about the likelihood of an unfavorable outcome of litigation, claims, or assessments because of inherent uncertainties, and the effect on the financial statements could be material, the auditor would ordinarily conclude that an explanatory paragraph should be added to an unqualified audit report in order to emphasize the lawyer’s inconclusive assessment. 2. If a client’s lawyer refuses to respond, auditor would ordinarily issue a qualified audit report based on limitation in audit scope. However, there is no limitation in scope if the lawyer simply limits the response to matters that the lawyer has given substantive attention in the form of legal representation.

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Table 19-3 Contents of Management Representation Letter and Lawyer Representation Letter

Management Representation Letter (AU 580 )

Lawyer Representation Letter (AU 501)

AU 580 Written Representations limits management representations to The contents of a lawyer representation letter include: material matter that are directly related to amounts included in the  A list and evaluation of any pending or threatened litigation to financial statements, such as the disclosure of compensating balance which the attorney has devoted substantial attention. The client’s arrangements involving related parties. Accordingly, this limitation management may prepare and provide the listto the auditor. Types does not apply to those management representations that are not of litigation include: directly related to amounts included in the financial statements, such as (1) Breach of contract the availability of minutes of stockholders’ and directors’ meetings. (2) Patent infringement The contents of a management representation letter include: (3) liability (4) Product Violations of government legislation, such as (a) securities laws,  Financial statements Management’s acknowledgement of its responsibility for the fair (b) anti-discrimination status based on race, sex, or age, (c) antitrust presentation in the financial statements of financial positions, and cashlaws, (d) income tax regulations, (e) environmental protection laws, (f) flows in conformity with GAAP. Foreign Corrupt Practices Act, and (g) RICO. Management’s belief that the financial statements are fairly presented  A list of unasserted claims and assessments considered by in conformity with GAAP. management to be probable of assertion and reasonably possible of  Completeness of information unfavorable outcome. Availability of all financial records and related data.  A request that the attorney describes and evaluates the Absence of unrecorded transactions. outcome of each pending or threatened litigation. This should  Recognition, measurement, and disclosure include the progress of the case, the action of the entity plan to take, Information concerning fraud involving (a) management, (b) the likelihood of unfavorable outcome, and the amount or range of employees who have significant roles in internal control, or (c) others potential loss. where the fraud could have a material effect on the financial  A request for additions to the list provided by the management statements. or a statement that the list is complete. Information concerning related party transactions and amounts receivable from or payable to related parties.



Significant risks and uncertainties Unasserted claims or assessments that the cli ent’s attorney has advised are probable of assertion and must be disclosed in accordance with FASB No. 5, Accounting for Contingencies. Satisfactory title to assets, liens or encumbrances on assets, and assets pledged as collateral. Compliance with aspects of contractual agreements that may affect the financial statements.  Subsequent events Subsequent events that have a direct effect on the financial statements and require adjustment. Subsequent events that have no direct effect on the financial statements but for which disclosure is advisable.



A request that the attorney comment on unasserted claims where his/her views differ from management’s evaluation.



A statement by management acknowledging an understanding of the attorney’s professional responsibility involving unasserted claims and assessments.



A request that the attorney indicates if his/her response is limited and the reasons for such limitation. A description of any materiality levels agreed upon for the purposes of the inquiry and response. 


Figure 19-3 An Example of a Management Representation Letter ABC Company 1st Street, San Francisco February 8, 201x XYZ CPA, LLP P. O. Box 888, San Francisco Gentlemen: We are providing this letter in connection with your audit of the consolidated balance sheet of ABC Company as of December 31, 201x, and the related consolidated statements of operations, stockholders’ equity, and cash flows for the years then ended for the purpose of expressing an opinion as to whether the consolidated financial statements present fairly, in all material respects, the financial position, results of operations, and cash flows in conformity with generally accepted accounting principles. Certain representations in this letter are described as being limited to matters that are material. Items are considered material, regardless of size, if they involve an omission or misstatement of accounting information that, in the light of surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information would be changed or influenced by the omission of misstatement. We confirm, to the best of our knowledge and belief, as of February 8, 201x, the following representations made to you during your audit. 1. The financial statements referred to above are fairly presented in conformity with generally accepted accounting principles. 2. We have made available to you all a. Financial records and related data. b. Minutes of the meetings of stockholders, directors, and committees of directors, or summaries of actions of recent meetings for which minutes have yet been prepared. 3. There have been no communications from regulatory agencies concerning noncompliance with or deficiencies in financial reporting practices. 4. There are no material transactions that have not been properly recorded in the accounting records underlying the financial statements. 5. There has been no a. Fraud involving management or employees who have significant roles in internal control. b. Fraud involving others that could have a material effect on the financial statements. 6. The company has no plans or intentions that may materially affect the carrying value of classification of assets and liabilities. 7. The following have been properly recorded or disclosed in the financial statements. a. Related-party transactions, including sales, purchases, loans, transfers, leasing arrangements, and guarantees, and amounts receivable from or payable to related parties. b. Guarantees, whether written or oral, under which the company is contingently liable. c. Significant estimates and material concentrations known to management that are required to be disclosed in accordance with the AICPA’s Statement of Position 94-6,Disclosure of Certain Significant Risks a nd Uncertainties. 8. There are no a. Violations or possible violations of laws or regulations whose effects should be considered for disclosure in the financial statements or as a basis for recording a loss contingency. b. Unasserted claims or assessments that out lawyer have advised us are probable of assertion and must be disclosed in accordance with Financial Accounting Standards Board (FASB) Statement No. 5, Accounting for Contingencies . c. Other liabilities or gain or loss contingencies that are required to be accrued or disclosed by FASB Statement No.5 9. The company has satisfactory title to all owned assets, and there are no liens or encumbrances on such assets, nor has any asset been pledged as collateral. 10. The company has complied with all aspects of contractual agreements that would have a material effect on the financial statements in the event of noncompliance. 11. Receivables recorded in the financial statements represent valid claims against debtors for sales or other charges arising on or before the balance sheet date and have been appropriately reduced to their estimated net realizable value. 12. Provision has been made to reduce excess or obsolete inventories to their estimated net realizable value. 13. Arrangements with financial institutions involving compensating balances or other arrangements involving restrictions on cash balances, line of credit, or similar arrangements have been properly disclosed. 14. We have fully disclosed to you all sales terms, including all rights of return or price adjustments and all warranty provisions. To the best of our knowledge and belief, no events have occurred subsequent to the balance sheet date and through the date of this letter that would require adjustment to or disclosure in the aforementioned financial statements.

____________________________________________ Mr. A, Chief Executive Officer

____________________________________________ Mr. B, Chief Financial Officer

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510


Figure 19-4 An Example of a Client’s Inquiry of Lawyer Letter ABC Company 1st Street, San Francisco December 15, 201x L & L, Attorneys 3rd Street, San Francisco Gentlemen: Our auditors, XYZ CPA, LLP (P. O. Box 888, San Francisco), are conducting an audit of our financial statements for the fiscal year ended December 31, 201x. In connection with their audit, we have prepared and furnished to them a description and evaluation of certain contingencies, including those attached, involving matters with respect to which you have been engaged and to which your devoted substantive attention on behalf of the company in the form of legal consultation or representation. For the purpose of you response to this letter, we believe that as to each contingency an amount in excess of $30,000 would be material, and in total, $90,000. However, determination of materiality with respect to the overall financial statements cannot be made until our auditors complete their audit. Your response should include matters that existed at December 31, 201x, and during the period from that date to the date of the completion of their audit, which is anticipated to be on or about February 8, 201x. Please provide to our auditors the following information: 1. Such explanation, if any, that you consider necessary to supplement the listed judgments rendered or settlements made involving the company from the beginning of this fiscal year through the date of our reply. 2. Such explanation, if any, that you consider necessary to supplement the listing of pending or threatened litigation, including an explanation of those matters as to which your views may differ from those stated and an identification of the omission of any pending or threatened litigation, claim, and assessment or a statement that the list of such matters is complete. 3. Such explanation, if any, that you consider necessary to supplement the attached information concerning unasserted claims and assessments, including an explanation of those matters as to which your views may differ from those stated. We understand that whenever, in the course of performing legal services for us with respect to a matter recognized to involve an unasserted possible claim or assessment that may call for financial statement disclosure, you have formed a professional conclusion that we should disclose or consider disclosure concerning such possible claim or assessment, as a matter of professional responsibility to us, you will so advise us and will consult with us concerning the question of such disclosure and the applicable requirements of Statement of Financial Accounting Standards No.5. Please specifically confirm to our auditors that out understanding is correct. Please specifically identify the nature of and reason for any limitations in your response.

Sincerely

_____________________________ Mr. P, Chief Executive Office ABC Company

Review of Subsequent Events

The auditor reviews transactions and events occurring after the balance sheet date to determine whether they might affect the fair presentation or disclosure of the client’s financial statements. Figure 19-5 shows the period covered by the auditor’s review of subsequent events. Table 19-4 discusses the timing of the subsequent events and the auditor’s responsibilities for reviewing such subsequent events in compliance with AU 560 Subsequent Events and Subsequently Discovered Fa cts.


Figure 19-5 Period Covered by the Auditor’s Review of Subsequent Events

Balance sheet date

1. Completion of fieldwork date 2. Client’s director report date 3. Audit report date

Dec 12/31

Feb 2/28

Subsequent Events (SEs), also known as “formal SEs”. No effect on audit report date, i.e., dated at the usual completion of fieldwork date.

1. Audit report issue date 2. End of audit responsibility date

March 3/31

Subsequent Events (SEs), also known as “new SEs”. Audit report date options: 1. One date at the audit report date and one date at the new SEs date, refer to as “dual dating.” 2. Only one date at the new SEs date. Note: Both options are not permitted if the SEs are reviewed and tested but NOT disclosed in the financial statements. The audit report should then be dated at the usual completion of fieldwork date.

Subsequently Discovered Facts (SDFs) If SDFs is factual, has material impact on the financial statements, and condition existed at the audit report date, then request revision to the financial statements, withdraw the audit report, and reissue a new audit report.

Registration Statement under Securities Act 1933. Review SEs to the effective date of the Registration Statement.

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Table 19-4 Timing and Auditor’s Responsibilities for Reviewing Subsequent Events

Timing of Subsequent Events (SEs)

Auditor’s Responsibility

The auditor is responsible for reviewing and testing “formal” subsequent events occur within this period. Subsequent events occur within this period have no impact on the date of audit report. Officially, the auditor should date the audit report on the date of the completion of the fieldwork. However, the auditor usually dates the audit report on the date of the client’s director report. The auditor is responsible for reviewing and testing “new” subsequent Between audit report date (2/28) and audit report and financial events occur within this period. Two options:



Between balance sheet date (12/31) and audit report date (2/28). This period begins with the client’s year-end balance sheet date and the auditor’s audit report signing date. Subsequent events occur within this period is also known as “formal subsequent events”.



(1) The auditor expands the review and tests ofall SEs to the “new” SEs date. In this option, the audit report consists of only one date, which is the date of the new SEs. (2) The auditor does not expand the review and tests of all SEs to the new SEs date. Instead, the auditor restricts the review and tests to specific SEs occurring within this period. In this option, the audit report consists of two dates, known “dual as dating”. The first date is the completion of the fieldwork as usual and the second date is the date of the new SEs. For example, an audit report is dual dated as follows: February 28, 2010, except for note 8, as to which the date is March 31, 2010. Note 8 deals with the specific subsequent events in the client’s financial statements. the auditor’s official responsibilities end at the date the audit  After the audit report and financial statement issue date (3/31). Since report and financial statements are issued, s/he has no obligation to Auditor’s official responsibilities end at the date the audit report and review or test SE occurring after this date. financial statements are issued. SEs occurring after this date that are SDFs is discussed in Table 19-8. Two categories of subsequent events occurring after the audit report SE occurring after this date that involve registration statement under and financial statements issue date: the Securities Act of 1933; the auditor is responsible for reviewing and (1) Subsequently discovered facts (SDFs), or testing the SE beyond the audit report date to the date the registration (2) Registration statement events. statement becomes effective. datethe (3/31). This statement period is issue between audit report date and the date the signed audit report, together with the client’s financial statements, are printed and issued to the stockholders. Subsequent events occur within this periodis also known as “new subsequent events”.

Types of Subsequent Events and Auditor’s Testing Procedures

The auditor is responsible for reviewing and testing two types of subsequent events. Table 19-5 describes the two types of subsequent events reviewed by the auditor. The audit or’s tests of the subsequent events are divid ed into two categories. Table 19-6 describes the two categories of auditor’s testing procedures for subsequent events. Table 19-5 Auditor’s Review of Two Types of Subsequent Events

Type I Events

Type II Events









These are events occurring after the balance sheet date that provide additional evidence about conditions that existed on or before the balance sheet date. These events have a direct effect on the financial statements and require adjustment of the financial statements. Note that whenever there is an adjustment made to the financial statements, an accompanying footnote is also made to the financial statements.

These are events occurring after the balance sheet date that provide evidence about conditions that did not exist on or before the balance sheet date. These events have no direct effect on the financial statements but for which disclosure in the form of footnotes to the financial statements is recommended.

 Examples of Type I events include:  Examples of Type II events include: (1) An uncollectible account receivable resulting from continued (1) An uncollectible account receivable resulting from unexpected deterioration of a customer’s financial condition leading to bankruptcy conditions arising subsequent to the balance sheet date. after the balance sheet date. (2) Purchase or disposal of a business by the client after the balance (2) The settlement of a lawsuit after the balance sheet date for an sheet date. amount different from the amount recorded in the year-end financial (3) Sale of a capital stock or bond issue by the client after the balance statements. sheet date. (3) Disposal equipment being used in operation after the balance (3) Loss of manufacturing facility or assets resulting from fire or sheet date at aofprice below not the recorded year-end book value. flood. (4) Sale of available-for-sale investments after the balance sheet date at (5) Decline in the market value of available-for-sale investments after a price above or below the recorded purchase price (cost). the balance sheet date.


Table 19-6 Auditor’s Two Categories of Testing Procedures for Subsequent Events

Procedures perform as part of year-end TOB of Accounting Cycles



Cut off procedures performed in the various accounting cycles that relate to transactions occurring after the balance sheet date. For example, cut off procedures on purchases one week after the balance sheet date.



Valuation test procedures performed in the various accounting

cycles that relate to transactions occurring after the balance sheet date. For example, valuation test procedures on collectability of accounts receivable after the balance sheet.

Procedures perform after balance sheet date specifically to discover subsequent events



Read any interim financial statements that are available for the period after year-end; they should be compared to the prior-period statements, and any unusual fluctuations should be investigated



Examine the books of srcinal entry (such as sales journals, purchases journal, cash receipts and cash disbursements journals) for the subsequent events period and investigating any unusual transactions.

 Inquire of management about: (1) Whether there were or are any substantial contingent liabilities or commitments existing at the balance sheet date or at the date of inquiry. (2) Whether there have been any significant changes in capital stock, long-term debt, or working capital. (3) The current status of any items in the financial statements that were accounted for based on preliminary or inconclusive data. (4) Whether any unusual adjustments have been made during the subsequent event period. 

Read the available minutes of meetings of stockholders, directors, or other committees for the subsequent event period.



Inquire of client’s lawyer about any litigation, claims, or assessments against the company (see Table 19-3).



Obtain a representation letter from the management (see Table 19-3).

Final Evidence Evaluation Processes

In addition to review of contingent liabilities and subsequent events, the auditor performs a number of audit procedures procedures. before deciding on the appropriate audit report to issue to the client. Table 19-7 describes some of these Table 19-7 Audit Procedures in the Final Evaluation Processes

Audit Procedures in the Final Evaluation Processes



Performance of Final Analytical Procedures AU 520 Analytical Procedures requires the auditor to perform analytical procedures (Recall Table 7-10 in Chapter 7 concerning analytical

procedures) at completing the audit phase of the audit process to identify any unusual or unexpected balances not previously considered.



Evaluation of Accounting Estimates

AU 540 Auditing Accounting Estimates, including Fair Value Accounting Estimates and Related Disclosures requires the auditor to evaluate accounting estimates to (1) Provide reasonable assurance that management developed all material estimates, and (2) Assure that the estimates are reasonable (free from bias) and are presented in the financial statements in accordance with GAAP. Examples of accounting estimates include: Airline passenger revenue, warranty claims, uncollectible accounts receivables, obsolete inventory, depreciation and amortization, income tax and accrued property taxes, pension costs, subscription income, percentage of completion income on construction contracts, and loss contingencies. In evaluating the reasonableness of accounting estimates: (1) The auditor normally concentrates on keyfactors and assumptions that are (a)significant to the accounting estimates, (b) sensitive to variations, (c) deviations from historical patterns, and (d) subjective and susceptible to misstatement and bias. (2) The auditor should first obtain an understanding of how management developed the estimate and then, based on his/her understanding, consider (a) reviewing and testing the estimation process used by the management, (b) developing an independent estimate for comparison, and (c) reviewing transactions or events that occurred subsequent to the balance sheet date that may affect the estimates. (3) The auditor must evaluate the reasonableness of accounting estimates in the context of the financial statements taken as a whole, and (a) the difference between the estimates best supported by the audit evidence and the estimate in the financial statements must be reasonable, (b) if the estimate in the financial statements is not reasonable, it should be treated as a likely error or fraud and aggregated with other likely misstatements, and (c) if the differences are individually reasonable but collectively indicate possible bias, the auditor must reconsider the estimates as a whole. Most accrued liabilities (expense) represent obligations payable sometime during the succeeding period for services or privileges received before the balance sheet date. Examples include interest payable, accrued property taxes, accrued payrolls and payroll taxes, income taxes payable, and

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514


Audit Procedures in the Final Evaluation Processes amounts accrued under service guarantees. In other words, accrued liabilities represent accounting estimates made by the client amounts that will subsequently become payable. For most accrued liabilities the audit approa ch will emphasize a review and test of management’s process of developing the estimates. Subjective (as well as objective) factors may make it difficult to establish control over accrued liabilities. As a result, these estimates may be particularly susceptible to misstatement, especially in circumstances in which management is under pressure to show increased earnings (i.e., earnings management). The basic auditing procedures for testing accrual liabilities are: (1) Examine any contracts or other documents on hand that provide the basis for the accrual. (2) Appraise the accuracy of the detailed accounting records maintained for this category of liability. (3) Identify and evaluate the reasonableness of the assumptions made that underlie the computation of the liability. (4) Test the computations made by the client in setting up the accrual. (5) Determine that accrued liabilities have been treated consistently at the beginning and end of the period. (6) For Consider the need for accrual of other accrued liabilities not considered (that is, test completeness). significant estimates, perform a retrospective analysis of thepresently prior year’s estimates for evidence of management bias. (7) The audit procedures for testing specific accrued liabilities are summarized in Table 19-8.



Review of Related-Party Transactions

AU 550 Related Parties defines related-parties to include (1) the reporting client; (2) its affiliates; (3) principal owners (own more than 10% of the voting interests), management and members of their immediate families; (4) equity-method investees; (5) trusts for the benefit of employees (e.g., pension or profit-sharing trusts that are managed by, or under the trusteeship of, management); and (6) any other party that can exercise significant influence over the reporting client, or over which the reporting client can exercise significant influence. Examples of related-party transactions include: (1) Parent-subsidiary transactions; (2) Transactions among subsidiaries of a common parent; (3) Transactions between related parties that are not given accounting recognition, such as, a parent providing free services to a subsidiary; (4) Transactions between related parties that disclose the legal form but which does not reflect the economicsubstance of the transactions, such as (a) Borrowing or lending money without charging interest or at an interest rate significantly lower than current market rate; (b) Making loans without scheduled repayment terms, (c) Selling real estate at a price considerably different from its appraised value, (d) Exchanging property for similar property in a non-monetary transaction. The auditor’s procedures for identifying and examining related-party transactions are summarized in Table in 19-9. After identifying and examining related-party transactions, the auditor must evaluate the appropriateness and sufficiency of evidence concerning the related-party transactions and determine the adequacy of their disclosure. Disclosure (i.e., understandability) is the primary specific audit objective concerning related party transactions. As a rule of thumb, if the client’s financial statement discloses a material related-party transaction that was not carried out on terms equivalent to those that would have prevailed inan arm’s length transaction , the auditor would issue a qualified or adverse opinion. Recall Table 5-1 in Chapter 5 that Sarbanes-Oxley Act of 2002 specifically prohibits related party transactions that involve personal loans to executives. It is now illegal for any public company to extend or maintain credit, to arrange for the extension of credit, or to renew the extension of credit in the form of personal loan to any director or executive officers. These restrictions do not apply to any loan, such as a home loan or credit card agreement, made by a bank or other insured financial institution under normal banking operation using market terms offered to the general public.

620 Using the Work of a n Auditor’s Specialist defines a specialist as a person possessing special skill or knowledge in a particular field other AU than accounting or auditing. Specialists include: actuaries (to determine the amount of a pension plan); appraisers (to evaluate assets such work of art); engineers (to determine the % of completion of a construction project); environmental consultants (to determine the impact of environmental laws and regulations), and attorneys (to assess the probable outcome of pending litigation). The auditor’s procedures on using the work of a speci alist are summarized in Table 19-10. As rule of thumb, after reviewing the work of a specialist, the auditor does not refer to the work of the specialist in the audit report. This is because such a reference may confuse readers of the audit report. However, the auditor may decide to refer to the work of the specialist in the audit report. A full spectrum of the auditor’s reporting alternatives concerning the work of a specialist is as follows: (1) Auditor issues unqualified opinion in a standard audit report - no reference to the work of the specialist in the audit report. – make reference to the work of the (2) Auditor issues unqualified opinion with an explanatory paragraph added to the standard audit report specialist in the audit report only if doing so will help clarify the reason for the explanatory paragraph. – no reference to the work of the specialist in the audit report. (3) Auditor issues qualified or disclaimer of opinion based on scope limitation (4) Auditor issues qualified or adverse opinion based on departure from GAAP – make reference to the work of the specialist in the audit report only if doing so will help clarify the reason for the qualification or adverse opinion. Review the Work of a Specialist



Evaluation of th e Client’s Going -Concern Status



Obtain a Management Representation Letter

AU 570 Going Concern requires the audit to perform analytical procedures (recall Tables 7-10, 7-11 and 7-12 in Chapter 7) and review of subsequent events at the completing the auditto evaluate whether there is substantial doubt about a client’s ability to continue as a going concern. AU 580 Written Representations requires the auditor to obtain a representation letter from the management (see Table 19-3 above) at the completing the audit phase of the audit process to corroborate oral representations made to the auditor and to reduce misunderstanding concerning the responses provided by the management to the auditor’s inquiry.

 Final Assessment of Audit Results The auditor’s final assessment of audit results is concerned with two i ssues: (1) The sufficiency of the audit evidence. The auditor determines whether there is sufficient evidence to support (a) specific audit objectives, (b) the assessment of IR and CR, and (c) the planned level of DR. If this final assessment indicates that the evidence is not sufficient to meet the planned level of audit risk, the auditor may need to gather additional evidence. (Recall Chapter 9 on audit risk). (2) The effects of detected misstatements in the financial statements.


Audit Procedures in the Final Evaluation Processes The auditor compares the total amount of misstatements to the amount of materiality allocated (TM) to the relevant component of the financial statement. The auditor also considers the effect of unadjusted immaterial misstatements. (Recall Chapter 9 on materiality). Finally, the auditor considers whether to include the previous year uncorrected (unadjusted) material misstatements to the current year uncorrected (unadjusted) material misstatements. Historically, the auditor may use either of two methods (approaches): (1) The rollover method (approach)– This method considers only the amount of the misstatement srcinating in the current year income statement. For example, if expenses were materially misstated by $20,000 in the previous year and $30,000 during the current year, the rollover , ignoring the previous year’s misstatement. method would quantify the total misstatement as $30,000 (2) The iron curtain method (approach)– This method considers the balance sheet effect of correcting the total misstatement existing at the end of the year, regardless of when the misstatement srcinated. For example, if expenses were materially misstated by $20,000 in the previous year and $30,000 during the current year, the iron curtain method would quantify the total misstatement as $50,000. Note that the SECStaff Accounting Bulletin No. 108 (SAB No.108) decreased the auditor’s flexibility in choosing between the two methods by bothbethe requiring that rollover ironthe curtain methods be the considered. If either method resultswould in a material misstatement, (correction) must made. Thus,and under rollover method, current year financial statements be adjusted (corrected) an foradjustment the current year $30,000 misstatement. On the other hand, under the iron curtain method, the current year financial statements would be adjusted (corrected) for the current year $30,000 misstatement as well as the previous year $20,000 misstatement as carryover misstatement that srcinated in the previous year. In addition, the previous year financial statements would be restated for the previous year $20,000 misstatement under both methods. Figure 19-7 show an example of the total misstatements documented in a working paper. Note that the misstatements in Figure 20-7 are adjusted for the effects of income taxes. To illustrate, consider the first misstatement, which represents an overstatement of prepaid expenses of $6,500. If that adjustment is not made, net income before taxes will be overstated by that amount. However, since taxable income is also overstated by $6,500, the company’s income tax expense is overstated, in this case by $2,600 (40% of $6,500). Also note that the 40 percent rate is used because it represents the company’s marginal tax rate.



Evaluation of Financial Statement Presentation and Disclosure



Review of Audit Working Papers

The auditor reviews a draft copy of the financial statements to ensure compliance with GAAP, proper presentation of accounts, and inclusion of all necessary disclosures. Most CPA firms use some type of financial statement checklist to assist the auditor in this evaluation process. (1) During the days of field work. An audit team member senior to the person preparing the working papers should review all audit work to ensure that (a) The audit was properly planned and supervised, (b) The evidence supports the audit objectives tested, and (c) The evidence is sufficient for the type of audit report issued. The senior auditor should conduct a detailed reviewof the working papers prepared bythe staff and follow-up on any unresolved problems or issues. The audit manager should review the working papers prepared by the senior auditor and to counteract any bias that enters into the senior auditor’s judgments. The engagement partner normally reviews working papers related to criti cal audit areas as well as working papers prepared by the manager. (2) On or about the last day of field work. The engagement partner reviews the entire set of working papers in detail to determine whether the working papers demonstrate compliance with GAAS and with the CPA firm’s quality control and performance standards. Usually, the engagement partner uses some type of working paper review checklist to do the review. Figure 19-6 shows an example of a working paper review checklist. After such a review, the engagement partner reaches an overall conclusion about the presentation of the financial statements taken as a whole. If the financial statements taken as a whole are presented fairly, the engagement partner would consider issue an unqualified opinion. Otherwise the engagement partner would consider issuing a qualified opinion, adverse opinion, or a disclaimer of opinion. Chapter discusses 20 the auditor’s opinion in greater detail.



Obtain an Independent Partner Review of the Engagement

known as a “cold review.” The Most CPA firms have a policy of requiring an independent partner to review the entire audit engagement,oals independent partner focuses on the sufficiency of the audit approach, findings, and conclusion, and the consistency of the audit report, financial statements, and footnotes for the audit engagement taken as a whole.

Table 19-8 Auditor’ s Procedures for Testing Specific Accrued Liabilities

Auditor’s Procedures for Testing Specific Accrued Liabilities (1) Accrued Property Taxes Property taxes payments are usually few in number and substantial in amount. It is, therefore, feasible for the audit working papers to include an analysis showing all of the year’s property tax transactions. Tax payments should be verified by inspection of the property tax bills issued by local government units and by reference to the related paid checks. If the tax accruals at the balance sheet date differ significantly from those of prior years, an explanation of the variation should be obtained The auditor should verify that property tax bills have been received on all taxable property or that an estimated tax has been accrued. (2) Accrued Payrolls Accrued gross salaries and wages appear on the balance sheets of virtually all companies. The accuracy of the amount accrued may be significant in the determination of total liabilities and also in the proper matching of costs and revenue. The verification procedure consists principally of comparing the amounts accrued to the actual payroll of the subsequent period and reviewing the method of allocation at the balance sheet date. Payments made at the first payroll dates of the subsequent period are reviewed to determine that no significant unrecorded payroll liability existed as of the balance sheet date. (3) Pension Plan Accruals permanent Auditing procedures for the accrued liability for pension costs may begin with a review of the copy of the pension planeinauditors’ th file. Then consideration should be given to the provisions of the Employee Retirement Income Security Act (ERISA). The auditors must determine that the client’s accrued pension liability is presented in accordance with FASB No.87, Employers’ Accounting for Pensions (as

515

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Auditor’s Procedures for Testing Specific Accrued Liabilities amended by FASB Nos. 132 and 158), including consideration of service cost, interest cost, amortization of transition and service costs, and gains and losses on pension plan assets. In auditing these amounts the auditor will obtain representations from an actuary and confirm the activity in the plan with the trustee, In evaluating the evidence from the actuary, the auditors should comply with the requirements of AU Using 620, the Work of an Auditor’s Specialist. (4) Postemployment Benefits Other Than Pensions Under FASB No.106, Employer’s Accounting for Postemployment Benefits Other tha n P ensions , companies must accrue, during the years that employees perform services, the expected costs ofproviding health and similar retirementbenefits to the employees,their beneficiaries, and their dependents. Determining the amount of these liabilities is a very complex procedure, because assumptions must be made about matters such as employee work lives and increases in medical costs. Since actuaries and other specialists develop these assumptions the auditor should evaluate the assumptions and the specialists’ qualifications in accordance with AU 620Using the Work of a n Auditor’s Specialist. (5) Accrued Vacation Pay This type of liability arises from two situations: (a) an employee entitled by contract to a vacation during the past year may have been prevented from taking it by an emergency work schedule, and (b) an employee may be entitled to a future vacation of which part of the cost must be accrued to achieve a proper matching of costs and revenue. The auditor’s verification of accrued vacation pay may begin with a review of the permanent file copy of the employment contract or agreement stipulating vacation terms. The computation of the accrual should then be verified the terms of the company’s vacation policy. both as to arithmetical accuracy and for agreement with (6) Product Warranty Liabilities The products of many companies are sold with a guarantee of agree service or replacement during a rather extended warranty period. The costs of rendering such services should be recognized as expenses in the year the product is sold rather than in a later year in which the replacement is made or the repair service is performed. If this policy is followed, the company will make an annual charge to expense and a credit to a liability account based on the amount of the year’s sales and the estimated future service or replacement cost. As repairs and replacements take place, the costs will be charged to the liability account. The auditor should review the client’s annual provision for estimated future expenditures and compute the percentage relationship between the amount in the liability account and the amount of the year’s sales. If this elationship r varies sharply from year to year, the client should be asked for an explanation. The auditor should also review the charges to the liability account month by month and be alert for the improper recording of other expenses in this account. Sudden variation in the monthly charges to the liability account requires investigation. In general, the auditor should determine that the balance in the liability account for service guarantees moves in reasonable relationship with the trend of sales. The auditor also should be alert for changes in the client’s products or repair costs that might affect the amount of the warranty liability. Finally, current income tax laws prohibit the deduction of provisions for warranty liabilities; deductions are permitted only when actual expenditures are incurred. Accordingly, the auditors should ascertain that the client is properly allocating income taxes attributable to the nondeductible provisions. (7) Accrued Commissions and Bonuses Accrued commissions to sales representatives and bonuses payable to managerial personnel also require verification. The essential step in this case is reference to the authority for the commission or bonus. The basis contracts should be examined and traced to minutes of directors’ meetings. If the bonus or commission is based on the total volume of sales or some other objective measure, the auditor should verify the computation of the accrual by applying the prescribed rate to the amount used as a base. (8) Income Taxes Payable Federal, state, and foreign income taxes on corporations represent a material factor in determining both net income and financial position. The auditor cannot express an opinion on either the balance sheet or income statement of a client without first obtaining evidence that the provision for income taxes has been properly computed. In the audit of small and medium-size clients, it is customary for the audit engagement to include the preparation of the client’s tax returns. If the client’s staff or other persons have prepared the income tax returns. The auditor must nevertheless verify the reasonableness of the tax liability in order to express an opinion on the fairness of the financial statements. In performing such a review of a tax return prepared by the client’s staff or by others, the auditor may sometimes discover an opportunityfor a tax saving that has been overlooked; obviously such a discovery tends to enhance the client’s appreciation of the services rendered by the auditor. In addition, the auditor should analyze the Income Taxes Payable account and vouch all amounts to income tax returns, paid checks, or other supporting documents. The final balance in the Income Taxes Payable account will ordinarily equal the computed federal, state, and foreign taxes on the current year’s income tax returns, less any payments thereon. The tax expected to be paid by a client often differs from the actual tax paid due to temporary differences between taxable income and pretax accounting income. These differences result in the need to establish deferred tax liabilities or assets. The auditor determines the amount of deferred tax liabilities using schedules referred to as “Tax Accrual” working papers, which usually are reviewed by one of the CPA firm’s tax specialists. Besides reviewing the computation of the income tax liability for the current year, the auditors should determine the date on which income tax returns for prior years were examined by IRS agents, as well as the particulars of any disputes or additional assessments. Review of the reports of revenue agents is also an essential audit procedure. In the firstudit a of a new client, the auditor should review any prior years’ income tax returns not yet examined by revenue agents to make sure that there has been no substantial underpayment of taxes that would warrant presentation as a liability. (9) Accrued Professional Fees Fees of professional firms include charges for the services of attorneys, public accountants, consulting engineers, and other specialists who often render services of a continuing nature but present bills only at infrequent intervals. By inquiry of officers and by review of corporate minutes, the auditor may learn of professional services received for which no liability has yet been reflected in the accounts. Review of the expense account for legal fees is always essential because it may reveal damage suits, tax disputes, or other litigation warranting disclosure in the financial statements. Recall the discussion on analyzing legal expenses in Chapter 14 Expenditure Cycle.

Table 19-9 Auditor’s Procedures for Identifying and Examining Related-Party Transactions

Auditor’s Procedures for Identifying and Examining Related-Party Transactions (1) Gain an understanding of theclient’s control environment (recall Table 8-1 in Chapter 8) that deliberately promotes or obscures related-party transactions. Examples of such control environment include:


Auditor’s Procedures for Identifying and Examining Related-Party Transactions

      

Lack of sufficient working capital or credit to continue in business. Desire for favorable earnings record to support expected stock price. An overly optimistic earnings forecast. Significant litigation between stockholders and management. Excess capacity or a declining industry with a large number of business failures. Dependence on a single (or relatively few) products, customers, or transactions for the ongoing success of the business. Significant risk of obsolescence because of being in a high technology industry.

(2) Identify obvious related-party transactions that are material by:  Evaluating the client’s procedures for identifying and accounting for related-party transactions.



Requesting the management for the names of all related parties and documenting any related-party transactions among them in the management representation letter (see point #7a in Figure 19-3 above).

  

Reviewing prior year’s audit working papers for the names of known related parties.

Inquiring the predecessor, principal, or other auditors of related parties as to their knowledge of known related-party transactions.

Determining the names of all pensions and trusts established for the benefit of employees and the names of their officers and trustees. These pension and trust transactions are relatedparty transactions if managed by or under the trusteeship of the client’s management.



Reviewing SEC filings for the names of related parties and for other business in which officers and directors occupy directorship or management positions.

 

Reviewing shareholder listings of closely held companies to identify principal stockholders.

Reviewing material investment transactions to determine whether the nature and extent of investment during the period create related parties. (3) Identify not so obvious related-party transactions that are material by:

 

Providing the audit team with the names of known related parties.

Reviewing the minutes of meetings of the board of directors and executive or operating committees for information about material transactions authorized or discussed at their meetings.

  

Reviewing proxy statements filed with the SEC for information about material transactions with related parties.

Reviewing conflict-of-interest statements obtained by the client from its management. Reviewing the extent and nature of business transacted with major customers, suppliers, borrowers, and lenders for indications of previously undisclosed relationships.



Reviewing the extent and nature of business transacted with major customers, suppliers, borrowers, and lenders for indications of guarantees by parties that may be considered related parties.



Reviewing invoices from law firms that have performed special services for indications of the existence of related parties or related-party transactions.

 

Reviewing confirmations of loans receivable and payable for indications of guarantees by parties that may be considered related parties.

Inquiring whether non-monetary transactions, such as free accounting or management expertise, are being provided but not recorded. (4) Apply audit procedures to assess the purpose, nature, extent, and effect of the related-party transactions on the financial statements. The procedures should extend beyond simply making inquiries of management to include: (a) Obtain an understanding of the business purpose of the related-party transaction by:

    

Examining pertinent documents such as invoices, contracts, and receiving and shipping documents. Determining whether appropriate officials, such as the board of directors, have approved the transaction. Testing the reasonableness of the amounts to be disclosed (or considered to be disclosed) in the financial statements. Contacting the auditors of related-parties (or related-party companies) for relevant information.

Inspecting the transferability and value of collateral. (b) Performing additional procedures needed to fully understand the particular related-party transaction by:

   

Confirming the amounts and terms of the transactions (including guarantees) with the other parties. Inspecting evidence that is in the possession of the other party (or parties) to the transaction. Confirming relevant information with such intermediaries as banks, guarantors, or attorneys.

Referring to trade journals, credit agencies, websites, etc., to verify transactions that disclose the legal form but which does not reflect the economic substance of the transactions.

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Auditor’s Procedures for Identifying and Examining Related-Party Transactions



Obtaining information on the financial stability of the other party (parties) with respect to material uncollected balances, guarantees, and other obligations.

Table 19-10 A uditor’s Procedures on Using the Work of a Specialist

Auditor’s Procedures on Using the Work of a Specialist (1) Evaluate the professional qualifications of the specialist. The auditor should evaluate the professional qualifications of the specialist to determine that the specialist possesses the necessary skill or knowledge. This is normally done by considering:

  

The professional certification, license, or other recognition of competence. The reputation and standing of the specialist in the views of peers and others.

The specialist’s experience in the type of work under consideration. Either the client’s managementor the auditor may engage the specialist. (2) Understand the work of the specialist. The auditor should obtain an understanding of the work performed by the specialist. This understanding covers the following:

 

The specialist’s objectives and scope of work.

The specialist’s relationship to the client. It depends on the client-specialist relationship. For example, if the client has the ability, through employment or family relationship, to directly or indirectly influence the work of the specialist significantly,then the auditor maynot accept the work of the specialist. As such, the auditor should perform additional auditing procedures or engage another specialist. On the other hand, if the client does not significantly influence the work of the specialist, such as the client-specialist relationship is strictly a contractual relationship, then the auditor may accept the work of the specialist.



The specialist’s methods and assumptions. Ordinarily, the auditor should obtain an understanding of the methods andassumptions used by the specialist to determine whether the evidence/findings of the specialist are appropriate and sufficient for attesting he management’s t assertions in the financial statements. (3) Form a conclusion about the work of the specialist. The auditor’s conclusion about the work of the specialist includes:



The auditor is unable to form a conclusion on whether the work of the specialist provides sufficient appropriate evidence to the related assertions. Here, the auditor should either perform additional procedures, or should seek the opinion of another specialist to resolve the matter. If the matter remains unresolved, the auditor issues qualified or disclaimer opinion based on scope limitation.



The auditor concludes that the work of the specialist provides sufficient appropriate evidence to support the related assertions. In this case, the auditor issues an unqualified opinion.



The auditor concludes that the work of the specialist provides sufficient appropriate evidence that does not support the related assertions. In this case, the auditor issues a qualified or adverse opinion based on departure from GAAP.

Figure 20-6 An Example of a Working Paper Review Checklist

Working Paper Review Checklist Mechanical Accuracy:       

Trace supporting balanceson individual workingpaper schedules to lead schedules. Trace lead schedule balances toworking trial balances. Trace trial balance amountsto the financial statements. Review compliance with restrictive loan covenants. Review indexing of working papers. Review cross-referencing within the working papers. Test significant calculationsin the working papers,for example:

    



 

Accruals for interest income and expense. Accruals for state, local, and federal income taxes. Accruals for pension and profit-sharing plans. Depreciation. Inventory price testing. Lease calculations.

Earnings per share. Determine thatall audit working papersare complete,properly headed,and dated.


Working Paper Review Checklist Audit Scope: 

Determine that theconsideration of internal controlis adequate andthat the scope of year-end tests ofbalances is justifiedgiven the level of control risk. Determine that audit programs were appropriate forthe circumstances. Determine thataudit procedures adequatelyaddressed the auditassertions ofexistence or occurrence, completeness, rights and obligations, valuation and allocation, and understandability. Determine thatthe scope and results of the accounts receivable confirmationswere reasonable. Determine that the physical inventoryobservation procedureswere adequate. Determine thatmanagement representation lettersare accurate, complete, andsigned by the CEO and another official.

     

Determine that thatrelated-party the lawyer representation letters are appropriate andsigned. Determine transactionsare disclosed as necessary. Review all proposed adjusting journal entries. Determine thatthe auditedfinancial statementsare properly presentedin accordancewith GAAP. Determine thatthe opinion expressed in the audit report is justified by evidence documented withinthe working papers. Determine thatall exceptions andreview notes within the working papershave been cleared.

    

Communications with the Audit Committee and M anagement (Those Charged with Governance)

The auditor’s communications with the audit committee and management (those charged with governance) at completing the audit fall into three categories: 1. Communications with the audit committee regarding the general conduct of the audit engagement in compliance with AU 260 The Auditor’s Communication with Those Charged With Governance . This communication may be oral (should keep a memorandum in the working papers) or written (should restrict circulation of the report to appropriate parties), and it should address the following matters:

   

The auditor’s responsibility under GAAS.

    

Disagreement with the management. Management’s consultation with other accountants.

Significant accounting policies. Management judgments and accounting estimates. Significant audit adjustments.

Major issues discussed with management before the auditor was retained. Difficulties the auditor encountered with management during the audit.

Fraud involving senior management. Ordinarily, the oral or written communication of recurring matters need not be repeated in each year of audit. Moreover, as long as the communication is timely, it need not be made before the issuance of the audit report. 2. Communication with those charged with governance including the audit committee regarding material weaknesses in compliance with AU 265 Communicating Internal Control Related Matters Identified in an Audit. This communication is in writing and addresses significant deficiencies in the client’s internal controls. (See Table 8-4 in Chapter 8 about the material weaknesses report). 3. Communication with the management regarding insignificant weakness in internal controls in a management letter, also known as a client’s advisory comment letter. This letter makes recommendations for improvement to the client’s internal controls. (See Table 8-4 in Chapter 8 about the management letter). It should be noted that Sarbanes- Oxley Act of 2002 expands the auditor’s communications with the audit committee and management to include: 1. Matters related to the auditor’s review of quarterly financial statements. The auditor committee must be informed of any significant matter identified during the quarterly review of the financial statements by the external auditor (Recall Table 2-10 in Chapter 2). 2. Reporttheon management’s assessment of internal controls. Under the control. SarbanesThe -Oxley Actisofrequired 2002, PCAOB requires management to report (and certify) on its assessment of internal auditor to issue an opinion in the audit report on the management’s report of its assessment of internal control. In the report, the auditor is required to disclose any material deficiencies in internal control and any material noncompliance found in

519

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the auditor’s understanding and testing of the internal control during the audit of the financial statements. (Recall Section 404 discussed in Chapter 8). Consider Subsequently Discovered Facts (SDFs)

Although the auditor has no obligation to perform audit tests for SDFs occurring after the audit report issue date, the auditor should take certain steps to address the SDFs in accordance to AU 560 Subsequent Events and Subsequently Discovered Facts . Table 19-11 describes these steps. Table 19-11 Audit Steps in Considering Subsequently Discovered Facts

Audit Steps in Considering Subsequent Discovery of Facts (SDFs) (1) When SDFs are encountered that may affect the previously issued financial statements and audit report. The auditor should:

 

Consult his or her attorney about the legal implications of the SDFs.

Determine whether the facts are reliable; have material impact on the financial statements, and relate to conditions existing at the audit report date.

 Discuss the matter with the management and request cooperation in investigating the SDFs. (2) If the auditor determines that the SDFs affect the previously issued financial statements and audit report. The auditor should: 

Request that the client issues an immediate revision to the financial statements and reissue an audit report dated at the revised financial statements date.



Request that the client contacts the SEC, stock exchanges, and other regulatory agencies concerning the revision to the financial statement and the new audit report.

 Ensure that the client describes the reasons for the revision as footnotes to the revised financial statements. (3) If the client refuses to cooperate and make the necessary revision to the financial statements. The auditor should: 

Notify the client that the auditor’s report must no longer be associated with the financial statements. In other words, the uditor a withdraws the previous audit report.

 

Notify any regulatory agencies having jurisdiction over the client that the auditor’s report can no longer be relied upon.

Notify each person known to the auditor to be relying on the financial statements either by notifying the stockholders atstockholders’ the meeting or notifying the SEC.



Disclose to each person known to the auditor to be relying on the financial statements the effect the SDFs would have had on the auditor’s previously issued report had it been known to the auditor.


Figure 19-7 Total Misstatements Documented in a Working Paper ABC Company

W/P Ref : TM#4-7

Obama Reviewed by: FC

Total Misstatements

Prepared by:

12/31/201x Overstatement (Understatement)

Current Assets

Noncurrent Assets

Current Liabilities

Noncurrent Liabilities

Owners’ Equity

Income before Taxes

Date: 1/1/201x Date: 1/5/201x

Tax Expense

W/P Ref.

Unadjusted Known Misstatements:

Overstatement of prepaid expenses Overstatement of prior year’s depreciation Unrecorded liabilities

$6,500

$2,600

$6,500 $(2,600) $(10,000) $4,000 $11,215 $(4,486)

$6,500

$30,000 $(12,000)

$30,000

$12,000

$5,000 $(2,000)

$5,000

$2,000

$(10,000) $(40,000) $(11,215)

$2,600

E#-6 P#-3

11,215 $4,486

C#-5

Projected Misstatements:

Overstatement of accounts receivable (positive confirmation results)

$30,000

$12,000

R#-8

Other Estimated Misstatements:

Understatement of allowance for uncollectable accounts Total Likely Misstatements: Materiality Threshold (MT):

$5,000

$2,000

$41,500

$(10,000)

$5,871

-

$25,629

$52,715

$100,000

$12,500

$100,000

$12,500

$50,000

$150,000

$21,086

C#-2 C#-7 P#-4

Conclusion: The total likely misstatements in each category is below the materiality threshold (MT) respectively; therefore, the financial statements, taken as a whole, is not materially misstated.

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522



The audit step most likely to reveal the existence of contingent liabilities is a. a review of vouchers paid during the month following the year-end. b. accounts payable confirmation. c. an inquiry directed to legal counsel. d. mortgage-note confirmation.

19-2

When obtaining evidence regarding litigation against a client, the auditor would be least interested in determining a. an estimate of when the matter will be resolved. b. the period in which the underlying cause of the litigation occurred. c. the probability of an unfavorable outcome. d. an estimate of the potential loss.

19-3

A principal purpose of a letter of representation from management is to a. serve as an introduction to company personnel and an authorization to examine the records. b. discharge the auditor from legal liability for the audit. c. confirm in writing management’s approval of limitations on the scope of the audit d. remind management of its primary responsibility for financial statements.

19-4

The date of the management representation letter should be coincide with the a. date of the audit report. b. balance sheet date. c. date of the latest subsequent event referred to in the notes to the financial statements. d. date of the engagement agreement.

19-5

Management’s refusal to furnish a written representation on a matt er that the auditor considers essential constitutes

a. prima facie evidence that the financial statements are not presented fairly. b. a violation of the Foreign Corrupt Practice Act. c. an uncertainty sufficient to preclude an unqualified opinion. d. a scope limitation sufficient to preclude an unqualified opinion. 19-6

Subsequent events for reporting purposes are defined as events that occur subsequent to a. balance sheet date. b. date of the auditor’s report. c. balance sheet date but before the date ofthe auditor’s report. d. the auditor’s report issue date.

19-7

Which of the following subsequent events would normally not require disclosure in the financial statements a. decrease sales volume resulting from a general business recession. b. serious damage to the client’s plant from a flood. c. issuance of a widely advertised capital stock issue with restrictive covenants. d. settlement of a large liability for considerably less than the amount recorded.

19-8

With respect to issuance of an audit report that is dual-dated fora subsequent eventoccurring afterthe completion offield work but before issuance of the auditor’s report, the auditor’s responsibility for events occurring subsequent to the completion of field work is a. extended to include all events occurring until the date of the last subsequent event referred to. b. limited to the specific event referred to. c. limited to all events occurring through the date of issuance of the report. d. extended to include all events occurring through the date of submission of the report to the client.

19-9

A written representation from a client’s management that, among other matters, acknowledges responsibility for the fair presentation of financial statements should normally be signed by the

a. chief executive officer and the chief financial officer. b. chief financial officer and the chairman of the board of directors. c. chairman of the audit committee. d. chief executive officer and the client’s lawyer.


19-10

An auditor is obligated to communicate a proposed audit adjustment to a client’s audit committee only if the adjustment a. has not been recorded before the end of the auditor’s field work. b. has a significant effect o n the client’s financial reporting process. c. is a recurring matter that was proposed to management the prior year. d. results from the correction of a prior period’s departure from GAAP.

19-11

Which of the following subsequentevents might result in adjustment ofthe year-end financialstatements? a. Sale of a major subsidiary. b. Adoption of accelerated depreciation methods. c. Write-off of a substantial portion of inventory as obsolete. d. Collection of 90% of the accounts receivable existing at December 31.

19-12

An auditor’s decision concerning whether or not to “dual date” the audit report is based upon the auditor’s willingness to a. assume responsibility for events subsequent to the issuance of the auditor’s report. b. permit inclusion of a footnote to the date of the audit report. c. accept responsibility for subsequent events. d. extend auditing procedures to subsequent events before the issuance of the auditor’s report..

19-13

In the subsequentperiod, a charge (credit)to a notes receivableaccount from the cash disbursements recordsshould alert the auditor to the possibility that a. a provision for contingencies is required. b. a contingent asset has come into existence in the subsequent period. c. a contingent liability has become a real liability and has been settled. d. a contingent liability has come into existence in the subsequent period.

19-14

An attorney is responding to an auditor as a result of the audit client’s letter of inquiry. The attorney may appropriately limit the response to

a. asserted claims and litigation. b. asserted, overly threatened, or pending claims and litigation. c. items which have an extremely high probability of being resolved to the client’s detriment. d. matters to which the attorney has given substantive attention in the form of legal consultation or representation. 19-15

An auditor has received a lawyer’s letter in which no significant disagreement with the client’s assessments of contingent liabilities werenoted. The resignation of the client’s lawyer shortly after receipt of the letter should alert the auditor that

a. a qualified audit opinion will be necessary. b. undisclosed unasserted claims may have arisen. c. the auditor must begin a completely new examination of contingent liabilities. d. the attorney was unable to form a conclusion with respect to the significance of litigation. claims, and assessments. 19-16

Which of the following is not a reason why the auditor requests thatthe client provide a letter of representation? a. It provides written documentation of the oral responses already received to inquiries of management. b. It provides written documentation that is a higher quality of evidence than management’s oral responses to inquiries. c. It impresses upon management its responsibility for the accuracy of the information in the financial statements. d. Professional auditing standards requires the auditor to obtain a letter of representation.

19-17

The auditor’s responsibility for reviewing the subsequent events of a public company that is registered to issue new securities is normally limited to the period of time a. beginning with the balance sheet date and ending with the date of the auditor’s report. b. beginning with the start of the fiscal year under audit and ending with the balance sheet date. c. beginning with the start of the fiscal year under audit and ending with the date of the auditor’s report. d. beginning with the balance sheet date and ending with the date the registration statement becomes effective.

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524


19-18

Which of the following isthe most efficient auditprocedure forthe detection ofunrecorded liabilitiesat the balance sheet date? a. Compare cash disbursement in the subsequent period with the accounts payable trial balance at year-end. b. Examine purchase orders issued for several days prior to the close of the year. c. Confirm large accounts payable balances at the balance sheet date. d. Obtain an attorney’s representation letter from the client’s attorney.

19-19

Which of the following statements regarding the client’s representation letter is not correct? a. It is prepared on the client’s letterhead. b. It is addressed to the CPA firm. c. It is signed by two high-level corporate officials. d. It is optional, not required, that the auditor obtain such a letter from management.

19-20

Which of the followingis not an audit procedurethat is commonly usedby auditor to search for contingent liabilities? a. Inquiries of management (orally and in writing). b. Analyze legal expense for the period under audit. c. Review of the current year’stax return (Form 1120) d. Review the minutes of directors’ and stockholders’ meetings.

19-21

Which of the following proceduresmight be useful in discovering acontingent liabilityfor a lawsuit thatmanagement is intentionally neglecting to disclose? a. Inquiries of management (orally and in writing) b. Analyzing legal expense and review invoices and statements from outside legal counsel. c. Obtaining a management representation letter that it is aware of no undisclosed contingent liabilities. d. None of the three procedures above because they are all not useful for discovering a contingent liability.

19-22

The standard client’s inquiry of lawyer letter should be prepared on

a. plain paper (no letterhead) and signed by a company official. b. lawyer’s stationery and signed by the lawyer. c. auditor’s stationery and signed by the auditor. d. client’s stationery and signed by a company official. 19-23

When subsequently discoveredfacts (SDFs) are encountered thatmay affect the previously issuedfinancial statements and audit report. The auditor should: a. consult his or her attorney about the legal implications of the SDFs. b. determine whether the facts are reliable; has material impact on the financial statements, and relates to condition existed at the audit report date. c. discuss the matter with the management and request cooperation in investigating the SDFs. d. all the three above.

19-24

In auditing accountingestimates, suchas intangible assets,an auditor mostlikely would review or re-compute amortization and determine whether the amortization period is reasonable in support of management’s financial statement assertion of a. valuation or allocation. b. existence or occurrence. c. completeness. d. rights and obligations.

19-25

Which of the following procedures would an auditor ordinarily perform first in evaluating management’s accounting estimates for reasonableness? a. Develop independent expectations of management’s estimates. b. Consider the appropriateness of the key factors or assumptions used in preparing the estimates. c. Test the calculations used by management in developing the estimates. d. Obtain an understanding of how management developed its estimates.


19-26

An auditor most likely would modify an unqualified opinion if the client’s financial statements include a footnote on material related-party transactions a. disclosing loans to related parties at interest rates significantly below prevailing market rates. b. describing an exchange of real estate for similar property in a non-monetary related party. c. stating that a particular material related-party transaction occurred on terms not equivalent to those that would have prevailed in an arm’s-length transaction. d. presenting the dollar amount of related party transactions and the effects of any change in the method of establishing terms from prior periods.

19-27

Which of the following auditingprocedures mostlikely would assist an auditor in identifying related-party transactions? a. Inspecting correspondence with lawyers for evidence of unreported contingent liabilities. b. Vouching accounting records for recurring transactions recorded just after the balance sheet date. c. Performing analytical procedures for indications of possible financial difficulties. d. Reviewing confirmations of loans receivable and payable for indications of guarantees.

19-28

When auditing related-partytransactions, anauditor places primary emphasis on which of the following management assertions? a. Ascertaining the rights and obligations of the related parties. b. Confirming the existence or occurrence of the related parties. c. Verifying the valuation or allocation of the related-party transactions. d. Evaluating the presentation and disclosure of the related-party transactions.

19-29

After identifying thata related-party transaction has,in fact, occurred, an auditor should first a. add a separate paragraph to the auditor’s standard repor t to explain the transaction. b. perform analytical procedures to verify whether similar transactions occurred, but were not recorded. c. obtain an understanding of the business purpose of the transaction. d. substantiate that the transactions were con summated on terms equivalent to an arm’s length transaction.

19-30

Which of the following most likely would indicate the existence of related parties? a. Writing down obsolete inventory just before year end. b. Borrowing money at an interest rate significantly below the market rate. c. Failing to correct previously identified internal control deficiencies. d. Depending on a single product for the success of the entity.

19-31

Which of the following statements extracted from a lawyer’s represent ation letter concerning litigation, claims, and assessments most likely would cause the auditor to request clarification? a. “I believe that the possible liability to the company is nominal in amount.” b. “I believe that the action can be settled for less than the damages claimed.” c. “I believe that the plaintiff’s case against the company is without merit.” d. “I believe that the company will be able to defend this action successfully.”

19-32

The refusal of a client’s attorney to provide information requested in an inquiry letter generally is considered

a. grounds for an adverse opinion. b. reason to withdraw from the engagement. c. a limitation on the scope of the audit. d. equivalent to a material weakness. 19-33

The scope of an audit is not limited when an attorney’s response to an auditor as a result of a client’s letter of inquiry limits the response to a. matters to which the attorney has given substantive attention in the form of legal representation. b. an evaluation of the likelihood of an unfavorable outcome of the matters disclosed by the client. c. the attorney’s opinion of the client’s historical experience in recent similar litigation. d. the probable outcome of asserted claims and pending or threatened litigation.

525

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19-34

The primary reason an auditor requests an inquiry of lawyer letter to be sent to a client’s attorney is to provide the auditwith

a. the probable outcome of asserted claims and pending or threatened litigation. b. corroboration of the information furnished by management about litigation, claims, and assessments. c. the attorney’s opinions of the client’s historical experiences in recent similar litigation. d. a description and evaluation of litigation, claims, and assessments that existed at the balance sheet date. 19-35

Which of the following isan audit procedure thatan auditor mostlikely would performconcerning litigation, claims,and assessments? a. Request the client’s lawyer to evaluate whether the client’s pending litigation, claims, and assessments indicate a going concern problem. b. Examine the legal documents in the lawyer’s possession concerning litigation, claims, and assessments to which the lawyer has devoted substantive attention. c. Discuss with management its policies and procedures adopted for evaluating and accounting for litigation, claims, and assessments. d. Confirm directly with the client’s lawyer that all li tigation, claims, and assessments have been disclosed in the financia l statements.

19-36

A client’s lawyer is unable to form a conclusion about the likelihood of an unfavorable outcome of pending litigation because of inherent uncertainties. If the litigation’s effect on the client’s financial statements could be material, the auditor most likely would a. issue a qualified auditor report because of the lawyer’s scope limitation. b. withdraw from the engagement because of the lack of information furnished by the lawyer. c. disclaim an opinion on the financial statements because of the materiality of the litigation’s effect. d. add an explanatory paragraph to the auditor’s unqualified audit report to emphasize the uncertainty.

19-37

Which of the following statement is correct concerning an auditor’s use of the work of aspecialist?

a. The auditor need not obtain an understanding of the methods and assumptions used by the specialist. b. The auditor may not use the work of a specialist in matters material to the fair presentation of the financial statements. c. The reasonableness of the specialist’s assumptions and their applications are strictly the auditor’s responsibility. d. The work of a specialist who has a contractual relationship with the client may be acceptable under certain circumstances. 19-38

An auditor may refer to the work of a specialist in the audit report if, as a result of the specialist’s evidence/findings, the auditor a. becomes aware of conditions causing substantial doubt about the entity’s ability to continue as a going concern; and the auditor issues an unqualified opinion with an additional paragraph about the going concern status in the audit report. b. desires to disclose the specialist’s findings, which implies that a more thorough audit was performed. c. is able to corroborate another specialist’s earlier findings that were consistent with management’s representations. d. discovers significant deficiencies in the design of the client’s i nternal control that management does not correct.

19-39

Which of the following matterswould an auditor mostlikely include in a management representation letter? a. Communications with those charged with governance concerning weakness in internal control. b. The completeness and availability of minutes of stockholders’ and directors’ meetings. c. Plans to acquire or merge with other entities in the subsequent year. d. Management’s acknowledgement of its responsibility for the detection of employee fraud.

19-40

A purpose of a management representation letter is to a. reduce audit risk to an aggregate level of misstatement that could be considered material. b. remove the auditor’s responsibility to detect material misstatements contained in the letter. c. promote the management’s full disclosure of contingent liability information onlitigation, claims and assessment. d. limit the scope of the auditor’s procedures concerning related party transactions.


19-41

Which of the following matterswould materialitylimits to amounts included in the financial statementsnot apply in a written management representation letter? a. Losses from purchase commitments at prices in excess of market value. b. The availability of minutes of stockholders’ and directors’ meetings. c. The disclosure of compensating balance arrangements involving related parties. d. Reductions of obsolete inventory to net realizable value.

19-42

An auditor would least likely communicate with a client’s audit committee concerning

a. the accounting methods used to account for significant unusual transactions. b. the maximum dollar amount of misstatements that could exist without causing the financial statements to be materially misstated. c. indications of fraud and illegal acts committed by a corporate officer that were discovered by the auditor. d. disagreements with management as to accounting principles that were resolved during the current year’s audit. 19-43

Which of the following statements is correct concerning an auditor’s required communication with an entity’ audit committee?

a. Significant audit adjustments proposed by the auditor and recorded by management need not be communicated to the audit committee. b. Any significant matter communicated to the audit committee also should be communicated to management. c. The communication hs ould include management’s changes in the application of significant accounting policies. d. The communication must occur just before the auditor issue the audit report on the financial statements. 19-44

In identifying matters for communication with a client’s audit committee, an auditor most likely would ask management whether a. the turnover in the accounting department was unusually high. b. there were any subsequent events of which the auditor was unaware. c. the management agreed with the audito r’s assessed level of control risk. d. the management consulted another CPA firm about accounting matters.

19-45

An auditor completed the fieldwork of a client’s December 31, 2001 financial statements on March 6, 2002. A subsequent event requiring adjustment of the 2001 financial statements occurred on April 10, 2002, and came to the auditor’s attention on April 24, 2002. The auditor issue the audit report on April 30, 2002. If the adjustment is made without disclosure of the event, the auditor’s report should be dated

a. March 6, 2002. b. April 10, 2002. c. April 24, 2002. d. using ‘dual dating’. 19-46

An auditor issued an audit reportthat was dual dated for a subsequent eventoccurring afterthe completionof fieldwork but before issuance of the auditor’s report. The auditor’s responsibility for this subsequent event was a. extended to the date of the specific subsequent event occurred. b. extended to the date of the specific subsequent event was aware by the auditor. c. extended to the date of the issuance of the audit report. d. extended to the date of the completion of the audit fieldwork.

19-47

An auditor determines that subsequently discovered facts (SDFs) affect a client’s previously issued financial statements and audit report. The client revised the financial statements, and the auditor reissued an audit report. The reissued audit report should be dated a. using ‘dual dating’. b. at the date of the reissued audit report. c. at the date of the revised financial statements. d. at the date the auditor is aware of the SDFs.

19-48

The primary source of information tobe reported aboutlitigation, claims,and assessments isthe (Hint: Notprimary source of corroborative information) a. client’s lawyer.

b. court records. c. client’s management. d. independent auditor.

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19-49

Which of the following isnot an audit procedure thatthe auditor wouldperform with respect to LCAs? a. Inquire of and discuss with management the policies and procedures adopted for LCAs. b. Obtain from management a description and evaluation of LCAs that existed at the balance sheet date. c. Obtain assurance from management that it has disclosed all unasserted claims that the lawyer has advised are probable of assertion and must be disclosed. d. Confirm directly with the client’s lawyer that all claims have been recorded in the financial statements.

19-50

Which of the following procedures should an auditor ordinarily perform regarding subsequent events? a. Compare the latest available interim financial statements with the financial statements being audited. b. Send second requests to the client’s customers who failed to respond to initial accounts receivable confirmation requests. c. Communicate material weaknesses in internal control to those charged with governance. d. Review the cutoff bank statements for several months after the year-end.

19-51

Which of the following procedureswould an auditor mostlikely perform to obtain evidenceabout the occurrence of subsequent events? a. Confirming a sample of material accounts receivable established after year-end. b. Comparing the financial statements being reported on with those of prior period. c. Investigating personnel changes in the accounting department occurring after year-end. d. Inquiring as to whether any unusual adjustments were made after year-end.

19-52

Which of the following procedureswould an auditor mostlikely perform to obtain evidenceabout the occurrence of subsequent events? a. Recompute a sample of large-dollar transactions occurring after year-end for arithmetic accuracy. b. Investigating changes in stockholders’ equity occurring after year-end.. c. Inquiring of the entity’s lawyer concerning LCAs arising after year-end. d. Confirming bank accounts established after year-end.

19-53

Which of the following procedureswould an auditor mostlikely perform to obtain evidenceabout the occurrence of subsequent events? a. Determining that changes in employee pay rates after year-end were properly authorized. b. Recompute depreciation charges for plant assets sold after year-end.. c. Inquire about payroll checks that were recorded before year-end but cashed after year-end. d. Investigate changes in long-term debt occurring after year-end..

19-54

After issuing an audit report,an auditor hasno obligation tomake continuing inquiriesor perform other procedures concerning the audited financial statements, unless udit a. information, which existed at the audit report date and may affect the a report, comes to the auditor’s attention. b. client’s management requests the auditor to reissue the auditor’s report in a document submitted to a third party that contains information in addition to the basic financial statements. c. information about an event t hat existed after the end of field work (audit report date) comes to the auditor’s attention. d. final determinations or resolutions are made of contingencies that had been disclosed in the financial statements.

19-55

Which of the following events occurring after the issuance of an auditor’s report most likely would cause the auditor to make further inquiries about the previously issued financial statements? a. An uninsured natural disaster occurs that may affect the cli ent’sability to continue as a going concern. b. A contingency is resolved that had been disclosed in the audited financial statements. c. New information is discovered concerning undisclosed lease transactions of the audited period. d. A subsidiary is sold hat t accounts for 25% of the client’s consolidated net income.

19-56

Subsequent to the issuance of an auditor’s report, the auditor became aware of facts existing at the report date that would have affected the report had the auditor been aware of such facts. After determining that the information is reliable, the auditor should next

a. determine whether the information has material effect on the users of the audited financial statements. b. request that management disclose the newly discovered information by issuing revised financial statements. c. issue revised pro forma financial statements taking into consideration the newly discovered information. d. give public notice that the auditor is no longer associated with the financial statements.


19-57

To which of the following matterswould an auditor not apply materiality judgmentwhen obtaining specific written management representations? a. Disclosure of compensating balance arrangements involving restrictions on cash balances. b. Information concerning related party transactions and related amounts receivable or payable. c. The absence of errors and unrecorded transactions in the financial statements. d. Fraud involving employees with significant roles in internal control.

19-58

“There have been no communications from regulatory agencies concerning noncompliance with, or deficiencies in, financial reporting practices that could have a material effect on the financial statements.” The foregoing passage is most likely from a

a. report on internal control. b. special report. c. management representation letter. d. letter for underwriters. 19-59

Which of the following statements is correct about an auditor’s required communication with a client’s audit committee?

a. Any matters communicated to the client’s audit committee are also required to be communicated to the client’s management. b. The auditor is required to inform the client’s audit committee about fraud involving senior management. c. Disagreements with management about the application of accounting principles are required to be communicated in writing to the client’s audit committee. d. Weaknesses in internal control previously reported to the client’s audit committee are required t o be communicated to the audit committee after each subsequent audit until the weaknesses are corrected. 19-60

Which of the following statements is correct concerning an auditor’s required communication with a client’s audit committee?

a. This communication should include disagreements with management about significant audit adjustments, whether or not satisfactorily resolved. b. If matters are communicated orally, it is necessary to repeat the communication of recurring matters each year. c. If matters are communicated in writing, the report is required to be distributed to both the audit committee and management. d. This communication is required to occur before the auditor’s report on the financial statements is issued. 19-61

Whichof the following matters is an auditor required to communicate to a client’s audit committee? a. The basis for assessing control risk below the maximum. b. The process used by management in formulating sensitive accounting estimates. c. The auditor’s preliminary judgments about material levels. d. The justification for performing substantive procedures at interim dates.

19-62

Should an auditor communicate the following matters to a client’s audit committee?

a. b. c. d. 19-63

Significant Audit Adjustments Recorded by the client Yes Yes No No

Issues Discussed with Management Prior to the Auditors’ Retention Yes No Yes No

In using the work of a specialist, an auditor referred to the specialist’s findings in the auditor’s report. This would be an appropriate reporting practice if the

a. client is not familiar with the professional certification, personal reputation, or particular competence of the specialist. b. auditor, as a result of the specialist’s findings, added an explanatory paragraph emphasizing a matter regarding the financial statements. c. client understands the auditor’s corroborative use of the specialist’s findings in relation to the representations in the financial statements. d. auditor, as a result of the specialist’s findings, decides to indicate a division of responsibility with the specialist.

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19-64

When using the work of a specialist, an auditor may refer to and identify t he specialist in the auditor’s report if the

a. auditor wishes to indicate a division of responsibility. b. specialist’s work provides the auditor greater assurance of reliability. c. auditor expresses a qualified opinion as a result of the specialist’s findings. d. specialist is not independent of the client. 19-65

Which of the following statements is correct about the auditor’s use of the work on a specialist? a. The specialist should not have an understanding of the auditor’s corroborative use of the specialist’s findings. b. The auditor is required toperform substantive procedures to verify the specialist’s assumptions and findings. c. The client should not have an understanding of the nature of the work to be performed by the specialist. d. The auditor should obtain an understanding of the methods and assumptions used by the specialist.

19-66

An auditor searching for related party transactions should obtain an understanding of each subsidiary’s relationship to the total entity because

a. this may permit the audit of inter-company account balances to be performed as of concurrent dates. b. inter-company transactions may have been consummated on terms equivalent to arm’s-length transactions. c. this may reveal whether particular transactions would have taken place if the parties had not been related. d. the business structure may be deliberately designed to obscure related party transactions. 19-67

Which of the following events most likely indicates the existence of related parties? a. Borrowing a large sum of money at a variable rate of interest. b. Selling real estate at a price that differs significantly from its book value. c. Making a loan without scheduled termsfor repayment of thefunds. d. Discuss merger terms with a company that is a major competitor.

19-68

Which of the following statements is true about related party transactions? a. In the absence of evidence to the contrary, related party transactions should be assumed to be outside the ordinary course of business. b. An auditor should determine whether a particular transaction would have occurred if the parties had not been related. c. An auditor should substantiate that related party transactions were consummated on terms equivalent to those that prevail in arm’s-length transactions. d. The audit procedures directed toward identifying related party transactions should include considering whether transactions are occurring but are not being given proper accounting recognition.

19-69

In evaluating the reasonableness of a client’s account estimates, an auditor normally is concerned about assumptions that are

a. susceptible to bias. b. consistent with prior periods. c. insensitive to variance. d. similar to industry guidelines. 19-70

Auditors must obtain and evaluate sufficient appropriate evidence to support significant accounting estimates. Differences between the estimates best supported by the audit evidence and those estimates in the financial statements a. are per se unreasonable and should be treated as misstatements if collectively material. b. may be individually reasonable but collectively indicate possible bias. c. may be individually unreasonable, but if they collectively indicate no bias, aggregation of the differences with other likely misstatements is not required. d. should arouse concern only when estimates are based on hypothetical assumptions or subjective factors.

19-71

At completing theaudit, theaudit work performed byeach assistantshould bereviewed to determine whetherit was adequately performed and to evaluate whether the a. audit procedures performed are approved in the professional standards. b. audit has been performed by assistants having adequate technical training and proficiency. c. auditor’s system of quality control has been maintained at a high level. d. results are consistent with the conclusions to be presented in the auditor’s report.


19-72

The auditor withfinal responsibilityfor an engagementand one of the assistants havea difference ofopinion aboutthe results of an auditing procedures. If the assistant believes it i s necessary to be disassociated from the matter’s resolution, the CPA firm’s procedures should enable the assistant to a. refer the disagreement to the AICPA’s Peer Review Board. b. document the details of the disagreement with the conclusion reached. c. discuss the disagreement with the client’s management or its audit committee. d. report the disagreement to an impartial peer review monitoring team.

19-73

After fieldwork audit procedures arecompleted, a partner of the CPA firm who has not been involved in the audit performs a second or wrap-up working paper review. This second review usually focuses on a. the fair presentation of the financial statements in conformity with GAAP. b. fraud involving the client’s management and its employees. c. the materiality of the adjusting entries proposed by the audit staff. d. the communication of internal control weaknesses to those charged with governance.

19-74

Which of the following relatedparty transactions isspecifically prohibited bythe Sarbanes-Oxley Act of 2002? a. Home loan made by a bank to its executive officers under normal banking operation using market terms offered to the general public. b. Real estate sold by a real estate company to its executive officers at a price considerably different from its appraised value. c. Exchange of fix assets between a company and its executive officers that is made in a non-monetary transaction. d. Personal loan made by a companyto its executive officers that is not an arm’s length transaction.

19-75

Sarbanes-Oxley Act expands the auditor’s communications with the audit committee and management. Which of the following is not one of the expanded communications? a. Auditor is required to communicate material subsequently discovered facts to the audit committee and management. b. Auditor is required to communicate material matters identified in reviewing the client’s quarterly financial statements to the audit committee and management. c. Auditor is required to communicate material weakness in internal controls identified in the financial audit to the audit committee and management. d. Auditor is required to communicate matters relating to an audit engagement to the audit committee and management prior to the approval andsigning of theaudit engagement letter.

19-76

Ordinarily, audit procedures for testing accounting estimates of accrual liabilities do not include a. Appraising the accuracy of the detailed accounting records maintained for this category of liability. b. Testing the computations made by the client in setting up the accrual. c. Considering the need for accrual of other accrued liabilities not presently considered. d. Performing a prospective analysis of the future year’s estimates for evidence of management bias.

19-77

In auditing accounting estimatesof accrual liabilities, theauditor is ordinarily not required to a. Examine any contracts or other documents on hand that provide the basis for the accrual. b. Identify and evaluate the reasonableness of the assumptions made that underlie the computation of the liability. c. Test the computations made by the specialist hired to provide estimates of the accrual liabilities. d. Perform a retrospective analysis of the prior year’s estimates for evidence of management bias.

19-78

Which of the following accrued liabilities typically requires the service of a specialist? I. Accrued vacation pay, product warranty liabilities, and accrued property taxes. II. Accrued payrolls, accrued commissions and bonuses, and accrued professional fees. III. Pension plan accruals and postemployment benefits other than pensions. a. I b. II c. III d. I and II

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19-79

The auditor considers prioryear uncorrected (unadjusted)material misstatements at the completion ofaudit phase. If accruals were materially misstated by $20,000 in the previous year and $30,000 during the current year; and if the auditor uses the iron curtain method according to the SEC Staff Accounting Bulletin No.108 (SAB No.108), the total amount of material misstatements to becorrected (adjusted) in the current year financial statements would be a. $30,000. b. $20,000. c. $50,000. d. $10,000.


19-1 c. 19-2 a. 19-3 d. 19-4 a. 19-5 d. 19-6 c. 19-7 a. 19-8 b. 19-9 a. 19-10 b. 19-11 c. 19-12 d. 19-13 c. 19-14 d. 19-15 b. 19-16 b. 19-17 d. 19-18 a. 19-19 d. 19-20 c. 19-21 b. 19-22 d. 19-23 d. 19-24 a. 19-25 d. 19-26 c. 19-27 d. 19-28 d. 19-29 c. 19-30 b. 19-31 b. 19-32 c. 19-33 a. 19-34 b. 19-35 c. 19-36 d. 19-37 d. 19-38 a. 19-39 b. 19-40 c. 19-41 b. 19-42 b. 19-43 c. 19-44 d. 19-45 a. 19-46 a. 19-47 c. 19-48 c. 19-49 d. 19-50 a. 19-51 d. 19-52 c. 19-53 d. 19-54 a. 19-55 c. 19-56 a. 19-57 d. 19-58 c. 19-59 b. 19-60 a. 19-61 b. 19-62 a. 19-63 b. 19-64 c. 19-65 d. 19-66 d. 19-67 c. 19-68 d. 19-69 a. 19-70 b. 19-71 d. 19-72 b. 19-73 a. 19-74 d. 19-75 a. 19-76 d. 19-77 c. 19-78 c. 19-79 c.


Simulation Question 19-1 Simulation Question 19-1 is an adaptation with permission from a case by Eynon, G., and K. Steven in Issues the in Accounting Education , a publication of the American Accounting Association in Sarasota, Florida. This simulation question is based upon a true set of facts; however, the names and places have been changed.

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Accounting for Contingent Environmental Liabilities

Marietta Nola, chief financial officer (CFO) of Willis, Inc., has worked at Willis for many years and helped it grow from a moderate leasing operation to a sizable corporation with subsidiaries in several industries. She is now close to retirement and has accumulated a significant investment in stock options on Willis at favorable prices. At a recent social gathering, she discovered that the Environmental Protection Agency (EPA) had informed a local manufacturer that it was investigating an abandoned hazardous waste site previously used by the company. In the ensuing discussion, learned that the site (CEO) investigation and potentialwas subsequent cleanup was fraught uncertainty. Since theshe chief executive officer of the process local manufacturer an old friend, sheprocess later called him to with see how he was handling the potential environmental cleanup uncertainty. He told her that his company had deposited one of the byproducts of its production process, a toxic chemical, in a legal landfill in the 1970s. They had always used a licensed waste hauler and complied with all waste treatment and disposal requirements. He had been surprised to find that the liability imposed under federal environmental regulations is strict, that is, can be imposed without regard to fault. Further, the liability for the cleanup costs is joint and several, so it was possible that that it was possible that his firm would have to bear the bulk of the remediation costs for the site, even though its contribution of waste to the site was small. He stated that he was g aspects of his firm’s currently gathering all the relevant information he could. He was concerned with the legal, regulatory and financial reportin new situation and would have to review this information once he obtained it before he could fully assess his position. After hanging up, Nolan began to worry about Willis’ most recently acquired subsidiary, a small privately held manufacturer of machine tools. Until now, Willis had never had any investments in industries at all associated with hazardous waste disposal. She was relatively uninformed about the manufacturing process at Johnson Manufacturing Co., the new subsidiary, and decided to meet with the CEO of Johnson for a review of the production process. She specifically asked about the generation and disposal of hazardous wastes and learned that Johnson had used a solvent in its production in the 1970s that was considered hazardous. Therefore, the CEO was very familiar with hazardous waste disposal requirements. However, he stressed that Nolan should not be concerned with potential environmental liabilities, since Johnson had always disposed of its only toxic output (at a legal landfill not far from the one under investigation by the EPA) in accordance with every regulation. Despite his assurances, she realized that his knowledge of hazardous waste disposal was limited to the dumping requirements in place in the 1970s and did not extend to the federal Comprehensive Environmental Response, Compensation, and Liability Act (CERCLA, or Superfund) that governs the cleanup of abandoned hazardous waste sites. After reading an article about environmental matters in the December 1992 issue ofThe Journa l of Accountancy , “The auditor, SAS No.54 and environmental violations” by Specht, L.B., Nolan decided t o conduct an information gathering process similar to the one used by her friend. She sent letters with general and specific questions to the outside corporate attorney, Philips and Graham, and the CPA firm, Gibson & Fishburne, which audits Willis’ financial statements each year.You should access Data File 19-1 in iLearn for Figures 1 through to 3 for the corporate attorney’s responses and attachments.

Philip, the corporate attorney, recommended that Nolan obtain more information by consulting a specialist. The attorney also sent Nolan a copy of an article that discussed several considerations in the hiring of a reputable consulting firm. Form this she learned that there is no professional certification in the field of environmental consulting, and that some consultants have obtained their credentials via mail order. firm’s general, Following the cautions mentioned in the articles, such as reviewing resumes and checking the limits of liability onconsulting the pollution and professional liability insurance policies; she located two reputable firms, Environmental Assessors and Environmental strategists. Nolan hired Environmental Assessors (EA) to review the situation at Johnson Manufacturing, Inc. Eventually, EA reported that prior clients that had disposed of similar types and volumes of waste as Willis (but at different sites) had been held responsible for significant cleanup costs by the EPA. In EA’s opinion, Willis would probably be held responsible and incur significant costs if the EPA investigated this site. Given the ambiguous nature of environmental claims, Nolan was not satisfied that one expert’s opinion was sufficient. She decided ot obtain the opinion of the other environmental auditing and consulting firm she had located, Environmental Strategists (ES). After their investigation, this firm agreed with EA that the costs of cleaning up the entire site could prove to be significant. However, ES also pointed out to Nolan that many other financially stable companies had contributed far more waste to the site and that the EPA has a tremendous backlog in discovering and identifying Superfund sites and determining potentially responsible parties (PRPs). Thus, ES concluded that it was unlikely that Willis would be designated a PRP, and even if so designated, was unlikely to bear significant costs. Thus, Nolan is confronted with a dilemma. She understands the technical guidance provided by the Financial Standards Board (FASB) and the Securities and Exchange Commission (SEC), but the reporting standards are based on ambiguous terms such as “probable” and “reasonably estimated.” An additional problem is that the experts in the field have arrived at differing conclusions. Therefore, it is difficult to estimate both the amount and the materiality of the loss. She must now decide whether she should report a contingent environmental liability to the SEC in the 10-K and/or in the annual report to the shareholders. Her dilemma is this: the technical reporting requirements do not provide her with clear guidance on whether, or even what, to report. She must now use her moral reasoning skills to decide who is affected by her decision, how they are affected and whose interests she should serve.

Required 1. Research Internet and read: a. FAS No.5 (FASB 1986a), SEC Regulation S-K, Item 303 (SEC1986) and SEC Financial Reporting Release No.36 (FRR 36 (SEC 1989), which provides interpretive guidance on compliance with SEC Regulation S-K, Item 303. b. Concept Statement No.1 (CON1), para.24-27 and 50, CON2, glossary and para.80 and 135, and CON6, para.40 of the FASB’s Conceptual Framework (CFW) (FASB 1986b). c. FASB (FASB 1986b) Interpretation 14(FIN14),Reasonable Estimation of the Amount of Loss. d. Statement of Auditing Standards AU 540,Auditing Accounting Estimates , Including Fair Value Accounting Estimates and Related Disclosures. e. Statement of Auditing Standards AU 620,Using the Work of an Auditor’sSpecialist.

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2. Based on your research and reading in 1.a, b, c, d, and e; provide written answers to the following question: Assume you are the in-charge audit partner in Gibson & Fishburne who has received Nolan’s letter requesting general and specific questions on reporting environmental liabilities. You are to draft a Client Advisory Comment letter in response to her requests. Your responses should cover an in-depth discussion of: i. GAAP requirement onreporting contingentenvironmental liabilities. ii. SEC requirement on disclosing contingent environmental liabilities. iii. GAAS requirement on: (a) auditor’s responsibility regarding the two environmental consultant firms hired by Nolan, (b) the type of audit procedures that the auditor would likely use to investigate the environmental liabilities item, and (c) the type of audit report that Nolan would be likely to get relating to the environmental liabilities item. ) in response to Nolan’s requests serves as an example of theepth d and Note: The letter from the law firm in ( Data File 19-1 in iLearn professionalism that your letter to Nolan should be.

Simulation Question 19-2 Simulation Question 19-2 is an adaptation with permission from a case by J. R. Duncan in Issues the in Accounting Education , a publication of the American Accounting Association in Sarasota, Florida. This simulation question is based upon a true set of facts; however, the names and places have been changed.

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Year-End Adjustments

Cathy Thomas is the controller of a medium-sized division ofFortune a 500 company. Prior to appointment to her current position approximately two years ago, Cathy worked for the corporate accounting staff at headquarters. The company has a reputation for promoting its outstanding performers; marginal performers are “counseled out.” Cathy hopes to spend another year or so in her current position, and then be promoted to a larger division with more visibility and responsibility. Promotions are typically based on recommendations of division management, but must receive concurrence of functional heads at corporate headquarters. The division president strongly encourages division management personnel to be team players; those who fail to demonstrate team behavior are rated negatively in performance evaluations. Headquarters management expects its divisions to reach their respective earnings targets each year and has removed presidents of divisions for failing to meet targets in three consecutive years. Cathy’s division reached its earnings target for the first three quarters of the current year after failing to achieve targeted earnings the last two years. Divisional management bonuses are based on attaining the earnings target. Last week, the division president indicated to the company CEO that the division most likely will reach its earnings target in the fourth quarter and for the full year. Four accounts remain to be considered for adjustment before divisional earnings are finalized for the fourth quarter and the year. Bonus calculations will be made after earnings are finalized. The four accounts and related considerations are as follows (all amounts are after-tax effects):

1. Inventory Reserve

During the year-end physical inventory, approximately $200,000 of raw material was identified as possibly unusable in normal production before its shelf life would expire. Discussions with the division Purchasing Manager reveal it is possible that $50,000 of the raw material could be sold to another company. The division Purchasing Manager contacted the other company who indicated a 60 percent chance it could use the $50,000 of material. The division Purchasing Manager promised to contact other companies about buying the remaining $150,000 of material. 2. Litigation Liability

A former manager-level employee sued the division for age discrimination after being dismissed in a downsizing. In two different discussions with division legal counsel, the former employee offered to settle the lawsuit for $150,000, and later at $150,000 plus $50,000 in legal fee. Division legal counsel is still considering the settlement, but is not optimistic about the division prevailing in the lawsuit. However, division legal counsel indicated the trial does not occur for six months, and the legal system provides a series of appeals if the division loses. Therefore, it could be several years before the outcome is ultimately known. 3. Accrued Consulting

The division received an invoice for $300,000 from a consulting firm relating to work performed on a proposed new product. The invoice relates to work completed in the most recent quarter, but the division Research & Development (R&D) VP indicated that the invoice contains a significant overcharge based upon rate discussions held with the consulting firm project manager over lunch last week. Because the invoice is in dispute, the R&D VP requests that Cathy delay recording the invoice until he can resolve the amount with the consulting firm representative. The R&D VP believes he can negotiate a $175,000 discount and that the consulting firm will rescind the invoice until the matter is resolved. 4. Allowance for Bad Debts The division has a $200,000 7% note receivable from a customer who has, for the last ten years, purchased large volumes of the division’s

products. The VP of Sales indicates that the customer is currently experiencing cash flow problems and recommends an extension be granted for the note. Without an extension, the customer would be forced to default, and the division would likely recover only 75 percent of the amount sold through repossession of the products. The VP of Sales also believes the customer, upon recovery from its cash difficulties, would purchase its future product needs from competitors of the division. However, it is too early to tell whether the customer’s financial difficulties will be resolved or will worsen. The Sales VP believes that the division president would likely approve an extension.

Required Research Internet and read: a. Statement of Financial Accounting Standards (SFAS) No.5, Accounting for Contingencies. b. Statement of Financial Accounting Standards (SFAS) No.15, Accounting by Debtors and Cr editors for Troubled Debt Restructurings.


c. Statement of Financial Accounting Standard (SFAS) No. 114, Accounting by Cr editors For Impairment of a Loan. d. FASB (1986b) Interpretation 14 (FIN14), Reasonable Estimation of the Amount of Loss. e. SEC Staff Accounting Bulletin No. 99, Materiality. f. Statement of Auditing Standards AU 540, Auditing Accounting Es timates , Including Fair Value Accounting Estimates a nd Related Disclosures. g. Statement of Auditing Standards AU 501, Audit Evidence – Specific Consideration of Selected Items . If your last name’s first alphabet is A-M, answer questions inPart A only. If your last name’s first alphabet is N-Z, answer questions inPart B only. Part A (Answer Part A onlyif your last name’s first alphabet is A-M) The division’s preliminary results for t he fourth quarter reveal after-tax earnings of $10,200,000 versus a target of $10,000,000.

1. Assume you are Cathy, the controller, provide an estimate of the adjustments you would record in the fourth quarter: Preliminary Earnings $ 10,200,000 1. Inventory Reserve __________ 2. Litigation Liability __________ 3. Accrued Consulting __________ 4. Allowance for Bad Debts __________ Total Adjustments ___________ Division Net Earnings after Adjustments $ ___________ 2. Use the following format to document your rational for the adjustments you would record in the fourth quarter

Accounts Adjustments 1. Inventory Reserve 2. Litigation Liability 3.Accrued Consulting 4.Allowance for Bad Debts

List Factors that Contributed to Your Estimation of the Adjustments

Describe the Accounting Treatments Related to Your Adjustments

Reference/Cite Authoritative Accounting Literature You Used

3. Assume you are the senior auditor-in-charge of completing the audit of this company. Use the following format to document your plan to audit the adjustments in 1. above. Explain Your Assessment (in High, Moderate, Low) of the Risk and Describe the Auditing Procedures Materiality of the Adjustments You Plan to Test the Adjustments

Reference/Cite Authoritative Auditing Literature You Used


Part B (Answer Part B onlyif your last name’s first alphabet is N-Z) The division’s preliminary results for t he fourth quarter reveal after-tax earnings of $10,200,000 versus a target of $10,000,000.

1. Assume you are Cathy, the controller, provide an estimate of the adjustments you would record in the fourth quarter: Preliminary Earnings $ 10,900,000 1. Inventory Reserve __________ 2. Litigation Liability __________ 3. Accrued Consulting __________ 4. Allowance for Bad Debts __________ Total Adjustments ___________ Division Net Earnings after Adjustments $ ___________ 2. Use the following format to document your rational for the adjustments you would record in the fourth quarter


List Factors that Contributed to Your Estimation of the Adjustments

Describe the Accounting Treatments Related to Your Adjustments

Reference/Cite Authoritative Accounting Literature You Used

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3. Assume you are the senior auditor-in-charge of completing the audit of this company. Use the following format to document your plan to audit the adjustments in 1. above. Explain Your Assessment (in High, Moderate, Low) of the Risk and Describe the Audit ProceduresYou Materiality of the Adjustments Plan to Test the Adjustments

Reference/Cite Authoritative Auditing Literature You Used


Simulation Question 19-3 Simulation Question 19-3 is an adaptation with permission from a case by Knipe P. J., and M. E. Bitter inIssues the in Accounting Education , a publication of the American Accounting Association in Sarasota, Florida. This simulation question is based upon a true set of facts; however, the names and places have been changed.



Introduction

You are the in-charge (senior) accountant (ICA) on the June 30, 2010, audit of Central Florida Emphysema Foundation (CFEF), an affiliated, local chapter of the National Emphysema Foundation (NEF). CFEF is a significant client of K&B, a large, local accounting firm located in Orlando, your employer. K&B is a member of The U.S.A. Group of CPA Firms, commonly referred to as “TUSAG.” TUSAG, with a membership of 40 local firms nationwide, was organized to encourage and enhance the open exchange of technical, financial, and practice management information among its member firms. TUSAG firms pool resources for purposes of presenting continuing professional education courses, preparing member operating and other statistical surveys, promoting the TUSAG brand, and hiring a staff to oversee joint TUSAG activities. All of the participating firms of TUSAG operate autonomously in their respective, mutually exclusive, geographic areas; there is no centralized management in the group and no profit sharing among the group members. Because they are geographically dispersed, the TUSAG member firms do not compete among themselves for clients or personnel. NEF, headquartered in Washington, D.C., is a major client of L&M, the TUSAG member firm located in the same city. NEF requires all of its 120 nationwide chapters to have their financial statements audited annually. The local chapters of NEF are encouraged to use a TUSAG firm, if one is located nearby, but the Board of Trustees of each chapter has the final say in the auditor selection process. Annually, NEF “rolls up” the audited financial statements of its chapters into consolidated financial statements. NEF and all of its affiliated entities are incorporated as not-for-profit organizations. Last year, total fees for audit, tax, and consulting work amounted to $200,000 for CFEF and over $3,000,000 for NEF. NEF is under pressure from its Board to get its audit completed quickly after the end of the fiscal year (also June 30). This pressure is passed on by the NEF management to its auditors, L&M, and to the local chapters and their auditors.

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This Year’s Audit

The audit of CFEF has gone exceptionally well this year, the best in the three years that you have acted as ICA on the engagement. To this point, there have been no significant audit issues. Although relations between the entity's Executive Director and your firm historically have been strained, the client's accounting staff has been very cooperative and it looks as if you might beat the tight engagement time budget approved by your manager. If you do, there is a good chance that you will be recommended for promotion to manager this September, a full year ahead of your peer group. In fact, your audit manager is away on a week's vacation in the Caribbean and asked you to manage the job in her absence. She participated in the first two weeks of year-end fieldwork and has thoroughly reviewed the work completed during that time. She does not expect any problems and has expressed every confidence you are ready for the increased responsibility. While gone, in order to get some much-needed rest and to recharge her batteries, she has asked for no office contact unless there is an emergency. Tragically, shortly after your manager leaves for vacation, and near the end of the job, the CFEF audit partner, who is also K&B's managing partner, received word of a death in his family and leaves suddenly for an out-of-state funeral. He, too, requests no nonemergency contact until he returns so he can attend to pressing family financial and personal issues. He instructs you to review the client's draft copy financial statements and approve sending them to the NEF for national consolidation as soon as you are comfortable with the numbers. The audit partner expects to return in time to complete his review of the audit, sign the report, and meet the final delivery deadline. Being alone now and in charge, you are a bit nervous, but at the same time anxious to prove that you can perform at the manager level and that you really deserve an early promotion.



The Audit Issue

As the audit begins to wrap up, one of the two staff accountants on the job sends you an email message about a possible issue. Earlier in the engagement, while scanning the client's records for large, post year-end transactions, he had noticed a deposit entry of $5,000,000 posted on July 9. He wrote a “to do” note to himself to follow up on this transaction with client personnel. Caught up in the usual time pressures of the job and not really anticipating the deposit entry would be an issue, the staff accountant had simply moved on to other matters. As the audit was winding down, the staff accountan t noticed the outstanding issue on his “to do” list and investigated. The amount did not appear as a reconciling item (i.e., a deposit-in-transit) on the June 30 bank reconciliation prepared by the client, thus indicating the amount presumably was received by CFEF subsequent to year-end, in July. It was common for CFEF to receive large grants early in its fiscal year, but this amount was exceptionally large in comparison to amounts received in previous years. You reprimand the staff accountant for his failure to follow up on the item in a timely manner and for bringing this matter to your attention so late in the engagement. You ask him to determine the nature and source of the $5,000,000 deposit and report back to you as soon as possible, as you have received word that the audit partner on the NEF (national) engagement was getting anxious to receive a “draft copy” of CFEF's audited financial statements.


Later that day, the staff accountant consults briefly with CFEF personnel regarding the nature and source of the transaction, and reports back to you the entire $5,000,000 in question represented a bequest made to CFEF in the will of a local philanthropist whose wife had died several years ago from emphysema. He further reports that the client was in the process of pulling documentation for the staff accountant to review. Based on what the client had told him, the staff accountant indicates he believes the amount should be recorded in the next fiscal year (when it was received by CFEF) and perhaps footnote disclosure in the current year financial statements would be appropriate given the materiality of the amount. A timeline of various audit-related events is provided in Exhibit You 1. should access Data File 19-3 in iLearn for Exhibit 1, which presents the event time-line June 30, 2010 CFEF.

Requirement 1 Based on the information you have been provided to this point, answer the following questions: A. Did the staff accountant's explanation of the facts seem complete and accurate? B. Do you concur with the staff accountant's “conclusion” to record the $5,000,000 amount in the next fiscal year and perhaps include a footnote disclosure in this year's financial statements? DO NOT PROCEED TO THE NEXT SECTION UNTIL YOU HAVE COMPLETED REQUIREMENT 1 After further consideration, you decide to discuss the matter with the CFEF Executive Director yourself. You find that the philanthropist who made the bequest had died shortly after the completion of last year's audit. At that time, the CFEF Executive Director had learned from the law firm representing the estate that CFEF was designated as a residual beneficiary in the will. The amount ultimately to be received by CFEF was not immediately known because the estate had liabilities of an indeterminate amount that had to be paid out of the estate's assets and because the will had been contested by the children of the philanthropist. Ultimately, the Executive Director did not learn of the amount of the bequest until she received the check in July. The CFEF Executive Director also mentioned in passing that receiving the $5,000,000 in July was very good luck, indeed. CFEF had already surpassed its contributions goal for the year ended June 30, 2010, and simply did not need the additional revenue. But receiving the bequest in July was great timing because it gave CFEF a real “kick start” toward meeting next year's aggressive contributions goalthat had been set by its local Board. You ask the Executive Director if the check had actually been received by CFEF in June and simply held until July for deposit. The Executive Director assures you the money had been received in July and shows you the letter of transmittal from the estate's attorney dated July 7, 2010, and an envelope from the law firm postmarked July 8, 2010. She provides you with a copy of all correspondence from the attorney representing the estate, including the letter of transmittal and the postmarked envelope. The Executive Director further states she had specifically asked your staff accountant for his opinion as to when the $5,000,000 should be recorded. The staff accountant had agreed with the Executive Director that distributions from estates, in circumstances like this, should be recorded in the year received. In effect, the staff accountant had sided with the Executive Director in her strong desire to recognize the bequest in the following fiscal year.

Requirement 2 Based on the information you have been provided to this point, answer the following questions: A. Why does the Executive Director want the $5,000,000 to be recognized in the following fiscal year? B. Was the staff accountant's conversation with the Executive Director appropriate? C. What would you next discuss with the Executive Director? D. What would you later discuss with the staff accountant? DO NOT PROCEED TO THE NEXT SECTION UNTIL YOU HAVE COMPLETED REQUIREMENT 2 As your discussion with the Executive Director continues, you tell her you would like to speak with the attorney representing the by your continuing pursuit of a matter she believes to be a “nonissue.” She is frustrated the estate. The Executive Director becomes a bit gitated a audit is not complete and the phone is now ringing off the hook from executives at the NEF asking for CFEF's draft audited financial statements right away. The Executive Director asks you to hurry up and finish the audit and not to waste time calling the estate attorney. As you drive back to your office, you think about your predicament and your options. Excluding the $5,000,000 from the fiscal year 2010 financial statements is more conservative, for sure. And, thinking back to your study of auditor litigation in college, you cannot recall any cases where auditing firms got sued for issuing unqualified opinions on understated operating results and net assets. Overstatements were the issue. Right? You think about the engagement economics (your time budget), your opportunity for an early promotion, and, in addition to the pressure you are receiving from your client, the heat you are now feeling from the L&M audit partner running the NEF engagement in Washington, D.C., to get the job wrapped up. It's a lot to consider, so you circle the block a few times before pulling into the office parking lot.

Requirement 3 Based on the information you have been provided to this point, answer the following questions: A. What is t he Executive Director's “agenda”? B. Rethink your position on the implications of overstating versus understating an entity's assets and revenues. Were your initial thoughts correct? Be sure to consider the impact of the financial statements and the audit opinion on third-party users. C. Why is an engagement time budget so important? What, if anything, is more important than meeting or beating the time budget? D. Do you need the client's permission to call the estate's attorney? Would you call the estate's attorney against the Executive Director's wishes?

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DO NOT PROCEED TO THE NEXT SECTION UNTIL YOU HAVE COMPLETED REQUIREMENT 3 Once back in your office, you close the door and, against the wishes of the Executive Director, you call the estate's attorney. The attorney is in a meeting, so you leave a detailed message with his associate. The next afternoon, the attorney returns your call after having confirmed your identity with CFEF and obtaining written permission to speak to you about the specifics of the bequest. The attorney indicates the will had been adjudicated and the final court order was entered on June 28, 2010. The attorney states the matter had been concluded while he was out of the office on a long 4th of July break. When the attorney returned to his office and read the court order, he immediately dictated a letter and enclosed a check to CFEF for its share of the estate, $5,000,000.

Requirement 4 Based on the information you have been provided to this point, answer the following questions: A. What is meant by “adjudicated?” B. What were the “contingencies” in this estate matter? C. What would you do to confirm the estate attorney's statement about the date of the final court order? DO NOT PROCEED TO THE NEXT SECTION UNTIL YOU HAVE COMPLETED REQUIREMENT 4 You could probably use some help at this point, but you are determined to resolve this matter by yourself without disturbing your audit manager or partner. “This is not an emergency,” you tell yourself; the situation is not out of control. Besides, to get that early promotion, you believe you must prove you are capable of handling difficult client and professional situations. So, with your audit manager and audit partner still out of the office, you decide to call the NEF audit partner at L&M in Washington, D.C., directly and discuss the situation with him. The NEF audit partner informs you he has many years of experience auditing not-for-profit organizations. He tells you that you do not recognize a contingent asset (i.e., a gain contingency) until the amount to be received is known. The residual beneficiary of an estate usually does not know how much will be received until the estate debts are paid and any contesting litigation is settled. In this case, he says, CFEF did not know how much it would receive until July 9, 2010, the date it got the estate attorney's letter and the $5,000,000 check. The NEF audit partner also indicates that the $5,000,000 would be material to this year'sEF N“consolidated” financial statements and, under pressure from his client, he had already approved the release of a “draft copy” of the NEF audited financial statementsto the NEF Board earlier that morning. You learn the NEF statements included unaudited financial information provided directly by CFEF, and did not include any accrual for the estate distribution.

Requirement 5 Based on the information you have been provided to this point, answer the following questions: A. Was the NEF audit partner correct in his explanation of when to record the gain contingency? B. How, if at all, should CFEF report the $5,000,000 estate distribution in its 2010 financial statements? C. Assume that the $5,000,000 bequest should have been recognized in fiscal year 2010. Does it matter that the NEF Board had already received a “draft copy” of the entity's consolidated financial statements that did notinclude the $5,000,000 accrual? D. Was the NEF audit partner trying to persuade you to give up on your investigation of the matter? E. Would you drop the matter at this point? F. Should you contact your audit manager or audit partner on an “emergency” basis or seek help from other available K&B office personnel? DO NOT PROCEED TO THE NEXT SECTION UNTIL YOU HAVE COMPLETED REQUIREMENT 5 After speaking to the NEF audit partner and giving the situation some more thought, you decide to have another discussion with CFEF's Executive Director. Before you can say anything, the Executive Director gives you a good tongue-lashing r calling fo the estate's attorney “behind my back.” She explains the attorney had called her to get permission to discuss the nature of the bequest to CFEF with you. She had reluctantly agreed to grant the permission, but was angry you called the attorney despite her request that you not. The Executive Director also tells you she had contacted her counterpart at NEF, the National Executive Director, yesterday. The National Director considers himself to be quite experienced with not-for-profit accounting matters. He and the NEF audit partner are fairly close personal friends. Both had independently reviewed SFAS No. 116, “Accounting for Contributions Received and Contributions Made,”1 and the related literature, and both had concluded the $5,000,000 should be recorded in fiscal year 2011, when notification of the amount was received by CFEF. You then learn the National Executive Director had directed the CFEF Executive Director to close the CFEF books at June 30 without the $5,000,000 recorded and to submit the financial statements to NEF immediately for i nclusion in the “draft copy” national consolidation. Now it becomes clear to youhow the NEF audit partner had received unaudited financial information from CFEF.

Requirement 6 Based on the information you have been provided to this point, answer the following questions: A. Whose financial statements are they? Can you “dictate” how or when a particular transaction is or is not recorded? B. Do you think an audit adjustment should be proposed for the $5,000,000 distribution? C. If yes, what should the entry be? D. Is this beginning to feel like a bit of a conspiracy? E. Is it time t o “throw in the towel” and just walk away from the issue?

1

–605 (FASB 2010). Now part of FASB's Accounting Standards Codification (ASC) 958


DO NOT PROCEED TO THE NEXT SECTION UNTIL YOU HAVE COMPLETED REQUIREMENT 6 You are really feeling the heat now. The job is going over the time budget for sure, the draft audit report is going to be late, and you begin to worry that K&B may now be at risk of losing the $200,000 CFEF audit. In addition, there could be a risk of L&M, the TUSAG firm in —remember?). From what you have heard, if the NEF job is Washington, D.C., losing the NEF national audit ($3,000,000 in total annual fees lost, the audit partner at L&M will likely get a poor annual review and might face a forced, early retirement. You decide to call the NEF audit partner one last time.

Requirement 7 Based on the information you have been provided to this point, answer the following questions: A. How does the potential loss of audit fees by both K&B and L&M impact your thought process? B. Should you be concerned about the NEF audit partner's situation? C. What would you discuss on your anticipated call to the NEF audit partner? DO NOT PROCEED TO THE NEXT SECTION UNTIL YOU HAVE COMPLETED REQUIREMENT 7 Coincidentally, your audit manager and audit partner are both due back in the office on Monday. You know they both expect, based on their experiences with prior year CFEF audits and the status of this year's audit when they left the office, to see a finished CFEF audit, tied up “neatly in a bow,” with an unqualified opinion on the financial statements ready for signing. They will, of course, completetheir review of the engagement, but you know they really do not expect to see any problems. In spite of ongoing shaky relations with the Executive Director, CFEF has been a good client over the years and audit issues have been minor and minimal. As you now know from discussions with the NEF audit partner and the local Executive Director, CFEF did not record the $5,000,000 at June 30, 2010. However, it did disclose the matter in a subsequent events footnote to the financial statements. This, of course, is contrary to your conclusion that the $5,000,000 bequest should have been accrued at June 30, 2010. The statements were sent to the NEF without your final review.

Requirement 8 Based on the information you have been provided to this point, answer the following question: A. How would you prepare for your meeting with your audit manager and audit partner? DO NOT PROCEED TO THE NEXT SECTION UNTIL YOU HAVE COMPLETED REQUIREMENT 8 Your audit manager arrives in the office early the next morning and sees the CFEF audit ready for review. She reads your review notes first, including those documenting your discussions with the CFEF Executive Director and the NEF audit partner. She is shocked to see such differences of opinion on a major accounting issue. She quickly understands the CFEF Executive Director's position of wanting to “save” the $5,000,000 bequest until the next budget year. But she wonders and worries about the NEF audit partner's agreement with this position. After all, he is a well-respected partner at L&M and among the TUSAG firms and is widely reputed to have expertise in the not-for-profit area. She calls the audit partner, who is also back in the office, to schedule a conference and invites you to join the discussion. After thoroughly reviewing the matter, both the audit manager and audit partner agree with your position.

Requirement 9 A. At this point, what are the options available to K&B relative to the CFEF audit? B. What, if any, type of leverage can K&B employ to reinforce its position on accounting for the bequest?

Requirement 1 0 A. What course of action do you think was finally taken by K&B's CFEF audit team? B. What course of action do you think was taken by the CFEF Executive Director?

Requirement 1 1 In your estimation, what was the ultimate impact of the events that transpired on the following: A. The NEF national audit engagement B. The CFEF local audit engagement C. The NEF audit partner D. The CFEF Executive Director E. You Note: You must answer all the subparts of the 11 Requirements in order to earn the extra credit point.

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Chapter 20 Audit Report Chapter Learning Outcomes (LOs) Checklist


LO20-1 Write the important wordings of a standard unqualified audit report.



LO20-2 Identify 5 common situations for adding explanatory paragraphs to or modifying wordings of a standard unqualified audit report.



LO20-3 Identify 3 common situations that result in 3 types of qualified audit report depending on 3 levels of materiality.

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LO20-4 Discuss the auditor’s report concerning comparative financial statements.



LO20-5 Discuss the auditor’s report concerning financial statements prepared for use in other countries.


Chapter 20 Audit Report The final phase in the audit process is issuing the audit report. It is the culmination of a process of collecting and evaluating sufficient appropriate evidence concerning the fair presentation of management’s assertions in the financial statements. Guidance on audit reporting are provided by the following: PCAOB’s Auditing Standard No.1 (AS 1), References in Auditors’ Reports to the Standards of the Public Company Accounting Oversight Board, and Auditing Standard No 5 (AS 5), An Audit of Internal Control over Financial Reporting Performed that is Integrated with an Audit of Financial Statement , and AICPA’s AU 700, Forming an Opinion and Reporting on Financial Statements, AU 705 Modifications to the Audit Opinion in the Independent Auditor’s Report, AU 706 Emphasis of Matter Paragraphs and Other Matter Paragraphs in the Independent Auditor’s Report . Figure 20-1 provides an overview of audit reporting and Figure 20-2 provides an on overview of the various types of audit report. Figure 20-1 An Overview of Audit Reporting The Audit Process

Audit Plan

Tests of Controls

Tests of Balances

Financial Audit

One Audit Report (Opinion) on the Fairness of Financial Statements.


Audit Report

Integrated Audit

One Audit Report (Opinion) on the Fairness of Financial Statements. + One Audit Report (Opinion) on the Effectiveness of ICFR. OR One Combined Audit Report (Opinion) on the Fairness of Financial Statements and the Effectiveness of ICFR.

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Figure 20-2 An Overview of the Various Types of Audit Report ___________________________________________________________________________________________________________________

Effect of Materiality Type of Audit Report Others Types of Audit Report ____________________________________________________________________________________________ Immaterial

Scope limitation: 1. Client imposed 2. Condition imposed

Material

Unqualified with additional explanatory paragraph or modified wordings

Unqualified

Qualified

Scope limitation: 1. Client imposed 2. Condition imposed

Departure from GAAP

Qualified

Departure from GAAP

Additional explanatory paragraph for: 1. Lack of consistency in applying GAAP 2. Substantial doubt about going concern 3. Auditor agrees with departure from GAAP 4. Emphasis of a matter Modified wordings for: 5. Report involving other auditors

Other Types of Audit Report:

 

Comparative financial statements.

Other information in documents containing financial statements.

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Condensed financial statements and selected financial data.

 

Required supplementary information.

Letters for underwriters and certain other requesting parties. Pervasively Material

Disclaimer

Adverse

Issue disclaimer for: 1.A lack of independence in all cases. 2.A substantial doubt about going concern in some cases.



Filing statutes.

under

federal

securities

Financial statements prepared for use  other in countries.

____________________________________________________________________________________________________________________

The Auditor’s Standard Unqualified Audit Report

Figure 20-3 presents an example of a standard unqualified audit report (opinion) on financial statements and describes some important wordings or elements of the report according to AS 1 and AS 5 of the PCAOB in an integrated audit. As discussed in Chapter 8, AS 5 of the PCAOB also requires the auditor of a public company to perform an integrated audit and report on the effectiveness of ICFR. Accordingly, the auditor may choose to issue two separate reports (opinions): one on the fairness financial statements (see Figure 20-3) and one on the effectiveness of ICFR (see Figure 20-4), or one combined audit report (two opinion) on financial statements and ICFR (see Figure 20-5). Figure 20-5 presents an example of a combined unqualified audit report (two opinions) on financial statements and on the effectiveness of ICFR. Some important wordings or elements of the combined report include: 1. The introductory, scope, and opinion paragraphs are modified to include reference to management’s assessment of ICFR and the scope of the auditor’s work and opinion on ICFR. 2. The introductory and opinion paragraphs also refer to the framework used to evaluate internal control. 3. The report includes a paragraph after the scope paragraph defining ICFR. 4. The report also includes an additional paragraph before the opinion paragraph that addresses the inherent limitations of internal control. 5. Although the audit opinion on the financial statements may address multiple reporting periods (fiscal years), management’s assertion about the effectiveness of internal control is as of the end of the most recent fiscal year.


In addition, the auditor may issue a combination of unqualified opinion, qualified opinion, adverse opinion, or disclaimer of opinion on the effectiveness of ICFR. Figure 20-6 shows all potential variations of audit opinion on financial statements and audit opinion on the effectiveness of ICFR. Examples of these reports are shown in Figure 20-7, Figure 20-8, and Figure 20-9. Figure 20-3 An Example of a Standard Unqualified Audit Report (Opinion) on Financial Statements Title: The title includes the word “independent registered” Report of Independent Registered Public Accounting Firm so that the users know that the audit was conducted XYZ CPA, LLP objectively. Include also the city and state where the San Francisco, California auditor’s report has been issued. Addressee: The report should be addressed to the board of The Board of Directors and Stockholders directors and stockholders, and should not be ABC Corporation addressed to the management. Introductory paragraph: The introductoryparagraph should 1. State, “We have audited” to indicate that an audit was conducted. 2. Describe the financial statements that are covered by the audit. 3. State that the financial statements are the responsibility of the management. 4. State that the auditor’s responsibility is to express an opinion. Scope paragraph: The scope paragraph should 1. State the authoritative standards that were followed in conducting the audit. 2. Emphasize that the audit only provides “reasonable assurance” of no material misstatement. 3. Disclose that the an audit involves examining evidence on a “test basis”; assessing the accounting principle used and significant estimates, and evaluating the overall financial statement presentation. 4. Express the auditor’s belief that there was a “reasonable basis” for making an audit opinion. Opinion paragraph: The opinion paragraph should 1. State, “In our opinion” to indicate that the report is a statement of opinion not a statement of fact. 2. Use the phrase “present fairly” to indicate that it is an unqualified audit report. 3. Use the phrase “in all material respects” to stress the concept of materiality. 4. State, “in conformity with generally accepted accounting principles” to comply with the first standard of reporting. Explanatory paragraph referring to the audit of internal control: This paragraph refers to a separate report on the effectiveness of internal control over financial reporting.

We have audited the accompanying balance sheets of ABC Corporation as of December 31, 20xx, and the related statements of income, retained earnings, and cash flows for the year then ended. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of ABC Corporation as of December 31, 200x, and the results of its operations and its cash flows for the year then ended in conformity with generally accepted accounting principles.

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of XYZ Corporation’s internal control over financial reporting as of December 31, 20xx, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 31, 200x expressed an unqualified opinion that XYZ Corporation maintained, in all material respects, effective internal control over financial reporting.

Name of the auditor: Typically, the CPA firm’s name rather than individual XYZ CPA, LLP partner-in-charge of the engagement is used. Also, it is common to state LLP (limited liability partnership) to indicate the partnership structure of the CPA firm. Audit report date: The report should be dated on the completion of the March 31, 20xx fieldwork date, but it is common to date it the same date as the client’s director report date.

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Figure 20-4 An Example of an Unqualified Audit Report (Opinion) on the Effectiveness of ICFR

[TITLE] Report of Independent Registered Public Accounting Firm ABC CPA, LLP San Francisco, California [ADDRESSEE] The Board of Directors and Stockholders XYZ Corporation [INTRODUCTORY PARAGRAPH] We have audited XYZ Corporation ’s internal control over financial reporting as of December 31, 20xx, based on criteria establishedInternal in Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). XYZ Corporation’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the on the effectives of the company’s internal effectiveness of internal control over financial reporting. Our responsibility is to express an opinion control over financial reporting based on our audits. [SCOPE PARAGRAPH] We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit of internal control over financial reporting includes obtaining an understanding of internal control over financial reporting, evaluating management ’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinion. [DEFINITION PARAGRAPH] A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company, and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of he t company’s assets that could have a material effect on the financial statements. [INHERENT LIMITATIONS PARAGRAPH] Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. [OPINION PARAGRAPH] In our opinion, XYZ Corporation maintained, in all material respects, effective internal control over financial reporting as of December 31, 20xx, based on criteria established inInternal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). [EXPLANATORY PARAGRAPH] We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements of XYZ Corporation, and our report dated March 31, 20xx, expressed an unqualified opinion. [SIGNATURE OF THE AUDITOR] _____________________________ ABC CPA, LLP



Figure 20-5 An Example of a Combined Unqualified Audit Report (Two Opinions) on Financial Statements and Effectiveness of ICFR [TITLE] Report of Independent Registered Public Accounting Firm ABC CPA, LLP San Francisco, California [ADDRESSEE] The Board of Directors and Stockholders XYZ Corporation [INTRODUCTORY PARAGRAPH] We have audited the accompanying balance sheets of XYZ Corporation as of December 31, 20xx, and the related statements of income, retained earnings, and cash flows for the year then ended. We also have audited XYZ Corporation ’s internal control over financial reporting as of December 31, 20xx, based on criteria established inInternal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). XYZ Corporation’s management is responsible for these financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on these financial ements, stat an opinion on management’s assessment of internal control over financial reporting, and an opinion on the effectives of the company’s internal control over financial reporting based on our audits. [SCOPE PARAGRAPH] We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audit of financial statements includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over r financial reporting, evaluating management’s assessment, testing financial reporting includes obtaining an understanding of internal control ove and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinion. [DEFINITION PARAGRAPH] A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenanc e of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company, and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. [INHERENT LIMITATIONS PARAGRAPH] Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. [OPINION PARAGRAPH] In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of XYZ Corporation as of December 31, 20xx, and the results of its operations and its cash flows for the year then ended in conformity with generally accepted accounting principles in the United States of America. Also, in our opinion, XYZ Corporation maintained, in all material respects, effective internal control over financial reporting as of December 31, 20xx, based on criteria established Internal in Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).



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Figure 20-6 All Potential Variations of Audit Opinion on Financial Statements and Audit Opinion on the Effectiveness of ICFR.

Audit Opinion on Financial Statements Audit Opinion on the Effectiveness of ICFR Unqualified (U)

Unqualified (U)

Qualified (Q)

Disclaim Opinion /Withdraw (D/W)

Adverse (A)

(U) and (U) See Figure 8-11

(Q) and (U)

(D/W) and (U)

(A) and (U)

(D/W) and (Q)

(A) and (Q)

(D/W) and (D/W)

(A) and (D/W)

and Figure 8-12 Qualified (Q)

(U) and (Q)

(Q) and (Q) See Figure 20-7

Disclaim Opinion/Withdraw (D/W)

(U) and (D/W)

(Q) and (D/W)

Adverse (A)

(U) and (A) See Figure 20-8

(Q) and (A)

(D/W) and (A)

(A) and (A) See Figure 20-9

Figure 20-7 An Example of a Report Expressing a Qualified Opinion on Financial Statements and a Qualified Opinion on the Effectiveness of ICFR [TITLE] Report of Independent Registered Public Accounting Firm ABC CPA, LLP San Francisco, California [ADDRESSEE] The Board of Directors and Stockholders XYZ Corporation [STANDARD WORDING FOR INTRODUCTORY PARAGRAPH] [SCOPE PARAGRAPH] Except as described below, we conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards … [STANDARD WORDING FOR THE REMAINDER OF THE SCOPE PARAGRAPH.] [EXPLANATORY PARAGRAPH] A material weakness is a control deficiency, or a combination of significant deficiencies, in internal control over financial reporting (ICFR), such that there is a reasonable possibility that a material misstatement of the company’s annual or interim financial statements w ill not be prevented or detected on a timely basis. The following material weak ness has been identified and included in management’s assessment. Prior to December 15, 20xx, XYZ Corporation had an inadequate system for recording cash receipts, which could have prevented the company from recording cash receipts on accounts receivable completely and properly. Therefore, cash received could have been diverted for unauthorized use, lost, or other otherwise not properly recorded to accounts receivable. We believe this condition was a significant deficiency in the design or operation of the internal control of XYZ Corporation in effect prior to December 15, 20xx. Although the company implemented a new cash receipts system on December 15, 20xx, the system has not been in operation for a sufficient period of time to enable us to obtain sufficient evidence about its operating effectiveness. [STANDARD WORDING FOR DEFINITION PARAGRAPH] [STANDARD WORDING FOR INHERENT LIMITATIONS PARAGRAPH] [OPINION PARAGRAPH] In our opinion, except for the effect of matters we might have discovered had we been able to examine evidence about the effectiveness of the new cash receipt system, XYZ Corporation maintained, in all material respects, effective internal control over financial reporting as of December 31, 20xx, based on criteria established inInternal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). [EXPLANATORY PARAGRAPH REFERING TO THE AUDIT OF FINANCIAL STATEMENTS]


We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements of XYZ Corporation, and our report dated March 31, 20xx, expressed a qualified opinion.



Figure 20-8 An Example of a Report Expressing an Unqualified Opinion on Financial Statements and an Adverse Opinion on the Effectiveness of ICFR [TITLE] Report of Independent Registered Public Accounting Firm ABC CPA, LLP San Francisco, California [ADDRESSEE] The Board of Directors and Stockholders XYZ Corporation [STANDARD WORDING FOR INTRODUCTORY PARAGRAPH] [STANDARD WORDING FOR SCOPE PARAGRAPH] [STANDARD WORDING FOR DEFINITION PARAGRAPH] [STANDARD WORDINGFOR INHERENT LIMITATIONSPARAGRAPH] [EXPLANATORY PARAGRAPH] A material weakness is a control deficiency, or a combination of significant deficiencies, in internal control over financial reporting (ICFR), such that there is a reasonable possibility that a material misstatement of the company’s annual or interim financial statements w ill not be prevented or detected on a timely basis. The following material weakness has been identified and included in management’s assessment. XYZ Corporation had an inadequate system for recording cash receipts, which could have prevented the company from recording cash receipts on accounts receivable completely and properly. Therefore, cash received could have been diverted for unauthorized use, lost, or otherwise not properly recorded to accounts receivable. This material weakness was considered in determining the nature, timing, and extent of audit tests applied in our audit of the 20xx financial statements, and this report does not affect our report dated March 31, 20xx, on those financial statements. [OPINION PARAGRAPH] In our opinion, because of the effect of the material weakness described above on the achievement of the objectives of the control criteria, XYZ Corporation has not maintained effective internal control over financial reporting as of December 31, 20xx, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). [STANDARD EXPLANATORY PARAGRAPH REFERING TO THE AUDIT OF FINANCIAL STATEMENTS] We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements of XYZ Corporation, and our report dated March 31, 20xx, expressed an unqualified opinion.



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Figure 20-9 An Example of a Report Expressing an Adverse Opinion on Financial Statements and an Adverse Opinion on the Effectiveness of ICFR. [TITLE] Report of Independent Registered Public Accounting Firm ABC CPA, LLP San Francisco, California [ADDRESSEE] The Board of Directors and Stockholders XYZ Corporation [STANDARD WORDING FOR INTRODUCTORY PARAGRAPH] [STANDARD WORDING FOR SCOPE PARAGRAPH] [STANDARD WORDING FOR DEFINITION PARAGRAPH] [STANDARD WORDINGFOR INHERENT LIMITATIONSPARAGRAPH] [EXPLANATORY PARAGRAPH] A material weakness is a control deficiency, or a combination of significant deficiencies, in internal control over financial reporting (ICFR), such that there is a reasonable possibility that a material misstatementf the o company’s annual or interim financial statements will not be prevented or detected on a timely basis. We have identified the following material weakness that has not been identified as a material weakness in management’s assessment. [Include a description of the material weakness and its effect on the achievement of the objectives of the control criteria.] This material weakness was considered in determining the nature, timing, and extent of audit tests applied in our audit of the 20xx financial statements, and this report does not affect our report dated March 31, 20xx, on those financial statements. [OPINION PARAGRAPH] In our opinion, because of the effect of the material weakness described above on the achievement of the objectives of the control criteria, XYZ Corporation has not maintained effective internal control over financial reporting as of December 31, 20xx, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). [STANDARD EXPLANATORY PARAGRAPH REFERING TO THE AUDIT OF FINANCIAL STATEMENTS] We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements of XYZ Corporation, and our report dated March 31, 20xx, expressed an adverse opinion.



Five Common Situations for Adding Explanatory Paragraphs or Modifying Wordings to a Standard Unqualified Audit Report

There are five common situations that may require the auditor to add an explanatory paragraph to or modify the wordings to a standard unqualified audit report. They are: 1. Lack of Consistency in Applying GAAP

If there is a change in the accounting principle or in the method of its application that materially affects the comparability of the financial statements, the auditor should report the change by adding an explanatory paragraph after the opinion paragraph and by pointing to the footnote that discusses the change. For example:


Report of Independent Registered Public Accounting Firm XYZ CPA, LLP San Francisco, California The Board of Directors and Stockholders ABC Corporation [STANDARD WORDING FOR THE INTRODUCTORY, SCOPE, AND OPINION PARAGRAPHS] As discussed in Note 8 to the financial statements, the ABC Corporation changed its method of computing depreciation in 20xx. XYZ CPA, LLP March 31, 20xx

Examples of accounting changes that require adding an explanatory paragraph:



Change in accounting principle – such as a change from straight-line to double declining balance depreciation method.

 

Change in reporting entity – such as a change from equity to consolidation method of reporting.

 

Change in accounting estimate – such as a change in the estimated service life of an asset for depreciation.

Correction of an error in principle – such as a change form an unacceptable replacement cost to FIFO method for inventory. Examples of accounting changes that do not require adding an explanatory paragraph: (usually disclosed in the footnotes) Correction of an error that does not involve an accounting principle – such an adjustment for prior year’s mathematical error.



Change in classification and reclassification – such as a change from operating expenses to administrative expenses.

 Change expected to have a material future effect – such as research and development projects that have material future effect. In addition, the selected accounting principle must:  

Be appropriate in the circumstances for the client.

Reflect the underlying transactions and events in a manner that presents the financial position, results of operations, and cash flows (i.e., the financial statements taken as a whole) stated within a range of acceptable limits.



Reflect information presented in the financial statements that is classified and summarized in a reasonable manner. 2. Substantial Doubt about Going Concern (AU Going 570 Concern)

When there is substantial doubt about a client’s ability to continue as a going concern, the auditor should add an explanatory paragraph detailing the issues relating to the going concern judgment. For example: Report of Independent Registered Public Accounting Firm XYZ CPA, LLP San Francisco, California The Board of Directors and Stockholders ABC Corporation [STANDARD WORDING FOR THE INTRODUCTORY, SCOPE, AND OPINION PARAGRAPHS] The accompanying financial statements have been prepared assuming that ABC Corporation will continue as a going concern. As discussed in Note 10 to the financial statements, ABC Corporation has suffered recurring losses from operations and has a net capital deficiency that raise substantial doubt about the company’s ability to continue as a going concern. XYZ CPA, LLP March 31, 20xx

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In addition, the auditor may express a disclaimer of opinion when there is substantial doubt about a client’s abilityto continue as a going concern and the client ’s financial statements adequately disclose its financial difficulties. 3. Auditor Agrees with a Departure from GAAP

In some unusual situations, financial statements may be misleading if a promulgated accounting principle was followed. In such situations, the auditor should add an explanatory paragraph describing the agreed departure from GAAP, the effect of the departure, and reasons that compliance with the GAAP would have resulted in misleading financial statements. 4. Emphasis of a Matter

Under certain circumstances, an auditor may want to emphasize a specific matter, even though s/he intends to issue a standard unqualified report. The auditor usually adds a paragraph above the opinion paragraph to draw attention to the emphasized matter. For example: Report of Independent Registered Public Accounting Firm XYZ CPA, LLP San Francisco, California The Board of Directors and Stockholders ABC Corporation [STANDARD WORDING FOR THE INTRODUCTORY AND SCOPE PARAGRAPHS] As discussed in Note 12 to the financial statements, the ABC Corporation has a number of significant related-party transactions and important balance sheet date of December 31, 20xx. 5. events Reportoccurring involvingafter otherthe auditors [STANDARD WORDING FOR THE OPINION PARAGRAPH] XYZ CPA, LLP March 31, 20xx

5. Report Involving other Auditors

On some audit engagements, such as auditing consolidated financial statements, part of the audit (of subsidiary companies) may be completed by another CPA firm. In such cases, the principal auditor (auditor of the parent company) has three options:

 Make no reference in the audit report This option is usually followed when the other auditor audited an immaterial part of the consolidated financial statements; the other auditor is well known or closely supervised by the principal auditor, or the principal auditor has thoroughly reviewed the other auditor’s work.  Make reference in the audit report (A shared opinion report) In a shared opinion report, the principal auditor modifies the wording to a standard unqualified audit report to indicate the shared audits in the introductory paragraph; the shared responsibility in the scope paragraph, and the shared opinion in the opinion paragraph. An example of the shared opinion report is presented in Figure 20-10.  Issue a qualified audit report If the principal auditor is not willing to assume any responsibility for the work of the other auditor, s/he may issue a qualified or disclaimer report. In addition, if the principal auditor is unable to be satisfied as to the independence and professional reputation of the other auditor, s/he may issue a qualified or disclaimer report. Finally, if the other auditor qualified his/her part of the a udit, the principal auditor may decide to issue a qualified report.


Figure 20-10 An Example of a Shared Opinion Audit Report

Report of Independent Registered Public Accounting Firm XYZ CPA, LLP San Francisco, California The Board of Directors and Stockholders ABC Corporation We have audited the consolidated balance sheets of ABC Corporation as of December 31, 20xx, and the related consolidated statements of ompany’s income, retained earnings, and cash flows for the year then ended. These financial statements are the responsibility of the C management. Our responsibility is to express an opinion on these financial statements based on our audits. We did not audit the financial statements of DEF Company, a consolidated subsidiary in which the ABC Corporation had an equity interest of 70% as of December 31, 20xx. Those statements were audited by other auditors whose report has been furnished to us, and our opinion, insofar as it relates to the amount included for DEF Company, is ba sed solely on the report of the other a uditors.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits and the report of the other auditors provide a reasonable basis for our opinion. In our opinion,based on our audits and the report of the other auditors, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of ABC Corporation as of December 31, 20xx, and the consolidated results of its operations and its cash flows for the year then ended in conformity with generally accepted accounting principles. XYZ CPA, LLP March 31, 20xx

The Auditor’s Qualified Audit Report

There are three types of qualified audit report (qualified, disclaimer, or adverse) depending on three situations (scope limitation, departure from GAAP, or lack of independence) and three levels of materiality (immaterial, material, or pervasively material). The three types of qualified audit report are: Type 1 – Qualified Opinion

The auditor issues a qualified opinion when either a scope limitation or a departure from GAAP exists, but overall the financial statements present fairly in conformity with GAAP. In a qualified report, the auditor describes the nature of the scope limitation and effects of the GAAP departure on the financial statements and indicates in the opinion paragraph that the financial statements present fairly “except for” the departure or scope limitation. Type 2 – Disclaimer of Opinion

The auditor disclaims an opinion on the financial statements either because there is insufficient appropriate evidence to form an opinion on the overall financial statements or because there is a lack of independence. In a disclaimer, the auditor explains the reasons for withho lding an opinion and explicitly indicates that “no opinion is expressed.” Type 3 – Adverse Opinion

The auditor issues an adverse opinion when the financial statements do not present fairly due to a GAAP departure that materially affects the overall financial In an adverse report the auditor explains andin effects of the misstatement and states in thestatements. opinion paragraph that the financial statements “do the not nature, presentsize, fairly” accordance with GAAP.

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The three situations resulting in a qualified audit report are: Situation 1– Scope Limitation

When the auditor has not accumulated sufficient evidence to conclude whether financial statements are stated in accordance with GAAP, a scope limitation exists. There are two major causes of scope limitations: limitations imposed by the client and those caused by circumstances beyond the either the client’s or auditor’s control. An example of a client limitation is management’s refusal to permit the auditor to confirm material accounts receivables or to physically observe inventory count. An example of a limitation caused by circumstances is the client’s lawyer refuses to sign and return the lawyer representation letter. When there is a scope limitation, the auditor should perform alternative procedures to gather sufficient evidence. If there is sufficient evidence using alternative procedures, an unqualified report is appropriate. However, if alternative procedures cannot be performed, a qualified opinion or disclaimer of opinion is appropriate depending on materiality. A qualified opinion on scope limitation requires adding a third paragraph before the opinion paragraph to describe the limitation. A disclaimer of opinion on scope limitation requires modifying the wordings of the introductory paragraph from “We have audited ...” to “We were engage to audit ...” The scope paragraph is deleted to avoid stating anything that might lead readers to believe that other parts of the financial statements were audited and therefore might be fairly stated. A second paragraph is added to describe the limitation and state unable to gather evidence by using alternative audit procedures. Situation 2– Departure from GAAP

A departure from GAAP exists when the financial statements are prepared or presented in a manner that departs from GAAP, whether due to error or fraud. An example of a departure from GAAP is when the client insists on using replacement costs for fixed assets or values inventory at selling price rather than historical cost. If the financial statements are materially affected by a departure from GAAP, the auditor should issue a qualified or adverse opinion, depending on materiality. A qualified opinion on departure from GAAP requires adding an explanatory paragraph before the opinion paragraph to disclose the effects of the departure on the financial statements and the opinion includes the words “except for...” An adverse opinion on departure from GAAP also requires adding an explanatory paragraph before the opinion paragraph to disclose the effects of the departure on the financial statements and the opinion paragraph is modified to state that the financial statements “do not present fairly” in conformity with GAAP. Situation 3– Lack of Independence

A lack of independence arises when the auditor and the client have any financial or business relationship that does not comply with the second general standard of the GAAS and Rule 101 of the Code of Professional Conduct. If the auditor is not independent, a disclaimer of opinion must be issued at all-time regardless of materiality. In a disclaimer of opinion, the auditor should not state the reasons for the lack of independence not describe any audit procedures performed. This requirement is intended to prevent the auditor from attempting to minimize or explain away the circumstances. Also, a title is not required in the disclaimer report. A common definition of materiality is that a misstatement in the financial statements can be considered material if knowledge of the misstatement will affect a decision of a reasonable user of the financial statements. The three levels of materiality consideration in issuing an audit report are: Level 1 – Immaterial

When a misstatement in the financial statements exists but is unlikely to affect the decisions of a reasonable user, it is considered to be immaterial. An unqualified opinion is therefore appropriate. For example, management recorded prepaid insurance as an assethas in failed the previous year and decides to expense in small the current to reduce recordkeeping costs. Management to follow GAAP, but if the amountsitare that isyear unlikely to affect the decisions of a reasonable user of the financial statements, a standard unqualified audit report is appropriate.


Level 2 – Material

The second level of materiality exists when a misstatement in the financial statements would affect a user’s decision, but the overall statements are still fairly stated and therefore useful. In other words, amounts are material but do not overshadow the financial statements as a whole. For example, a large misstatement in fixed assets might affect a user’s willingness to loan money to a client if the assets were the collateral. However, a misstatement of fixed assets does not mean that cash, accounts receivable, and other parts of the financial statements, taken as a whole, are materially misstated. When the auditor concludes that a misstatement is material but does not overshadow the financial statements, taken as a whole, a qualified opinion using the words “except for” is appropriate. The auditor judges whether a GAAP departure (Situation 2) misstatement is material based on three factors:

1. The concept of materiality discussed in Chapter 9. The auditor compares the total amount of misstatement to an appropriate base (e.g., total assets) and uses a rule of thumb (e.g., the 5% rule) to evaluate the materiality of the misstatement. To evaluate materiality of the financial statements, taken as whole, the auditor should combine all unadjusted misstatements and consider whether there are individually immaterial misstatements that, when combined, become material. The extent (pervasiveness) to which these misstatements affect other parts of the financial statements should also be considered. 2. Measurability. The dollar amount of some misstatements may not be accurately measured. For example, any misstatement in the fair value measurement of an acquisition (in business combination) subsequent to the balance sheet date may be difficult to determine during the year-end audit. In this situation, the auditor should consider the effect on statement users of the failure to make the disclosure. 3. Quality. The decision of a user may be affected by the quality of the misstatement. Qualitative factors include: a. A immaterial misstatement that is illegal or fraudulent. b. A misstatement may materially affect some future periods, even though it is immaterial when only the current period is considered. c. A misstatement has a “psychic” effect, for example, the misstatement changes a small loss to a small profit, maintains a trend of increasing earnings, or allows earnings to exceed analysts’expectation. d. A misstatement may be important in terms of possible consequences arising from contractual obligations. For example, the effect of failure to comply with a debt covenant may result in a material loan being recalled. The auditor judges whether a scope limitation (Situation 1) misstatement is material based on the same three factors above, but with one difference – the effect of potential misstatements, rather than known misstatements (as in the case of departure from GAAP) in determining whether an unqualified opinion, a qualified opinion, or a disclaimer of opinion is appropriate. For example, if the auditor is prevented from observing physical inventory count, the auditor must evaluate the potential misstatement in inventory account and decide how materially the financial statement could be affected. Level 3 – Pervasively Material

The highest level of materiality exists when users are likely to make incorrect decisions if they rely on the overall financial statements. When determining whether a misstatement is highly material, the extent to which the misstatement affects different parts of the financial statements must be considered – this is called pervasiveness. For example, if inventory is the largest balance on the financial statements, a large misstatement would extensively affect other parts of the financial statement that the auditor’s report should indicate the financial statements, taken as a whole, cannot be considered fairly stated. When the highest level of materiality exists, the auditor should issue either a disclaimer of opinion or an adverse opinion, depending on which situations (scope limitation or departure from GAAP) exist. In the case of a lack of independence (Situation 3), a disclaimer must be issued at all-time regardless of the level of materiality. This strict requirement reflects the importance of auditor independence under Rule 101 of the Code of Professional Conduct (Recall Chapter 3).

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Table 20-1 presents a matrix of the three types of qualified audit report depending on the three situations and the three levels of materiality. Table 20-1 Three Types of Qualified Audit Report Depending on Three Situations and Three Levels of Materiality

Type of Qualified Audit Report



Situation

 Scope limitation When the auditor is unable to accumulate sufficient evidence. The scope limitation can be client-imposed (e.g., management’s refusal to provide certain evidence; missing part of the financial statements) or conditionimposed (e.g., auditor is unavailable to observe the inventory count; inadequate accounting records; client’s lawyer refusal to sign lawyer representation letter).

Qualified The auditor’s opinion states, “except for…” the financial statements “present fairly”  Material – Users decisions are likely to be affected by the exceptions. (1) Add a third paragraph to explain the scope limitation and state unable to gather the evidence by applying other audit procedures. (2) State in the opinion paragraph the possible effects of the scope limitation on the financial statements. See Figure 20-11.

 Departure from GAAP  Material – Users decisions When the financial statements are likely to be affected by the are affected by a departure exceptions. from GAAP (e.g., fail to Add a third paragraph to describe disclose illegal act; omit the departure from GAAP. certain financial statements; See Figure 20-13 fail to justify/report accounting change). of independence When the auditor does not  Lack comply with the second standard and Rule 101 of the Code of Professional Conduct. In addition, when the auditor is associated with financial statements that were not audited or reviewed by him/her.



Not Applicable

 Disclaimer  Adverse The auditor’s opinion states, “we do The auditor’s opinion states, not express an opinion” on the the financial statements “do not present fairly” financial statements.  Pervasively material – Users  Not Applicable – the decisions are likely to be auditor has no reasonable extensively affected by the basis to state that the exceptions. financial statements do not (1) Modify introductory paragraph to present fairly. “We were engaged to audit …” (2) Omit the scope paragraph. (3) Add a second paragraph to explain the scope limitation and state unable to gather the evidence by applying other audit procedures. See Figure 20-12.



Not Applicable – the auditors are expected to determine the effect of a departure from GAAP.

Regardless the auditor issuesofa materiality disclaimer –at  all time. (1) No title is required. (2) No reasons for the lack of independence are offered. (3) Must not include piece meal opinions on specific accounts of the financial statements. See Figure 20-15



Pervasively material – Users decisions are likely to be extensively affected by the exceptions. Add a third paragraph to describe the departure from GAAP. See Figure 20-14



Not Applicable


Figure 20-11 Qualified Opinion due to Scope Limitation Report of Independent Registered Public Accounting Firm XYZ CPA, LLP San Francisco, California The Board of Directors and Stockholders ABC Corporation [STANDARD WORDING FOR THE INTRODUCTORY PARAGRAPH] Except as discussed in the following paragraph, we conducted our audit … [SAME WORDING AS FOR THE REMAINDER OF THE STANDARD SCOPE PARAGRAPH]. We were unable to obtain audited financial statements supporting the Corporation’s investment in a foreign affiliate stated ta$10,000,000 at December 31, 20xx, or its equity in earnings of that affiliate of $1,000,000, which is included in net income for the years then ended as described in Note 14 to the financial statements, nor were we able to satisfy ourselves as to the carrying value of the investment in the foreign affiliate or the equity in its earnings by other audit procedures.

In our opinion, except for the effects of such adjustments, if any, as might have been determined to be necessary had we been able to examine evidence regarding the foreign affiliate and earnings, the financial statements referred to … [SAME WORDING AS FOR THE REMAINDER OF THE STANDARD OPINION PARAGRAPH]. XYZ CPA, LLP March 31, 20xx

Figure 20-12 Disclaimer of Opinion due to Scope Limitation Report of Independent Registered Public Accounting Firm XYZ CPA, LLP San Francisco, California The Board of Directors and Stockholders ABC Corporation We were engaged to audit … [SAME WORDING AS FOR THE REMAINDER OF THE INTRODUCTORY PARAGRAPH]

[THE STANDARD SCOPE PARAGRAPH IS OMITTED] We were unable to obtain audited financial statements supporting the Corporation’s investment in a foreign affiliate stated at $10,000,000 at December 31, 20xx, or its equity in earnings of that affiliate of $1,000,000, which is included in net income for the years then ended as described in Note 14 to the financial statements, nor were we able to satisfy ourselves as to the carrying value of the investment in the foreign affiliate or the equity in its earnings by other audit procedures. Since we were unable to obtain audited financial statements and we were unable to satisfy ourselves as to the carrying value of the investment, the scope of our work was not sufficient to enable us to express, and we do not express, an opinion on these financial statements. XYZ CPA, LLP

Figure 21-6 March 31, 20xxQualified Opinion due t o Departure from GAAP

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Figure 20-13 Qualified Opinion due to Departure from GAAP Report of Independent Registered Public Accounting Firm XYZ CPA, LLP San Francisco, California The Board of Directors and Stockholders ABC Corporation [STANDARD WORDING FOR THE INTRODUCTORY AND SCOPE PARAGRAPH] The Corporation has excluded, from property and debt in the accompanying balance sheets, certain lease obligations that, in our opinion, should be capitalized in order to conform with generally accepted accounting principles. If these lease obligations were capitalized, property would be increased by $8,000,000, long-term debt by 7,000,000, and retained earnings by $600,000 as of December 31, 20xx, respectively. Additionally, net income would be increased by $600,000 and earnings per share would be increased by $2.50, respectively. In our opinion, except for the effects of not capitalizing obligations as discussed in the preceding paragraph, the financial statements referred to … [SAME WORDING AS FOR THE REMAINDER OF THE STANDARD OPINION PARAGRAPH]. XYZ CPA, LLP March 31, 20xx

Figure 20-14 Adverse Opinion due to Departure from GAAP Report of Independent Registered Public Accounting Firm XYZ CPA, LLP San Francisco, California The Board of Directors and Stockholders ABC Corporation [STANDARD WORDING FOR THE INTRODUCTORY AND SCOPE PARAGRAPH] The Corporation has excluded, from property and debt in the accompanying balance sheets, certain lease obligations that, in our opinion, should be capitalized in order to conform with generally accepted accounting principles. If these lease obligations were capitalized, property would be increased by $8,000,000, long-term debt by 7,000,000, and retained earnings by $600,000 as of December 31, 20xx, respectively. Additionally, net income would be increased by $600,000 and earnings per share would be increased by $2.50, respectively. In our opinion, because of the effects of the matters discussed in the preceding paragraph, the financial statements referred to above do not present fairly, in conformity with generally accepted accounting principles, the financial position of ABC Corporation as of December 31, 20xx, or the results of its operation or its cash flows for the years then ended. XYZ CPA, LLP March 31, 20xx

Figure 20-15 Disclaimer of Opinion due to Lack of Independence We are not independent with respect to ABC Corporation, and the accompanying balance sheet as of December 31, 20xx, and the related statements of income, retained earnings, and cash flows for the year then ended were not audited by us. Accordingly, we do not express an opinion on them.


Other Types of Audit Report In addition to the type of audit reports discussed above, auditors report several other types of audit reports. A brief discussion on seven other types of audit report is provided in Table 20-2. Table 20-2 Other Types of Audit Report

Other Types of Audit Report



Comparative financial statements.

The phrase “financial statements taken as a whole” in the fourth reporting standard applies to current period statements and prior period comparative statements. AU 700 Forming an Opinion and Reporting on Fina ncial Statements states therequirements concerning comparative financial statements asfollows: (1) General requirements

Continuing auditor (include continuing auditor through merger of CPA firms) should: (a) Update (not reissue) the prior period audit report. (b) Date the comparative statements as of the date of completion of the most recent audit. (c) Alert for circumstances or events affecting prior period financial statements. (2) No update of prior period audit report is required For example, prior year’s financial statements are restated following a pooling of interest in the current year,

which is a change in the reporting entity that requires restating financial statements of all prior periods presented, but which does not affect the audit report (opinion) issued in all periods. Continuing auditor may issue different opinions on comparative statements, for example, (a) a standard unqualified opinion on prior years’ financial statements but qualifies the current year opinion. See Figure 20-16 for an example. (b) a standard unqualified opinion for the current year financial statements but qualified or disclaimed prior years’ financial statements. See Figure 20-17 for an example. (3) Update of prior period audit report is required For example, prior year’s financial statements are restated to conform with GAAP, which removes the

previously qualified opinion due to a departure from GAAP, and should be updated in the current period audit report. The current auditor should updatethe opinions of prior period financial statements byadding an explanatory paragraph above the opinion paragraph of current period financial statement to disclose: (a) The date of the previous report. (b) The type of opinion previously expressed. (c) The circumstances or events that resulted in a different opinion. (d) Notification that the updated opinion differs from the previous opinion. See Figure 20-18 for an example. (4) Client specifically requests the predecessor auditor (not the continuing auditor) to reissue audit reports of prior period financial statements

The predecessor auditor should: (a) Read the financial statements of the current period. (b) Compare the prior period financial statements reported on with the current year financial statements. (c) Obtain a representation letter from the successor auditor which should state whether the successor auditor discovered any material items that might affect, or require disclosure in, the financial statements reported on by the predecessor auditor. (d) Obtain a representation letter from the management which should state whether the management knew of new events that might affect, or require disclosure in, the financial statements reported on by the predecessor auditor. (e) Make inquiries and perform any procedures considered necessary on items or events that affect prior period financial statements. (5) Report options involving predecessor auditor include:

(a) Predecessor auditor may reissue the prior period report without any revision by using the date of the previously issued report. (b) Predecessor auditor may revise the prior period report by dual dating (recall dual rt. (c) Predecessor auditor’s report is not presented (included): (i) date concept in Chapter 20) the reissued repo The prior report is unqualified (standard). The successor auditor should indicate in the introductory paragraph that the prior period statements were audited by another auditor (should not name the predecessor auditor) and mention the date and the type of report issued by the predecessor auditor. See Figure 20-19 for an example. (ii) The prior report isqualified (not standard). The successor auditor should describe in the introductory paragraph the nature of and reasons for an explanatory paragraph added to the pre decessor’s report. See Figure 20-20 for an example. 6. Prior period comparative statements were un-audited (e.g., a nonpublic company) but current period statements are audited



Other information in documents containing financial statements.

In these circumstances, the audit report on comparative statements presented in documents filed with the SEC would not refer to the un-audited statements, and these statements should be clearly marked as un-audited, and either (1) the audit report on the prior period should be reissued, or (2) the audit report on the current period should include as a separate paragraph an appropriate description of the responsibility assumed for the financial statements of the prior period. See Figure 20-22 for a memory aid diagram. A client may publish many documents that contain other information in addition to audited financial statements and the audit report. For example, the president’s letter in the annual report. AU 720,Other Information in Documents Containing Audited Financial Statements, states that the auditor has no responsibility to other information; and no obligation to perform any audit procedures to corroborate the other information. However, the auditor is required to read the other information and consider whether such information is consistent with the information contained in the audited financial statements. If a material inconsistency exists, the auditor should request the client to revise the other information. If the other information were not revised, the auditor should revise the audit report to include an explanatory paragraph in

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Other Types of Audit Report



Required supplementary information.



Condensed financial statements and selected financial data.



Letters for underwriters and certain other requesting parties



Filling under federal securities status.



Financial statements prepared for use in other countries.

the audit report, withhold the audit report, or withdraw from the engagement. AU 730 Required Supplementary Information describes procedures in an audit of financial statements containing supplementary information required by the FASB and GASB as follows: (1) The auditor does not need to audit the supplementary information. However, the auditor should apply limited procedures and report deficiencies in, or the omission of, such information. (2) Examples of limited procedures include (a) Inquiry of management about the methods of preparing the information, and (b) Comparing the information for consistency within audited financial statements. (3) Deficiencies in, or the omission of, the supplementary information include (a) Information is omitted. (b) Measurement or presentation departs materially from prescribed FASB or GASB guidelines. (c) Auditor is unable to complete the prescribed procedures. (d) Auditor has substantial doubt about conformity with prescribed guidelines. Deficiencies in, or the omission of, the supplement information do not affect the auditor’s opinion on the (4) basic financial statements. However, the auditor needs to add an explanatory paragraph to the audit report to refer to the deficiencies in, or the omission of, the supplementary information. See Figure 20-21 for an example. AU 810 Engagements to Report on Summary Financial Statements states that the auditor may report (e.g., when asked by the client to do so) on condensed financial statements and selected financial data that are derived from audited financial statements as follows: The auditor’s report should (1) State that the auditor has audited and expressed an opinion on the complete financial statements. (2) Provide the date of the report on the complete statements. (3) Indicate the type of opinion expressed on the complete statements. (4) Express an opinion as to whether the information in the condensed financial statements or selected financial data is fairly stated in all material respects in relation to the complete statements. Investment banking firms that underwrite a securities issue often request independent auditors who audited the financial statements and schedules in the registration statement to issue a letter, known as a “comfort letter”, for the underwriters. The comfort letter helps the underwriters in fulfilling their obligation to perform a reasonable investigation of the securities registration statement. AU 920 Letter for Underwriters and Certain Other Requesting Parties , provides guidance that an auditor’s comfort letter may include the following subjects: (1) The independence of the auditors. (2) Whether the audited financial statements and schedules included in the registration statement comply with the accounting requirements of the Securities Act of 1933 and related regulations. (3) Un-audited financial statements; condensed interim financial information, and pro forma financial information. For these financial statements and information, known as “capsule information”, theauditor may provide negative assurance if the auditor has reviewed them in accordance with AU 930 Interim Financial Information . (4) Changes in selected financial statement items during a period subsequent to the date and period of the

latest financial statements included in the registration statement. (5) Table, statistics, and other financial information included in the registration statements. (6) Negative assurance as to whether certain non-financial statement information included in the registration statement complies with SEC regulations. According to AU 925 Filings With the U.S. Securities and Exchange Commission Under the Securities Act of 1933 : (1) When an auditor issues a review report after reviewing un-audited interim financial information; and if the review report is presented in a registration statement filed with the SEC, the prospectus (filed with the registration statement) should include astatement clarifying that the auditor’s review report “is not part of the registration statement within the meaning of the Securities Act of 1933.” (2) The auditor is responsible to make a “reasonable investigation” on subsequent events occurred from the date of the review report to the effective date of the registration statement. The auditor’s reasonable investigation includes (a) Apply the normal audit procedures on subsequent events. (b) Read the prospectus and the registration statements. (c) Obtain written representation from the client about subsequent events. (3) A predecessor auditor has the same responsibility for material subsequent events affecting the prior period financial statements. Ordinarily, the predecessor auditor would obtain a letter of representation concerning the subsequent events from the successor auditor. The auditor’s report on financial statements prepared in conformity with GAAP of another country depends on the intended use of the financial statements. AU 910 Financial Statements Prepa red in Accordance Wit h a Financial Reporting F ramework Generally A ccepted in Anothe r Country states that: (1) If the use is only outside of the U.S., the report may either be (a) the U.S.style - auditor’s report modified for the accounting principles of another country, or (b) the standard report of the other country. (2) If the use is also within the U.S., the U.S. style auditor’s report should be used with a qualified or adverse opinion, depending on the materiality of departures from the U.S. GAAP. (3) In the case of 1(a) above, the modification to the U.S. - style audit report include: (i) The introductory paragraph should state that the financial statements are prepared on the basis of accounting principles generally accepted in (name of country). (ii) The scope paragraph should indicate that the audit was made in accordance with the standards of thePublic Company Accounting Oversight Boardin the United Statesand, if appropriate, the auditing standards of (name of country). (iii) The opinion paragraph should state in conformity with generally accepted accounting principles in (name of country). (4) In the case of 1(b) above, the auditor should (i) ascertain that the report would be used by auditors in the


Other Types of Audit Report other country in similar circumstances, and (ii) understand, and be in a position to make, the attestations contained in such a report. The attestations may include explicit or implicit assurance of statutory compliance with the local laws. The U.S. auditor is responsible to clearly understand the accounting principles generally accepted in the other country; obtain written representations from management about the purpose and uses of the statements, and comply with the general and field work standards of the U.S. GAAS.

Figure 20-16 Unqualified in Prior Years but Qualified in Current Year for Not Been in Conformity with GAAP Report of Independent Registered Public Accounting Firm XYZ CPA, LLP San Francisco, California The Board of Directors and Stockholders ABC Corporation [STANDARD WORDING FOR THE INTRODUCTORY AND SCOPE PARAGRAPHS] The Corporation has excluded, from property and debt in the accompanying balance sheets, certain lease obligations that, in our opinion, should be capitalized in order to conform with generally accepted accounting principles. If these lease obligations were capitalized, property would be increased by $8,000,000, long-term debt by 7,000,000, and retained earnings by $600,000 as of December 31, 2011, respectively. Additionally, net income would be increased by $600,000 and earnings per share would be increased by $2.50, respectively. In our opinion, because of the effects of the matters discussed in the preceding paragraph, the financial statements referred to above do not present fairly, in conformity with generally accepted accounting principles, the financial position of ABC Corporation as of December 31, 2011, or the results of its operation or its cash flows for the years then ended. XYZ CPA, LLP March 31, 2012

Figure 20-17 Disclaimer for a Scope Limitation in Prior Years but Unqualified in Cu rrent Year Report of Independent Registered Public Accounting Firm XYZ CPA, LLP San Francisco, California The Board of Directors and Stockholders ABC Corporation [STANDARD WORDING FOR THE INTRODUCTORY PARAGRAPH] Except as explained in the following paragraph … [SAME WORDING AS FOR THE REMAINDER OF THE STANDARD SCOPE PARAGRAPH]

We did not observe the taking of the physical inventory as of December 31, 2011, since that date was prior to our appointment as auditors for the Corporation, and we were unable to satisfy ourselves regarding inventory quantities by means of other auditing procedures. Inventory amounts as of December 31, 2011, enter into the determination of net income and cash flows for the year ended December 31, 2012. Because of the matter discussed in the preceding paragraph, the scope of our work was not sufficient to enable us to express, and we do not express, an opinion on the results of operations and cash flows for the year ended December 31, 2012. In our opinion, the balance sheets of ABC Corporation as of December 31, 2013 and 2012, and the related statements of income, retained earnings, and cash flows for the year ended December 31, 2013, presented fairly, in all material respects, the financial position of ABC Corporation as of December 31, 2013 and 2012, and the results of its operations and its cash flows for the year ended December 31, 2013, in conformity with generally accepted accounting principles, the financial position of ABC Corporation. XYZ CPA, LLP March 31, 2014

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Figure 20-18 Update Prior Year Report in Current Year Report Report of Independent Registered Public Accounting Firm XYZ CPA, LLP San Francisco, California The Board of Directors and Stockholders ABC Corporation [STANDARD WORDING FOR THE INTRODUCTORY AND SCOPE PARAGRAPHS] In our report dated March 31, 2012, we expressed an opinion that the 2011 financial statements did not fairly present financial position, results of operations, and cash flows in conformity with generally accepted accounting principles because of two departures from such principles: (1) the Corporation carried its property, plant, and equipment at appraisal values, and provided for depreciation on the basis of such values, and (2) the Corporation did not provide for deferred income taxes with respect differences to between income for financial reporting purposes and taxable income. As described in Note 10, the Corporation has changed its method of accounting for these items and restated its 2011 financial statements to conform with generally accepted accounting principles. Accordingly, our present opinion on the 2011 financial statements, as presented herein, is different from that expressed in our previous report. [STANDARD WORDING FOR THE OPINION PARAGRAPH] XYZ CPA, LLP March 31, 2013

Figure 20-19 Example of a Successor Auditor’s Unqualified Report When the Predecessor Auditor’s Unqualified Report is Not Presented Report of Independent Registered Public Accounting Firm XYZ CPA, LLP San Francisco, California The Board of Directors and Stockholders ABC Corporation [STANDARD WORDING FOR THE INTRODUCTORY PARAGRAPH] We have audited the balance sheet of ABC Corporation as of December 31, 2012… [BUT ADD A REFERENCE TO PREDECESSOR’S REPORT] … The financial statements of ABC Corporation as of December 31, 2011, were audited by other auditors whose report dated March 31, 2012, expressed an unqualified opinion on those statements. [STANDARD WORDING FOR THE SCOPE PARAGRAPH] [STANDARD OPINION PARAGRAPH EXCEPT CHANGE THE FIRST LINE] In our opinion, the 2012 financial statements referred to above presented fairly, in all materialrespects, the financial position of ABC Corporation as of December 31, 2012, and the results of its operation or its cash flows for the years then ended in conformity with generally accepted accounting principles. XYZ CPA, LLP March 31, 2013


Figure 20-20 Example of a Successor Auditor’s Unqualified Report When the Predecessor Auditor’s Qualified (Not Standard) Report is Not Presented Report of Independent Registered Public Accounting Firm XYZ CPA, LLP San Francisco, California The Board of Directors and Stockholders ABC Corporation [STANDARD WORDING FOR THE INTRODUCTORY PARAGRAPH] We have audited the balance sheet of ABC Corporation as of ADD Corporation A REFERENCE THE EXPLANATORY PARAGRAPH THE PREDECESSOR’S …2012, December 31, statements 2012… [BUT The financial of ABC as ofTO December 31, 2011, were audited by otherOF auditors whose report datedREPORT] March 31, on those statements included an explanatory paragraph that described the change in the Corporation’s method of computing depreciation discussed in Note 16 to the financial statements.

[STANDARD WORDING FOR THE SCOPE PARAGRAPH] [STANDARD OPINION PARAGRAPH EXCEPT CHANGE THE FIRST LINE] In our opinion, the 2012 financial statements referred to above presented fairly, in all materialrespects, the financial position of ABC Corporation as of December 31, 2012, and the results of its operation or its cash flows for the years then ended in conformity with generally accepted accounting principles. XYZ CPA, LLP March 31, 2013

Figure 20-21 Auditor Adds an Explanatory Paragraph to Refer to Deficiencies in, or the Omission of, Required Supplementary Information Report of Independent Registered Public Accounting Firm XYZ CPA, LLP San Francisco, California The Board of Directors and Stockholders ABC Corporation [STANDARD WORDING FOR THE INTRODUCTORY AND SCOPE PARAGRAPHS] The ABC Corporation has not presented a schedule of insurance coverage that the Financial Accounting Standards Board has determined is necessary to supplement, although not required to be part of, the basic financial statements. [STANDARD WORDING FOR THE OPINION PARAGRAPH] XYZ CPA, LLP March 31, 20xx

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Figure 20-22 A Memory Aid o n Audit Reports for Comparative Financial Statements

Comparative Financial Statements

Prior A/R no update is required

Prior A/R update is required

Provide a different opinion in the current A/R is acceptable (See Figure 20-17)

Add an explanatory paragraph above the opinion paragraph in the current A/R (See Figure 20-18)

Reissue with no change in the prior A/R date

OR

Prior A/R reissue is requested

Mark prior F/S not audited and either reissue prior A/R or add an explanatory paragraph in the current A/R to describe the assumed responsibility for the prior F/S

Reissue with dual-dating in the prior A/R

Prior A/R is not included in the current A/R

Prior A/R is Unqualified

No naming the prior auditor but mention the date and type of prior A/R in the introductory paragraph of the current A/R (See Figure 20-19)

A/R = Audit Report F/S = Financial Statements

Prior F/S is not audited

Prior A/R is Qualified

No naming the prior auditor but mention the nature of and reasons for an explanatory paragraph added to the prior A/R in the introductory paragraph of the current A/R (See Figure 20-20)


SEC’s Corporate Responsibilities Rules on Financial Reporting

The Sarbanes-Oxley Act of 2002 establishes the Public Company Accounting Oversight Board (PCAOB), whose responsibilities are to oversee the audits of public companies that are subject to the securities laws. These responsibilities include overseeing the corporate responsibilities rules on financial reporting under the Act. If the PCAOB determines that any public company has engaged in practices in violation of the rules, the Board may impose sanctions, including a fine of not more than $5 million and/or imprisonment of up to 20 years. Sections of the corporate responsibilities rules on financial reporting are as follows: Section 302– Corporate Responsibilities for Financial Reporting

Section 302 of the Sarbanes-Oxley Act requires the SEC to adopt rules requiring the CEO and CFO to certify in each quarterly and annual report filed by the company in accordance with the Securities Exchange Act of 1934. In response, in August 2002, the SEC issued a final rule, Certification in Companies’ Quarterly and Annual Reports, which requires a public company’s CEO and CFO each to certify, with respect to the company’s quarterly and annual reports filed under new Sections 13a-15 and 15d-15 of the Securities Exchange Act of 1934, that: 1. They have reviewed the report being filed. 2. Based on their knowledge, the report does not contain any untrue statement or omit any material facts. 3. Based on their knowledge, the financial statements fairly present in all material respects the financial condition, results of operations, and cash flows of the company (terms are not similar to AU 700 Forming an Opinion and Reporting on Financial Statements, see discussion below). 4. They are responsible for establishing and maintaining “disclosure controls and procedures” (new terms see discussion below) for the company and have: a. Designed such disclosure controls and procedures to ensure that material information is made known to them. b. Evaluated the effectiveness of the disclosure controls and procedures within 90 days prior to the filing date of the report. c. Present in the report their conclusions about the effectiveness of the disclosure controls and procedures. 5. Based on their evaluation of the effectiveness of the disclosure controls and procedures, they have disclosed to the audit committee: a. All significant deficiencies in thesummarize, design or and operation of internal controls, that could adversely affect the company’s ability to record, process, report financial data. b. Any fraud, whether or not material, that involves management or other employees with a significant role in the company’s internal control. 6. They have indicated in the report any significant changes in internal controls subsequent to their evaluation of the effectiveness of the disclosure control and procedures. The terms “financial condition, results of operations, and cash flows” in point 3 above refer to all financial information in the annual or quarterly report, including the financial statements, footnote disclosures, selected financial data, management’s discussion and analysis (MD&A), results of operations, and other financial information in the report. The terms “fairly present” in point 3 above does not limit the certification to a representation that financial information is fairly presented in accordance with GAAP. Footnote 55 of the final rule states that “presenting financial information in conformity with [GAAP] may not necessarily satisfy obligations under the antifraud provisions of feder al securities laws.” The SEC’s interpretation is that Congress intended this certification to provide assurances that the financial information presented in the annual or quarterly report meets a standard of accuracy and completeness that is broader than the financial reporting requirements of GAAP. The new terms “disclosure controls and procedures” in point 4 above refer to controls and other procedures of a company that are designed to ensure that information required to be disclosed by the company in the reports that it files with the SEC is recorded, processed, summarized and reported, in a timely manner. Note that existing Section 13 (b) (2) (B) of the Securities Exchange Act of 1934 requires that companies establish and maintain systems of internal controls with respect to financial reporting. The disclosure controls and procedures required by the new Section 13a-15 and

15d-15 of the Securities Exchanges Act of 1934 are in addition (and not in lieu of) those existing requirements. A complete summary of the rule, Certification in Companies ’ Quarterly and Annual Reports (Release No.33-8124, 3446427, IC-25722) is posted on the SEC’s Web site at http://www.sec.gov/rules/final/33 -8124.htm/

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Section 906– Failure of Corporate Officers to Certify Financial Reports

The CEO and CFO of a company must certify that the financial statements and disclosures fully comply with provisions of the Securities Exchange Act and that they fairly present, in all material respects, the operations and financial condition of the issuer. Maximum penalties for willful certification of the financial statements knowing that they don’t fully comply with the requirements are a fine of not more than $5million and/or imprisonment of up to 20 years.



An auditor’s unqualified report

a. implies only that items disclosed in the financial statements and footnotes are properly presented and takes no position on the adequacy of disclosure. b. implies that disclosure is adequate in the financial statements and footnotes. c. explicitly states that disclosure is adequate in the financial statements and footnotes. d. explicitly states that all material items have been disclosed in conformity with generally accepted accounting principles. 20-2

The date of the audit’s opinion on a client’s financial statements should be the date of the a. closing the client’s book b. receipt of the client’s letter of representation c. completion of all important audit procedures. d. submission of the report to the client.

20-3

If a principal auditordecides to refer in his report the audit of another auditor, theprincipal auditorshould disclose the a. name of the other auditor. b. nature of the principal auditor’s review of the other auditor’s work. c. portion of the financial statements audited by the other auditor. d. reasons why the principal auditor is unwilling to assume responsibility for the other auditor’s work.

20-4

A client changed from the straight–line method to the double declining-balance method of depreciation for all newly acquired assets. This change has no material effect on the current year’s financial statements but is reasonably certain to have a substantial effect in later years. If the change is disclosed in the notes to the financial statements, the auditor should issue a report with a (n) a. qualified opinion. b. unqualified opinion with explanatory paragraph. c. unqualified opinion. d. qualified opinion with explanatory paragraph regarding consistency.

20-5

An auditor will issue an adverse opinion if a. the scope of the auditis limited by the client. b. exception to the fairness of presentation is so material that an “except for” qualified opinion is not justified. c. the auditor did not perform sufficient auditing procedures to form an opinion on the financial statements taken as a whole. d. major uncertainties exist concerning the company’s future.

20-6

Under which of the following sets of circumstances shouldan auditor issue a qualified opinion? a. The financial statements contain a departure from generally accepted accounting principles, the effect of which is material. b. The principal auditor decides to make reference to the report of another auditor who audited a subsidiary. c. There has been a material change between periods in the method of the application of accounting principles. d. There are significant uncertainties affecting the financial statements.

20-7

In which of the following situations would an auditor ordinarily choose between expressing an “except for” qualified opinion and expressing an adverse opinion? a. The auditor did not observe the client’s physical inventory and is unable to become satisfied as to its balance by other auditing procedures. b. The financial statements fail to disclose information that is required by generally accepted accounting principles. c. The auditor is asked to report only on the client’s balance sheet and not on the other basic financial statements. d. Events disclosed in the financial statements cause the auditor to have substantia l doubt about the entity’s ability to continue as going concern.

20-8

An auditor includes a separate paragraph in an otherwise unmodified reportto emphasize that the entity being reported upon had significant transactions with related parties. The inclusion of this separate paragraph a. is appropriate and would not negate the unqualified opinion. b. is considered an “except for” qualification of the opinion. c. violates generally accepted auditing standards if this information is already disclosed in footnotes to the financial statements. d. necessitates a revision of the opinion paragraph to include the phrase “with the foregoing explanation”.

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20-9

When the limitation in scope is so material that a disclaimer opinion is required, thescope paragraphwould a. be qualified. b. be deleted. c. be expanded. d. be unchanged.

20-10

A client’s financial statements contain a departure from generally accepted accounting principles because, due to unusual circumstances, the statements would otherwise be misleading. The auditor should express an opinion that is a. unqualified but not mention the departure in the auditor’s report. b. unqualified and describe the departure in a separate paragraph. c. qualified and describe the departure in a separate paragraph. d. qualified or adverse, depending on materiality, and describe the departure in a separate paragraph.

20-11

In which of the following circumstanceswould an auditor usuallychoose betweenissuing a qualified opinionand issuing a disclaimer of opinion? a. Departure from generally accepted accounting principles. b. Inadequate disclosure of accounting policies. c. Inability to obtain sufficient appropriate evidential matter. d. Unreasonable justification for a change in accounting principle.

20-12

In which of the following situationswould an auditor ordinarilyissue an unqualified auditopinion withoutan explanatory paragraph? a. The auditor wishes to emphasize that the entity had significant related-party transactions. b. The auditor decides to refer to the report of another auditor as a basis, in part, for the auditor’s opinion. c. The entity issues financial statements that present financial position and results of operations but omits the statement of cash flows. d. The auditor has substantial doubt about the entity’s ability to continue as a going concern, but the ci rcumstances are fully disclosed in the financial statements.

20-13

When an auditor encountersa situation involvingmore than one of the conditionsrequiring adeparture froma standard unqualified report, the auditor should modify his or her opinion of each condition unless one has the effect of neutralizing the others. In which of the following situations would the auditor not include more than one modification in the report? a. There is a material scope limitation, and there is a material GAAP violation. b. There is a material GAAP violation, and the auditor is not independent. c. There is a material scope limitation, and the audit or has substantial doubt about the company’s going concern status. d. None of the above.

20-14

Which of the following is not a cause of an explanatoryparagraph or modified wordingto be added to the standard unqualified report? a. Emphasis of a matter. b. Reports involving other auditors. c. Auditor disagrees with client’s departure from GAAP. d. Lack of consistent application of GAAP.

20-15

Which of the following is not one of the principal CPA firm’s options when issuing a report for which another CPA firm performed part of the audit?

a. A qualified opinion or disclaimer, depending on materiality, is required if the principal auditor is not willing to assume any responsibility for the work of the other auditor. b. Make reference to the other auditor in the report by using modified wording (a shared opinion or report). c. Make no reference to the other auditor in the report, and issue the standard unqualified report. d. issue a joint report signed by both CPA firms.


20-16

For the audit report containing adisclaimer forlack of independence, thedisclaimer is in the a. fourth (explanatory) paragraph. b. third (opinion) paragraph. c. second (scope) paragraph. d. first and only paragraph.

20-17

When there is uncertainty about an audit cli ent’s ability to continue as a going concern, the auditor’s concern is the possibility that the client may not be able to continue its operations or meet obligations for a “reasonable period of time.” For this purpose, a reasonable period of time is considered not to exceed a. six months from the date of the financial statements. b. six months from the date of the audit report. c. one year from the date of the financial statements. d. one year from the date of the audit report.

20-18

An audit clienthas presented allrequired financialstatements withthe exception ofthe statement ofcash flows.The auditor has completed the audit and is satisfied that the financial statements, with the exception of the missing statement of cash flows, are presented fairly. In such a situation, the auditor a. must issue a qualified opinion. b. must issue an adverse opinion. c. may issue either an unqualified or a qualified opinion. d. may issue an unqualified opinion.

20-19

Whenever an auditor issues a qualified opinion, the implication is that the auditor a. does not know if the statements are present fairly. b. does not believe the statements are present fairly. c. is satisfied that the statements are present fairly. d. is satisfied that the statements are presented fairly “except for” a specific aspect of them.

20-20

When a misstatement in the financial statements would materially affect a user’s decision but the financial statements taken as whole are still fairly stated, the auditor should issue

a. a qualified opinion. b. an unqualified opinion. c. an adverse opinion. d. a disclaimer of opinion. 20-21

For a client’s financial statements to be presented fairly in conformity with GAAP, it is not required that the accounting principles selected

a. be appropriate in the circumstances for the particular client. b. reflect transactions in a manner that presents the financial statements within a range of acceptable limits. c. present information in the financial statements that is classified and summarized in a reasonable manner. d. be applied on a basis consistent with those followed in the prior year. 20-22

For a client’s financial statements to be presented fairly in conformity with GAAP, it is required that the accounting principles selected

a. be approved by the Auditing Standards Board or the appropriate industry subcommittee. b. reflect transactions in a manner that presents the financial statements within a range of acceptable limits. c. match the principlesused by most other clients within the client’s particular industry. d. be applied on a basis consistent with those followed in the prior year. 20-23

When financial statementscontain a departure fromGAAP because, dueto unusual circumstances,the statements would otherwise be misleading, the auditor should explain the unusual circumstances in a separate paragraph and express opinion that is a. unqualified. b. qualified. c. adverse. d. a disclaimer.

567

568

20 Audit Report

20-24

How are management’s responsibilityand the auditor’s responsibility represented in the standard auditor’s report?

a. b. c. d. 20-25

Management’s Responsibility Explicitly Implicitly Implicitly Explicitly

Auditor’s Responsibility Explicitly Implicitly Explicitly Implicitly

An auditor’s responsibility to express an opinion on the financial statements is a. implicitly represented in the auditor’s standard report. b. explicitly represented in the opening paragraph of the auditor’s standard report. c. explicitly represented in the scope paragraph of the auditor’s standard report. d. explicitly represented in the opinion paragraph of the auditor’s standard report.

20-26

Which paragraph of an auditor’s standard report on financial statements should referGAAS to and GAAP?

a. b. c. d. 20-27

GAAS Opening Scope Scope Opening

GAAP Scope Scope Opinion Opinion

Which of the following statements is included in a standard audit report? a. The auditor provides assurance that the financial statements are free of misstatement. b. The auditor evaluates the overall internal controls relating to the financial statements. c. An auditor includes assessing significant estimates made by management. d. The auditor provides an opinion about the consistency of the financial statements with those of the prior period.

20-28

Which of the following representationsdoes an auditor make explicitly andwhich implicitly when expressing an unqualified opinion? (Hint: Think about the third standard of reporting)

a. b. c. d. 20-29

Conformity with GAAP Explicitly Implicitly Implicitly Explicitly

Adequacy of Disclosure Explicitly Implicitly Explicitly Implicitly

A CPA is engaged by AA Corp., a client, to audit the financial statementsof BB Corp., a company that is not the CPA’s client. AA Corp. expects to present BBB Corp.’s audited financial statements with the CPA’s audit report to Bank of America to obtain financing in AA Corp.’s attempt to purchase BB Corp. In these ci rcumstances,the CPA’s audit report would usually be addressed to a. AA Corp., the client that engaged the CPA. b. BB Corp., the company audited by the CPA. c. Bank of America. d. Both AA Corp. and Bank of America.

20-30

In which of the following circumstances wouldan auditor usually choose betweenexpressing aqualified opinionand disclaiming opinion? a. Departure from generally accepted accounting principles. b. Inadequate disclosure of accounting policies. c. Inability to obtain sufficient appropriate evidential matter. d. Unreasonable justification for a change in accounting principle.

20-31

An auditor is prevented by the client’s senior management and legal counsel from obtaining sufficient appropriate evidence concerning a suspected illegal bribery scheme. Under these circumstances, the auditor should

a. express an unqualified opinion. b. express a qualified opinion. c. express a disclaimer opinion. d. express an adverse opinion.


20-32

In which of following circumstances would an auditor issue a qualified opinion? a. There has been a material change between periods in accounting principles. b. Quarterly financial data required by the SEC have been omitted. c. The auditor wishes to emphasize an unusually important subsequent event. d. The auditor is unable to obtain audited financial statements of a consolidated investee.

20-33

A limitation onthe scope of an audit sufficient topreclude anunqualified opinionwill usually resultwhen management a. presents financial statements that are prepared in accordance with the cash receipts and disbursements basis of accounting. b. states that the financial statements are not intended to be presented in conformity with generally accepted accounting principle. c. does not make t he minutes of the board of directors’ meetings available to the auditor. d. asks the auditor to report on the balance sheet and not on the other basic financial statements, and the auditor is not restricted to apply any audit procedures and access to any audit-related information.

20-34

When qualifying anopinion becauseof an insufficiency ofaudit evidence,an auditor shouldrefer to the situation inthe

a. b. c. d. 20-35

Opening Paragraph No Yes Yes No

Scope Paragraph No No Yes Yes

If an auditor issues a qualified opinion because a major inadequacy of a client’s computerized accounting records prevents the auditor from applying necessary procedures, the opinion paragraph of the audit report should state that the qualification pertains to

a. a client-imposed scope limitation. b. a departure from generally accepted auditing standards. c. the possible effects on the financial statements. d. inadequate disclosure of necessary information. 20-36

Under which of the following circumstances woulda disclaimer of opinion not be appropriate? a. The auditor is unable to observe physical inventory counts or apply alternative procedures to verify their significant balances. b. The auditor is unable to determine the amount associated with significant fraud committed by the client’s management. c. The financial statements fail to contain adequate disclosure concerning related-party transactions. d. The client refuses to permit its lawyer to furnish information requested in a letter of audit inquiry.

20-37

Which of the following situationswould an auditor ordinarilychoose betweenexpressing aqualified opinionor an adverse opinion? a. The auditor did notconfirm the client’s accounts receivable and is unable to become satisfied as t o its balance by other auditing procedures. b. The financial statements neither account for nor disclose a client’s illegal act. c. The auditor asked to report only the lient’s c balance sheet and not the other basic financial statements. d. Events disclosed in the financial statements cause the auditor to have substantial doubt about the client’s ability to continue as a going concern.

20-38

Which of the following phrases would an auditor most likely i nclude in the auditor’s report when expressing a qualified opinion because of inadequate disclosure? a. Subject to the departure from generally accepted accounting principles, as described above. b. With the foregoing explanation of these omitted disclosures. c. Except for the omission of the information discussed in the preceding paragraph. d. Does not present fairly in all material respects.

569

570

20 Audit Report

20-39

If a client issuesfinancial statementsthat purport to present itsfinancial positionand results of operations butomits the statement of cash flows, the auditor ordinarily will express a(n) a. disclaimer of opinion. b. qualified opinion. c. review report. d. unqualified opinion with a separate explanatory paragraph.

20-40

An auditor would express an unqualified opinion with an explanatory paragraph added to the auditor’s report for

a. b. c. d. 20-41

An Unjustified Accounting Principle Change Yes Yes No No

A Material Weakness in Internal Control Yes No Yes No

When management does not provide reasonable justificationfor a change in accounting principle,and it presents comparative financial statements, the auditor should express a qualified opinion a. only in the year of the accounting principle change. b. each year that the financial statements initially reflecting the change are presented. c. each year until management changes back to the accounting principle formerly used. d. if the change to an accounting principle is justified.

20-42

An auditor concludes that a client’s i llegal act, which has a material effect on the financial statements, is neither properly accounted for nor disclosed. Depending on its materiality effect on the financial statements, the auditor should express either a (an)

a. qualified opinion or an adverse opinion. b. adverse opinion or a disclaimer of opinion. c. unqualified opinion or a disclaimer of opinion. d. unqualified opinion or adverse opinion. 20-43

An auditor may not express a qualified opinion when a. a scope limitation prevents the auditor from completing a significant part of the audit. b. the auditor’s report refers to the work of a specialist. c. an accounting principle that is inconsistent with prior period is used. d. the auditor lacks independence with respect to the client.

20-44

In which of the following circumstances wouldan auditor be most likely to express an adverse opinion? a. Information comes to the auditor’s attention that raises substantial doubt about the client’s ability to continue as a going concern. b. The CEO refuses the auditor access to minutes of board of directors’ meetings. c. TOC show that the client’s internal control is so poor that it cannot be relied upon. d. The financial statements are not in conformity with the FASB Statements regarding the capitalization of leases.

20-45

An auditor’s report includes the following statement: “The financial statements do not present fairly the financial position, results of operations, or cash flows in conformity with generally accepted accounting principles.” This auditor’s report was most likely issued in connection with financial statements that are

a. b. c. d. 20-46

inconsistent. based on prospective financial information. misleading. affected by a material uncertainty that is properly disclosed.

When an auditor expresses an adverse opinion, the opinion paragraph should include a. the principle effects of the departure from GAAP. b. a direct reference to a preceding paragraph explaining the basis for the opinion. c. the substantive reasons for the financial statements being misleading. d. a description of the scope limitation that prevents an unqualified opinion.


20-47

Under which of the following circumstances would a disclaimer opinion not be appropriate? a. The auditor is unable to determine a significant amounts associated with an employee ‘kiting’ scheme. b. The client refuses to permit the auditor to confirm a significant amount of accounts receivable balances or apply alternative procedures to verify their balances. c. The management does not provide reasonable justification for a change in accounting principles. d. The CEO is unwilling to sign the management representation letter.

20-48

When disclaiming anopinion because ofa client-imposed scopelimitation, anauditor shouldomit the

a. b. c. d. 20-49

Scope Paragraph No Yes No Yes

Opinion Paragraph Yes Yes No No

When an auditor is associated withthe financial statementsof a public company(e.g., assistsin preparing itsfinancial statements) but has not audited or reviewed such statements, the associated report to be issued must include a(n) a. regulation S-X exemption. b. report on pro forma financial statements. c. unqualified association report. d. disclaimer of opinion.

20-50

Due to scope limitation, an auditor disclaimed an opinion on the financial statements taken as a whole, but the auditor’s report included a statement that the current asset portion of the client’s balance sheet was fairly stated. The inclusion of this statement is a. not appropriate because it may tend to overshadow the auditor’s disclaimer of opinion. b. not appropriate because the auditor is prohibited from reporting on only one basic financial statement. c. appropriate provided the auditor’s scope paragraph adequately describes the scope limitation. d. appropriate provided the statement is in a separate paragraph preceding the disclaimer of opinion paragraph.

20-51

Auditor A was engaged to audit thefinancial statementsof XYZ Company, a new client, for the year ended 12.31.2001. Auditor A obtained sufficient audit evidence for all XYZ Company’s financial statement it ems except its opening inventory, which has a significant balance. Auditor A could not verify XYZ Company’s 1.1.2001 inventory balances by applying alternative audit procedures. Auditor A ‘s opinion on XYZ Company’s 2001 financial statements most likely will be (Hint: Think in which basic financial statements is/are the opening inventory balance)

a. b. c. d. 20-52

Balance Sheet Disclaimer Unqualified Disclaimer Unqualified

Income Statement Disclaimer Disclaimer Adverse Adverse

When part of an audit is performed by another auditor,the principalauditor mayissue a qualified auditreport when a. the other auditor refers to the findings of a specialist. b. the other auditor issue an unqualified audit report onthe part of the audit performed by him. c. the client’s financial statements are prepared on the cash receipts and disbursement basis of accounting. d. the principal auditor is not willing to assume responsibility for the work of another auditor.

20-53

A principal auditor decides not to refer to the audit of another auditor who audited a subsidiary of the principal auditor’s client. After making inquiries about the other auditor’s professional reputation and independence, the principal auditor most likely would a. add an explanatory paragraph to the auditor’s report indicating that the subsidiary ‘s financial statements are not material to the consolidated financial statements. b. document in the engagement letter that the principal auditor assumes no respons ibility for the other auditor’s work. c. obtain written permission from the other auditor to omit the reference in the principal auditor’s report. d. contact the other auditor and review the audit program and working papers pertaining to the subsidiary.

571

572

20 Audit Report

20-54

In which of the following situationswould a principal auditorleast likelymake referenceto another auditor who audited a subsidiary of the audit client? a. The other auditor was retained by t he principal auditor, and the work was performed under the principal auditor’s guidance and control. b. The principal auditor finds it impractical to review the other auditor’s work or otherwise be satisfied asto the other auditor’s work. c. The financial statements audited by the other auditor are material to the consolidated financial statements covered by the principal auditor’s opinion. d. The principal auditor is unable to be satisfied as to the independence and professional reputation of the other auditor.

20-55

When a principal auditor decides to refer to another auditor’s audit, the principal auditor’s report should always indicate clearly, in the introductory, scope, and opinion paragraphs, the

a. magnitude of the portion of the financial statements examined by the other auditor. b. disclaimer of responsibility concerning the portion of the financial statements examined by the other auditor. c. name of the other auditor. d. division of responsibility in terms of shared audit, shared responsibility, and shared opinion. 20-56

The following explanatory paragraph was included in an auditor’s report to indicate a lack of consistency: As discussed in note #2 to the financial statements, the company changed its method of computing depreciation in 2001. How should the auditor report on this matter if the auditor concurred with the change?

a. b. c. d. 20-57

Type of Opinion Unqualified Unqualified Qualified Qualified

Location of Explanatory Paragraph Before opinion paragraph After opinion paragraph Before opinion paragraph After opinion paragraph

When therehas been a change in accounting principles, butthe effect of the change on the comparabilityof the financial statements is not material, the auditor should a. refer to the change in an explanatory paragraph. b. explicitly concur that the change is preferred. c. not refer to consistency in the auditor’s report. d. refer to the change in the opinion paragraph.

20-58

When the auditor concurs witha change in accounting principlethat materially affects the comparability of the comparative financial statements, the auditor should Concur Explicitlywith the Change Express a Qualified Opinion Refer to the Change in an Explanatory Paragraph a. No No Yes b. Yes No Yes c. Yes Yes No d. No Yes No

20-59

Management believesand the auditor issatisfied thata material loss probably willoccur when pending litigationis resolved. Management is unable to make a reasonable estimate of the amount or range of the potential loss but fully discloses the situation in the notes to the financial statements. If management does not make an accrual in the financial statements, the auditor should express a(n) (Hint: Think of LCAs in Chapter 19) a. qualified opinion due to a scope limitation. b. qualified opinion due to a departure from GAAP. c. Unqualified opinion with an explanatory paragraph. d. Unqualified opinion in a standard auditor’s report.

20-60

An auditor mostlikely would expressan unqualified opinionand would not add explanatoryparagraph to the report if the auditor a. wishes to emphasize that the entity has significant transactions with related parties. b. concurs with the client’s change in its method of computing depreciation. c. discovers that supplementary information required by FASB has been omitted. d. believes that there is a remote likelihood of a material loss resulting from an uncertainty arising from pending litigation.


20-61

An auditor concludes that there is substantial doubt about a client’s ability to continue as a going concern. If the client’s financial statements adequately disclose its financial difficulties, the auditor’s report should

Include an Explanatory Paragraph following the Opinion Paragraph____ a. Yes b. Yes c. Yes d. No 20-62

“Possible Discontinuance of Operations” Yes Yes No No

“Reasonable Period of Time, Not to Exceed One year” Yes No Yes No

An auditor concludes that there is substantial doubt about a client’s ability to continue as a going concern. If the client’s financial statements adequately disclose its financial difficulties, the auditor’s report may express

a. b. c. d. 20-64

Specifically Use Words “Substantial Doubt” Yes No Yes Yes

An auditor concludes that there is substantial doubt about a client’s ability to continue as a going concern. If the client’s financial statements adequately disclose its financial difficulties, the auditor’s report should includean explanatory paragraph that specifically used the phrase(s)

a. b. c. d. 20-63

Specifically Use the Words “Going Concern” Yes Yes No Yes

Disclaimer of Opinion Yes No No Yes

Qualified Opinion Yes No Yes No

An auditor includesa separate paragraph inan unqualified auditreport to emphasize that the client has significant transactions with related parties. This inclusion a. Violates GAAS if this information is already disclosed in the footnotes. b. necessitates a revision of the opinion paragraph to include the phrase “with the foregoing explanation.” c. is appropriate and would not negate the unqualified opinion. d. is considered a qualification of the opinion.

20-65

How does an auditor make the following representations when issuing the standard auditor’s report on comparative financial statements?

a. b. c. d. 20-66

Examination of Evidence on a Test Basis Explicitly Implicitly Implicitly Explicitly

Consistent Application of Accounting Principles Explicitly Implicitly Explicitly Implicitly

AuditorA had substantial doubt about C Corp.’s ability to continue as a going concern when reporting on C Corp.’s audited financial statements for the year ended December 31, 2001. That doubt has been removed in 2002. What is auditor A’s reporting responsibility if C Corp.’s is presenting its financial statements for the year ended December 31, 2002, on a comparative basis with those of 2001? a. The explanatory paragraph included in the 2001 auditor’s report should not be repeated. b. The explanatory paragraph included in the 2001 auditor’s report should be repeated in its entirety. c. A different explanatory paragraph describing auditor A’s reasons for the removal of doubt should be included. d. A different explanatory paragraph describing C Corp.’s plan for financial recovery should be included.

573

574

20 Audit Report

20-67

When a predecessor auditor reissues the report on the prior period’s financial statements at the request of the former client, the predecessor auditor should

a. indicate in the introductory paragraph of the reissued report that the financial statements of the subsequent period were audited by another CPA. b. obtain a representation letter from the successor auditor but obtain no such a letter from the management. c. compare the prior period’s financial statements that the predecessor reported on with the financial statements to be presented for comparative purposes. d. add an explanatory paragraph to the reissued report stating that the predecessor has not performed additional auditing procedures on the prior period’s financial statements. 20-68

When reporting oncomparative financialstatements, an auditor ordinarilyshould change the previously issuedopinion on the prior year’s financial statements if the a. prior year’s financial statements are restated to conform with GAAP. b. auditor is a predecessor auditor who has been requested by a former client to reissue the previously issued report with the current period report date. c. prior year’s opinion was unqualified and the opinion on the current year’s financial statements is modified due to a lack of consistency. d. prior year’s financial statements are restated following a pooling interest in the current year.

20-69

The predecessor auditor,who is satisfied afterproperly communicating withthe successor auditor,has reissued areport because the audit client desires comparative financial statements. The predecessor auditor’s report should a. refer to the report of the successor auditor only in the scope paragraph. b. refer to the report of the successor auditor in the scope and opinion paragraphs. c. refer to both the work and the report of the successor auditor only in the opinion paragraph. d. not refer to the report or the work of the successor auditor.

20-70

P, the predecessor auditor audited C Corp.’s prior-year financial statements. These financial statements are presented with those of the of the current year for comparative purposes but without (i.e., not include) P, the predecessor auditor’s report , which expressed a qualified opinion. In drafting the current year’s auditor’s report, S, the successor auditor, should

I. Not name P as the predecessor auditor. II. Indicate the typeof report issued by P, the predecessor auditor. III. Indicate the substantive reasons for P, the predecessor auditor’s qualification in the introductory paragraph. a. I only. b. I and II only. c. II and III only. d. I, II, and III. 20-71

When un-audited financialstatements arepresented incomparative formwith audited financialstatements in a document filed with the SEC, such statements should be

a. b. c. d. 20-72

Marked as “Un-audited” Yes Yes No No

Withheld Until Audited No No Yes Yes

Referred to in the Auditor’s Report No Yes Yes No

When un-audited financialstatements of a nonpublic companyare presented incomparative formwith audited financial statements in the subsequent year, the un-audited financial statements should be clearly marked to indicate their status and I. The report on theun-audited financial statements should be reissued. II. The report on the audited financial statements should include a separate paragraph describing the responsibility assumed for the un-audited financial statements. a. I only. b. II only. c. both I and II. d. either I or II

20-73

When audited financial statements contain other information, the auditor should a. perform inquiry and analytical procedures to ascertain whether the other information is reasonable. b. add an explanatory paragraph to the auditor’s report without changing the opinion on the financial statements. c. perform the appropriate substantive auditing procedures to corroborate the other information. d. read the other information to determine that it is consistent with the audited financial statements.


20-74

An auditor concludesthat thereis a material inconsistency inthe other informationin annual reportto shareholders containing audited financial statements. If the auditor concludes that the financial statements do not require revision, but the client refuses to revise or eliminate the material inconsistency, the auditor may a. revise the auditor’s report to include a separate explanatory paragraph describing the material inconsistency. b. express a qualified opinion after discussing the matter with thelient’s c directors. c. consider the matter closed because the other information is not in the audited statements. d. disclaim an opinion on the financial statements after explaining the material inconsistency in a separate paragraph.

20-75

If management declines to present supplementary information required by the Governmental Accounting Standards Board (GASB), the auditor should express a. an adverse opinion. b. a qualified opinion with an explanatory paragraph. c. an disclaimer of opinion. d. an unqualified opinion with an additional explanatory paragraph.

20-76

An auditor mayreport on condensed financialstatements thatare derived fromcomplete auditedfinancial statementsif the a. condensed financial statements are not read in conjunction with the most recent complete financial statements. b. auditor indicates whether the condensed financial statements are fairly stated in all material respects in relation to the audited complete financial statements. c. auditor describes the additional review procedures performed on the condensed financial statements. d. condensed financial statements are distributed only to management and the board of directors.

20-77

For condensed financial statements that are derived from a public company’s audited financial statements, a CPA should indicate that the

a. condensed financial statements are prepared in conformity with other comprehensive basis of accounting. b. CPA has audited and expressed an opinion on the complete financial statements. c. condensed financial statements are not fairly presented in all material respects. d. CPA expresses limited assurance that the financial statements conform with GAAP. 20-78

An auditor is engaged to report on selected financialdata that are included ina client-prepared document containing audited financial statements. Under these circumstances, the report on the selected data should a. be limited to data derived from the audited financial statements. b. be distributed only to senior management. c. state that the presentation is a comprehensive basis of accounting other than GAAP. d. indicate that the data are not fairly stated in all material respects.

20-79

Comfort letters ordinarily are signed by the client’s

a. independent auditor. b. underwriters of securities. c. audit committee. d. senior management. 20-80

Comfort letters ordinary are addressed to a. the SEC. b. the intermediary who negotiated the agreement with the client. c. creditor financial institutions. d. the client’s audit committee.

20-81

Which of the following matters is covered in a typical comfort letter? a. Negative assurance concerning whether the entity’s internal control activities operated as designed during the period being audited. b. An opinion regarding whether the entity compiled with laws and regulations under Government Auditing Standards and the Single Audit Act. c. Positive assurance concerning whether un-audited condensed financial information compiled with GAAP. d. Negative assurance as to whether the audited financial statements comply, in all material respects, with the applicable accounting requirements of the SEC.

575

576

20 Audit Report

20-82

When an auditor issuesto an underwriter acomfort lettercontaining commentson data that have not been audited, the underwriter most likely will receive a. positive assurance on supplementary disclosures. b. negative assurance on capsule information. c. a disclaimer on prospective financial statements. d. a limited opinion of pro forma financial statements.

20-83

Which of the following statementsis correct concerningletters for underwriters, commonlyreferred to as comfort letter? a. Letters for underwriters are required by the Securities Act of 1933 for the initial public offering of registered securities. b. Letters for underwriters typically give negative assurance on un-audited interim financial information. c. Letters for underwriters usually are included in the registration statement accompanying a prospectus. d. Letters for underwriters ordinarily update auditors’ opinion on the prior year’s financial statements.

20-84

An auditor issued a review report based on a review of the client’s interim financial information. If this review report is presented in a registration statement filed with the SEC, a prospectus should include a statement clarifying that the a. auditor’s review report is not a part of the registration statement within t he meaning of the Securities Act of 1933. b. auditor assumes no responsibility to update the report for subsequent events occurring after the date of the report. c. auditor’s review was performed in accordance with standards established by the SEC. d. auditor obtained corroborating evidence to determine whether material modifications are needed for such information.

20-85

A registration statementfiled with the SEC contains theaudit reportsof two independent auditorson their audits of financial statements for different periods. The predecessor auditor who audited the prior period financial statements generally should obtain a letter of representation from the a. principal underwriter. b. client’s audit committee. c. successor auditor. d. SEC.

20-86

Before reporting on the financial statements of a U.S. entity that have been prepared in conformity with another country’s accounting principles, an auditor practicing in the U.S. should a. be certified by the appropriate auditing or accountancy board of the other country. b. notify management that the auditor is required to disclaim an opinion on the financial statements. c. receive a waiver from the auditor’s state board of accountancy to perform the engagement. d. understand the accounting principles generally accepted in the other country.

20-87

The financial statementsof America Corp., a U.S. entity, are prepared forinclusion in the consolidated financialstatements of its non-U.S. parent Corporation. These financial statements are prepared in conformity with the accounting principles generally accepted in the parent Corporation’s country and are for use only in that country. How may America Corp.’s auditor report on these financial statements? I. A U.S. – style audit report (unmodified). II. A U.S. – style audit report modified to report on the accounting principles of the parent’s country. III. The audit report style of the parent’s country.

a. b. c. d. 20-88

I_ Yes No Yes No

II_ No Yes No Yes

III No No Yes Yes

New Sections of the Securities ExchangeAct of 1934 on corporate responsibilityfor financial reportscontain theterms “disclosure controls and procedures” which refer to a. control and otherprocedures that disclose significant deficienciesin the designand operation of internal controls. b. control and other procedures that ensure information that is filed with the SEC is processed and reported in a timely manner. c. control and other procedures that prevent and detect fraud involves management and other employees. d. control and other procedures that establish and maintain systems of internal controls with respect to financial reporting.


20-89

Under Sarbanes-OxleyAct of 2002, the CEO and CFO of a public companymust certifytheir quarterly andannual reports. Which of the following is not covered by that certification? a. Their reports do not contain any untrue statement or omit any material facts. b. The financial statements in their reports fairly present in all material respects the financial condition, results of operations, and cash flows of the company. c. The financial statements in their reports are limited to the presentation requirements of the GAAP. d. Their reports indicate any significant changes in internal controls subsequent to the evaluation of the effectiveness of the disclosure control and procedures.

20-90

Which of the following bestdescribes therelationship betweenthe audit reportissued by the auditor and the certified report filed by the management? a. The auditor’s audit report attests t o the accuracy of the management’s certified report filed with the SEC. b. The management’s certified report and the auditor’s audit report are filed independently with the SEC. c. The auditor’s audit report must be completed before the management can certify its report. d. The management’s certified report supports the opinion issued in the auditor’s audit report.

20-91

When reporting oncomparative financialstatements, whichof the following isnot a consideration to the auditor? a. If the management requested the prior audit report to be reissue, the auditor should consider reissuing the prior audit report under the dual-dating concept. b. If the management requested the prior audit report to be reissue, the auditor should consider not naming the prior auditor and mentioning the date and type of prior audit report in the introductory paragraph of the current audit report. c. If the management requested the prior audit report to be reissue, the auditor should consider not including the prior audit report in the current audit report. d. If the management requested the prior audit report to be reissue, the auditor should consider naming the prior auditor and not mentioning the nature of an explanatory paragraph added to the prior audit report.

20-92

Auditing Standard 5 (AS 5) of the PCAOB requires the auditor to perform an integrated audit and to report on the client’s effectiveness of ICFR (Internal Control Over Financial Reporting). Which of the following is an appropriate form of report(s) to be issued by the auditor ? a. One report on the auditor’s opinion on the financial statements and a separate report on the auditor’s opinion on the effectiveness of ICFR. b. One report onthe auditor’s opinion on the financial statements, and a separate report on the management’s assessment of the effectiveness of ICFR and the auditor’s opinion on the effectiveness of the ICFR. c. A combined report of the auditor’s opinion on the financial statements and the auditor’s opinion on the effectiveness of the ICFR. d. A combined report of the auditor’s opinion on the financial statements and the management’s assessment of the effectiveness of ICFR.

20-93

The wordings of a combined auditreport on financial statementsand ICFR differs from the wordings of a standard unqualified audit report in several ways. Which of the following is not one of the differences? a. The combined report includes an additional paragraph after the opinion paragraph that addresses the inherent limitations of internal control. b. The combined report includes a paragraph after the scope paragraph defining internal control over financial reporting. c. The combined report includes a reference to the framework of the COSO (Committee of Sponsoring Organizations) in the introductory paragraphs. d. The combined report includes a reference to the framework of the COSO (Committee of Sponsoring Organizations) in the opinion paragraphs.

577

578

20 Audit Report

20-94

In an integrated audit,the auditor encountereda minor scope limitation inidentifying areasonably possibleand significant deficiency that has no material magnitude; assuming everything else stays constant, which of the following opinions would the auditor normally issue in a combined audit report? (Hint: Refer to Chapter 8) A Combined Audit Report

I. II. III. IV.

Auditor’s Opinion on Financial Statements Adverse Disclaimer Unqualified Qualified

+

Auditor’s Opinion on Management’s Assessment of ICFR Unqualified Disclaimer Unqualified Unqualified

+

Auditor’s Opinion on the Effectiveness of ICFR Qualified Disclaimer Unqualified Unqualified

a. All the three opinions in I. b. All the three opinions in II. c. All the three opinions in III . d. All the three opinion in IV. 20-95

In an integrated audit, the auditor chooses to issue separate reports for the client’s financial statements and its effectiveness of ICFR. The management makes an adverse assessment of internal control because of a material weakness (i.e., ICFR is not effective). The auditor agrees with the management’s assessment and the auditor’s opinion of the ICFR is also not effective. However, the auditor concludes that the financial statements taken as a whole is not affected by the material weakness. Assuming everything else stays constant, which of the following opinions would the auditor normally issue in separate audit reports? (Hint: Refer to Chapter 8) An Audit Report

I. II. III. IV.

A Separate Audit Report

Auditor’s opinion on Financial Statements

Auditor’s Opinion on Management’s Assessment of ICFR

Unqualified Adverse Unqualified Qualified

Adverse Disclaimer Adverse Unqualified

+

Auditor’s Opinion on the Effectiveness of ICFR

Adverse Disclaimer Unqualified Unqualified

a. All the three opinions in I. b. All the three opinions in II. c. All the three opinions in III . d. All the three opinion in IV. 20-96

In evaluating the materiality level between a scope-limitation-misstatement and a departure-from-GAAP-misstatement, a key factor that distinguishes between them for the purpose of issuing an appropriate audit opinion is a. a scope-limitation-misstatement is usually related to some illegal or fraudulent acts, whereas a departure-from-GAAP-misstatement is usually not the case. b. a scope-limitation-misstatement has a “psychic” effect on users of the financial statements, whereas a departure-from-GAAP-misstatement has no such an effect. c. a scope-limitation-misstatement generally does not affect future accounting periods, whereas a departure-from-GAAP misstatement does so. d. a scope-limitation-misstatement is evaluated by its potential effect on users of the financial statements, whereas a departure-from-GAAP is evaluated by its known effect on the users.



20-1 b. 20-2 c. 20-3 c. 20-4 c. 20-5 b. 20-6 a. 20-7 b. 20-8 a. 20-9 b. 20-10 b. 20-11c. 20-12 b. 20-13 a. 20-14 c. 20-15 d. 20-16 d. 20-17 c. 20-18 a. 20-19 d. 20-20 a. 20-21 d. 20-22 b. 20-23 a. 20-24 a. 20-25 b. 20-26 c. 20-27 c. 20-28 d. 20-29 a. 20-30 c. 20-31 c. 20-32 d. 20-33 c. 20-34 d. 20-35 c. 20-36 c. 20-37 b. 20-38 c. 20-39 b. 20-40 d. 20-41 b. 20-42 a. 20-43 d. 20-44 d. 20-45 c. 20-46 b. 20-47 c. 20-48 d. 20-49 d. 20-50 a. 20-51 b. 20-52 d. 20-53 d. 20-54 a. 20-55 d. 20-56 b. 20-57 c. 20-58 a. 20-59 d. 20-60 d. 20-61 a. 20-62 d. 20-63 d. 20-64 c. 20-65 d. 20-66 a. 20-67 c. 20-68 a. 20-69 d. 20-70 d. 20-71 a. 20-72 d. 20-73 d. 20-74 a. 20-75 d. 20-76 b. 20-77 b. 20-78 a. 20-79 a. 20-80 b. 20-81 d. 20-82 b. 20-83 b. 20-84 a. 20-85 c. 20-86 d. 20-87 d. 20-88 b. 20-89 c. 20-90 d. 20-91 d. 20-92 b. 20-93 a. 20-94 c. 20-95 a. 20-96 d.

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Simulation Question 20-1 Simulation Question 20-1 is an adaptation with permission from a case by Eckstein C., P. Kyviakidis, and D. Tinkelman inIssues the in Accounting Education , a publication of the American Accounting Association in Sarasota, Florida. This simulation question is based upon a true set of facts.



Introduction

Joe Hooker is an audit partner at the accounting firm of Burnside & Polk (hereafter, BP), a regional firm with 30 partners. Due to the sudden illness of Polk, Hooker has been assigned to take over the audit of InterActive Inc. (hereafter, IA). While the company has been a client of his firm for years, Hooker has had no prior experience with it. Hooker reviewed the firm’s audit and correspondence files to obtain a general understanding of IA’s business and industry. Relations with the client are excellent, and the company’s management has understood about the change in partners. The 1995 audit is nearly complete. IA is planning to go public shortly, with an offering of a million shares, to be priced at $8.25 per share. The company has submitted a draft SEC registration statement on Form S-1, containing draft 1995 financial statements and a draft unqualified audit report, to the SEC for preliminary comments. BP’s policies provide that all companies making an initial public offering (IPO) be automatically considered high-risk clients. Accordingly, the quality control partner, Georgia Meade, reviewed the prospectus and key audit working papers and memoranda. In prior years, there was no review by any partner other than Polk, and he had always rendered unqualified audit opinions. Meade raised a number of questions that must be addressed before the audit report can be issued. See Meade’s comments and questions in her Review Notes that is presented in Question 1 below. The remainder of this simulation question should be considered in responding to her concerns.



The Company

Bill Sedgewick, an inventor, founded IA in 1990. He contributed to the company its key asset, a patented, proprietary interactive video compression technology involving both specialized equipment and unique computer software. This technology allows viewers to interact specially prepared television programming, and to personalize the programs. Each program, when viewed, has potentially thousands of permutations available for a viewer to experience. The advertisements shown differ for viewers who chose different versions, allowing marketers to better target their audience. The particular show any viewer sees is based on the viewer’s individual selections, input through a remote keypad. For example, viewers would be able to continually choose among several camera angles when watching a baseball game, or to switch between live feeds of different sports as they watch the Olympics, or event to change the plot of a movie as they watch it. The company is a pioneer in the development, marketing and distribution of interactive television programming. Management expects markets for interactive television technology and programming to develop in cable television, industrial and educational training, distance learning, in-room hotel entertainment, and business television. The company has produced a number of interactive programs that performed well in market tests. Through the end of 1995, IA has been unprofitable on an operating basis. You should access Data File 20-1 in iLearn for Table 1, which presents IA’s 1995 financial statements, Table 2, which presents excerpts from the draft -1, and Form Table S 3, which presents excerpts from SEC comment letter. The company’s technology requires four channels to operate at its best, and cable operators do not believe

they can charge enough of a premium to justify the number of channels used. IA is attempting to overcome this problem, both by refining its compression technology so that its programs will require fewer channels, and by making more attractive programs. It has spent significant funds attempting to adapt its technology for commercial use and developing an inventory of video programs. The general expenditures for adapting the technology were charged to research and development expense. However, all the expenditures of producing videos, including costs of trying to adapt existing videos to use fewer channels, were capitalized to inventory. The only significant revenues IA has ever had were from licensing programs and producing interactive videocassette programs. IA believes its best opportunity for future success lies in continuing to develop and market interactive technology. However, if required, it could reduce research efforts and change its operations to raise immediate cash. Its inventory of programs and commercials, while designed specifically for use with interactive technology, can be used with conventional television technology. The company has received offers from conventional television outlets to license or buy these programs. These offers have been refused, since management believes that using the programs interactively will ultimately prove more profitable. Since its inception, IA required outside financing parties to develop and market its technology. When the company started in 1990, capital was provided by venture capitalists. During the next several years, various arrangements were made to obtain additional financing. The most significant was the arrangement with Cable Co., a large Canadian-based cable network. Under the terms of the agreement, a separate corporation, Entertainment (hereafter, E), was founded in 1993, owned 50 percent each by IA and Cable Co. IA contributed the right to use its proprietary technology in cable television applications in return for shares, and Cable Co. contribute $9 million and promised to contribute an additional $9 million when the interactive programs achieved “commercial acceptance.”1 Cable Co. later changed its business strategy, and declined to make the second $9 million payment. The two companies then agreed that IA would become the 100 percent owner of E and that Cable Co. would have the right to air some of E’s programs over its networks in Canada and Europe without paying further royalties,2 as long as E’s name was prominently displayed. As a result of this agreement, IA’s 1995 royalty income was zero, although the display of its name had resulted in numerous inquiries about its products from potential customers.



The Market

At the present time, there is significant uncertainty regarding the market for interactive television products. Interactive television programs must compete with other forms of entertainment, including standard television and movies. The size of the market that will ultimately develop will depend on consumer demand as well as developments in technology. Interactive technologies allow viewers to engage in dialogue with their television. The company performed successful market tests of its products, and received favorable responses from consumers. However, some research on people’s motivations for watching television suggests factors that may limit demand. Interactive te levision requires

1

The technology had been recorded on IA’s books at a nominal value and IA recorded a $9 million gain upon its contribution toE. IA continued to pursue markets for its technology other than cable television. 2 Because of the change in licensing arrangements with Cable Co., there were no licensing revenues in 1995.


attention from users, and tends to be an individual activity, while much television viewing is a social activity, and viewers often prefer devoting less than their full attention to the television. Various other companies have developed interactive systems, although none allow the viewer to affect what is seen on the television in the same manner or to the same extent as IA’s products. For example, some companies market “play -along systems” that allow the Viewer, using a game console, to receive data and play along with a game show, without affecting what is shown on the television screen. Other companies have systems, used primarily for interactive shopping, that allow viewers to choose various still frames and audio about topics of particular interest.

Required charge of IA’s 1995 audit; prepare a memorandum that responds to the issues raised by Meade in Assume you are Hooker, the audit partner inher Quality Control Partner Review Notes below. You should access Data File 20-1 in iLearn for Table 4, which contains excerpts from various authoritative pronouncements that would help you in drafting the memorandum.

Quality Control Partner Review Notes Prepared by: G. Meade

The following points need to be resolved and properly documented before issuance of our report. Either support the treatment now used in the financial statements, or propose to the client appropriate changes in the financial statements. vero the company’s 1. The company has had losses, and currently has an accumulated deficit. Should our report mention a concern ability to continue as a going concern? The prospectus says the company’s major asset is proprietary technology, which uses both special equipment and software. The 2. company has booked a $9 million asset and recorded a 1994 gain based on the joint venture transaction. It has also recorded amortization expense in both 1994 and 1995 based on the $9 million value. I see the SEC staff wants no value placed on the technology (see Table 3). They cite SAB No.48. Do you agree? Please explain to me what GAAP is on this topic and how you plan to address the SEC’s concerns. I suspect they will not budge on their interpretation. If the company accepts the SEC staff’s position, how would the financial statements be affected? (Assume 40 percent tax rate). Since we have previously rendered an unqualified opinion on the 1994 income, what are our responsibilities with regard to a change in accounting treatment? 3. The company’s assets include “video program inventory” and “demonstration programs and commercials,” both classified as noncurrent assets. This raises a number of issues (a) Since Cable Co. can use some of the inventory without paying royalties; does that part of the inventory have value? (b) Do we agree with treating inventory as a long-term asset? (c) Should there be amortization? If so, over what life? The working papers apply FASB standards for motion picture accounting to television program is a reasonable in theexpected absencerevenues. of specific Motion picture accounting rules would trycosts, to setwhich amortization to matchapproach costs against Canstandards. the amount and timing of future revenues be predicted here? Using motion picture accounting, the company has capitalized all production costs. By my reading of the working papers and discussions with staff, about $100,000 of these costs each year represent payroll for programmers trying to adapt existing programs to run on two cable channels. Should this be expensed as R & D? The client apparently feels these costs are similar in nature to the usual situation in film production costs, where all the costs of experimenting with various special effects are capitalized. We need a clearly researched and documented position on this. The files do not contain our standard form discussing the desirability of retaining the client. Considering both my comments and the risk factors cited in the draft Form S-1, do we want to keep this audit client? (See Table 3 for excerpts from the draft Form S-1). (d)

4.

Simulation Question 20-2 Simulation Question 20-2 is an adaptation with permission from a case by M. Kohlbeck in Issues the in Accounting Education , a publication of the American Accounting Association in Sarasota, Florida. This simulation question is based upon a true set of facts.



The Company

A group of M.B.A. students formed Summer Technology, Inc. (hereafter, the Company) after graduation in 1989. The Company design and manufactures home technology applications. Although the Company has not been profitable in the past, this year it has reached a turning point as the profits from past R&D expenditures are being realized in product innovations and in increased sales. To further ensure its success, the company has embarked on a focused effort to control costs. As the result of these efforts, the Company expects to recognize its first profit in 2003. However, the Company’s ultimate success depends on whether it will continue to be profitable over the next fe w years. The Company’s strength is it s management, research and development, and production employees. The average employee is 35 years old, educated, and dedicated. salaries are above average (although salary increases to average), moralbyisa strong, the Company has experienced littleStarting turnover. In addition, to good salaries and healthcare benefits,are all close employees are covered defined and benefit pension plan. The pension plan provides retirement benefits based on the employees’ pre-retirement salary levels and years of service with the firm. The Company amortizes any unrecognized prior service costs and gains/losses using the straight-line method over the average remaining service life.

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The future outlook for the Company has improved, but it is still uncertain. Analysts are bullish on the Company and have rated its common stock a buy. The current market price of the Company’s common stock is $4.25 per share and the 2003 average price was $3.65 er p share. The Company has also discussed a major borrowing package from a consortium of banks. These banks are considering a $100 million long-term package bearing interest at 5.8 percent. Continued support from the financial markets will allow the Company to enter a growth stage as additional products are introduced to the consumer markets. At the beginning of the current year, the Company had accumulated substantial net operating loss carry-forwards totaling $35 million that will begin to expire in five years. In the past, management provided a valuation allowance at 100 percent of the deferred tax asset from the net operating lossbased on the Company’s uncertain future. In 2003, management reevaluated the need and the amount of the deferred tax asset valuation allowance because of the current profitability and improved outlook for the Company. Management now believes there is only a 10 percent probability that ll of the net operating loss carry-forwards will be used and a more likely scenario is that the Company will report annual y’s analysis, management determined that it pretax profits over the next five years between 0.5 and 1 percent of total assets. Based on the Compan was “more likely than not” that 80 percent of the deferred tax assets would not be realized.

 During the past year, the Company was party to a number of major transactions that impacted the financial statements. These transactions are discussed in the following paragraphs. Major Transactions during the Past Year

Litigation

In 2003, the Company was named as a defendant in a patent infringement lawsuit. The plaintiff is seeking over $100 million in economic, noneconomic and liquidated damages, plus punitive damages. The company’s counsel reviewed the preliminary court rulings and believes that some payment will probably be required, although an amount cannot be determined. In December, after extensive discussion with the Company’s counsel, management offered the plaintiffs $1 million to settle t he claim. As of today, the offer has not beenaccepted or rejected. The Company does not know what it will do if the offer is rejected, but it has accrued $1 million as a minimum loss contingency for this claim. In the ordinary course of its business, the Company is also a party to a number of other lawsuits. Management believes, however, that the outcome of any other such litigation would not have a material adverse effect on its financial statements. Investment in Airtime

In 2002, the Company invested $25 million in bonds (par value of $25 million) issued by Airtime Inc. Airtime is a publicly held company that produces highly specialized home area network that the Company uses in its home technology packages. The investment is classified as available-for sale. On January 1, 2003, the Company purchased an 18 percent interest in the common stock of Airtime for $20 million and became Airtime’s largest shareholder. At this point, no other firm or individual other than the Company owns more than 10 percent. Additionally, the Company names one member of Airtime’s board of directors. Because the ownership of common stock is less than 20 percent, the Company is following SFAS No.115 for passive investments and has classified the equity investment as available for sale. Lease

The Company entered into a lease agreement for the use of a $12 million high-speed assembly line at its main production facility with General Capital. The five-year lease (January 1, 2003 to December 31, 2007) requires annual payments of $2.52 million beginning on January 1, 2003. Moreover, the lease does not contain a bargain purchase option or transfer at the end of the lease term. Due to the embly ass line’s reliance on current technology, the Company estimated the useful life of the assembly line to be six years. The Company is unaware of General Capital’s implicit interest rate and used an 8 percent interest rate in its lease analysis. Amortization of the capitalized lease asset for financial statement and tax purposes, however, is the same.



Economic Conditions

A synopsis of key economic factors, including overall economy, interest rates, unemployment, and inflation that describe the conditions that the Company faces are as follows: Overall Economy The Conference Board’s index of leading economic indicators continues to post small gains. The overall figure, however, is based on

increases in just four of the ten components in the index. Over the past six months, the positive trend looks more solid. The index rose 2.1 percent, with seven of the ten components showing improvement. The S&P500 Index continues to increase, although the average annual returns are only 6.2 percent. Interest Rates The Federal Reserve Board’s Open Market Committee left its target for the federal funds rate unchanged at a 25-year low of 1.5

percent. The federal funds rate, which is the interest rate that banks charge each other for overnight loans needed to meet reserve requirements, term rates. In the committee’s judgment, the risk of deflation still exceeds that of a rise in inflation. The has a strong influence on other shortOpen Market Committee also said that because of weakening in the labor market, there probably would be no increase in the target rate for a considerable period. The yield of the ten-year U.S. treasury note fell 10 basis points to 4.16 percent last week and has ranged from 4.16 to 4.65 percent during 2003. Yields on investment grade bonds are slightly higher at 5.5 percent. Unemployment Overall, unemployment remains at 6.2 percent. However, the labor market in the Company’s region is slightly stronger with 5.8

percent unemployment. Inflation

Over the past 12 months, the CPI rose just 1.3 percent, the lowest full-year rate recorded since January 1966. Much of the increase was due to a large jump in neergy prices, which in turn resulted from a 6.0 percentrise in gasoline prices. The sore CPI figure, which exclud es volatile food and energy prices to better gauge the breadth and sustainability of any inflation pressures, rose just 0.1 percent.



Preliminary Financial Statements

The Company’s CFO, Mr. Kevin Marksman, has prepared: 1. The preliminary financial statements andummary s of selected accounting policies.Y ou should access Data File 20-2 i n iLearn for Exhibit 1, which presents the Company’s preliminary financial statements, and Exhibit 2, which presents the summary of selected nting accou policies. 2. Investments Analysis.You should access Data File 20-2 in iLearn for Exhibit 3, which presents the investment analysis. 3. Pension Analysis.You should access Data File 20 -2 in iLearn for Exhibit 4, which presents the pension analysis. 4. Lease Analysis.You should access Data File 20-2 in iLearn for Exhibit 5, w hich presents the lease analysis.


5.Tax Analysis.You should access Data File 20-2 in iLearn for Exhibit 6, which presents the tax analysis.

Required Part 1: Review of Preliminary Financial Statements Assume you are the audit partner incharge of Summer Technology, Inc.’s 2003 audit. Review the preliminary financial statements and prepare a

Review Notes that addresses the issues relating to each of the following five items. Use the format provided below and reference/cite relevant authoritative accounting/auditing standards where applicable. You should also refer to Chapter 19 on Fair Value Measurements and Disclosures.

Items

Explain the appropriateness/inappropriatenes s of the assumption(s)

Explain the appropriateness/inappropriateness of the amount

Explain your acceptance/rejection of the presentation/disclosure

1. Litigation Refer to “Accrued Liabilities” in Exhibit 1. 2. Investment in Airtime Refer to “Available-for-Sale” in Exhibit 1 and “Investments Analysis” in Exhibit 3. 3. Lease Refer to “Capital Lease Obligation” in Exhibit 1 and “Lease Analysis” in Exhibit 5. 4. Pension Expense Refer to “Selling, General, and Administrative” in Exhibit 1 and “Pension Analysis” in Exhibit 4. 5. Valuation Allowance for Deferred Tax assets Refer to “Taxes” in Exhibit 2 and “Tax Analysis” in Exhibit 6. Part 2: Consider Earnings Management

After you have completed your analysis in Part 1 above, Kevin Marksman, the CFO, stopped by your office to discuss the earnings release. Preliminary and unreported basic earnings per share are $0.19 per share for 2003. However, Mr. Marksman indicated that the consensus analyst forecast for annual basic earnings per share is $0.20 per share. He emphasized how important it is for a growth company with a history of losses such themay Company meetexpansion or beat theplans consensus theadditional, Companyitwere to miss consensus forecast, share or price would likely sufferasand inhibittofuture of the forecast. company.IfIn is likely thatthe annual bonuses will bethe reduced eliminated. Mr. Marksman implied that he was looking for alternative ways of accounting that would increase basic earnings per share from $0.19 to $0.20. Given Mr. Marksman’s motivation to engage in earnings management; for each of the five items in Part 1 above, explain how Mr. Marksman could possibly use alternative accounting ways to increase basic earnings per share from $0.19 to equal or greater than $0.20. Use the format provided below and reference/cite relevant authoritative accounting/auditing standards where applicable.

Items 1. Litigation Refer to “Accrued Liabilities” in Exhibit 1. 2. Investment in Airtime Refer to “Available-for-Sale” in Exhibit 1 and “Investments Analysis” in Exhibit 3. 3. Lease Refer to “Capital Lease Obligation” in Exhibit 1 and “Lease Analysis” in Exhibit 5. 4. Pension Expense Refer to “Selling, General, and Administrative” in Exhibit 1 and “Pension Analysis” in Exhibit 4. 5. Valuation Allowance for

Deferred Tax assets Refer to “Taxes” in Exhibit 2 and “Tax Analysis” in Exhibit 6.

Show all your calculations on how alternative Explain clearly how each of the five items could be accounting ways could increase the earnings per subjected to earnings management. share from $0.19 to equal or greater than $0.20.

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Part 3: Preliminary Audit Report

Assume Mr. Marksman engaged in earnings management on all five items in Part 2 above, form an overall audit opinion about the Company and draft a preliminary audit report given the Company’s preliminary financial statements (Exhibits 1 through to 6) and your rev iew in Part 1 and analyses in Part 2. Note:

1. You should refer to Figure 20-2 and Table 20-1 (in this Chapter 20) to formulate your overall audit opinion. 2. You should also refer to Figures 20-3 through to 20-15 (in this Chapter 20) to draft your preliminary audit report in the proper format.

Simulation Question 20-3 Simulation Question 20-3 is an adaptation with permission from a case by Bierstaker, J., T. F. Monahan, and M. F. Peters inIssues the in Accounting Education , a publication of the American Accounting Association in Sarasota, Florida. This simulation question is based upon a true set of facts.



Introduction

You have recently been assigned to HT Company as a staff auditor. HT is a technology company that began a few years prior to the dot-com debacle and operates in a very competitive environment. The senior on the job has asked you to provide an initial analysis of whether HT should be classified as a going concern and to identify potential audit issues associated with non-GAAP earnings. Since this is a new assignment, you set out to build your background on HT's industry, the history of the company and their product and service lines, and their overall competitive position in the industry.



Industry Background

HT Company operates in a technology niche that helps companies manage how they spend money on their business. In the last decade, technology-based solutions have emerged to help companies increase the efficiency of the procurement and cash management processes and, as a result, more effectively manage their spending (i.e., operating expenditures). These solutions allow organizations to automate critical tasks such as identifying global suppliers, sourcing goods and services, negotiating and managing contracts, processing invoices and payments, and managing trading relationships. Procurement organizations were among the first to embrace spend management solutions as a way to achieve corporate savings targets. Today, finance departments are leveraging these solutions to drive improved cost management, business unit decision making and planning, budgeting, forecasting, and cash and working capital management. Legal departments are implementing them to more effectively author and manage contracts, and IT departments are deploying them to enhance the value of existing systems and increase returns on investment.



Overview of Company

In its 10-K, HT describes itself as the leading provider of on-demand spend management solutions, which are ways of monitoring operating expenditures such as raw materials, legal, administrative, etc. Its mission is to transform the way companies of all sizes, industries, and geographies operate by delivering software, service, and network solutions that enable them to holistically source, contract, procure, pay, manage, and analyze theiroperating spendingexpenditures and supplier and relationships. Delivered improvements on demand, its in enterprise-class empower companies achieve greater control of their to drive continuous financial and offerings supply chain performance. Thetocompany claims that HT® Spend Management™ solutions are easy to use, cost effective, and quick to deploy and integrate with enterprise resource planning (“ERP”) and other software systems. More than 1,000 companies, including more than half of the 2011 Fortune 500 companies, use HT solutions to manage their operating expenditures, from sourcing and orders through invoicing and payment. HT was incorporated in Delaware in September 1996 and went public in 1999. The company's stock price moved from $944.30 per share on August 1, 2000, to $99.00 per share on February 1, 2001, and settled at $13.68 per share on August 1, 2001. This represented a 98.5 percent reduction in price over a one-year period, while the founders took out a considerable amount of money from stock sales over a two-year period prior to the stock's collapse. This resulted in a Securities and Exchange Commission (SEC) investigation and the resignation of the CEO and chairman of the board, along with most of the other board members. The newly hired CFO became CEO and has run the company successfully for the past ten years.



Sourcing and Procurement Software Market

In a 2011 Supply Management Market Sizing Report, AMR Research, a third-party research firm, projected the spend management market to grow at 10 percent Compound Annual Growth Rate (“CAGR”), becoming a $4.3 billion market in 2015 (i.e., $4.3 billion in revenues).Further, it noted that the highest growth segments within the spend management market over the next five years are projected to be in areas in which HT participates (CAGR in these areas is predicted to be between –10 11 percent). Contract management is another area that HT is expected to be involved with, and this area is also expected to grow substantially during 2012 and 2013.



Competition

You recognize that the market for spend management applications is highly competitive, rapidly evolving and fragmented and subject to changing technology and shifting customer needs. Moreover, the following description in HT's preliminary 10-K makes you feel somewhat uneasy:1 Our principal direct competition comes from ERP vendors whose software is installed by customers directly. We also compete with specialty vendors that offer their software on a hosted basis or under a perpetual license. In our services business, we compete with several large and regional service providers. We anticipate additional competition from other established and emerging companies as the spend management market continues to expand.

1

This disclosure is adapted from a company's actual 10-K. Companies will often disclose these types of risks in an attempt to avoid investor litigation.


Our current principal competitors include: Enterprise software application vendors, including SAP AG and Oracle; Smaller specialty vendors, including Emptoris, BravoSolution, Zycus, and American Express S2S; Smaller niche SaaS vendors, including Perfect Commerce, cc-Hubwoo, Ketera Technologies, and Iasta; and Service providers, including A.T. Kearney and McKinsey & Company. We believe the principal competitive factors considered with respect to, and the relative competitive standing of, our spend management software solutions are: Interoperability with existing commonly used ERP systems; Ease of use and rates of user adoption; Price and demonstrable cost-effective benefits for customers; Performance, security, scalability, flexibility, and reliability of the software; Vendor reputation and referenceable customers; Quality of customer support; and Financial stability of the vendor. Many of our current and potential competitors, such as ERP software vendors, including Oracle and SAP, have longer operating histories, greater name recognition, larger marketing budgets and significantly greater resources, and a larger installed base of customers than we do. They may be able to devote greater resources to the development, promotion, and sale of their products than we can to ours, which can enable them to respond more quickly to new technology, introduce new spend management modules, and respond to changes in customer needs. In addition, many of our competitors have well-established relationships with our current and potential customers and have extensive knowledge of our industry. In the past, we have lost potential customers to competitors for various reasons, including lower prices and other incentives not matched by us. Current and potential competitors have established or may establish cooperative relationships among themselves or with third parties to increase the ability of their products to address customer needs and achieve greater market acceptance. The industry has experienced consolidation, with both larger and smaller competitors acquiring companies to broaden their offerings or increase scale. As a result, we may not be able to successfully compete against our current and future competitors.



HT’s GAAP Financial Performance

Over the past few years, HT Company has experienced strong growth in revenue from its existing product lines (i.e., particularly, the recurring high growth revenue from cloud computing-based subscriptions has increased 31 percent from 2010 to 2011), but has been unable to generate positive income from operations. In fact, during fiscal year 2011, its overall revenue increased 8 percent while, at the same time, its net loss before income taxes increased from $13 million (in 2010) to over $40 million (in 2011). However, HT maintained a significant cash balance, experienced strong cash flows over this two-year period, and enjoyed limited leverage (see Appendix You A). should access Data File 20-3 in iLearn for Appendix A, which presents the consolidated financial statements.



Rational for Reporting Non-GAAP Earnings

HT's financial performance viewed from a GAAP incometostatement is less than impressive. Over the HT has emphasized the importance of (as non-GAAP earnings, especially investors.perspective) As often discussed by HT and the Street, theyears, basic however, argument for reporting non-GAAP earnings is that these numbers more accurately capture financial measures that are comparable across years and across firms and that will impact future operations. Non-GAAP earnings are often referred to in press releases. The non-GAAP financial measures disclosed in Company press releases are thought to be used by boards of directors and senior management teams to evaluate operating performance. Non-GAAP adjustments represent certain income statement items that are non-recurring and/or non-cash, although not every adjustment fits into these two categories. In addition, the use of a particular non-GAAP adjustment may differ based on the type of analysis. For example, investors may use certain non-GAAP adjustments for valuation purposes (i.e., as proxies for recurring cash flows) while auditors may use different non-GAAP adjustments for going concern assessments. As a result, the non-GAAP adjustments that are arrived at by an investor may differ from the non-GAAP adjustments that are arrived at by an auditor. In the case of HT, although it had three years of GAAP losses, the firm's stock price increased from around $7 to $18 over this same period. This raises the issue that non-GAAP earnings could have an important impact on company valuations (See Appendix You B). should access Data File 20-3 in iLearn for Appendix B, which presents HT's non-GAAP adjustments .



Going Concern Provisions

The going concern assumption relates to the entity's inability to continue to meet its obligations as they become due without substantial changes to their operations (i.e., disposition of assets outside the ordinary course of business, restructuring of debt, externally forced revisions of its operations, or similar actions). The time period generally used for measuring a going concern is not to exceed one year beyond the date of the financial statements being audited. Once the auditors believe there is substantial doubt about the entity's ability to continue as a going concern, they should obtain information about management's plans to mitigate the effect of such conditions or events, and assess the likelihood that such plans can be effectively implemented. The current audit guidelines for determining a going concern are presented in detail in Appendix C. You should access Data File 20-3 i n iLearn for Appendix C, which current auditing guidelines dealing with a going. concern The above information on the competitive risk faced by HT, its net losses over the past few years, its positive non-GAAP earnings over this same time period, and the role of non-GAAP earnings in general has raised the issue of a going concern for the audit team. In addition, you recognize that the audit is targeted at GAAP and that there is no requirement to audit non-GAAP earnings (however, the audit of non-GAAP earnings is under review by the PCAOB).

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20 Audit Report

Required 1. In reviewing Appendix C in iLearn(“Current Auditing Guidelines Dealing with a Going Concern”),comment on which provisions are most applicable to this case. (a) Should HT be assigned a going concern classification —why or why not? Consider whether the amounts in question would be material (i.e., impact the decision-making of investors). For example, a cash-only business would not have a material amount of receivables. Use Appendices A and B to support your answer. (b) Identify key ratios derived fromthe financial statements that: • Support your position regardinga going concern. • Do not support your conclusion regarding a going concern. For example, profit margins (net income/sales) would poten tially support a going concern qualification, whereas free cash flow percentage (operating cash flows/investing cash flows) may not. Note: See the following link for common ratio formulas: http://beginnersinvest.about.com/od/financialratio/Financial_Ratios.htm or refer to the discussion on applying analytical procedures on a going concern in Chapter 7. 2. As the staff auditor examining this issue, your audit team has asked you to provide brief summaries about following the with regard to nonGAAP earnings (see Appendix B in iLearn ): (a) In general, whydo firms report non-GAAP earnings? (b) In general, are certain components ofnon-GAAP earnings more appropriate forcertain decisions (e.g., going concern), but not so for other decisions (e.g., valuation)? Note: You may find it helpful to consult Regulation G, which provides the SEC rules for disclosing non-GAAP metrics and reconciling nonGAAP and GAAP earnings (see the link below):http://www.sec.gov/rules/final/33-8176.htm For current research on non-GAAP earnings, see Curtis et al. (2012) at the following link: http://www.business.utah.edu/sites/default/files/documents/school-of-accounting/whipple_2nd_year_paper.pdf In addition, the Canadian Institute of Chartered Accountants (CICA) has a document on non-GAAP earnings that may serve as helpful background reading. It is available at:http://www.cica.ca/publications/list-of-publications/manual/item12848.pdf 3. For HT, are there any audit risksthat you foresee with the Street relying on non-GAAP earnings to evaluate and make predictions about changes in stock price and HT separately reporting such earnings? 4. Review the non-GAAP adjustments listed for this company inAppendix B in iLearn . (a) Put yourself in the position of a company spokesperson. Explain a rationale that the company would communicate to the investment community that supports the use of these specific adjustments. (b) Now put yourself in the position of the staff auditor (Q1 and Q2). Are there characteristics with some of these adjustments that were more important when finalizing this opinion? Note: For another example of a press release that describes a significant difference between GAAP and non-GAAP earnings, please see the link below for the press release from Salesforce.com:http://www.salesforce.com/company/news-press/press-releases/2012/02/120223.jspAlthough the company has a net loss per share (which might concern an auditor), an analyst might be excited about its revenue growth and positive nonGAAP earnings (with stock-based compensation being one of the major adjustments to GAAP earnings), leading to its $20 billion market capitalization. 5. Research two other company earnings releases and identify two additional non-GAAP adjustments that would beimportant in a going concern designation, and explain why they would be important. (a) Company 1: (b) Company 2: Note: You must fully answer all five questions in order to earn the extra credit point.


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Chapter 21 Other Audit Engagements Chapter Learning Outcomes (LOs) Checklist


LO21-1 Identify the authoritative guidance for other audit engagements.



LO21-2 Identify the types of procedure performed for other audit engagements.



LO21-3 Describe specific procedures for review; compilation; specific elements or accounts; prospective financial statements, and internal control engagements.



LO21-4 Identify the types of assurance/opinion for other audit engagements.



LO21-5 Differentiate the forms of report for other audit engagements.



LO21-6 Describe some future other audit engagements.


Chapter 21 Other Audit Engagements Recall as discussed in Chapter 1, CPA firms offer four broad types of attestation services (financial/integrated audit, examination, review, and agreed-upon procedures) and a wide variety of “other” assurance services (web trust, risk assessment, etc.). This chapter discusses some of these att estation and assurance services as “other audit engagements” in addition to the usual audit engagement discussed thus far from Chapter 1 through to Chapter 20. Specifically, fourteen other audit engagements are discussed and presented in Figure 21-1 and Table 21-1. Figure 21-1 Other Audit Engagements 4. Audit of Financial Statements that Use a Financial Reporting Framework Other Than GAAP

Other Audit Engagements

1. Review of Financial Statements 2. Compilation of Financial Statements 3. Review of Interim Financial Information of Public Companies 4. Audit of Financial Statements that Use a Financial Reporting Framework Other than GAAP 5. Audit of Specific Elements, Accounts or Items 6. Audit of Information Accompanying the basic Financial Statements 7. Audit of Compliance with Debt Agreement 8. Attestation of Prospective Financial Statements 9. Attestation of Internal Control over Financial that Is Integrated with an Audit of Its Financial Statements 10. Attestation of Websites 11. Attestation of Information Systems 12. Attestation of Management Discussion and Analysis 13. Service Organization Control 14 Agree-upon Procedures Engagements

Authoritative Guideline

Type of Procedure

Type of Assurance

PCAOB ASs

Examination

Positive

AICPA AUs

Audit

Negative

AICPA ATs

Review

No Opinion

AICPA ARs

Compilation

Agreed-upon findings

Agreed-upon Procedures

Form of Report

A Special Report Similar to a Standard Audit Report Except Modified Wordings/Paragraphs A Review Report Similar to a Standard Audit Report Except Modified Wordings/Paragraphs A Compilation Report Depending on Management’s Required Disclosure A WebTrust/SysTrust Report A Service Organization Report An Agreed-upon Report

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Authoritative Guideline

Each of the fourteen other audit engagements follows one or more of the following authoritative guidelines: 1. Statements on Auditing Standards issued by the AICPA. These are referred to as AICPA’s auditing standards and are labeled as AUs. See Appendix A for a list of AUs. 2. Auditing Standards issued by the PCAOB. These are referred to as PCAOB’s auditing standards and are labeled as ASs. See Appendix B for a list of ASs. 3. Standards for Attestation Engagements (SSAE) issued by the AICPA. These are referred to as AICPA’s attestation standards and arefor labeled as ATs.and SeeReview Appendix C for a(SSARS) list of ATs. 4. Statements on Standards Accounting Services issued by the AICPA. These are referred to as AICPA’s accounting and review standards and are labeled as ARs. See Appendix D for a list of ARs. Type of Procedure

Each of the fourteen other audit engagements involves one or more of the following types of procedure: 1. Audit (financial/integrated) – In an audit, the CPA obtains and evaluates evidence about a client’s financial statements which contain assertions made by the management. Based on the audit, the CPA issues a “positive” (means certain or confident) expression of opinion on whether the financial statements are presented fairly in conformity with established criteria such as GAAP. 2. Examination – In an examination, the CPA obtains and evaluates extensive evidence about a variety of situations, which contain assertions made by another party, to provide the highest level of assurance on the assertions. Based on the examination, the CPA issues a “positive” expression of opinion on whether the other party’s assertion, in all material respects, conforms to certain applicable criteria. 3. Review – In a review, the CPA makes inquiries of a client’s management performs comparative analyses of financial information. The scope of this service is significantly less than that of an audit or examination in that it usually does not involve obtaining and evaluating evidence. Based on the review, the CPA issues a “negative” (means uncertain or unconfident) expression of opinion on whether the financial information is presented fairly in conformity with established criteria such as GAAP. 4. Agreed-upon procedures – In agreed-upon procedures, the procedures to be performed on specified financial statement/non-financial statement matters are agreed upon by the CPA, the responsible party making the assertions, and the intended users of the CPA’s report. The level of assurance provided on the assertions depends on the nature and scope of the procedures agreed upon with the specified users. Based on the agreed-upon procedures, the CPA issues a “summary of findings” report, which does not include an opinion. 5. Compilation – In a compilation, the CPA undertakes to present, in the form of financial statements, information that is the representation of management without undertaking to express any assurance on the statements (i.e., express no opinion). Type of Assurance

Each of the fourteen other audit engagements issues one of the following types of opinions: 1. Positive opinion – A “positive” (means certain or confident) opinion is an expression of opinion on whether the financial statements are presented fairly in conformity with the GAAP and Auditing Standards AUs/ASs. 2. Negative opinion – A “negative” (means uncertain or unconfident) opinion is an expression of opinion on whether the financial information is presented fairly in conformity with established criteria such as GAAP. Thus, instead of stating a “positive” opinion that “the financial statements are presented fairly in conformity with GAAP”, a “negative” opinion is usually stated as that “ we are not aware of any material modifications that should be made to the statements in order for them to be in conformity with GAAP.” 3. No opinion – A disclaimer of opinion that explains the reasons for withholding an opinion and explicitly indicates that “no opinion is expressed.” 4. Agreed-upon findings – Usually a “summary of findings” report that does not include an opinion. Form of Report

Each of the fourteen other audit engagements comprises one of the following forms of report:


1. A special report similar to a standard audit report except modified wordings/paragraphs. 2. A review report similar to a standard audit report except modified wordings/paragraphs. 3. A compilation report depending on management’s required disclosure. 4. A WebTrust/SysTrust report. 5. A service organization report. 6. An agreed-upon report. Note that since all standards issued by the ACIPA were adopted as interim auditing standards by the PCAOB, all other audit engagements involving public companies must follow the standards issued by the AICPA as if they were issued by the PCAOB. This means that the paragraph on “authoritative standards” in the reports of all other audit engagements should be worded appropriately according to whether the engagements involve public or private (nonpublic) companies. For example, a report on a forecast (see Figure 21-12) for private companies should state, “Our examination was made in accordance with the Statements on Standards for Attestation Engagements issued by the American Institute of Certified Public Accountants ...” On the other hand, the same report for public companies should state, “Our examination was made in accordance with the standards of the Public Company Accounting Oversight Board ...” Table 21-1 Fourteen Other Audit Engagements

Key Feature and Authoritative Guideline

Type of Procedure

Review of management.  A review engagement is performed Inquiries Apply Analytical on the financial statements of nonpublic procedures. companies (also referred to as nonissuers) See Table 21-2 for to express a limited assurance that the details. financial statements are prepared in accordance with GAAP.

1. Review of Financial St atements

Type of Assurance /Opinion Negative

Form of Report A review report is similar to a standard audit report, except



In the opening paragraph, substitute the word “audit” by “review” and state “All information … is the representation of the management ...”.



In the scope paragraph, state that a review consists of inquiry of management and application of analytical procedures. Also, the testing is less in scope than an audit.



The engagement is performed in accordance with the Statements on Standards for Accounting and Review

Change the opinion paragraph to “We  are not aware of any material exceptions…” (Negative assurance).

Services (SSARS) AR 90 Review of Financial Statements.



This engagement does not review the effectiveness of aclient’s internal controls.



If the client departs from GAAP, issue a modified negative opinion with the wordings, “With the exception of the matter described in the following paragraph, we are not aware of an material modifications ...” and add a separate paragraph in the report to describe the departure.



In a review engagement, each page of the client’s financial statements should be marked “See accountants’ review report” to clearly indicate that an audit engagement was not performed.



Unlike an audit, the auditor is not required to communicate with predecessors in a review engagement. However, AR 400 points out that such communication is desirable in certain situations, such as when the auditor has limited knowledge of the client’s industry.

See Figure 21-2 for an example of the review report.

Note: The auditor is not required to determine the effect of the departure from GAAP.

Note: PCAOB’s AS 5 prohibits a review of ICFR for public companies (also referred to as issuers).

Compilation Preparation of financial A compilation engagement is the preparation of financial statements for statements. See Table 21-3 for nonpublic companies for which no details. assurance is expressed about the presentation of the financial statements.

2. Compilation of Financial Statements





The engagement is performed in

Do not express an opinion or any other form of assurance.

Form of report depends on management’s required disclosures with the financial statements:

Compilation with full  accordance with GAAP

disclosure in or other

comprehensive basis. See Figure 21-3 for an example.



Compilation that omits substantially all

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Type of Procedure

Type of Assurance /Opinion

accordance with the Statements on Standards for Accounting and Review Services (SSARS) AR 80 Compilation of Financial Statements.



The auditor is not required to assess control risk or to perform any evidencegathering procedures.

See Figure 21-4 for an example.



In a review engagement, each page of the client’s financial statements should be marked “See accountants’ compilation report.”

Compilation independence accordance with without CPC. Add a separatein  paragraph in either Figure 21-3 or 21-4: “We are not independent with respect to XYZ Company.”



Unlike an audit, the auditor is not required to communicate with predecessors in a compilation engagement. However, AR 400 points out that such communication is desirable in certain situations, such as when the auditor has limited knowledge of the client’s industry.



Add another separate paragraph to each of the above three reports if the client departs from GAAP. All compilation reports should include a statement that:



The compilation is limited to financial statement representation of the management.

Note: The following engagements are not subject to AR 80: (1) preparing a working trial balance; (2) assisting in adjusting the books of account; (3) consulting on accounting, tax, and similar matters; (4) preparing tax returns; (5) providing various manual or computerized bookkeeping or processing financial data services unless the output consists of year-end financial statements, and (6) processing financial data for clients of other accounting firms.



The compilation is accordance with the SSARS.



The review engagement is performed in accordance with the Statements on Standards for Accounting and Review Services (SSARS) AR 90 Review of Financial Statements for nonpublic companies.



The review engagement is performed in accordance withthe AICPA’s Auditing Standards AU 930 Interim Financial Information and the Sarbanes-Oxley Act’s requirement for a review of ICFR and interim financial information filed with the SEC for public companies.

The interim review engagement does

in

The CPA has not reviewed or audited the statements.



The CPA doses not express an opinion or any form of assurance. Note: The auditor has no responsibility to assess the conformity of the client’s financial statement with GAAP.

Review the same review procedures under AR 90 in Table 21-2, but differ in (1) The auditor must obtain an understanding of the client’s internal control, and (2) The auditor reads the minutes of the directors’ and stockholders’ meetings, instead of inquiries of management. To obtain an understanding of the client’s internal control, the auditor (1) Reads working papers of prior year’s review, (2) Reviews results of TOC on current year’s financial statements, and (3) Determines any changes in the client’s business activities that

The auditor performing the review might affect the internal  engagement must also be engaged to control. perform the audit of the client’s annual financial statements for the current year.



performed



3. Review of Interim Financial Information Use of Public Companies

 A review of interim financial information is performed to: (1) help management of public companies meet their filings of 10Q reports with the SEC, and (2) report whether material modifications should be made for the interim financial information to conform with GAAP.

Form of Report disclosures in accordance with GAAP or other comprehensive basis. Add a last sentence, “The financial statements are not designed for those who are uninformed about the omitted disclosures.” Also, the omission must not be intended to mislead the users of the financial statements.

Negative

A report similar to a review report in Figure 21-2, except



Substitute the standards of “SSARS” by the standards of “PCAOB”. Also, if the client departs from GAAP, issue a modified negative opinion with the wordings, “With the exception of the matter described in the following paragraph, we are not aware of any material modifications ...” and add a separate paragraph in the report to describe the departure.



Communicate to the audit committee about significant adjustments found during the review.



Mark “un-audited” on each page of the interim financial information. See Figure 21-5 for an example .




Type of Procedure

Form of Report

not require a complete assessment of control risk each quarter or gathering sufficient appropriate evidential matter on which to base an opinion on interim financial information.

4. Audit of Financial Statements that Use a Audit Financial Reporting Framework Other Audit in accordance with Than GAAP AU 800. Table 21-4 for  Financial statements that use a GAAP See details.

Positive



State the specific type of financial statements in the introductory paragraph.

financial reporting framework is referred to as financial statements that use ageneralpurpose financial reporting frameworks . On the other hand, financial statements that use a financial reporting framework other than a GAAP financial reporting framework is referred to as a specialpurpose financial reporting frameworks .



Add a third paragraph to disclose the basis used to prepare the financial statements.



Add a paragraph that restricts the distribution of the report to those within the entity if the financial statements are prepared on a regulatory basis in accordance with AU 905, Alerts as to the Intended Use or Purpose of the Auditor’s Written Communication .



AICPA AU 800 defines four such special-purpose financial reporting frameworks: (1) Regulatory basis, (2) Tax basis, (3) Cash basis, and (4) Contractual basis financial reporting frameworks.



AU 800 requires the auditor to consider whether the financial statements are suitably titled. If they are not, the auditor should disclose any reservations in an explanatory paragraph and qualify the opinion. For example, a cash basis “Balance Sheet” should be appropriately titledas “Statement of Assets and Liabilities Arising from Cash Transactions.”



Audit of financial statements that use a special-purpose financial reporting framework is performed in accordance with the AICPA AU 800 Special Considerations – Audits of Financial Statements Prepared in Accordance Frameworks.

With

Special

A special report similar to a standard audit report, except


Purpose

Note: In the case of financial statements prepared in accordance with a regulatory or contractual basis of describe the auditor’s report theaccounting, purpose for whichin the financial statements are prepared or refer to a note in the special purpose financial statements that contains that information.

5. Audit of Specified Elements, Accounts Audit It is like an audit but is or Items



Examples of this engagement include a report on rentals, royalties, and profit participation. It may be performed as a separate engagement or as part of an audit of a client’s complete financial statements. For profit participation, it must be performed as part of an audit of the client’s complete financial statements.



The engagement is performed in accordance with the AU 805 Special

Positive

applied to less than the full financial statements. Materiality is defined in terms of the elements, accounts, or items involved rather than in relation to the overall financial statements. See Table details.

21-5



The specified elements, accounts, or items are identified.



The basis on which the specified elements, accounts, or items are presented is described.



A paragraph that restricts the distribution of the report is added in accordance with AU 905, Alerts as to the Intended Use or Purpose of the Auditor’s Written Communication .

for


Considerations-Audits of Single Financial Statements and Specific Elements, Accounts, or Items of a Financial Statement .

6. Audit of Information Accompanying the Audit Basic Financial Statements It is like an audit but is

usually performed with  Information accompanying the basic fewer details (i.e., apply financial statements includes comparative limited audit procedures) statements supporting the control totals, and the auditor should


Positive or disclaimer



The report is also known as a long-form audit report.



The report is a standard audit report except additional wordings are added to the

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Key Feature and Authoritative Guideline supplementary FASB or SEC, of insurance comments on statements.

Type of Procedure


report any deficiencies in, or the omission of, supplementary information required by FASB or SEC. measurement of  This engagement is performed in The materiality is the same as accordance with the AU 725 that used in the basic Supplementary information in Relation to financial statements taken the Financial Statements as a Whole . as whole.

7. Audit of Agreement

information required by statistical data, a schedule coverage, and specific changes in the financial

Compliance

with

Debt



This engagement is to report whether an audit client that enters into loan agreements complies with certain debt agreements or regulatory requirements related to audited financial statements. An example is the auditor provides assurance that the client has complied with bond indenture provisions relating to the maintenance of certain financial ratios and restrictions on the payment of dividends.

Audit It is like an audit but the auditor should be qualified to evaluate the debt agreement, e.g., s/he is a qualified CPA and an attorney.


Positive Express no opinion The type of prospective financial assurance statements is prohibited varies with by AT 301. the specific See Table 21-6 for procedures details. agreed to and performed. Note: If an auditor concurrently provides more than one level of service (i.e., concurrently performs several types of procedures) such as a compilation, an agreedupon procedures, and an audit or examination, the CPA ordinarily issues a report that is appropriate

An attestation report similar to a standard audit report, except

The engagement is performed in accordance with the AU 806 Reporting on Compliance With Aspects of Contractual Agreements or Regulatory Requirements in Connection With Audited Financial Statements.



Exercise of due care and professional skepticism about noncompliance are prerequisites for this engagement.

8. Attestation of Prospective Financial Examination Compilation Statements (i.e. Prospective Financial Statements based on Financial Forecasts Agreed-upon procedures A review engagement of or Projections).

Prospective financial statements are financial information representing the financial position, results of operations, and cash flows for some period of time in the future.



Financial forecasts are prospective financial statements that present a client’s expected financial position, results of operations, and cash flows, to thebest of the responsible party’s knowledge and belief. Banks commonly require this information as a part of loan applications.



Financial projections are prospective financial statements that present a client’s financial position, results of operations, and cash flows, to the best of the responsible party’s knowledge and belief, given one or more hypothetical assumptions. For example, projected financial statements might assume the client’s is able to increase the price of its primary product by


Negative Note: An audit usually provides a positive opinion; but it provides a negative opinion here because the substance of this engagement involves reviewing documents and regulations. Therefore, it is essentially a review service that results in a negative opinion.





Form of Report opinion paragraph of the standard audit report to express an opinion onall the supplementary information depending whether sufficient evidence had been gathered (positive opinion) or had not been gathered (disclaimer of opinion) in relation to the basic financial statements taken as a whole.

for the highest level of assurance service rendered (i.e., the audit or examination engagement).



The opinion is in the form of a negative assurance and is worded as “ … nothing came to our attention that caused us to believe that the Company failed to comply with the …”



A paragraph that restricts the distribution of the report is added in accordance with AU 905, Alerts as to the Intended Use or Purpose of the Auditor’s Written Communication . See Figure 21-9 for an example.



The opinion paragraph states the reasonableness of the underlying and hypothetical assumptions and the preparation and presentation of the prospective financial statements. Note: The opinion paragraph also state the reasonableness of the hypotheticalassumptions for projections because projections may contain certain underlying assumptionsan d hypothetical assumptions. On the other hand, forecasts only contain certain underlying assumptions (i.e., no hypothetical assumptions); therefore, the opinion paragraph for forecasts only states the reasonableness of the underlying assumptions.



A caveat statement that the prospective results may not be met.



A statement that the CPA assumes no responsibility to update the report for events and circumstances occurring after the dates of the report.



The date of the examination report. Because the report is a forecast or projection, the date of the forecasted or projected financial



Type of Procedure


10 per cent based on a hypothetical assumption of no reduction in units sold.

Form of Report statements should be after the audit report date of a normal audit of the historical financial statements.



Prospective financial statements based on financial forecasts or projections contain certain underlying assumptions whereas prospective financial statements based on projections contain certain underlying assumptions as well as certain

See Figure examination See Figure examination

21-10 report 21-11 report

for on a for on a

an example of an financial projection an example of an financial forecast.

Note: Because a financial projection is for limited use, an examination report on a financial projection must include a statement that the report distribution is restricted to the identified users. On the other hand, because a financial forecast is for general use, an examination report on a financial forecast does not contain such a statement. In the case of a compilation of a prospective financial statement, the attestation report should also include: (1) a statement that a compilation of a projection is limited in scope, (2) a disclaimer of responsibility to update the report for events occurring after the report’s date, and (3) a separate paragraph that describes the limitations on the usefulness of the presentation (e.g., the prospective statements fail to provide footnotes).

hypothetical assumptions.



This engagement does not attest to the accuracy of the prospective financial statements; rather, it attests to the reasonableness of the underlying and hypothetical assumptions in the preparation and presentation of the prospective financial statements.



The engagement is performed in accordance with the Statements on Standards for Attestation Engagements (SSAE) AT 301 Financial Forecasts and Projections .



Financial forecasts are forgeneral use (i.e., available to any users).

See Figure 21-12 for an example compilation report for a forecast.



Financial projection and agreed-upon procedures are for limited use (i.e., available only to restricted and identified users).

of

a

In the case of agreed-upon procedures to prospective financial statements, three conditions for accepting such an engagement are: (1) the specific users have participated in determining its nature and scope, and they take responsibility for the adequacy of the procedures; (2) report distribution is restricted to those users, and (3) the statements include a summary of significant assumptions. See Figure 21-13 for an example of an agreedupon procedures report for a forecast.

9. An Examination of an Entity’s InternalExamination under AT Control over Financial Reporting that Is 501 for private companies: Integrated with an Audit of Its Financial Statements All areas of internal

control are examined This engagement is usually done for a unless specifically client’s management or audit committee, or excluded by agreement. for meeting the requirements of a See Table 21-7 for regulatory agency. details.  The engagement may be performed on a specified date or during a specified period of time.



Presence or absence of material weaknesses according to AU 265.

See Figure 21-14 for an example of an examination report on internal control over financial reporting that is integrated with an audit of its financial statements of private companies.



The conditions necessary for an auditor to accept this engagement are: (1) Management accepts responsibility for the effectiveness of internal control, (2) Integrated Audit under Management evaluates the effectiveness of AS 5 for public internal control using reasonable criteria, companies: (3) Sufficient evidence exists, and (4) As a part of the audit of Management provides its written assertion internal control over to the auditor reporting (ICFR) performed in  For private companies, the financial engagement is performed in accordance conjunction with an audit of financial statement. with AICPA’s AT 501An Examination of Table 8-6 in an Entity’s Internal Control Over See Financial Reporting That Is Integrated

Chapter 8 for details.

An attestation report similar to a standard audit report. Note: If the management’s assertion about the effectiveness of internal control includes a statement that the cost of corrective action exceeds the benefits of implementing new/additional controls, the auditor should include, as a last paragraph to the attestation of internal control report, a disclaimer opinion on the management’s cost-benefit statement.

Positive according to PCAOB’s AS 5.

Recall in Chapter 8, the PCAOB’s AS 4, Reporting on Whether a Previously Reported Material Weakness Continue to Exist , provides

guidance for the auditor in reporting on whether a material weakness continues to exist at an interim date. According to this standard AS 4, making a client wait twelve months to rather receivethan an unqualified opinion regarding its ICFR in the next year-end ICFR report, the auditor can provide an interim opinion once management has remediated the material weakness. This standard

595

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Type of Procedure


Form of Report allows the auditor to attest on a timely basis as to whether a client has eliminated the cause of a previously issued adverse opinion regarding its ICFR. However, the auditor’s engagement to report on whether a previously reported material weakness continues to exist in conformity with AS4 is voluntary.

With an Audit of Its Fina ncial Statements



For public companies, the engagement is performed in accordance with PCAOB’s Auditing Standard AS 5 An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements .

See Figure 8-10 and Figure 8-11 in Chapter 8 for examples of reports on ICFR of public companies.

Examination 10. Attestation of Websites (also known as WebTrust Service) Examining the website

Positive

A WebTrust report is in the form of a clickable WebTrust seal that states whether a client’s website meets the WebTrust principles developed by a joint AICPA/CICA task force. See Figure 21-15 for an example of a WebTrust report.

Positive

A SysTrust report is similar to the WebTrust report shown in Figure 21-15. It states whether a client’s information systems meets the SysTrust principles developed by a joint AICPA/CICA task force, and includes management’s assertions about the effectiveness of the controls over the information systems.

Positive Negative

An attestation report similar to an examination report. An attestation report similar to a review report. The auditor’s report on MD&A is to provide assurance on whether (1) The presentation includes, in all material respects, the required elements of the rules and regulations adopted by the SEC. (2) The historical financial amounts included in the presentation have been accurately derived, in all material respects, from the client’s financial statements.

 This engagement provides reasonable for: (1) Adequacy of assurance that a client’s website complies disclosure. with Trust Services principles and criteria (2) Transaction integrity. for electronic commerce. (3) Information integrity.  The engagement is performed in accordance with Statements on Standards for Attestation Engagements (SSAE) AT 101 Attestation Enga gements . 

At least once every 12 months, the auditor tests a client’s website to ensure that its website continues to comply with the Trust Services principles and criteria. If the website does not comply, the WebTrust seal can be revoked.

Examination 11. Attestation of Information Systems Examining (also known as SysTrust Service) This engagement provides reasonable  assurance that a client’s information systems complies with Trust Services principles and criteria for electronic commerce.



The engagement is performed in accordance with Statements on Standards for Attestation Engagements (SSAE) AT 101 Attestation Enga gements .

the information systems for: (1) Availability for operation. (2) Security against unauthorized access. (3) Integrity of system process. (4) Maintainability of system resources.



The auditor tests a client’s information systems to determine whether controls over the system were operating effectively during a specified period. If the system meets the requirements of theTrust Services principles and criteria, an unqualified attestation report is issued.

12. Attestation of Management Discussion and Analysis (MD&A)



An auditor can examine or review MD&A.



The engagement is performed in accordance with Statements on Standards for Attestation Engagements (SSAE) AT 701 Management’s Discussion and Analysis.



To accept an engagement to examine MD&A, the auditor must have audited the

Examination Review



Type of Procedure


most recent financial statement period to which the MD&A applies, and the other financial statement periods also must have been audited by the same or other auditors.

Form of Report (3) The underlying information, determinations, estimates, and assumptions of the client provide a reasonable basis for the disclosures contained in the presentation.



The auditor can accept an engagement to review MD&A for an annual or interim period.

13. Attestation of Service Organization Control

Examination

Positive

User Auditor Service Auditor AICPA AU 402 Audit Considerations See Table 21-8 for Relating to an Entity Using a Service details. Organization requires an auditor (known as an user auditor) of a company (known as an user entity) that uses a service



the suitability of the design of controls. (2) Type 2 report – A report on a management’s description of a service organization’s system and the testing of the design and operating effectiveness of controls.

organization to obtain an understanding of how the user entity uses the service organization, including the nature and significance of the services and the effect on internal control.

In determining the sufficiency and appropriateness of the audit evidence provided by the service auditor’s report, the user auditor should consider the professional competence of the service auditor and his/her independence with respect to the service organization.



Many service organizations perform similar processing services for numerous user entities. If the auditor of each user entity were to visit the service organization for the purpose of reviewing controls, they would ask similar questions and perform similar tests. Thus, it is often advantageous for the service organization to engage its own auditor (known as aservice auditor) to examine its controls and issue a service organization control report (known as a SOC report) that is relevant to the user

If the user auditor’s control risk (CR) assessment includes an expectation that controls at the service organization operate effectively, the user auditor should obtain a Type 2 report (if available), or perform appropriate tests of controls (TOC).

entity’s internal control over financial reporting. The user auditor may then elect to rely on this report as an alternative or in addition to performing testing procedure at the service organization.

14. Agreed-upon Procedures Engagements



This is an engagement when the auditor and management or a third party user agree that the audit will be limited to certain specific audit procedures.

 The engagement is performed in accordance to: (1) AT 201 Agreed-Upon Procedures Engagements for financial statement matters such as agreed-upon audit procedures for gross sales account for a lease agreement, and (2) AT 201 Agreed-Upon Procedures Engagements for non-financial statement matters such as agreed-upon audit procedures for testing compliance with federal affirmative action laws. 

This engagement is allowed when the agreed-upon procedures are not sufficient to express an opinion, provided that: (1) The parties involved have a clear understanding of the procedures to be

AICPA AT 801 Reporting on Controls at a Service Organization describes two types ofSOC reports that a service auditormay issue: (1) Type 1 report– A report on a management’s description of a service organization’s system and

If the service auditor’s Type 2 report provides an adequate basis for the user auditor’s assessment of control risk, usually there is no need for the user auditor to perform his/her own tests at the service organization. See Figure 21-16 for an example of a service auditor’s Type 2 report.

Agreed-upon audit procedures

The type of assurance varies with the specific procedures agreed to and performed.

The form of report varies with the specific procedures agreed to and performed. A report on an agreed-upon procedures engagement should identify the specified users and describe in detail the procedures the users decided were necessary; state the work is not an audit or review that results in an overall opinion or assurance; and describe each of the agreedupon procedures and the specific findings related to each procedure. No overall positive or negative opinion is given as a conclusion to the report. Instead, the report provides the accountant’s findings based on the procedures performed. See Figure 21-17 for an example for an agreed-upon procedures report.

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Type of Procedure


Form of Report

performed, and (2) Use of the report is to be restricted to the specified parties.



For this engagement, clearly worded engagement letters specially delineating the desired procedures to be performed are of utmost important.

Future Other Audit Engagements XBRL XBRL, eXtensible Business Reporting Language, is an international information format designed specifically for business information. It assigns all individual disclosure items within business reports unique electronically readable tags that are mapped to taxonomies. XBRL offers major benefits in the preparation, analysis, and communication of business information through its cost-effective and improved reliability as compared to other existing systems. Audited financial statements are now being provided using XBRL. In 2009, the SEC issued rules requiring public companies to provide financial information in a form that can be easily downloaded directly into interactive spreadsheets to make it easier for investors to analyze and to assist in automating regulatory filings. The SEC mandated that this form of financial information to be posted to a company’s website. Under the current SEC rules and professional auditing standards, auditors are not required to perform procedures or provide assurance on XBRLtagged data in the cont ext of audited financial statements. Accordingly, the auditor’s report on the financial statements does not cover the process by which XBRL-tagged data that results from this process, or any representation of XBRL-tagged data. However, auditors may choose to engage in XBRL-related assurance engagements (services) such as 1. Agree-upon procedures engagements on XBRL-tagged data to assist management in its evaluation of the XBRL-tagged data and the audit committee in its oversight role. 2. Assurance engagements on the controls related to the XBRL-tagging process and examinations of the accuracy of the XBRL-tagged data itself. 3. Assurance engagements on financial information as presented in particular pre -defined instance documents. Continuous Auditing A demand exists for assurance beyond that provided on quarterly and annual financial statements. Continuous auditing engagement provides assurance using a series of reports provided simultaneously or shortly after the related information is released. Continuing auditing engagement is expected to grow significantly as companies provide more and more up-to-date financial information on their Web sites. Table 21-2 Procedures for Review Engagement

Procedures for Review Engagement A review engagement consists primarily of inquiries of management and analytical procedures. It does not include obtaining an understanding of internal control, TOC, TOB, or specific tests of balances such as confirmation of receivables or observation of physical inventory. AR 90 recommended the following procedures for a review engagement:

 

Obtain knowledge of the accounting principles and practices of the client’s industry, such as, by using the AICPA’s industryguides.

Obtain knowledge of the client, which includes the nature of business transactions, type of accounting records, and the form of financial statements.



Make inquiries of management concerning: (1)The management’s procedures for recording, classifying, and summarizing transactions, and disclosing information in the statements. (2) The management actions taken at meetings of stockholders and board of directors. (3) The management’s preparation of the financial statements in conformity with GAAP.



Perform analytical procedures (Recall Chapter 7 on analytical procedures): (1) Develop expectations by identifying and using plausible relationships that are reasonably expected to exist. (2) Compare recorded amounts or ratios developed from recorded amounts to expectations. (3) Compare the consistency of management’s responses inght li of results of other review procedures and knowledge of business and industry.



Obtain a management representation letter (Recall Chapter 19 on management representation letter).

Based on these procedures, a CPA may become concerned that financial information is incorrect, incomplete, or otherwise unsatisfactory due to a departure from GAAP. If so, additional procedures should be performed before the CPA issues either a standard “negative” opinion or a modified standard “negative” opinion with the wordings “With the exception of the matter described in the following paragraph, we are not aware of an material modifications ...” and add a paragraph in the report to describe the departure.


Figure 21-2 Example of a Review Report

We have reviewed the accompanying balance sheet of XYZ Company as of December 31, 20xx, and the related statements of income, retained earnings, and cash flows for the year then ended, in accordance with Statements on Standards for Accounting and Review Services issued by the American Institute of Certified Accountants. All information included in these financial statements is the representation of the management of XYZ Company. A review consists principally of inquiries of company personnel and analytical procedures applied to financial data. It is substantially less in scope than an audit in accordance with the Standards of the Public Company Accounting Oversight Board, the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion. Based on our review, we are not aware of any material modifications that should be made to the accompanying financial statements in order for them to be in conformity with generally accepted accounting principles.

Table 21-3 Procedures for Compilation Engagement

Procedures for Compilation Engagement A CPA is not required to be independent in the preparation of a client’s financial statements. However, the CPA is required ot exercise due care in preparing the financial statements as follows:

   

Possess knowledge of the accounting principles and practices of the cli ent’s industry.

Know the client and the nature of its business transactions and records. The knowledge can be less than that for a review. Make inquiries to determine whether the client’s information is satisfactory.

Read the compiled financial statements and be alert for any obvious omissions or errors.

According to AR 80, a compilation engagement includes:



Preparation of financial statements either manually or through the use of computer software based on GAAP or on a comprehensive basis of accounting other than GAAP.



Modification of client-prepared financial statements by materially changing account classifications, amounts, or disclosures directly on the client-prepared financial statements. According to AR 80, a compilation engagement does not include:

      

Typing or reproducing client-prepared financial statements without modification , as an accommodation to the client. Preparing standard monthly journal entries such as depreciation and expiration of prepaid expenses. Providing a financial statement format without dollar amounts to be used by the client in preparing financial statements. Reading client-prepared financial statements. Proposing/suggesting correcting journal entries or disclosure to be recorded by the client. Advising a client about the selection of computer software to prepare financial statements. Providing a client with the use of computer hardware or software to generate financial statements.

Figure 21-3 Example of a Compilation Report with Full Disclosure

We have compiled the accompanying balance sheet of XYZ Company as of December 31, 20xx, and the related statements of income, retained earnings, and cash flows for the year then ended, in accordance with the Statements on Standards for Accounting and Review Services issued by the American Institute of Certified Public Accountants. A compilation is limited to presenting in the form of financial statements information that is the representation of management. We have not audited or reviewed the accompanying financial statements and, accordingly, do not express an opinion or any other form of assurance on them.

Figure 21-4 Example of a Compilation Report that Omits Substantially All Disclosures

We have compiled the accompanying balance sheet of XYZ Company as of December 31, 20xx, and the related statements of income, retained earnings, and cash flows for the year then ended, in accordance with Statements on Standards for Accounting and Review Services issued by the American Institute of Certified Public Accountants. A compilation is limited to presenting in the form of financial statements information that is the representation of management. We have not audited or reviewed the accompanying financial statements and, accordingly, do not express an opinion or any other form of assurance on them.

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Management has elected to omit substantially all of the disclosures and the statement of cash flows required by generally accepted accounting principles. If the omitted disclosures were included in the financial statements, they might influence the user’s conclusionsabout the company’s financial position, results of operations, and cash flows. Accordingly, these financial statements are not designed for those who are not informed about such matters.

Figure 21-5 Example of a Review of Interim Financial Information Report

We have reviewed the accompanying balance sheet of XYZ Company as of March 31, 20xx, and the related statements of income, retained earnings, and cash flows for the three-month periods then ended, in accordance with the Public Company Accounting Oversight Board (United States). All information included in these financial statements is the representation of the management of XYZ Company. A review of interim financial information consists principally of inquiries of company personnel and analytical procedures applied to financial data. It is substantially less in scope than an audit in accordance with the standards of the Public Company Accounting Oversight Board, the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion. Based on our review, we are not aware of any material modifications that should be made to the accompanying financial statements in order for them to be in conformity with generally accepted accounting principles.

Table 21-4 Procedures for an Audit of Financial Statements Prepared in Accordance With a Special Purpose Financial Reporting Framework

Procedures for an Audit of Financial Statements Prepared in Accordance With a Special Purpose Financial Reporting Framework AU 800 requires that auditors of special purpose framework statements:



Obtain an understanding of (1) the purpose for which the financial statements are prepared, (2) the intended users, and (3) the steps taken by management to determine that the special purpose framework is acceptable in the circumstances.



Obtain the agreement of management that it acknowledges and understands its responsibility to include all informative disclosures that are appropriate for the special purpose framework used to prepare the financial statements, including, but not limited to, additional disclosures beyond those required by GAAP that may be necessary to achieve fair presentation. The auditor is required to evaluate whether such disclosures are necessary.



In the case of special purpose financial statements prepared in accordance with a contractual basis of accounting, obtain an understanding of any significant interpretations of the contract that management made in the preparation of those financial statements and to evaluate whether the financial statements adequately describe such interpretations.  When management has a choice of financial reporting frameworks in the preparation of the financial statements, explain manage ment’s responsibility for the financial statements in the auditor’s report and refer to management’s responsibility for determining that the applicable financial reporting framework is acceptable in the circumstances.

Figure 21-6 Example of a Report on Financial Statements Prepared in Accordance With an Income Tax Basis – A Special Purpose Financial Reporting Framework

–income tax basis of ABC Partnership as of December 31, 200x, We have audited the accompanying statements of assets, liabilities, and capital and the related statements of revenue and expenses–income tax basis and of changes in partners’ capital accounts –income tax basis for the year then ended. These financial statements are the responsibility of the Partnership’s management. Our responsibility is to expre ss an opinion on these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. As described in Note 3, these financial statements were prepared on the basis of accounting the Partnership uses for income tax purposes, which is a comprehensive basis of accounting other than generally accepted accounting principles. In our opinion, the financial statements referred to above present fairly, in all material respects, the assets, liabilities, and capital of ABC Partnership as of December 31, 20x x, and its revenue and expenses and changes in partners’ capital accounts for the year then ended, on t he basis of accounting described in Note 3.


Table 21-5 Procedures for Auditing Specified Elements, Accounts, or Items of a Financial Statement

Procedures for Specified Elements, Accounts, or Items of a Financial Statement The same audit procedures in an ordinary audit of full financial statements are used in an audit of specified elements, accounts, or items of a financial statement. However, there are three key differences:



Materiality is defined in terms of the elements, accounts, or items involved rather than in relation to the overall financial statements. The effect is that more evidence is required than if the same information were considered as part of an audit of the overall financial statements.



The first standard of reporting underPCAOB’s GAAS does not apply because the presentation of elements, accounts, or items is not a financial statement prepared in accordance with GAAP.



The audit must extend audit procedures to other elements, accounts, or items that are interrelated with those elements, accounts, or items

under consideration. For example, ifthe auditor were engaged to audit a client’s accounts receivable, other accounts such as sales and allowance for bad debts should also be considered.

Figure 21-7 Example of a Report of Specified Elements, Accounts or –Items Gross Sales for the Purpose of Computing Rent

We have audited the accompanying schedule of gross sales (as defined in the lease agreement dated March 31, 20xx, between ABC Company, as lessor, and DEF Company, as lessee) of DEF Company at itsth 6Street Store, San Francisco, for the year ended December 20xx. This schedule is the responsibility of the DEF Company’s management. Our responsibility is to express an opinion on this schedule based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the schedule of gross sales is free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the schedule of gross sales. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall schedule presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the schedule of gross sales referred to above present fairly, in all material respects, the gross sales of DEF Company at thits 6 Street store, San Francisco, for the year ended December 31, 20xx, as defined in the lease agreement referred to in the first paragraph. This report is intended solely for the information and use of the boards of directors and management of ABC Company and DEF Company and should not be used by anyone other than these specified parties.

Figure 21-8 Example of a Report of Information Accompanying Basic Financial Statements

[STANDARD WORDING FOR THE INTRODUCTORY, SCOPE, AND OPINION PARAGRAPHS] (When there is a positive opinion on the accompanying information) Our audit was conducted for the purpose of forming an opinion on the basic financial statements taken as a whole. The accompanying information on pages x through y is presented for purposes of additional analysis, and is not a required part of the basic financial statements. Such information has been subjected to the auditing procedures applied in the audit of the basic financial statements and, in our opinion, is fairly stated in all material respects in relation to the basic financial statements taken as a whole. (When there is a disclaimer of opinion on the accompanying information) Our audit was conducted for the purpose of forming an opinion on the basic financial statements taken as a whole. The accompanying information on pages x through y is presented for purposes of additional analysis, and is not a required part of the basic financial statements. Such information has not been subjected to the auditing procedures applied in the audit of the basic financial statements and, accordingly we express no opinion on it.

Figure 21-9 Example of a Debt Compliance Report

We have audited, in accordance with the standards of the Public Company Accounting Oversight Board, the balance sheet of ABC Company as of December 31, 20xx, and the related statements of income, retained earnings, and cash flows for the year then ended, and have issued our report thereon dated March 31, 20xx. In connection with our audit, nothing came to our attention that caused us to believe that the Company failed to comply with the terms, covenants, provisions, or conditions of sections xx to xx inclusive, of the indenture dated July 21, 20xx, with Bank of America insofar as they relate to accounting matters. However, our audit was not directed primarily toward obtaining knowledge of such non-compliance. This report is intended solely for the information and use of the boards of directors and managements of ABC Company and Bank of America and should not be used for any other purpose.

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Table 21-6 Procedures for Attestation of Prospective Financial Statements

Procedures for Prospective Financial Statements In an examination of prospective financial statements, the auditor obtains satisfaction as to the completeness and reasonableness of all the assumptions. In a compilationof prospective financial statements, the auditor is primarily involved with the computational accuracy of the statements, and not the reasonableness of the assumptions. In agreed-upon proceduresof prospective financial statements, the auditor and all users of the statements agree on specific, limited attestation procedures. AT 301 describes four elements in anexaminationof prospective financial statements:

   

Evaluating the preparation of the prospective financial statements. Evaluating the support underlying (forecast) and hypothetical (projection) the assumptions. Evaluating the presentation of the prospective financial statements for conformity with AICPA presentation guidelines. Issuing an examination report.

These four elements are based primarily on accumulating evidence about the completeness and reasonableness of the underlying and hypothetical assumptions as disclosed in the prospective financial statements. As such, the auditor is required to

  

Become familiar with the client’s business and industry.

Identify the key factors on which the prospective results are expected to depend. Determine that appropriate assumptions are included in determining prospective results.

The auditor’s report on an examination of prospective financial statements should include the following:

 

An identification of the prospective financial statements presented.

A statement that the examination of the prospective financial statements was made in accordance with AICPA standards and a brief description of the nature of such an examination.



The CPA’s opinion that the prospective financial statements are presented in conformity with AICPA presentation guidelines and that the underlying assumptions (for forecast) and hypothetical assumptions (for projection) provide a reasonable basis for the prospective financial statements.

 

A caveat that the prospective results may not be achieved. A statement that the accountant assumes no responsibility to update the report for events and circumstances occurring after the date of the

report. AT 301 describes the following requirements in an agreed-upon proceduresfor prospective financial statements:

    

The auditor is independent. The auditor and the specified users agree upon the procedures performed or to be performed by the auditor. The specified users take responsibility for the sufficiency of the agreed-upon procedures for their purposes. The prospective financial statements include a summary of significant assumptions.

The prospective financial statements to which the procedures are to be applied are subject to reasonably consistent evaluation against criteria that are suitable and available to the specified parties.

 

Criteria to be used to determine findings are agreed upon between the auditor and the specified users.

The procedures to be applied to the prospective financial statements are expected to result in reasonably consistent findings using the criteria.

  

Relevant evidence is expected to exist to provide a reasonable basis for the auditor’s report.

The auditor and the specified users agree on materiality limits for reporting purposes, where applicable. Use of the report is restricted to the parties who have agreed with the auditor on the procedures to be performed.

AT 301 describes acompilationof prospective financial statements that involves the followings:

 

statements based on the responsible party’s assumptions. Assembling, to the extent necessary, the prospective financial

Performing the required compilation procedures, which include reading the prospective financial statements with their summaries of

significant assumptions and accounting policies and considering whether they appear to be (1) presented in conformity with the attestation standards and (2) not obviously inappropriate.



Issuing a compilation report.


Figure 21-10 Example of an Examination Report on a Financial Projection

We have examined the accompanying projected balance sheet, statements of income, retained earnings, and cash flows of ABC Company, as of December 31, 20xx, and for the year then ending.ABC Company’s management is responsible for the projection, which was prepared for the Bank of America for the purpose of negotiating a loan to expand ABC Company’s plant. Our responsibility is to express an opinion on the projection based on our examination. Our examination was made in accordance with the Statements on Standards for Attestation Engagements issued by the American Institute of Certified Public Accountants and, accordingly, included such procedures as we considered necessary to evaluate the assumptions used by management and the preparation and presentation of the projection. In our opinion, the accompanying projection is presented in conformity with guidelines for presentation of a projection established by the American Institute of Certified Public Accountants, and the underlying and hypothetical assumptions provided a reasonable basis for management’s projection, assuming the granting of the requested loan for the purpose of expanding ABC Company’s plant as described in the summary of significant assumptions. However, even if the loan is granted and the plant is expanded, there will likely be differences between the projected and actual results, because events and circumstances frequently do not occur as expected, and those differences may be material. We have no responsibility to update this report for events and circumstances occurring after the date of this report. The accompanying projection and this report are intended solely for the information and use of ABC Company and Bank of America and are not intended to be and should not be used by anyone other than these parties.

Figure 21-11 Example of an Examination Report on a Financial Forecast

We have examined the accompanying forecasted balance sheet, statements of income, retained earnings, and cash flows of ABC Company, as of December 31, 20xx, and for the year then ending. ABC Company is responsible for the forecast. Our responsibility is to express an opinion on the forecast based on our examination. Our examination was made in accordance with the Statements on Standards for Attestation Engagements issued by the American Institute of Certified Public Accountants and, accordingly, included such procedures as we considered necessary to evaluate both the assumptions used by management and the preparation and presentation of the forecast. We believe that our examination provides a reasonable basis for our opinion. In our opinion, the accompanying forecast is presented in conformity with guidelines for presentation of a forecast established by the American Institute of Certified Public Ac countants, and the underlying assumptions provided a reasonable basis for management’s forecast. However, there will usually be differences between the forecasted and actual results, because events and circumstances frequently do not occur as expected, and those differences may be material. We have no responsibility to update this report for events and circumstances occurring after the date of this report.

Figure 21-12 Example of a Compilation Report for a Forecast

We have compiled the accompanying forecasted balance sheet, statements of income, retained earnings, and cash flows of ABC Company, as of December 31, 20xx, and for the year then ending, in accordance with the Statements on Standards for Attestation Engagements issued by the American Institute of Certified Public Accountants. A compilation is limited to presenting, in the form of a forecast, information that is the representation of management and does not include evaluation of the support for the assumptions underlying the forecast. We have not examined the forecast and, accordingly, do not express an opinion or any other form of assurance on the accompanying statements or assumptions. Furthermore, there will usually be differences between the forecasted and actual results, because events and circumstances frequently do not occur as expected, and those differences may be material. We have no responsibility to update this report for events and circumstances occurring after the date of this report. This report is intended solely for the use of the boards of directors of ABC Company and XYZ Company and is not intended to be and should not be used by anyone other than these parties.

Figure 21-13 Example of an Agreed-upon Procedures Report for a Forecast

Board of Directors– ABC Company Board of Directors– XYZ Company At your request, we have performed certain agreed-upon procedures, as enumerated below, with respect to the forecasted balance sheet, and the related forecasted statements of income, retained earnings, and cash flows of ABC Company, a subsidiary of XYZ Company, as of December 31, 20xx, and for the year then ending. These procedures, which were agreed to by the boards of directors of ABC Company and XYZ Company, were performed solely to assist you in evaluating the forecast in connection with the sale of ABC Company to XYZ Company. agreed-upon procedures engagement conducted The in accordance the Statements Attestation of Engagements by This the American Institute of Certified Publicwas Accountants. sufficiencywith of these procedureson is Standards solely the for responsibility the specifiedissued users of the report. Consequently, we make no representation regarding the sufficiency of the procedures described below either for the purpose for which this report has been requested or for any other purpose. The procedures and associated findings are as follows: (1) With respect to forecasted rental income, we compared the assumptions about expected demand for rental of the housing units to demand for

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similar housing units at similar rental prices in the city area in which ABC C ompany’s housing units are located. No exceptions were found as a result of this comparison. (2) We tested the forecast for mathematical accuracy. The forecast was mathematically accurate. We were not engage to and did not conduct an examination, the objective of which would be the expression of an opinion on the accompanying prospective financial statements. Accordingly, we do not express an opinion on whether the prospective financial statements are presented in conformity with AICPA presentation guidelines or on whether the underlying assumptions provide a reasonable basis for the presentation. Had we performed additional procedures, other matters might have come to our attention that would have been reported to you. Furthermore, there will usually be differences between the forecasted and actual results, because events and circumstances frequently do not occur as expected, and those differences may be material. We have no responsibility to update this report for events and circumstances occurring after the date of this report.

Table 21-7 Procedures for Attestation of Internal Control over Financial Reporting that Is Integrated with an Audit of Its Financial Statements of Private Companies

Procedures for Attestation of Internal Control over Financial Reporting that Is Integrated with an Audit of Its Financial Statements of Private Companies The procedures in AT 501 for attestation of internal control over financial reporting that is integrated with an audit of its financial statements of private companies are similar to that in AS 5 for an audit of internal control over financial reporting that is integrated with an audit of its financial statements of public companies. They include the following steps:

 Plan the engagement. The auditor, client, and others involved first agree on the areas to be covered and the timing of the attestation. The auditor then obtains information about the client’s business, industry and regulatory requirements, and the nature of accounting transactions andthe record-keeping system.  Obtain an understanding of internal control. The auditor obtains detailed information about the transactions, their flow through the system, transaction-related audit objectives, and control activities used to achieve control.  Evaluate the design effectiveness of controls. The auditor should evaluate whether the controls are suitably designed to prevent or detect misstatements in specific financial statement assertions.  Test and evaluate the operating effectiveness of the controls. These tests are concerned with how the controls are applied and their consistency of application. The methodology for these procedures is similar to the procedures for performing TOC in an audit. Form an opinion about management’s assertion regarding the effectiveness of internal control. A material weakness in internal control generally precludes management from asserting that the client has effective internal control.

In addition, AT 501 requires the following conditions to be met before the auditor can conduct an examination of internal control over financial reporting that is integrated with an audit of its financial statements:

 

Management accepts responsibility for the effectiveness of its internal control.

Management’s evaluation of control is based on suitable and available criteria (e.g., t he Committee of Sponsoring Organizations (COSO) Report).

 

Management’s evaluation of control is supported by sufficient evidence.

Management presents its assertion about the effectiveness of its internal control in a written report that accompanies the ditors’ au report.

Figure 21-14 Example of an Examination Report on Internal Control over Financial Reporting that Is Integrated with an Audit of Its Financial Statements of Private Companies

We have examined management’s assertion that ABC Company maintained effective internal control over finan cial reporting as of December 31, 20xx, included in the accompanying management report. Our examination was made in accordance with the Statements on Standards for Attestation Engagements issued by the American Institute of Certified Accountants. Those standards require that we plan and perform the examination to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our examination of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, testing, and evaluating the design and operating effectiveness of internal control, and such other procedures as we considered necessary in the circumstances. We believe that out examination provides a reasonable basis for our opinion. Because of inherent limitations in any internal control, errors or fraud may occur and not be detected. Also, projection of any evaluation of the internal control over financial reporting to future periods is subject to the risk that internal control may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. In our opinion, management’s assertion that ABC Company maintained effective internal control over financial reporting as of December 31, 20xx, is fairly stated, in all material respects, based upon the criteria established Internal in Control – Integrated Framework issued by the


Committee of Sponsoring Organizations of the Treadway Commission.

Figure 21-15 Example of a WebTrust Report

We have examined the assertion [] by ABC Company regarding the disclosure of its electron ic commerce business practices on its web site and the effectiveness of its controls over transaction integrity and information protection for electronic commerce at [] during the period August 1, 20xx, through October 31, 20xx. These electronic disclosures and controls are the responsibility of ABC Company’s management. Our responsibility is to express an opinion on management’s assertions with regards to the AICPA/CICAWebTrust Criteria [] based on our examination. Our examination was conducted in accordance with the Statements on Standards for Attestation Engagements issued by the American Institute of Certified Public Accountants and, accordingly, included (1) obtaining an understanding of ABC Company’s electronic commerce business practices and its controls over the processing of electronic commerce transactions and the protection of related private customer information, (2) selectively testing transactions executed in accordance with disclosed business practices, (3) testing and evaluation the operating effectiveness of controls, and (4) performing such other procedures as we considered necessary in the circumstances. We believe that out examination provides a reasonable basis for our opinion. Because of inherent limitations in controls, errors or fraud may occur and not be detected. Furthermore, the projection of any conclusions, based on our findings, to future periods is subject to the risk that (1) changes made to the system or controls, (2) changes in processing requirements, or (3) changes required because of the passage of time may alter the validity of such conclusions. In our opinion, during the period August 1, 20xx, through October 31, 20xx, ABC Company, in all material respects, based on the AICPA/CICA WebTrust Criteria:



disclosed its business practices for electronic commerce transactions and executed transactions in accordance with its disclosed business practices,



maintained effective controls to provide reasonable assurance that customers’ ordersplaced using electronic commerce were completed and billed as agreed, and,



maintained effective controls to provide reasonable assurance that private customer information obtained as a result of electronic commerce was protected from uses not related to B AC’s business. The CPA WebTrust seal of assurance on ABC’s web site for electronic commerce constitutes a symbolic representation of the contents of t his report and it is not intended, nor should it be construed, to update this report or provide an additional assurance. This report does not include any representation as to the quality of ABC’s goods or services nor their suitability for any customer’s intended purpose.

Table 21-8 Procedures for Attestation of Service Organizations

Procedures for Attestation of Service Organizations Service organizations provide processing services to companies who decide to outsource their processing of data. Examples of services that are typically outsourced include cloud computing services, payroll processing services, information security services, and information system services.

User Auditor



AICPA AU 402 Audit Considerations Relating to an Entity Using a Service Organization requires an auditor (known as anuser auditor) of a company (known as anuser entity) that uses a service organization to obtain an understanding of how the user entity uses the service organization, including the nature and significance of the services and the effect on internal control. If the user auditor is unable to obtain a sufficient understanding from the user entity, s/he should obtain that understanding through performing one or more of the following procedures: (1) Contact the service organization, through the user entity, to obtain specific information. (2) Visit the service organization and perform necessary procedures about the relevant controls at the service organization. (3) Obtain and consider the report of as ervice auditor(auditor of the service organization).



between the user entity’s controls and those at the service organization, the user auditor may When there is a low degree of nteraction i find that controls applied by the user entity are adequate to endure that material errors or fraud in transactions are detected. For example, the user entity’s computer personnel may develop input control totals and compare them to the service organization’s output. When suchcontrols are adequate, the auditor needs test only the user entity’s controls to obtain appropriate evidence; there is no need toperform tests of controls at the service organization.



When there is a high degree of interaction between the user entity’s controls and those at the service organization, the userauditor may contact the service organization and, if necessary, perform procedures to obtain the required understanding of the service organization. In addition, if the user auditor’s plan includes a presumption that certain controls operate effectively, the user auditor should obtain evidence of their operating effectiveness regardless of whether those controls are applied by the user entity or by the service organization.



Many service organizations perform similar processing services for numerous user entities. If the auditor of each user entity were to visit the service organization for the purpose of reviewing controls, they would ask similar questions and perform similar tests. Thus, it is often advantageous for the service organization to engage its own auditor (i.e., a service auditor) to examine its controls and to issue a service organization control report (known as aSOC report) that is relevant to the user entity’s internal control over financial reporting. The user auditor may then elect to rely on this report as an alternative or in addition to performing testing procedure at the service organization.

605

606


Procedures for Attestation of Service Organizations



AICPA AT 801Reporting on Controls at a Service Organization describes two types of SOC reports that a service auditor may issue: (1) Type 1 report– A report on a management’s description of a service organization’s system and the suitability of the design of controls. (2) Type 2 report– A report on a management’s description of a service organization’s system and the testing of the design and operating effectiveness of controls.



In determining the sufficiency and appropriateness of the audit evidence provided by the service auditor’s report, the userauditor should consider the professional competence of the service auditor and his/her independence with respect to the service organization.



If the user auditor’s control risk (CR) assessment includes an expectation that controls at the service organization operate effectively, the user auditor should obtain a Type 2 report (if available), or perform appropriate tests of controls (TOC).



If the service auditor’s Type 2 report provides an adequate basis for the user auditor’s assessment of control risk, usually there is no need

for the user auditor to perform his/her own tests at the service organization.

Service Auditor



Many service organizations perform similar processing services for numerous user entities. If the auditor of each user entity were to visit the service organization for the purpose of reviewing controls, they would ask similar questions and perform similar tests. Thus, it is often advantageous for the service organization to engage its own auditor (i.e., a service auditor) to examine its controls and to issue a service organization control report (known as aSOC report) that is relevant to the user entity’s internal control over financial reporting. The user auditor may then elect to rely on this report as an alternative or in addition to performing testing procedure at the service organization.



The service auditor’s examination of a service organization’s system and the suitability of the design and operating effectiveness of the service organization’s controls to achieve the related control objectives involves preforming procedures to obtain sufficient and appropriate entation of the service organization’s system and the suitability of the design and operating effectiveness evidence about the fairness of the pres of those controls to achieve the related control objectives. The examination procedures include assessing the risks that the service organization’s system is not fairly presented and that the controls were not suitably designed or operating effectively to achieve the related control objectives. The examination procedures also include testing the operating effectiveness of those controls that the service auditor considers necessary to provide reasonable assurance that the related control objectives were achieved.



AICPA AT 801 Reporting on Controls at a Service Organization describes two types of SOC reports that a service auditor may issue: (1) Type 1 report– A report on a management’s description of a service organization’s system and the suitability of the design of controls. (2) Type 2 report– A report on a management’s description of a service organization’s system and the testing of thedesign and operating effectiveness of controls.



Specifically, a service auditor may issue the following three SOC Reports:

SOC 1 Reports (either Type 1 or Type 2 report)– SOC 1 reports are issued under AICAP AT 801, which report on service organization controls over financial reporting, particularly on those controls likely to be relevant to user entit ies’ financial statement s. These are restricteduse report primarily for user auditors. SOC 2 Reports either ( Type 1 or Type 2 report)– SOC 2 reports are issued under AT 101Attest Enga gements and relate to the Trust Services principles of security, availability, processing integrity, confidentiality, and/or privacy . SOC 2 Reports are designed to provide (1)

Organizations that outsource tasks and functions a mechanism for improving governance and oversight of service providers. (2) Service organizations the ability to communicate the suitability of the design and operating effectiveness of theircontrols. These arerestricted-use reports primarily for service organization and user entity’s stakeholders such as customers, regulators, business partners, suppliers, and directors. The report contents are similar to SOC 1 Report. SOC 3 Reports (Neither Type 1 nor Type 2 report)– SOC 3 reports are issued under AT 101 and AICPA Technical Practice Aid Trust Services Principles, Criteria and Illustrations . These reports provide a short description of the service organization’s system and report on whether the service organization maintained effective controls based on the Trust Services Criteria of security, availability, processing integrity, confidentiality, and/or privacy. They are general-use(for use by everyone) reports such as WebTrust and SysTrust reports (see other audit engagements No. 10 and No. 11).

See Figure 21-16 Example of a Service uditor’s A Type 2 Report

We have examined ABCService Organization’s description of i ts Computer Center system for processing user entities’ transactions throughout the year ended December 31, 20xx, and the suitability of the design and operating effectiveness of controls to achieve the related control objectives stated in the description. On page 01 of the description, ABC Service Organization has provided an assertion about the fairness of the presentation of the description and suitability of the design and operating effectiveness of the controls to achieve the related control objectives stated in the description. ABC Service Organization is responsible for preparing the description and for the assertion, including the completeness, accuracy, and method of presentation of the description and the assertion, providing the services covered by the description, specifying the control objectives and stating them in the description, identifying the risks that threaten the achievement of the control objectives, selecting the criteria, and designing, implementing, and documenting controls to achieve the related control objectives stated in the description. Our responsibility is to express an opinion on the fairness of the presentation of the description and on the suitability of the design and operating effectiveness of the controls to achieve the related control objectives stated in the description based on our examination. We conducted our examination in accordance with attestation standards established by the American Institute of Certified Public Accountants. Those standards require that we plan and perform our examination to obtain reasonable assurance about whether, in all material respects, the description is fairly presented and the controls were suitably designed and operating effectively to achieve the related control objectives stated in the description throughout the year ended December 31, 20xx. An examination of a description of a service organization’s system and the suitability of the design and operating effectiveness of the service


organization’s controls to achieve the related control objectives stated in the description involves preforming procedures to obtain evidence about the fairness of the presentation of the description and the suitability of the design and operating effectiveness of those controls to achieve the related control objectives stated in the description. Our procedures included assessing the risks that the description is not fairly presented and that the controls were not suitably designed or operating effectively to achieve the related control objectives stated in the description. Our procedures also included testing the operating effectiveness of those controls that we consider necessary to provide reasonable assurance that the related control objectives stated in the description were achieved. An examination engagement of this type also includes evaluating the overall presentation of the description and the suitability of the control objectives stated therein, and the suitability of the criteria specified by the service organization and described at page 01. We believe that the evidence we obtained is sufficient and appropriate to provide a reasonable basis for our opinion. Because of their nature, controls at a service organization may not prevent, or detect and correct, all errors or omissions in processing or reporting transactions. Also, the projection to the future of any evaluation of the fairness of the presentation of the description, or conclusions about the suitability of the design or operating effectiveness of the controls to achieve the related control objectives is subject to the risk that controls at a service organization may become inadequate or fail. In our opinion, in all material respects, based on the criteria described in ABC Service Organization’s assertion on page 01 (1) the description fairly presents the system that was designed and implemented throughout the year ended December 31, 20xx. (2) the controls related to the control objectives stated in the description were suitably designed to provide reasonable assurance that the control objectives would be achieved if the controls operated effectively throughout the year ended December 31, 20xx. (3) the controls tested, which were those necessary to provide reasonable assurance that the control objectives stated in the description were achieved, operated effectively throughout the year ended December 31, 20xx. The specific controls tested and the nature, timing, and results of those tests are listed in pages 10-20. This report, including the description of tests of controls and results thereof on pages 10-20 is intended solely for the information and use of ABC Service Organization, userentities of ABC Service Organization’s system during some or all of the year ended December 31, 20xx, and the independent auditors of such user entities, who have a sufficient understanding to consider it, along with other information including information about controls implemented by user entities themselves when assessing the risks of material misstatements of user entities’inancial f statements. This report is not intended to be and should not be used by any other than these specified parties.

Figure 21-17 Example of a n Agreed-Upon Procedures Report

We have performed the procedures enumerated below, which were agreed to by the Board of Directors and management of ABC Company, solely to assist you in determining the amount of gross sales as defined in the lease agreement dated September 1, 20xx, between MNO Company, lessor, and ABC Company, lessee, for the year ended December 31, 20xx. This agreement to apply agreed-upon procedures was performed in accordance with the Statements on Standards for Attestation Engagements issued by the American Institute of Certified Public Accountants. The sufficiency of these procedures is solely the responsibility of the Board of Directors and management of ABC Company. Consequently, we make no representation regarding the sufficiency of the procedures described below either for the purpose for which this report has been requested or for any other purpose. The procedures we performed are summarized as follows: 1. We obtained a schedule prepared by management, which reflected gross sales, as defined above, for the year ended December 31, 20xx, of $800,000,000. 2. We obtained the weekly cash reports submitted by the store manager for the year. These reports show information on gross sales, cash register readings, sales taxes, returns, and allowances for discounts and other information. 3. We compared monthly summarizations of these reports with the schedule of gross sales and compared approximately 5 percent of the daily cash net receipts shown in the weekly cash reports with the bank statements. Based solely on the foregoing procedures, we found: 1. The daily cash net receipts shown in the weekly cash reports that we compared with the bank statements to be in agreement. 2. The monthly summarizations to be in agreement with the schedule of gross sales we obtained from management. These agreed-upon procedures do not constitute an audit or review of financial statements of any part thereof, the objective of which is the expression of an opinion or limited assurance on the financial statements or a part thereof; accordingly, we do not express such an opinion. Had we performed additional procedures, other matters might have come to our attention that would have been reported to you. This report is intended solely for the use of the specified users listed and should not be used by those who have not agreed to the procedures and taken responsibility for the sufficiency of the procedures for their purposes.

607

608


Multi-Choice Questions 21-1

A CPA has been engaged to perform review servicesfor a client. Identifywhich of the following is a correct statement. a. The CPA must perform the basic audit procedures necessary to determine that the statements are in conformity with GAAP. b. The financial statements are primarily representations of the CPA. c. The CPA may prepare the statements from the books but may not assist in adjusting and closing the books. d. The CPA is performing an accounting service rather than an audit of the financial statements.

21-2

It is acceptable fora CPA to be associated withfinancial statementswhen he or she is not independentwith respect to the client and still issue a substantially unmodified report for which of the following: a. Audits of companies following GAAP. b. Audits of financial statements that use a financial reporting framework other than GAAP. c. Compilation of financial statements following GAAP. d. Review of financial statements following GAAP.

21-3

Which of the following bestdescribes the responsibility ofthe CPA in performing compilation services for a company? a. The CPA must understand the client’s business and accounting methods and read the financial statements for reasonableness b. The CPA has to satisfy only himself or herself that the financial statements were prepared in conformity with GAAP. c. The CPA should obtain an understanding of internal control and perform tests of controls. d. The CPA is relieved of any responsibility to third parties.

21-4

An auditor is reporting oncash basis financial statements.These statementsare best referred to in his or her opinion by which of the following descriptions? a. Cash receipts and disbursements and the assets and liabilities arising from cash transactions. b. Financial position and results of operations arising from cash transactions. c. Balance sheet and income statements resulting from cash transactions. d. Cash balance sheet and the source and application of funds.

21-5

Which of the following statements with respect to an auditor’s report expressing an opinion on a specific item on a financial statement is correct?

a. Materiality must be related to the specified item rather than to the financial statements taken as a whole. b. Suchattention a report devoted can be expressed only ifitem the auditor is also to audit entire set ofstatements financial statements. c. The to the specified is usually less engaged than it would be the if the financial taken as a whole were being audited. d. The auditor who has issued an adverse opinion on the financial statements taken as a whole can never express an opinion on a specified item in these financial statements. 21-6

When asked to perform an audit to express an opinion on one or more specified elements,accounts, oritems of a financial statement, the auditor a. may not describe auditing procedures applied. b. should advise the client that the opinion can be issued only if the financial statements have been audited and found to be fairly presented. c. may assume that the first standard of reporting with respect to GAAP does not apply. d. should comply with the request only if they constitute a major portion of the financial statements on which an auditor has disclaimed an opinion based on an audit.

21-7

Which of the following best describes the auditor’s reporting responsibility concerning information accompanying the basic financial statements?

a. The auditor has no reporting responsibility concerning information accompanying the basic financial statements. b. The auditor should report on the information accompanying the basic financial statements only if he or she participated in its preparation. c. The auditor should report on the information accompanying the basic financial statements only if he or she did not participate in its preparation. d. The auditor should report on all the information accompanying the basic financial statements.


21-8

Information accompanying basic financial statements should not include a. exceptions or reservations to the standard auditor’s report. b. details of items in basic financial statements. c. statistical data. d. explanatory comments.

21-9

Which of the following professional services would be considered an attestation engagement? a. A management consulting engagement to provide IT advice to a client. b. An engagement to report on compliance with statutory requirements. c. An income tax engagement to prepare federal and state tax returns. d. A compilation of financial statements from a client’s accounting records.

21-10

Which of the following statements concerning prospective financial statements is correct? a. Only a financial forecast would normally be appropriate for limited use. b. Only a financial projection would normally be appropriate for general use. c. Any type of prospective financial statement would normally be appropriate for limited use. d. Any type of prospective financial statement would normally be appropriate for general use.

21-11

Which of the following best describes a CPA’s engagement to report on an entity’s internal control(ICFR)? a. An attestation engagement to examine and report on management’s written assertions about the effectiveness of its internal control (ICFR). b. An audit engagement to render an opinion on the entity’s internal control(ICFR). c. A prospective engagement to project, for a period not to exceed 1 year, and report on the expected benefits of the entity’s internal control (ICFR). d. A consulting engagement to provide constructive advice to the entity on its internal control (ICFR).

21-12

When reporting onfinancial statementsprepared on the basis of accounting usedfor income tax purposes, theauditor should include in the report a paragraph that a. Emphasizes that the financial statements are not intended to have been examined in accordance with generally accepted auditing standards. b. Refers to the authoritative pronouncements that explain the income tax basis of accounting being used. c. States that the income tax basis of accounting is a comprehensive basis of accounting other than generally accepted accounting principles. d. Justifies the use of the income tax basis of accounting

21-13

The SEC requires a footnote in the annual audited financialstatements disclosingquarterly informationfor sales, gross profit, income, and earnings per share for the past two years. The footnote is labeled “un-audited,” but the CPA firm must perform review procedures of the footnote information. Regarding the CPA firm’s review procedure, which of the following statements is correct? a. The review are required to be performed on a quarterly basis. b. The review are required to be performed on an annual basis. c. The review are required to be performed on a semi-annual basis. d. The review can be performed as part of the annual audit.

21-14

Which of the following typeof procedures onprospective financialstatements isprohibited byAT 301? a. A compilation. b. A review. c. An examination. d. An agreed-upon procedure.

21-15

When an auditor reports on financial statements prepared on a client’s income tax basis, the auditor’s report should a. disclaim an opinion on whether the statements were examined in accordance with GAAP. b. not express an opinion on whether the statements are presented in conformity with the comprehensive basis of accounting used. c. include an explanation of how the results of operations differ from the cash receipts and disbursements basis of accounting. d. state that the financial statements use a financial reporting framework other than GAAP.

609

610


21-16

An auditor’s report on financial statements prepared in conformity with the cash basis of accounting should include a separate explanatory paragraph before the opinion paragraph that

a. justifies the reasons for departing from GAAP. b. states whether the financial statements are fairly presented in conformity with another comprehensive basis of accounting. c. refers to the note to the financial statements that describes the basis of accounting. d. explains how the results of operations differ from financial statements prepared in conformity with GAAP. 21-17

An auditor’s report on financial statements prepared in conformity with the cash basis of accounting should include all of the following except

a. a reference to the note to the financial statements that describes the cash basis of accounting. b. a statement that the cash basis of accounting is not using a financial reporting framework other than GAAP. c. a positive opinion as to whether the financial statements are presented fairly in conformity with the cash basis of accounting. d. a statement that the audit was conducted in accordance with GAAS, specifically, AU 806. 21-18

A client, aninsurance company,prepares its financial statements ona financial reportingframework insurancecompanies use pursuant to the rules of a state insurance commission. If the client’s financial statements are not suitably titled, the auditor should a. disclose any reservations in an explanatory paragraph and qualify the opinion. b. apply to the state insurance commission for an advisory opinion. c. issue a special statutory basis report that clearly disclaims any opinion. d. explain in the notes to the financial statements the terminology used.

21-19

An auditor is permitted to accept a separate engagementto audit (i.e., not in conjunction withan audit of financial statements) and to issue a special report on a client’s

a. b. c. d. 21-20

Schedule of Accounts Yes Yes No No

ReceivableSchedule of Royalties Yes No Yes No

When an auditor is requested to express an opinion on the rentaland royalty income of a client. The auditor may a. not accept the engagement because to do so would be tantamount to agreeing to express a piecemeal opinion. b. not accept the engagement because unless also engaged to audit the full financial statements of the client. c. accept the engagement provided the auditor’s opinion is expressed in a special report as per AU 800. d. accept the engagement provided a paragraph is added that restricts the distribution of the report as per AU 905.

21-21

E is an employee of F Company. A, a CPA, is asked to express an opinion on E’s profit participation in F Company’s profit net income. A, the CPA, may accept this engagement only if a. A, the CPA, also audits F Company’s complete financial statements. b. F Company’s financial statements are prepared in conformity with GAAP. c. A, the CPA’s report is available for use by F Company’s other employees. d. E, the employee, owns a controlling interest in F Company.

21-22

An auditor may express an opinion on an entity’s accounts receivable balance even if the auditor has disclaimed an opinion on the financial statement taken as a whole provided that the

a. report on the accounts receivable discloses the reason for the disclaimer of opinion on the financial statements. b. use of the report on the accounts receivable is restricted as per AU 905. c. auditor also reports on the current asset portion of the client’s balance sheet. d. auditor reports the accounts receivable balance in a special report that is separated from the disclaimer of opinion on the financial statement taken as a whole. 21-23

An auditor’s report is issued in connection with which of the following is generally not considered to be a special report?

a. Compliance with aspects of contractual agreements or regulatory requirements unrelated to audited financial statements. b. Compliance with aspects of contractual agreements or regulatory requirements related to audited financial statements. c. Specified elements, accounts, or items of a financial statement presented in a document. cordance with an entity’s income tax basis. d. Financial statements prepared in ac


21-24

A CPA may accept an engagement toapply agreed-upon proceduresthat are not sufficientto express an opinion on one or more specified accounts or items of a financial statement provided that a. the CPA’s report does not enumerate the procedures performed. b. the financial statements are prepared in accordance with a financial reporting framework other than GAAP. . c. use of the CPA’s report is restricted to specified parties. d. the CPA is also the entity’s continuing auditor.

21-25

An objectiveof a review of interim financialinformation ofa public companyis to provide a CPA with a basis for reporting whether a. a reasonable basis exists for expressing an updated opinion regarding the financial statements that were previously audited. b. material modification should be made for the interim financial information to conform with GAAP. c. the financial statements are presented fairly in accordance with standards of interim reporting. d. the financial statements are presented fairly in accordance with GAAP.

21-26

Which of the following proceduresordinarily shouldbe applied whenan auditor conductsa review of interim financial information of a public company? a. Verify changes in key account balances. b. Read the minutes of the board of directors’ meetings. c. Inspect the open purchase order file. d. Perform cutoff tests for cash receipts and disbursements.

21-27

Which of the following circumstances requires modification ofthe auditor’s report on a review of i nterim financial information of a public company?

a. b. c. d. 21-28

An Uncertainty Yes No Yes No

Departure from GAAP Yes No No Yes

What is an auditor’s responsibility for supplementary information which is outside the basic financial statements, but required by the FASB?

a. The auditor has no responsibility for required supplementary information as long as it is outside the basic financial information. b. The auditor is responsible for testing of, but not for reporting on, the required supplementary information. c. The auditor is responsible to apply limited audit procedures and report deficiencies in, or omissions of, the required supplementary information. d. The auditor should apply TOB procedures to the required supplementary information and report any material misstatements in such information. 21-29

If information accompanyingthe basic financial statementshas been subjected tolimited auditing procedures, theauditor may express an opinion that the accompanying information is fairly stated in a. conformity with GAAP. b. all material respects in relation to the basic financial statements taken as a whole. c. conformity with standards established by the AICPA. d. accordance with GAAS.

21-30

When investment and property schedules are presented as information accompanying thebasic financial statements, the auditor’s measurement of materiality on such information is the a. lesser of the individual schedule of investments or schedule of property taken by itself. b. greater of the individual schedule of investments or schedule of property taken by itself. c. combined total of both the individual schedules of investments and property taken as a whole. d. same as that used in forming an opinion on the basic financial statements taken as a whole.

21-31

According to SSARS, which of the following is a compilation engagement? a. client-prepared statements, modification, as an accommodation theclient. client. b. Typed Provided a client with financial a financial statement without format without dollar amounts, to be used bytothe c. Suggest correcting journal entries to be recorded by the client. d. Generate, through the use of computer software, financial statements for the client on a financial reporting framework other than GAAP.

611

612


21-32

A CPA is engaged in a compilation servicein conformity with SSARS when I. Reproducing client-prepared financial statements, without modification, as an accommodation to aclient. II. Preparing standard monthly journal entries for depreciation and expiration of prepaid expenses. a. I only. b. II only. c. Both I and II. d. Neither I nor II.

21-33

When a CPA performsmore than one level of service (i.e., differentscope of service) suchas a compilation anda review, or a compilation and an audit, concerning the financial statements of a nonpublic entity, the CPA ordinarily should issue the report that is appropriate for a. The lowest level of service rendered - the compilation engagement. b. The highest level of service rendered– the audit engagement. c. The mid-level service rendered– the review engagement. d. All level of service rendered.

21-34

When compiling the financial statements of a client, a CPA should a. review agreements with financial institutions for restrictions on cash balances. b. understand the accounting principles and practices of the client’s industry. c. inquire of key personnel concerning related parties and subsequent events. d. perform ratio analyses of the financial data of comparable prior periods.

21-35

When compiling the financial statements ofa client, a CPA would be least likely to a. perform analytical procedures designed to identify relationships that appear to be unusual. b. read the compiled financial statements and consider whether they are free from obvious material errors. c. omit substantially all of the disclosures required by GAAP. d. issue a compilation report on one or more, but not all, of the basic financial statements.

21-36

Which of the following should not be included in a CPA’s standard report based upon the compilation of a client’s financial statements?

a. A statement that a compilation is limited to presenting in the form of financial statements information that is the representation of the management. b. A statement that the compilation was performed in accordance with the SSARS issued by the AICPA. c. A statement that the accountant has not audited or reviewed the statements. d. A statement that the accountant does not express an opinion but provides only negative assurance on the statements. 21-37

How does a CPA make the following representation when issuing a compilation report of a client’s financial statements?

a. b. c. d. 21-38

The Financial Statements have Not been Audited Implicitly Explicitly Implicitly Explicitly

The CPA has Compiled the Financial Statements Implicitly Explicitly Explicitly Implicitly

Compiled financial statements should be accompanied by a report stating that a. a compilation is limited to presenting in the form of financial statements information that is the representation of management. b. the CPA has compiled the financial statements in accordance with the AUs established by the Auditing Standard Board. c. a compilation is substantially less in scope than a review or an audit in accordance with GAAP. d. the CPA does not express an opinion but expresses only limited assurance on the compiled financial statements.

21-39

Financial statementsof a client compiledwithout auditor review by a CPA should be accompanied bya report stating that a. the scope of t he CPA’s procedures has not been restricted in testing the financial information. b. the CPA has assessed the accounting principles and significant estimates made by management. c. the CPA does not express an opinion or any form of assurance on the financial statements. d. the CPA has made inquiry of client’s personnel and applied analytical procedures to the financial data.


21-40

When a compilation engagementomits substantially alldisclosures requiredby GAAP, the CPA should indicatein the compilation report that the financial statements are a. not designed for those who are uninformed about the omitted disclosures. b. prepared in conformity with a comprehensive basis of accounting other than GAAP. c. not compiled in accordance with SSARS. d. special-purpose financial statement that are not comparable to those of prior periods.

21-41

A CPA may compile a client’s financial statements that omits substantially all of t he disclosures required by GAAP only if the omission is I. Clearly indicated in the accountant’s report. II. Not undertaken with the intention of misleading the financial statement users. a. I only. b. II only. c. Both I and II. d. Either I or II.

21-42

Which of the following representationsdoes a CPA make implicitly whenissuing a standard compilationreport of a client’s financial statements? a. The CPA is independent with respect to the client. b. The financial statement has not been audited. c. A compilation consists of primarily inquires and analytical procedures. d. The CPA does not express an assurance on the financial statements.

21-43

In a review engagement, a CPA should a. understand the accounting principles of the industry in which the client operates. b. develop audit programs to determine whether the client’s financial statements are fairly presented. c. assess the risk that a material misstatement could occur in a financial statement assertion. d. confirm with the client’s lawyer that material loss contingencies are disclosed.

21-44

Which of the following proceduresmost likely would not be included ina review engagement ofa nonpublic company? a. Obtaining a management representation letter. b. Considering whether the financial statements conform with GAAP. c. Assessing control risk. d. Performing analytical procedures.

21-45

Which of the following proceduresshould a CPA perform for a review engagementof a nonpublic company? a. Communicating material weaknesses discovered during the assessment of control risk. b. Obtaining a client representation letter from members of management. c. Sending bank confirmation letters to the client’s financial institutions. d. Examining cash disbursements in the subsequent period for unrecorded liabilities.

21-46

Which of the following proceduresis usually performedby a CPA in a review engagement ofa nonpublic company? a. Sending a letter of inquiry to the client’s lawyer. b. Confirm a significant percentage of accounts receivable by sending positive confirmation requests. c. Communicating material weaknesses discovered during the consideration of internal control. d. Comparing the financial statements with comparable statements of prior periods.

21-47

Performing inquiryand analytical proceduresis the primary basis for a CPA to issue a a. report on compliance with requirements governing major federal assistance programs in accordance with the Single Audit Act. b. report on prospective financial statements that present a client’s expected financial position, given one or more assumptions. c. management advisory report prepared at the request of a client’s audit committee. d. review report on comparative financial statements for a nonpublic entity in its second year of operations.

21-48

Which of the following statementsis true concerning bothan engagement tocompile and an engagement toreview a nonpublic company’s financial statements? a. The CPA neither obtains an understanding of internal control nor assesses control risk. b. The CPA must be independent in fact and in appearance. c. The CPA expresses no assurance on the financial statements. d. The CPA should obtain a written management representation letter.

613

614


21-49

Which of the following inquiryor analytical proceduresordinarily areperformed inan engagement toreview a nonpublic company’s financial statements? a. Analytical procedures designed to test the accounting records and to gather evidential matter. b. Inquiries concerning the company’s procedures for recording and summarizing transactions. c. Analytical procedures designed to test management’s assertions regarding continue existence. d. Inquiries of the company’s attorney concerning contingent liabilities.

21-50

A CPA who reviews thefinancial statementsof a nonpublic companyshould issuea report statingthat a review a. provides only limited assurance that the financial statements are fairly presented. b. includes examining, on a test basis, information that is the representation of management. c. consist principally of inquiries of company personnel and analytical procedures applied to financial data. d. does not obtain evidential matter or apply procedures ordinarily performed during an audit.

21-51

A CPA who reviews thefinancial statementsof a nonpublic companyshould issuea report statingthat a review a. is substantially less in scope than an audit. b. provides negative assurance that internal control is functioning as designed. c. provides only limited assurance that the financial statements are fairly presented. d. is substantially more in scope than compilation.

21-52

A CPA who reviews thefinancial statementsof a nonpublic companyshould issuea report statingthat a. the scope of the inquiry and analytical procedures performed by the CPA has not been restricted. b. all information included in the financial statements is the representation of management of the nonpublic company. c. a review includes examining, on a test basic, evidence supporting the amounts and disclosures in the financial statements. d. a review is greater in scope than a compilation, the objective of which is to present financial statements that are free of material misstatements.

21-53

A CPA who reviews thefinancial statementsof a nonpublic companyshould issuea report statingthat the CPA a. does not express an opinion or any form of limited assurance on the financial statements. b. is not aware of any material modifications that should be made to the financial statements for them to conform with GAAP. c. obtained reasonable assurance about whether the financial statements are free of material misstatements. d. examined evidence, on a test basis, supporting the amounts and disclosures in the financial statements

21-54

During an engagement toreview the financial statementsof a nonpublic entity,a CPA becomes awarethat several leases that should be capitalized are not capitalized. The CPA considers these leases to be material to the financial statements. The CPA decides to modify the standard review report because management will not capitalize the leases. Under these circumstances, the CPA should a. issue an adverse opinion because of the departure from GAAP. b. express no assurance of any kind on the entity’s financial statements. c. emphasize that the financial statements are for limited use only. d. disclose the departure from GAAP in a separate paragraph of the accountant’s report.

21-55

A CPA , without auditing an entity’s financial statements, may accept an engagement to examine management’s assertion about the effectiveness of the entity’s internal control over financial reporting in effect

a. b. c. d. 21-56

As of a Specified Date Yes Yes No No

During a Specified Period of Time Yes No Yes No

Which of the following conditions is necessary fora CPA to accept an attest engagement to examine an entity’s internal control over financial reporting? a. The CPA anticipates relying on the entity’s internal control in a financial statement audit. b. Management provides to the CPA its written assertion about the effectiveness of internal control. c. CPA is a continuing who hasin audited the-entity’s financial statements. thepreviously CPA’s report a general d. The Management agrees not auditor toinclude use documents.


21-57

When engaged to express an opinion on an examination of management’s assertion about the effectiveness of an entity’s internal control (ICFR), the CPA should a. obtain management’s written representations acknowledging responsibility for establishing and maintaining inte rnal control (ICFR). b. not directly express an opinion on the effectiveness of internal control (ICFR). c. keep informed of events subsequent to the date of the report that might have affected the opinion. d. accept responsibility for the establishment of the control procedures tested.

21-58

A CPA has been engaged to report on an examination of management’s assertion about an entity’s internal control(ICFR) without performing an audit of the financial statements. The management’s assertion is contained in a separate report that will accompany the CPA’s report on the entity’s internal control (ICFR). What restrictions, if any, should the CPA place on the use of this report (i.e., report on the entity’s ICFR)?

a. This report should be restricted for use by management. b. This report should be restricted for use by the audit committee. c. This report should be restricted for use by a specified regulatory agency. d. The CPA does not need to place any restriction on the use of this report. 21-59

A, a CPA was engaged to examine management’s written assertion about the effectiveness of internal control over financial reporting of Company C. A’s report should state that

a. because of inherent limitations of internal control, errors or fraud may occur and not be detected. b. management’s assertion is based on criteria established by the AICPA. c. the results of A’s tests will form the basis for A’s opinion on the fairness of C’s financial statement presentation. d. the purpose of the engagement is to plan an audit and determine the nature, timing, and extent of tests to be performed. 21-60

When a CPA expresses an unqualified opinion on management’s assertion that internal control over financial reporting is sufficient to meet the entity’s stated objectives, it is implied that the

a. entity has not violated provisions of the Sarbanes-Oxley Act of 2002. b. likelihood of management fraud is minimal. c. CPA has engaged in an improper form of reporting because the assertion is too subjective. d. CPA believes that management’s assertion about the effectiveness of i nternal controlover financial reporting is fairly stated. 21-61

Company C engaged A, a CPA, to examine management’s written assertion about the effectiveness of itsinternal control over financial reporting. A’s report described several material weaknesses and potential errors and fraudulent activities that could occur. Subsequently, Company C’s management included A’s report in its annual report t o the board of directors with a statement that the cost of correcting the weaknesses would exceed the benefits. A should a. disclaim an opinion as to management’s cost-benefit statement. b. advise the board that A either agrees or disagree with management’s statement. c. express an adverse opinion as t o management’s cost-benefit statement. d. advise both management and the board that A was withdrawing the opinion.

21-62

A CPA’s consideration of internal control (ICFR) in a financial statement audit (Hint: Consider audit versus examination) a. is usually more li mited than that made in connection with an engagement to examine management’s written assertion about the effectiveness of internal control (ICFR). b. is usually more extensive than that made in connection wi th an engagement to examine management’s written assertion about the effectiveness of internal control (ICFR). c. will usually be identical to that made in connection with an engagement to examine management’s written assertion about the effectiveness of internal control (ICFR). d. will usually result in a report on whether management’s written assertion about the effectiveness of internal control(ICFR) is fairly stated.

21-63

How do the scope, procedures, and purpose of an engagement to examine management’s written assertion about the effectiveness of an entity’s internal control compare with those for the consideration of internal control in a financial statement audit?

a. b. c. d.

Scope Similar Different Different Different

Procedures Different Similar Different Similar

Purpose Similar Similar Different Different

615

616


21-64

Which of the following accountingengagements maya CPA perform without being required to issue a compilation or review report as per the Statements on Standards for Accounting and Review Services (SSARS)? I. Preparing a working trial balance. II. Preparing standard monthly journal entries. a. I only. b. II only. c. Both I and II. d. Neither I nor II.

21-65

C, a privately held company, asked its tax accountant A, a CPA, to generate C’s interim financial statements on A’s computer when A prepared C’s quarterly tax return. A should not submit these interim financial statements to C unless, as a m inimum, int: Read the key word ‘generate’ as ‘compile’) A complies with the provisions of (H a. Statements on Standards for Accounting and Review Services (SSARS). b. Statements on Standards for Un-audited Financial Services. c. Statements on Standards for Consulting Services. d. Statements on Standards for Attestation Engagements (SSAE)

21-66

C, a privately held company, asked its tax accountant A, a CPA, t o reproduce C’s interim financial statements on A’s computer when A prepared C’s quarterly tax return. A should not submit these interim financial statements to C unless, as a minimum, A complies with the provisions of (Hint: Read the key word ‘reproduce’ as ‘process’)

a. Statements on Responsibilities in Tax Practice (SRTP) b. Statements on Standards for Accounting and Review services (SSARS). c. Statements on Standards for Attestation Engagements (SSAE). d. None of the answers are correct. 21-67

A CPA is required tocomply with the provisions ofStatements onStandards forAccounting andReview Services (SSARS) when

a. b. c. d. 21-68

Consulting on Accounting Matters Yes No Yes No

May a CPA accept an engagement tocompile or review thefinancial statementsof a not-for-profit client if the CPA is unfamiliar with the specialized industry accounting principles but plans to obtain the required level of knowledge before compiling or reviewing the financial statements?

a. b. c. d. 21-69

Processing Financial Data for Clients of other CPA Firms Yes Yes No No

Compilation No Yes No Yes

Review No No Yes Yes

If requested to perform a review engagementfor a nonpublic entity in which a CPA has an immaterial directfinancial interest, the CPA is a. not independent and, therefore, may not be associated with the financial statements. b. not independent and, therefore, may not issue a review report. c. not independent and, therefore, may issue a review report, but may not express an auditor’s opinion. d. independent because the financial interest isimmaterial and, therefore, issue a reviewreport.

21-70

The party responsible forassumptions identified in the preparation ofprospective financialstatements is usually a. a third-party lending institution . b. the client’s management. c. the reporting accountant. d. the client’s independent auditor.

21-71

An examination of a financial forecast is a professional service that involves a. assembling a financial forecast that is based on and management’s b. compiling restrictingor the use of theaccountant’s report to management the board ofassumptions. directors. c. assuming responsibility to update management on key events for one year after the report’s date. d. evaluating the preparation of a financial forecast and the support underlying management’s assumptions.


21-72

A CPA’s compilation report on a financial forecast should include a statement that

a. the forecast should be read only in conjunction with the audited historical financial statements. b. the CPA expresses only limited assurance on the forecasted statements and their assumptions. c. there will usually be differences between the forecasted and actual results. d. the hypothetical assumptions used in the forecast are reasonable in the circumstances. 21-73

When a CPA examinesa financial forecastthat fails to disclose severalsignificant assumptionsused to prepare the forecast, the CPA should describe the assumptions in the CPA’s report and express a. an unqualified opinion. b. an unqualified opinion with an additional explanatory paragraph. c. a positive opinion about the reasonableness of the assumptions. d. no opinion.

21-74

When a CPA examines a compilation of a projected financial statements, the CPA’s report should include a separate paragraph that

a. describes the limitations on the usefulness of the presentation. b. provides an explanation of the differences between an examination and an audit. c. states that the CPA is responsible for events and circumstances up to 1 year after the report’s date. d. disclaims an opinion on whether the assumptions provide a reasonable basis for the projection. 21-75

A CPA may accept an engagement to apply agreed-upon procedures toprospective financialstatements provide that a. distribution of the report is restricted to the specified users. b. the prospective financial statements are also examined. c. responsibility for the adequacy of the procedures performed is taken by the CPA. d. negative assurance is expressed on the prospective financial statements taken as whole.

21-76

A CPA ‘s standard report on a compilation of a projection should not include (Hint: Consider the key word ‘compile’)

a. statement that a compilation of a projection is limited in scope. nts occurring after the report’s date. b. disclaimer of responsibility to update the report for eve c. statement that the accountant expresses only limited assurance that the results may be achieved. d. separate paragraph that describes the li mitations on the presentation’s usefulness. 21-77

With regard to a client’s Management’s Discussion and Analysis (MD&A), a CPA may ordinarily perform which of t he following other audit engagements? I. Review of interim financial information. II. Audit of specified elements, accounts or items. III. Attestation of websites. IV. Audit of compliance with debt agreement. a. Type I engagement only. b. Type I and type II engagements. c. Type I and type IIIengagements. d. Type I and type IV engagement

21-78

What type of assurance may an auditor ordinarily provide on a client’s Management’s Discussion and Analysis (MD&A)? a. Either a negative or a positive opinion depending on the type of other audit engagements. b. Either a positive or a material weakness opinion depending on the type of other audit engagements. c. Either a negative or a disclaimer opinion depending on the type of other audit engagements. d. Express no opinion at all time.

21-79

Which of the following is not a principle of Trust Services? a. Security. b. Authentication. c. privacy. d. Confidentiality.

617

618


21-80

Which of the following is not an objective of an auditor’s examination of a client’s MD&A?

a. The presentation includes, in all material respects, the required elements of the rules and regulations adopted by the Securities and Exchange Commission. y’s financial b. The historical amounts included in the presentation have been accurately derived, in all material respects, from the entit statements. c. The presentation is in conformity with rules and regulations adopted by the AICPA. d. The underlying information, determinations, estimates, and assumptions provide a reasonable basis for the disclosures contained in the presentation. 21-81

An auditor’s report relating to a SysTrust engagement is most likely to express a. an opinion on whether the information system is electronically secure. b. an opinion on management’s assertion that the information system meets one or more of the SysTrustprinciples. c. negative opinion on whether the controls of the information system are adequate. d. no opinion or other assurance, but a summary of findings relating to the information system.

21-82

Which of the following distribution of service organization control (SOC) reports is appropriate?

I. II. III. IV.

SOC 1 Restricted-use report Restricted-use report General-use report Restricted-use report

SOC 2 Restricted-use report General-use report Restricted-use report Restricted-use report

SOC 3 General-use report Restricted-use report Restricted-used report Restricted-used report

a. I b. II c. III d. IV 21-83

An auditor’s service organization control (SOC) report that reports on management’s description and design of its controls and control operating effectiveness is a a. Type 1 SOC report. b. Type 2 SOC report. c. Type 1 or Type 2 SOC report. d. Neither Type 1 nor Type 2 report.

21-84

An auditor’s service organization control (SOC) report that reports on service organization controls over financial reporting, particularly on those controls likely to be relevant to user entities financial statements is a

a. SOC1 report. b. SOC 1 and SOC 2 reports. c. SOC 1, SOC2, and SOC3 reports. d. SOC 2 and SCO3 reports 21-85

A service organization control (SOC) report is usually issued by the a. user auditor. b. user auditor and service auditor. c. service auditor. d. internal auditor.


Key to Multi-Choice Questions

21-1 d. 21-2 c. 21-3 a. 21-4 a. 21-5 a. 21-6 c. 21-7 d. 21-8 a. 21-9 b. 21-10 c.

21-11 a.

21-12 c. 21-13 d. 21-14 b. 21-15 d. 21-16 c. 21-17 b. 21-18 a. 21-19 a. 21-20 c. 21-21 a. 21-22 d. 21-23 a. 21-24 c. 21-25 b. 21-26 b. 21-27 d. 21-28 c. 21-29 b. 21-30 d. 21-31 d. 21-32 d. 21-33 b. 21-34 b. 21-35 a. 21-36 d. 21-37 d. 21-38 a. 21-39 c. 21-40 a. 21-41 c. 21-42 a. 21-43 a. 21-44 c. 21-45 b. 21-46 d. 21-47 d. 21-48 a. 21-49 b. 21-50 c. 21-51 a. 21-52 b. 21-53 b. 21-54 d. 21-55 a. 21-56 b. 21-57 a. 21-58 d. 21-59 a. 21-60 d. 21-61 a. 21-62 a. 21-63 d. 21-64 c. 21-65 a. 21-66 d. 21-67 d. 21-68 d. 21-69 b. 21-70 b. 21-71 d. 21-72 c. 21-73 d. 21-74 a. 21-75 a. 21-76 c. 21-77 b. 21-78 a. 21-79 b. 21-80 c. 21-81 b. 21-82 a. 21-83 b. 21-84 a. 21-85 c.

619

620


Simulation Question 21-1 Simulation Question 21-1 is an adaptation with permission from a case by Ivancevich, S. H., and G.W. Joseph inIssues the in Accounting Education , a publication of the American Accounting Association in Sarasota, Florida. This simulation question is based upon a true set of facts; however, the names and places have been changed.

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Zacha Technology Center, Inc.

Zacha Technology Center Incorporated (hereafter, ZTC) is a privately held wholesale/retail computer hardware and software store. ZTC also performs computer repair services for its retail customers. ZTC is a for-profit entity that operates in an unregulated industry. William Zacha, founder and Chief Executive Officer, currently holds all of its shares. Since ZTC is privately held, none of its activities are a matter of public record. ZTC has never been audited, nor has theinternal control (IC) system ever been evaluated by a CPA firm. Business-to-consumer (B2C) sales occur over-the-counter the which store, and by mail,byfax, corporate web site. Business-to-business (B2B) transactions are conducted via a networkinhub, is operated theemail, store. and The on hubthe enables electronic data interchange (EDI) trading partners to connect via commercial telephone lines directly to the store or via value added networks (VANs) that provide connectivity for EDI customers. The network hub is used for placing wholesale customer purchase orders and for initiating supplier sales invoices. Members of ZTC’s Board of Directors serve mostly in unpaid, advisory role, sharing their business expertise with the business’ sole owner. Over the past several years, the business has expanded significantly. William Zacha expects this trend to continue and foresees the need to raise additional capital and possibly sell common stock via an initial public offering (IPO). If ZTC goes public, the firm will seek to raise approximately $9 million.

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Your CPA firm



ZTC’s Request

You are a CPA and an audit partner in the CPA firm of Hayes, Talus, Armstrong and Yee. The firm audits several small companies registered with the SEC, and has periodically provided consulting services to both audit and non-audit clients seeking to initiate a public offering. The CPA firm has never been, and willnot be, enga ged as ZTC’s financial stat ement auditor. You were solicited by ZTC because of your professional reputation for thoroughly evaluating IC systems and your experience in advising on the ISO-9000 (International Organization for Standardization) certification process. You meet the appropriate professional guidelines for independence regarding an audit and/or attestation relationship with ZTC. You are not an accredited ISO-9000 registrar possessing the ability to certify that the client is ISO-9000 qualified. However, you are qualified to advise clients on their readiness to pursue certification. William Zacha wants you to “evaluate” ZTC’s IC system and to report on the completeness and strength of the ICs. He would also like you to provide some guidance on what steps might be required and what forms would be necessary to prepare for an IPO. With respect to the ICs, Zacha would like one auditor’s report that could be used for multiple purposes. summarizes ZTC’s requests. You should access Data File 21-1 in iLearn for Tablewhich 1,

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ZTC’s Documentation on IC System ZTC’s documentation is consistent with that of many technology companies of similar age and size. There is no central, comple te set

of documentation regarding the total IC system. Individual departments (e.g., cash disbursements, situations, etc.) have and written defining how transactions should be processed, who may authorize actions, howpurchasing, to handle contingency/unusual otherprocedures matters of importance. The documentation pr ovides adequate information to enable the practitioner to “visualize” internal control strengths and weaknesses with respect to segregation of duties. This documentation does not provide any assurance that the procedures that are supposed to be in place are actually operable. The company has taken steps to protect itself in the event of a disaster. A contract exists with a disaster-recovery service provider that provides an alternate hot site should ZTC’s computer fail. The hot site1 is the disaster recovery service provider’s location, where a computer system is ready to resume data processing in the event that ZTC’s computer is disabled. The service provider contract stipulates the maximum acceptable down times, speeds of recovery for specific applications, and other agreed-upon procedures. As part of the contract, the service provider reconfigures its own equipment t o mimic ZTC’s system. In other words, the vendor builds a duplicate hardware systemsufficient to handle all of ZTC’s software applications and processing. ZTC periodically updates data files stored the hot site, as well as copies of software when new releases or versions are made operational. Annually, as required by the contract, ZTC exercises the procedures by relocating to the service providers as if experiencing a disaster. Lessons learned during these trial runs are recorded and any procedural changes are adequately documented.



Useful Information Relating to ZTC’s Requests

International Organization for Standardization (ISO) 9000. ISO-9000 is a set of international quality standards produced by the ISO. The overall objective of ISO is to promote the development of standardized requirements to ease the international exchange of goods and services. Many nations and economic blocks have adopted ISO-9000 certification as a prerequisite to selling goods and services within their jurisdictions. Foreign Corrupt Practices Act (FCPA 1977). The purpose of the FCPA is to control questionable or illegal foreign payments by U.S. companies. All companies in the U.S. are prohibited from bribing a foreign governmental official, foreign political, foreign political party, foreign party official, or candidate for a foreign political office for the purpose of promoting business interests. The FCPA subjects companies and their employees to civil liability and criminal prosecution under federal securities laws (as incorporated into Section 30A of the Securities Exchange Act of 1934). WebTrust and Other Web Site Certification Seals . A number of different organizations and commercial firms provide certification seals that provide Internet customers with a greater sense of confidence that e-commerce transactions will be conducted properly and 1

A hot site (or recovery operations center) is a ready-to-use location with computer equipment in place that may be used to resume computer processing in the event of a disaster. Alternatively, a cold site (or empty shell) is a location lacking computer hardware that can be equipped and used as the data processing site in the event of a disaster.


TM confidentially, Some of the more common seals are BBBOnline Reliability®, TRUSTe, VeriSign , BizRate®, ICSA®, and WebTrust. WebTrust was jointly developed and is administered by the American Institute of Certified Public Accountants (AICPA) and the Canadian Institute of Chartered Accountants (CICA) to evaluate and test e-commerce web sites to reduce customer concerns about transaction integrity, control, authorization, confidentiality, and anonymity. Any of the web site seals can be displayed in an attempt to provide greater assurance to potential customers that the web site’s business practices have appropriate internal controls and that these controls have been evaluated. SystTrust. The AICPA and the CICA have also jointly developed an assurance service to evaluate and test whether a business system is reliable when measured against four essential principles: availability, security, integrity, and maintainability. Under the SysTrust guidance, a business system is “organized to transform data inputs into information outputs” using i nfrastructure, software, people, procedures, and data (http://www.aicpa.org, AICPA/CICA 2001a). Service Organization IC Evaluations. A service organization provides services to user organizations by processing certain accounting transactions. The service organization executes transactions and maintains the related accountability and/or records transactions and processes related data. The service organization performs, for the using organization, some ICs related to the transactions processed, and also takes responsibility for one or more of the five management assertions that auditors test for during a financial statement audit. A service organization can have its ICs evaluated by its own independent service auditor and report to the auditors of using organizations on the strength of its ICs. AU 402, Audit Considerations Relating to an Entity Using a Service Organization, governs the responsibility of both the service auditor and the user auditors.

Required 1. In order for you to provide the appropriate assurance services to ZTC: (a) Research and summarize the important characteristics of ISO-9000. You should research (i) ISOhttp://www.iso.ch at for information on the requirements for ISO-9000 certification, (ii) American National Standards Institution (ANSI) http://www.ansi.org at for information on ISO-9000 certification, and (iii) Registrar Accreditation Board (ANSI-RAB) for its role and rules on ISO-9000. (b) Research and summarize the important characteristics of service organizations’ IC. You should research AU 402, Audit Considerations Relating to an Entity Using a Service Organization at http://www.aicpa.orgfor information on service organizations’ IC evaluations.

(c) Research and summarize the important characteristics of IPO filing. You should research SEChttp://www.ansi.org at for information on IPO filing requirements for small businesses, and (ii) Foreign Corrupt Practices Act of 1977 on IC compliance for purposes of an IPO. 2. Review and evaluate the following Web Site Certification Seals to recommend a certification seals that is of greatest value to ZTC: BBBOnline Reliability seal program at http://www.bbbonline.org TRUSTe seal program athttp://www.truste.org VeriSign seal program athttp://www.verisign.com BizRate seal program athttp://www.bizrate.com ICSA seal program athttp://www.trusecure.com WebTrust seal program athttp://www.cpawebtrust.org 3. Review the following AICPA’s Professional Standards to determine which one(s) is(are) applicable to providing assurance services to ZTC. Fill out each column of the table below. An entry is made in the first row as an example.

Professional Standard Attestation: AT 101

Attestation: AT 401 Attestation: AT 501 Attestation: AT 601 Attestation: AT 701 Auditing: AU 402 Auditing: AU 265 Auditing:

Engagement Requirements Written management assertions, with criteria established by a recognized body or regulatory agencies and other bodies composed of experts. Criteria from a body designed by the AICPA are considered reasonable criteria.

Type of Investigation Can perform any of three types: 1. Examination 2. Review 3. Agreed Upon Procedures

Type of Report 1. Examination, express positive opinion about assertions conforming to criteria. 2. Review, state scope was less than an examination, and express negative assurances only. 3. Agreed Upon Procedures, report only procedures and findings.

Distribution of Report For Examination and Review, can distribute generally. For Agreed Upon Procedures, restrict to specified users.

621

622


AU 260 Auditing: AU 920, AU 925 Accounting & Review services: AR 110 4. Based on your work in 1, 2 and 3 above, fill out each column of the table below to address the ZTC’s requests (Access Data File 21-1 in iLearn for Table 1, which summarizes ZTC’s requests ). An entry is made in the first row as an example.

Professional Standard that Applies ZTC’strading Requestspartners and their Service Type ofauditor Engagement Needed 1. To assure B2B examination independent auditors 2. To assure e-commerce (B2C) retail web customers 3. To assure general creditors 4. To assure bank credit line providers 5. To assure the ZTC Board of Directors’ oversight committees 6. To support an ISO-9000 certification 7. To assure ZTC’s independent financial statement auditors 8. To improve the internal control system 9. To comply with the 1977 FCPA for purpose of an IPO.

AU 402

Simulation Question 21-2 Simulation Question 21-2 is an adaptation with permission from a case by Swain, M. R., R. D. Allen, D. M. Cottrell, and K. Pexton Issues in the in Accounting Education , a publication of the American Accounting Association in Sarasota, Florida. This simulation question is based on fictional data.

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Other Audit Engagement involving an E-Commerce Company

Monday Morning

It had been a long forworked Sheri Brinker. Shenow had in joined TechMall.com, Inc. (hereafter, TMC)of seven months ago,required following acquisition by Wahoo.com. Sheweekend had never harder than her position as TMC’s first Vice President Finance. IT had a its Herculean effort to build her new finance team and to help TMC meet its new public reporting responsibility that accompanied its acquisition by Wahoo.com. TMC’s amazingly fast growth since beginning operations just three years ago had fostered an environment where financial reporting and internal controls were quite loose. TMC had (until the acquisition by Wahoo) been financed by a small group of private investors who were much more focused on technology and marketing than on accounting systems and financial reports. Because TMC had never required any debt financing, the company never even had to respond to the reporting requirements of a bank or loan officer. As a result, Sheri often found herself to be the bearer of bad news as she and her newly hired finance team worked through one accounting issue after another. Early in December, with the end of TMC’s fiscal year (and its first audit) approaching at the end of the month, Sheri turnedher attention to the issue of revenue recognition. Her previous public accounting work caused her to be reasonably familiar with SAB No.– the 101 Securities and Exchange Commission (SEC) Staff Accounting Bulletin on revenue recognition – as well as EITF (Emerging Issues Task Force) No. 99-19, Recording Revenue Gross as a Principal versus Net as an Agent , which was released by the Financial Accounting Standards Board (FASB). However, prior to her employment as TMC, Sheri had little previous experience with Internet companies and their typically aggressive approach to revenue recognition. As a result, Sheri’s long weekend had been spent carefully rereading all the material she had collected on SAB No. 101 and EITF No. 99-19. She wanted to be ready at Tuesday’s weekly Executive Committee meeting to outline all possible revenue recognition problems TMC might be facing as it headed into its first audit. As Sheri sat reviewing her notes on Monday for the next day’s Executive Committee meeting, Steve Tambasco, TMC’s VP for ce and proudly announced, “I’ve solved the revenue problem. We’re going to make the -ofendyear bonus for sure!” Marketing, burst into her offi Sheri didn’t say a word, but simply waited for the details. Steven rushed on: I’ve spent the entire morning on the phone with PlayBall.com. You know how hard I’ve been working these past two months on a partnership with them to combine our inventory fulfillment system with their merchant base and roll out a new channel for sports equipment merchants in the Wahoo portal. The big problem with closing this deal has been getting an agreement on how we’re going to spl it the revenues in the partnership. I think I may have been pushing their president a little hard today on that issue because he was getting frustrated and said something about how he wished he could just buy our technology and roll out the new channel himself. I think he is right. Why not sell them our technology? I know that’s never been part of our business model before. However, if we put into the contract all kinds of non-compete agreements and guarantees that they won’t resell our technology to anyone else, this could solve the problem I’ve been havinggetting PlayBall to agree to the kinds of splits on merchant revenue we normally have in our partnerships with other merchant aggregators. How does this sale help with the revenue splits, Steve?” responded Sheri.


I figure the price on this deal should be worth at least what we’d expect to get out of a t ypical revenue split arrangement with PlayBall over the next two years. Your accounting staff will have to run the numbers, but I’ll be surprised if they come up with a number less than $600,000. And if I can’t get PlayBall to agree to at least $400,000, then you’d betterfire me! Sheri, I’m convinced that PlayBall is not interested in having us control the relationship with and pricing of their merchants; so this is probably the only way we’re going to be able to do business if we can get this sale made before the end of the year, we’ll easily have enough revenue and with them. Now the only important thing is that income to make our quarterly performance goal. This was startling news for Sheri. At last week’s executive team meeting, she reported that, by her estimates, ht e company would be just short of its quarterly revenue target and would miss the quarterly operating profit target by somewhere between $150,000 and $200,000. Obviously, the executive team was not happy with the report. Steve’s idea had the potential to bring in $400.000 in revenue and very little incremental cost over a short time period. A deal like this would certainly put TMC over the top in terms of both its revenue and profit goals, resulting in significant bonus money for the executive team, as well as a number of managers and key engineers. Sheri wanted to ask some questions, but Steve was already headed out her office door. I have got to run, Sheri. I need to get over to Engineering and talk to Kristie [TMC’s VP of Technology] about what we needto do in order to deliver the technology to PlayBall. Then I need to get back on the phone with PlayBall to start working out somethe ofdetails. I’ve already briefed Doug (TMC’ president] on the deal, and he’s pretty excited! I can’t wait to tell everyone else at the executive meeting tomorrow to plan on the bonus!

With a slam of the door, Steve was gone. If he had stayed, though, he might have been surprised to see that Sheri was not starting her own private celebration as she returned to her outline of concerns with some of TMC’s revenue recognition practices. Sheri found it almost ironic that Steve’s idea to sell technology also had potential revenue recognition problems. Her weekend with SAB No.101 had also included some research of Statement of Position (SOP) No. 97-2, the American Institute of Certified Public Accountants (AICPA) statement on software revenue recognition. The AICPA had taken a pretty firm stand on the criteria required to immediately recognize revenue on a software sale. Sheri was afraid that this new deal of Steve’s might have difficulty passing the tests laid out by this statement. “Great,” she thoughtas she looked over notes from her weekend reading. “Steve’s going to come t o tomorrow’s team meeting like a knight in shining armor, and I’ll likely end up again looking like a bean counter getter i n the way of business.” The TMC Company

TMC is a class Internet startup company based in Madison, Wisconsin. IT was initially formed by Doug Liddle,Steve Tambasco, and Kristi Smith-Meyers. Doug and Steve has srcinally been heavily involved in sales and distribution of consumer electronics and related equipment. It was clear to these two individuals that many merchants of consumer electronic goods (e.g., computers, digital cameras, audit equipment, cell phones and pagers, etc.) were focusing on the Internet, but these merchants were not sure how to integrate the Internet with their businesses. Certain that the potential of the Internet could somehow be merged with their excellent understanding of, and connections within, the electronics distribution industry, Dough and Steve recruited Kristi, a project manager working for a large local networking company, to help them create an Internet channel that was essentially a virtual mall of “cyber stores” for electronics merchants. Kristi immediately began assembling a team of engineers and programmers to build web-based technology that eventually became a complete e-commerce solution for the targeted merchants. The technology was designed to include hosting, web site development, registration in a key search engine, inventory management and fulfillment/shipping, and the ability to process customer payments. One important challenge faced and overcome by Kristi’s team was the creation of an inventory system that allow merchants to build and maintain a unique mix of products and prices while seamlessly providing receiving and shipping capabilities from the merchant’s own physical warehouse as well as direct shipments on behalf of merchants from key electronics parts distributors. Perhaps most importantly, it was relatively inexpensive and easy to set up merchants in the technology Kristi and her engineering team designed, and the technology was a stable and straightforward platform for the merchants themselves to use. With Dough designated as TMC’s President and Kristi working as the VP of Technology, Steve took on the role of VP of Marketing. IN order for TMC to be successful in the very competitive and fast-moving e-commerce world, it was critical that Steve identify and quickly ps with “merchant bring large blocks of electronics merchants into the TMC virtual mall. The process he followed was one of creating partnershi aggregators,” defined as organizations that have business relationships already established with numerous retailers of electronics parts and products. These merchant aggregators for TMC included manufacturers, wholesalers/distributors, and industry organizations and associations. Even magazines and other consumer electronics trade publications were possible partners in the effort to market the TMC virtual mall to the thousands of potential Internet merchants of electronic goods and services in North America. Hence, rather than try to sell space in the TMC virtual mall directly to individual merchants, the strategy was instead to form a partnership with a potential merchant aggregator and have that partner market TM space to o its own merchant base. TMC’s revenue streams from an individual merchant are based on the following schedule: Standard Pricing Schedule

Nonrefundable Setup Fee Monthly Statement Fee Transaction Fee Revenue Split

$750 $50 (no charge for initial setup month) 2 percent of total sales dollars ($200 maximum fee per sale transaction) 70:30 (i.e., 30 percent of all merchant fees collected by TMC are remitted to the merchant aggregator partner.

The standard pricing schedule shows the standard prices that the merchant aggregator is to use when marketing TMC services to potential merchant clients. While it is possible that the merchant aggregator can negotiate with TMC form more favorable pricing for its own merchants, TMC has yet to concede any price reductions to any merchant aggregators. Exhibit 1 depicts the structure of TMC’s relationships with its merchant clients and its merchant aggregators.Y ou should access Data File 21-2 in iLearn for Exhibit 1, which shows the structure of TMC. In this relationship, the merchant aggregator establishes a partnership with TMC to market space in the TMC virtual mall to its own collection of merchants. Once set up in the TMC channel, the merchant client sells electronic goods and services to its own customers within the TMC channel. Although there is no termination date for the merchant, one of Kristi’s engineers determined that the average length of time that a merchant is actively registered to use the TMC system is eight quarters (two

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years). TMC ‘s virtual mall technology facilitates delivery to the customer; and in a manner similar to the function of a traditional credit card processor, collects the sales price and remits the sales price (less all transaction fees) back to the merchant client. In addition to the initial setup fee collected from the merchant, TMC also collects a fixed monthly maintenance fee (called a Statement Fee) and a fee on each sales transaction (which is variable based on the dollar volume of the merchant’s transactions). All three types of fees are remitted directlyto TMC, which then splits these revenue with the appropriate merchant aggregator using a predetermined revenue split ratio. It was clear to the founders early on that the key to securing the enthusiasm and commitment of a prospective merchant aggregator partners was the ongoing revenue splits from the virtual mall. TMC partners could make a lot of money in this arrangement, depending on how many merchants they arranged to have TMC set up in the virtual mall, as well as on the dollar volume of retail sales subsequently generated by these merchants. An additional appeal for the merchant aggregators is that they bear very little business risk in this arrangement. All the merchant aggregator needs to do is contact and inform its set of potential e-commerce merchants, obtain a list of applicants, and deliver to TMC the name and contact information for the merchant applicant. TMC then becomes entirely responsible to set up the merchant, collect the setup fee, and handle any customer support issues that come from the merchant client. At the beginning of each subsequent month, TMC is then responsible for electronically invoicing the merchant and collecting the monthly statement fee. Each day, TMC is responsible for settling the merchants’ sales transactions, retaining 2 percent of the transaction amount, and electronically remitting theest r of the money back to the merchant. At the end of each month, TMC determines the amount of setup fees, statement fees, and transaction fees that were actually collected, and remits 30 percent of the collected fees back to the appropriate partner. TMC is responsible to pay the merchant aggregator only as it is able to actually collect the setup fee, statement fee, or transaction fee. Hence, TMC and its partners share the credit risk of nonpayment merchants. While TMC is not liable to the merchant’s customer for goods and services sold by the merchant, TMC is solely liable to the merchant for transaction problems due to technology breakdowns in the virtual mall system. Conversely, the merchant aggregator does not have any liability to the merchant for problems in the TCM system. Both Steve and Doug felt that the strength of this reasonably simple business model was the potential to create revenue and cash in both the early stages and the mature stages of TMC’s life cycle. As merchant aggregators work to bring retail merchants into the TMC system, large setup fees are immediately generated. Later, as these merchants’ new Internet businesses grow and become successful, C TM and its partners are positioned to grow and become successful by sharing in the total sales value of each customer transaction. One important aspect of this revenue model is that it motivates TMC tohelp merchant clients grow their Internet business. Further, even if a merchant’s virtual store within the portal struggles to grow as a viable e-commerce business, TMC still expects to realize an ongoing revenue stream via the monthly statement fee. The initial financial results of this revenue model were impressive. TMC was generating significant operating profits and positive cash flows by the end of its first year of operations. Revenues continued to grow an average of nearly 20 percent a month through the second year and into the t hird year with operating margins of approximately 50 percent. TMC’s success soon began drawing attention from largecompanies and investors in the e-commerce industry. Late in the third year of operations, as Dough and the other founders began discussing with attorneys the possibility of an IPO (initial public offering), inquiries began surfacing that indicated a merger or acquisition of TMC could beon the horizon. Early in its fourth year, two large Internet portal companies contacted Doug within days of one another to invite him to consider selling or merging his company with theirs. Within 60 days of that first call, after surprising little due diligence on the part of the buying company, TMC was acquired by Wahoo.com Company, a multifaceted Internet company out of Austin Texas. At that time, TMC had 52 employees, partnership contracts with 32 merchant aggregators, and nearly 8,000 merchants in its virtual mall. At the close of its third year, TMC reported revenues of $2.59 million and net income of $1.35 million. The total acquisition price was $55.5 million, cash and stock. The Finance Team Before its acquisition, TMC’s employees consisted of engineers, technical support staff, marketing, and office administration

personnel. Other than an accounts payable clerk and two individuals in charge of account collections, little management attention was paid to financial reporting and control. When it became obvious that TMC would soon have significant financial reporting responsibilities as a result of rm,fiSheri was hired as TMC’s first VP of the acquisition, Sheri Brinker was hired. An aggressive and extremely competent CPA from a local Finance. She was immediately consumed bythe intense acquisition process initiated by Wahoo.com Company,a well-managed public company trading on the NASDAQ with a market cap of close to $4 billion. Sheri immediately hired a controller to handle the general ledger system and began expanding the finance staff. Not unexpectedly, Sheri continued to make necessary changes t o TMC’s accounting system. Asa result, TMC’s growth in reported operation income was declining rather than increasing for the first time in its rather short history. One example of TMC’s poor financial discipline prior to the acquisition was the company’s management of receivables. The analysis of bad debts performed in the three years of TMC’s existence was severely inadequate. With a lot of effort, Sheri determined that Wahoo’s initial estimates during the due diligence period of the acquisition gravely underestimated the actual bad debts on TMC’s balance sheet. A little more than 30 percent of the charges to the next quarter’s income statement in order to “catch current receivables balance was determined to be uncollectible. The subsequent up” on underestimations of past receivables were both sizable and painful. Dough, Steve, and Kristi were quite concerned about the impact of Sheri’s work on the monthly income statements,. Their concern was due in large part to the bonus plan that had been negotiated into the acquisition deal with Wahoo.com. As a first-year incentive to the TMC executive team, Wahoo had been persuaded to commit an additional 5 percent of the acquisition deal price to a series of quarterly bonuses to be shared across most of the TMC management- and engineering-level employees. The bonus plan was based on achieving certain revenue and operating profit goals in its first four quarters as a wholly owned subsidiary of Wahoo. Naturally, as each quarter was drawing to a close, the bonus plan became a major discussion topic in executive team meetings. At last week’s executive meeting, Sheri’s financial projections showed that revenue and operating income were going to be just short of t he fourth quarter’s bonus targets.Y ou should access Data File 21-2 in iLearn for Exhibit 2, which presents TMC’s Income Statement. Some of the comments made in the ensuing discussion strongly implied that a large share of the responsibility for missing the quarterly bonus belonged to Sheri and her “draconian accounting policies.” Back to Monday

As Sheri sat in her office musing over her experie nce at TMC and her analysis of the company’s revenue recognition practices, she could clearly see thattoa serious confrontation likelystatement. at the next day’s executive teamtwo meeting. Sheri’s policies” were ue line of thewas income Basically, there were revenue issues“draconian at stake inaccounting TMC’s current business now shifting focus the reven model. First, TMC had always recognized all fees invoiced to the merchant client as gross revenue, then immediately booked a commission expense to the appropriate reseller (the merchant aggregator partner). SAB No. 101 indicates that the SEC staff takes a hard look at the need for some companies (e-commerce related or otherwise) to book net revenues instead of gross revenues, though operating income is unaffected in either case. Nevertheless, there was specific pressure on TMC’s revenues due to the bonus plan. Sheri also wondered about the timing of her


company’s revenue recognition. In addition to the gross vs. net revenues issue, she wondered if TMC needed to defer the setup fee over the average life of a merchant rather than follow the current practice of recognizing the full merchant setup fee in the srcinal invoice month. Next month, Wahoo.com’s auditors, Price Firehouse, LLP, were scheduled to begin work on TMC’s first audit, and Sheri was sure that they would be asking a lot of hard questions. She did not want to be making significant changes to her financial statements as a result of that audit. Sheri decided e the projected quarterly results that she had srcinally presented at last week’s executive committee meeting that the best start would be to tak and alter the projected results as needed in light of SAB No. 101 and EITF No. 99-19. Of even larger concern was Steve’s proposed technology sale to PlayBall. Steve clearly saw this deal as the panacea to their problem of meeting the current bonus plan targets. However, SOP No. 97-2 outlined specific software revenue recognition criteria, the same basic criteria d make it difficult for Sheri to immediately recognize revenue from Steve’s proposed sale. Further, SOP contained in SAB No.101, which coul No. 97-2 expanded the revenue recognition criteria in the case of software sales to include such important elements as: 1. Objective Evidence of Vendor-Specific Fair Value. 2. Post-Contract Customer Support. 3. Licenses with the Right of Upgrade. SOP No. 97-2 is based on the concept that revenue must be deferred and recognized ratably over the period of time for which any services are rendered to the customer. As a result, software revenue recognition was becoming controlled by increasingly conservative guidelines. It appeared to Sheri that key to the decision to defer the contract revenue was the notion of objective evidence of vendor-specific fair value. The one positive aspect to this deal was that it was still in its infancy. If there was a way to structure the contract appropriately, Sheri wondered if she might be able to recognize most or all of the entire proposed contract sales price before the year ended. In fact, she seemed to recall that the AICPA had issued a Technical Practice Aid that addressed implementation issues surrounding SOP No. 97-2. She wondered if this publication might help her analyze the impact of SOP No. 972 on TMC’s accounting or f the proposed sale of TMC technology. As Monday afternoon moved on, it became evident that Sheri would have a long evening at the office. Her career transition from auditor to business manager during the last seven months had been both an exciting and challenging personal evolution. Yet she knew from past experience at TMC that, unlike her previous life, she couldn’t walk into the executive team meeting tomorrow and simply lay out the “accounting facts” according to Generally Accepted Accounting Principles (GAAP). The team expected her to present proposed solutions that were technically correct, yet as good for the company as possible. Sheri always prided herself on being true to the standards of her CPA profession, but that was an easier personal standard to uphold when she was with her CPA firm working with client companies. Now that she was actually part of a corporate team and working to build a career as inside the business, she was feeling emotionally conflicted. She still winced as she recalled an executive meeting about four months earlier when after presenting a difficult analysis involving expense projections on the accounts receivable project, Doug had looked her coldly in the eye and in front of the rest of the team said, “Sheri, I appreciate your work here, but you need to drop tour auditor mindset. Don’t tell me what I can’t do. What I need from you are solutions. Tell me what I can do and how to do it!”

Required Sheri, the VP of finance, wants to be ready at Tuesday’s weekly Executive Committee meeting to outline all possible revenue recognition problems TMC might be facing as it heads into its first audit. She engages you for a WebTrust service (other audit engagement). Specifically, she wants you to draft her a “heads up” memo to be read by Doug Liddle, Tuesday morning, before the start of the executive team meeting. Your memo should address the following three separate issues in light of SAB No.101, EITF No. 99-19, SOP No. 97-2, and any relevant Technical Practice Aid(s) issued by the AICPA. 1. Gross vs. Net Fees

Analyze whether TMC should recognize revenues from merchant fees net of commissions paid to merchant aggregator partners (net method), or whether TMC should continue to recognize the entire fee amount as revenue with the commissions paid recognized as an expense (gross method). Note that the question of gross vs. net fees applies to all three types of merchant fees. In the case of the transaction fee, the revenue in question is the 2 percent transaction fee for service provided to the TMC merchant, not the total sales price collected by TMC for electronic goods sold by the TMC merchant to its customer refer ( to Exhibit 1 in iLearn ). For the analyses, you should research the following two authoritative literatures: i. SEC Staff AccountingBulletin No. 101,Revenue Recognition in Financial Statements (Questions 5 and 10): http://www.sec.gov ii. EITF No. 99-19,Recording Revenue Gross as a Principal versus Net as an Agent (Paragraphs 9-19): http://www.fasb.org 2. Deferral of Setup Fees

TMC charges its new vendor clients a $750 setup fee that TMC recognizes a s revenue in the srcinal invoice month when the vendor establishes an account. Analyze whether this treatment and revenue recognition practice is acceptable under current authoritative pronouncements, or whether some portion of this revenue should be deferred and recognized ratably in subsequent months. If some revenue should be deferred, analyze the potential impact of this deferral on Year 4 revenues. Remember that after being set up, the merchant can do business with the TMC portal as long as the merchant continues paying the monthly statement fee. Again, for the analyses, you should research the following two authoritative literatures: i. SEC Staff AccountingBulletin No. 101,Revenue Recognition in Financial Statements (Questions 5 and 10): http://www.sec.gov ii. EITF No. 99-19,Recording Revenue Gross as a Principal versus Net as an Agent (Paragraphs 9-19): http://www.fasb.org iii. Any authoritative literature onp rior period adjustment and materiality . 3a. Sale of Technology Analyze the potential impact of TMC’s proposed sale of technology to layBall.com. P In performing this analysis of when and how much revenue server can be recognized, assume that TMC charges a price of $400,000, which includes all work necessary to install the softwarePlayBall’s on

and provide unlimited technical support and maintenance for the next two years. Also, assume that the contract could be signed and the software installed before the end of the year. The term is generally used in professional accounting to describe the two years of unlimited technical support and maintenance that is to be bundled with the sale of the TMC software is post-contract customer support or PCS.

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For the analyses, you should research the following two authoritative literature: i. AICPA Statement ofPosition No. 97-2,Software Revenue Recognition (Paragraph 10, 12, 57, 59): http://www.aicpa.org ii. Technical Information Service (TIS) Section 5100 Revenue Recognition, TPA 5100.39 Software Revenue Recognition for Multiple-Element Arrangements and TPA 5100.54 Fair Value of PCS in a Multi-Year Time-Based License and Software Revenue Recognition

:

http://www.aicpa.org 3b. Restructure the Technology Sale Contract Given that the deal for selling TMC’s technology to PlayBall is still in the proposal stage (no contracts have yet been signed), are there any

options for Sheri to structure the deal so that TMC can Recognize more revenue in Year 4 from this proposed sale? For example, what if the twoyear proposed contract described in 3a. above was rewritten as a one-year contract at a somewhat lower price that covered software, installation, and one year of PCS? Note that subsequent year or years of PCS would then be handled with a separate contract. Also, keep in mind that Sheri must carefully consider such adjustments in light of the expectations of her executive colleagues, the goals and strategies of the company, the expectations of the customer receiving the technology, and the standards of her profession as a CPA. Again, for the analyses, you should research the following two authoritative literatures: i. AICPA Statement ofPosition No. 97-2,Software Revenue Recognition (Paragraph 10, 12, 57, 59): http://www.aicpa.org ii. Technical Information Service (TIS) Section 5100 Revenue Recognition, TPA 5100.39 Software Revenue Recognition for Multiple-Element Arrangements and TPA 5100.54 Fair Value of PCS in a Multi-Year Time-Based License and Software Revenue Recognition

:

http://www.aicpa.org




Review and Approval of Other Audit Engagement Reports

You are the partner-in-charge of other audit engagements in your CPA firm. Auditors in your CPA firm submit their reports on other audit engagements to you for review and approval.

Required For each of the following six other audit engagement reports submitted to you for review and approval: 1. Identify the specific type of attestation report. 2. Identify any mistake in the written wording/paragraph. 3. Identify any mistake in the citing of authoritative guideline. 3. 4. 5. 6.

Identify Identify Identify Identify

any mistake in the description of the procedure performed. any mistake in the assurance/opinion issued. any omission of the required wording/paragraph. any inclusion of the non-required wording/paragraph.

1. Report Submitted by Auditor A

We have reviewed ABC Service Organization’s description of its Computer Center system for processing user entities’ transactions throughout the year ended December 31, 20xx, and the suitability of the design and operating effectiveness of controls to achieve the related control objectives stated in the description. On page 01 of the description, ABC Service Organization has provided an assertion about the fairness of the presentation of the description and suitability of the design and operating effectiveness of the controls to achieve the related control objectives stated in the description. ABC Service Organization is responsible for preparing the description and for the assertion, including the completeness, accuracy, and method of presentation of the description and the assertion, providing the services covered by the description, specifying the control objectives and stating them in the description, identifying the risks that threaten the achievement of the control objectives, selecting the criteria, and designing, implementing, and documenting controls to achieve the related control objectives stated in the description. Our responsibility is to express an opinion on the fairness of the presentation of the description and on the suitability of the design and operating effectiveness of the controls to achieve the related control objectives stated in the description based on our examination. We conducted our review in accordance with attestation standards established by the Public Company Accounting Oversight Board. Those standards require that we plan and perform our examination to obtain reasonable assurance about whether, in all material respects, the description is fairly presented and the controls were suitably designed and operating effectively to achieve the related control objectives stated in the description throughout the year ended December 31, 20xx. Because of their nature, controls at a service organization may not prevent, or detect and correct, all errors or omissions in processing or reporting transactions. Also, the projection to the future of any evaluation of the fairness of the presentation of the description, or conclusions about the suitability of the design or operating effectiveness of the controls to achieve the related control objectives is subject to the risk that controls at a service organization may become inadequate or fail. In our opinion, in all material respects, based on the criteria described in ABC Service Organization’s assertion on page 01 (1) the description fairly presents the system that was designed and implemented throughout the year ended December 31, 20xx. (2) the controls related to the control objectives stated in the description were suitably designed to provide reasonable assurance that the control objectives would be achieved if the controls operated effectively throughout the year ended December 31, 20xx.


(3) the controls tested, which were those necessary to provide reasonable assurance that the control objectives stated in the description were achieved, operated effectively throughout the year ended December 31, 20xx. The specific controls tested and the nature, timing, and results of those tests are listed in pages 10-20.

2. Report Submitted by Auditor B

We have reviewed management’s assertion that ABC Company maintained effective internal control over financialreporting as of December 31, 20xx, included in the accompanying management report. Our review was made in accordance with the Statements on Standards for Accounting and Review Services issued by the American Institute of Certified Accountants. Those standards require that we plan and perform the review to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our examination of internal control over financial reporting included obtaining an understanding of internal control over financial reporting. We believe that out examination provides a reasonable basis for our opinion. Because of inherent limitations in any internal control, errors or fraud may occur and not be detected. Also, projection of any evaluation of the internal control over financial reporting to future periods is subject to the risk that internal control may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. Based on our review, we are not aware of any material modifications that should be made to the accompanying financial statements in order for them to be in conformity with generally accepted accounting principles.

3. Report Submitted by Auditor C

We have examined the accompanying projected balance sheet, statements of income, retained earnings, and cash flows of ABC Company, as of December 31, 20xx, and for the year then ending.ABC Company’s management is responsible for the projection, which was prepared for the Bank of America for the purpose of negotiating a loan to expand ABC Company’s plant. Our examination was made in accordance with the Auditing Standards AU 800 issued by the American Institute of Certified Public Accountants and, accordingly, included such procedures as we considered necessary to evaluate the assumptions used by management and the preparation and presentation of the projection. In our opinion, the accompanying projection is presented in conformity with guidelines for presentation of a projection established by the American Institute of Certified Public Accountants, and the underlying assumptions provided a reasonable basis for management’s projection, assuming the granting of the requested loan for the purpose of expanding ABC Company’s plant as described in the summary of significant assumptions. However, even if the loan is granted and the plant is expanded, there will likely be differences between the projected and actual results, because events and circumstances frequently do not occur as expected, and those differences may be material.

4. Report Submitted by Auditor D

We have reviewed the accompanying schedule of gross sales (as defined in the lease agreement dated March 31, 20xx, between ABC Company, as lessor, and DEF Company, as lessee) of DEF Company at itsth 6Street Store, San Francisco, for the year ended December 20xx. This schedule is the responsibility of the DEF Company’s management. Our responsibility is to express an opinion on this schedule based on our reviews. Current review standards require that we plan and perform the review to obtain reasonable assurance about whether the schedule of gross sales is free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the schedule of gross sales. A review also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall schedule presentation. We believe that our audits provide a reasonable basis for our opinion. th The schedule of gross sales referred to above present fairly, in all material respects, the gross sales of DEF Company at its Street 6 store, San Francisco, for the year ended December 31, 20xx, as defined in the lease agreement referred to in the first paragraph. This report is intended solely for the information and use of the boards of directors and management of ABC Company and DEF Company and should not be used by anyone other than these specified parties.

5. Report Submitted by Auditor E

–income tax basis of ABC Partnership as of December 31, 200x, We have audited the accompanying statements of assets, liabilities, and capital and the related statements of revenue and expenses–income tax basis and of changes in partners’ capital accounts –income tax basis for the year then ended. These financial statements are the responsibility of the Partnership’s management. Our responsibility is to expre ss an opinion on these financial statements based on our audits. Our audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. As described in Note 3, these financial statements were prepared on the basis of accounting the Partnership uses for income tax purposes, which is a comprehensive basis of accounting other than generally accepted accounting principles. This report is intended solely for the information and use of the boards of directors and management of ABC Partnership.

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6. Report Submitted by Auditor F

We have reviewed the accompanying balance sheet of XYZ Company as of December 31, 20xx, and the related statements of income, retained earnings, and cash flows for the year then ended, in accordance with Statements on Standards for Attestation Engagement issued by the American Institute of Certified Accountants. All information included in these financial statements is the representation of the management of XYZ Company. A review includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. A review also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. Based on our review, the accompanying financial statements are presented fairly. This report is intended solely for the information and use of the boards of directors and management of XYZ and should not be used by anyone other than these specified parties.


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Appendix A

Appendix A AICPA Clarified Statements on Auditing Standards AU 200 200

210 220 230 240 250 260 265 AU 300-499 300 315 320 330 402 450 AU 500 500 501 505 510 520 530 540 550 560 570 580 585 AU 600 600 610 620 AU 700 700 705 706 708 720 725 730 AU 800 800 805 806 810 AU 900 905 910 915 920 925 930 935

General Principles and Responsibilities Overall Objectives of the Independent Auditor and the Conduct of an Audit in Accordance With Generally Accepted Auditing Standards Terms of Engagement Quality Control for an Engagement Conducted in Accordance With Generally Accepted Auditing Standards Audit Documentation Consideration of Fraud in a Financial Statement Audit Consideration of Laws and Regulations in an Audit of Financial Statements The auditor’s Communication With Those Charged With Governance Communicating Internal Control Related Matters Identified in an Audit Risk Assessment and Response to Assessed Risks Planning an Audit Understanding the Entity and Its Environment and Assessing the Risks of Material Misstatement Materiality in Planning and Performing an Audit Performing Audit Procedures in Response to Assessed Risks and Evaluating the Audit Evidence Obtained Audit Considerations Relating to an Entity Using a Service Organization Evaluation of Misstatements Identified During the Audit Audit Evidence Audit Evidence Audit Evidence-Specific Consideration for Selected Items External Confirmations Opening Balances-Initial Audit Engagements, Including Reaudit Engagements Analytic Procedures Audit Sampling Auditing Accounting Estimates, Including Fair Value Accounting Estimates and Related Disclosures Related Parties Subsequent Events and Subsequently Discovered Facts Going Concern Written Representations Consideration of Omitted Procedures After the Report Release Date Using the Work of Others Special Considerations- Audits of Group Financial Statements (including the Work of Component Auditors)

Using the Work of Internal Auditors Using the Work of an Auditor’s Specialist Audit Conclusions and Reporting Forming an Opinion and Reporting on Financial Statements Modifications to the Opinion in the Independent Auditor’s Report Emphasis of Matter Paragraphs and Other Matter Paragraphs in the Independent Auditor’s Report Consistency of Financial Statements Other Information in Documents Containing Audited Financial Statements Supplementary information in Relation to the Financial Statements as a Whole Required Supplementary Information Special Considerations Special Considerations-Audits of Financial Statements Prepared in Accordance With Special Purpose Frameworks Special Considerations-Audits of Single Financial Statements and Specific Elements, Accounts, or Items of a Financial Statement Reporting on Compliance With Aspects of Contractual Agreements or Regulatory Requirements in Connection With Audited Financial Statements Engagements to Report on Summary Financial Statements Special Considerations in the United States Alerts as to the Intended Use or Purpose of the Auditor’s Written Communication Financial Statements Prepared in Accordance With a Financial Reporting Framework Generally Accepted in Another Country Reports on Application of Requirements of an Applicable Financial Reporting Framework Letters for Underwriters and Certain Other Requesting Parties Filings With the U.S. Securities and Exchange Commission Under the Securities Act of 1933 Interim Financial Information Compliance Audits


Appendix B PCAOB Audit Standards AS No. AS 1 AS 3 AS 4 AS 5 AS 6 AS 7 AS 8 AS 9 AS 10 AS 11 AS 12 AS 13 AS 14 AS 15 AS 16

Title References in Auditors’ Reports to the Standards of the Public Company Accounting Oversight Board Audit Documentation Reporting on Whether a Previously Reported Material Weakness Continues to Exist An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements Evaluating Consistency of Financial Statements Engagement Quality Review Audit Risk Audit Planning Supervision of the Audit Engagement Consideration of Materiality in Planning and Performing an Audit Identifying and Assessing Risks of Material Misstatement The Auditor’s Responses to the Risks of Material Misstatement Evaluating Audit Results Audit Evidence Communications with Audit Committees

PCAOB Rules Section 1 Section 2

Section 3

Section 4

Section 5

Section 6

Section 7

General Provisions Registration and Reporting, which include Rule 2100 Registration Requirements for Public Accounting Firms Rule 2103 Registration Fee Professional Standards, which include: Rule 3520 Auditor Independence Rule 3521 Contingent Fees Rule 3523 Tax Services for Persons in Financial Reporting Oversight Roles Rule 3524 Audit Committee Pre-approval of Certain Tax Services Rule 3525 Audit Committee Pre-approval of Non-audit Services Related to Internal Control Over Financial Reporting Rule 3526 Communication with Audit Committees Concerning Independence Inspections, which include Rule 4003 Frequency of Inspections Rule 4009 Firm Response to Quality Control Defects Rule 4010 Board Public Reports Investigations and Adjudications, which include: Rule 5200 Disciplinary Proceedings Rule 5300 Disciplinary Sanctions International, which include: Rule 6001 Assisting Non-U.S. Authorities in Inspections Rule 6002 Assisting Non-U.S. Authorities in Investigations Funding

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Appendixes C D E

Appendix C

AICPA Statements on Standards for Attestation Engagements (SSAE) AT 20 50 101 201 301

Title Defining Professional Requirements in Statements on Standards for Attestation Engagements Statements on Standards for Attestation Engagement Hierarchy Attest Engagements Agreed-Upon Procedures Engagements Financial Forecasts and Projections

401 501

Reporting on Pro Forma FinancialInternal Information An Examination of an Entity’s Control Over Financial Reporting that is Integrated with an Audit of Its Financial Statements Compliance Attestation Management’s Discussion and Analysis Reporting on Controls at a Service Organization

601 701 801

Appendix D

AICPA Statements on Standards for Accounting and Review Services (SSARS) AR 20 50 60 80 90 110 120 200 300 400 600

Title Defining Professional Requirements in Statements on Standards for Accounting and Review Services Standards for Accounting and Review Services Framework for Performing and Reporting on Compilation and Review Engagements Compilation of Financial Statements Review of Financial Statements Compilation of Specified Elements, Accounts, or Items of a Financial Statement Compilation of Pro Forma Financial Information Reporting on Comparative Financial Statements Compilation Reports on Financial Statements Included in Certain Prescribed Forms Communications Between Predecessor and Successor Accountants Reporting on Personal Financial Statements included in Written Personal Financial Plans

Appendix E

AICPA Code of Professional Conduct (CPC) ET 50 90 100 200 300 400 500

Title Principles of Professional Conduct Rules: Applicability and Definitions Independence, Integrity, and Objectivity General Standards - Accounting Principles Responsibilities to Clients Responsibilities to Colleagues Other Responsibilities and Practices


Appendix F Key Terms

A

Absence of causal connection: An auditor’s legal defense under which the auditor contends that the damages claimed by the client

were not brought about by any act of the auditor. Acceptable risk of incorrect acceptance (ARIA): The risk that the auditor is willing to take of accepting a balance as correct when

the true misstatement in the balance is equal to or greater than tolerable misstatement. Acceptable risk of incorrect rejection (ARIR): The risk that the auditor is willing to take of rejecting a balance as incorrect when it is not misstated by a material amount. Acceptable risk of over-reliance (ARO): The risk that the auditor is willing to take of accepting a control as effective or a rate of monetary misstatements as tolerable when the true population exception rate is greater than the tolerable exception rate. Acceptable risk of under-reliance (ARU): The risk that the auditor is willing to take of accepting a control as effective or a rate of monetary misstatements as tolerable when the true population exception rate is smaller than the tolerable exception rate. Accounting estimate:A transaction involving management’s judgments or assumptions, such as determining the allowance for doubtful accounts, establishing warranty reserves, and assessing assets for impairment. Accounting records:The records of initial entries and supporting records, such as checks and records of electronic fund transfers; involves; contracts; the general and subsidiary ledgers, journal entries, and other adjustments to the financial statements that are not reflected in formal journal entries; and records such as work sheets and spreadsheets supporting cost allocations, computations, reconciliations, and disclosures. Accrued liabilities (accrued expenses): Short-term obligations for services of a continuing nature that accumulate over time. Examples include interest, taxes, rent, salaries, and pensions. They generally are not evidenced by invoices or statements. Accrued payroll expenses:The liability accounts associated with payroll; these include accounts for accrued salaries and wages, accrued commissions, accrued bonuses, accrued benefits, and accrued benefits, and accrued payroll taxes. Accuracy specific audit objective: the specific audit objective of verifying that amounts and other data relating to recorded transactions and events have been recorded appropriately and that financial and other information are disclosed fairly. Adjusting journal entries (AJEs): Journal entries designed to correct misstatements found in a client’s records. Adverse opinion (report):A report issued when the auditor believes the financial statements, taken as a whole, are so materially misstated that they do not present fairly the client’s financial posit ion or the results of its operations and cash flows in conformity with GAAP. Adverse opinion (report) on internal controls: A report in which the auditor communicates to shareholders that the company has not maintained effective internal control over financial reporting. Agreed-upon procedures engagement: An engagement in which the procedures to be performed are agreed upon by the CPA, the responsible party making the assertions, and the intended users of the CPA’s report. Allocation of the preliminary judgment about materiality: The process of assigning to each balance sheet account the misstatement amount to be considered material for that account based o the auditor’s preliminary judgment. Allowance for sampling risk (ASR): Also referred to as precision, an interval around the sample results in which the true population characteristic is expected to lie. Alternative procedure (in Accounts receivable confirmation): Procedures used to obtain evidence about the existence and valuation of accounts receivable when a positive confirmation is not returned. These procedures include examining cash collected after the confirmation date and vouching unpaid invoices to customer’s orders, sales, orders, shipping documents, and sales invoice s. Altman Z-score (model):A combination of weighted financial ratios to produce a score that predicts whether a company has a high potential for bankruptcy (non-going concern). American Institute of Certified Public Accountants (AICPA): A voluntary organization of CPAs that sets professional requirements, conducts research, and publishes materials relevant to accounting, auditing, management consulting services, and taxes. An examination of an entity’s internal control over financial reporting that is integrated udit withofanitsa financial statements:This engagement is usually done for a client’s management or audit committee, or for meeting the requirements of a regulatory agency. For private companies, the engagement is performed in accordance with AICPA’s AT 501.For public companies, the engagement is performed in accordance with PCAOB’s Auditing Standard AS . 5 Analytical procedure:Use of comparisons and relationships to assess whether account balances or other data appears reasonable. Analytical procedure risk: The risk that analytical procedures will fail to detect material misstatements. Application controls:Controls related to a specific use of information technology, such as the inputting, processing, and outputting of

sales or cash receipts. Application programs:Computer programs written to accomplish specific data processing tasks such as processing sales and

accounts receivable, updating inventory, computing payroll, or developing special management reports. Appropriateness of evidence:A measure of the quality of evidence; appropriate evidence is relevant and reliable for classes of transactions, account balances, and related disclosures. As of date (in ICFR):A concept applied to internal control over financial reporting (ICFR) by the Sarbanes-Oxley Act of 2002 and PCAOB Standard No.5. The internal control reports of both management and the auditors are for a particular point in time, “as theof” date, as oppose to the entire period under audit. This date is ordinarily the last day of the clients’ fiscal period. Asset impairment:A term used to describe management’s recognition that a significant portion of fixed assets is no longer as productive as had srcinally been expected. When assets are so impaired, the assets should be written down to their expected economic value. Asset misappropriationA : fraud that involves the theft or misuse of a client’s assets. Common examples include skimming cash, stealing inventory, and payroll fraud. It is one type of defalcation. Assertion:A representation or declaration made by the responsible party, typically management of the audit client. Assessment of control risk: A measure of the auditor’s expectation that internal controls will neither prevent material misstatements from occurring nor detect and correct them if they have occurred; control risk is assessed for each transaction-related objective in a cycle or class of transactions. Assurance service: An independent professional service that improves the quality of information for decision makers. An assurance

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Appendix F

Key Terms service differs from a consulting service in that the former focuses on optimizing a client’s decision making whereas the later focuses on improving a client’s outcomes or conditions. Attestation of prospective (forecast or projection) financial statements: Prospective financial statements are financial information representing the financial position, results of operations, and cash flows for some period of time in the future. This engagement is performed in accordance with the Statements on Standards for Attestation Engagements (SSAE) AT 301. Attestation of Service Organization Control: AICPA AU 402 requires an auditor (known as an user auditor) of a company (known as an user entity) that uses a service organization to obtain an understanding of how the user entity uses the service organization, including the nature and significance of the services and the effect on internal control. Attestation of information systems (also known as SysTrust Service): This engagement provides reasonable assurance that a client’s information systems complies with Trust Services principles and criteria for electronic commerce. The engagement is performed in accordance with Statements on Standards for Attestation Engagements (SSAE) AT 101. Attestation of Trust websites (also principles known as and WebTrust This engagement provides reasonable assurance that ainclient’ s website with complies with Services criteria Service): for electronic commerce. The engagement is performed accordance Statements on Standards for Attestation Engagements (SSAE) AT 101. Attestation service:A type of assurance service in which a CPA firm issues a report about the reliability of an assertion that is the responsibility of another party. Audit is a subset of attestation service, which in turn is a subset of assurance service. Attestation standards:(See Appendix C) A general set of standards intended to guide attestation work in areas other than audits of financial statements. The Auditing Standards Board issued 11 Attestation Standards that parallel the previously 10 GAAS. Following the same framework used for auditing standards, detailed interpretations of the 11 Attestation Standards are provided in more than 10 Statements on Standards for Attestation Engagements (ATs). Attribute:The characteristic being tested for in the population. Attribute estimation sampling (AES) technique: A statistical sampling technique for tests of controls (TOC) that evaluates a sample of items that result in an estimate of the proportion of the items in a population containing a control attribute (characteristic) of interest. Audit assurance:A complement to audit risk; an audit risk of 5 percent is the same as audit assurance of 95 percent. Audit committee:Selected members of a client’s board of directors whose responsibilities include ensuring auditors to remain independent of management. Members of the audit committee must be independent directors, that is, members of the board of directors who do not also serve as corporate officers or have other relationships that might impair independence. Audit documentation:Records of auditing procedures applied, evidence obtained, and conclusions reached by the auditor in the engagement. Audit evidence:Any information that corroborates ro refutes the auditors’ premise that the financial statements present fairly the client’s financial position and operating results. Audit failure:A situation in which the auditor issues an incorrect audit opinion as the result of an underlying failure to comply with the requirements of auditing standards. Audit of compliance with debt agreement: This engagement is to report whether an audit client that enters into loan agreements complies with certain debt agreements or regulatory requirements related to audited financial statements. The engagement is performed in accordance with the AU 806. Audit of financial statements that use a financial reporting framework other than GAAP: Financial statements that use a

financial reporting framework other than a GAAP financial reporting framework is referred to as a special-purpose financial reporting frameworks. Audit of financial statements that use a special-purpose financial reporting framework is performed in accordance with the AICPA AU 800. Audit of information accompanying the basic financial statements: Information accompanying the basic financial statements includes comparative statements supporting the control totals, supplementary information required by FASB or SEC, statistical data, a schedule of insurance coverage, and specific comments on changes in the financial statements. This engagement is performed in accordance with the AU 725. Audit of specified elements, accounts or items: Examples of this engagement include a report on rentals, royalties, and profit participation. It may be performed as a separate engagement or as part of an audit of a client’s complete financial statemen ts. This engagement is performed in accordance with the AICPAAU 805 Auditing: A systematic process of a. objectively obtaining and evaluating evidence regarding assertions about economic actions and events to ascertain the degree of correspondence between those assertions and established criteria and b. communicating the results to interested users. Auditing Standard Board (ASB): An important arm of the Auditing Standards Division is the Auditing Standards Board (ASB), which promulgates the 10 generally accepted auditing standards (GAAS) that guide the quality of audit services. Compliance with the 10 GAAS is mandatory for members of AICPA who perform auditing and other related professional services. The ASB replaced the 10 GAAS with 4 fundamental principles underlying an audit that are grouped into four categories: (1) the purpose and premise of an audit, (2) personal responsibilities of the auditor, (3) auditor actions in performing the audit, and (4) reporting. Auditing Standards (AU):Detailed guidance to the 10 GAAS are provided by more than 100 Statements of Auditing Standards (AUs) issued by the ASB. The AUs are labeled by their AU numbers #, which are based on the topical content with which they are issued. as part of improving clarity and converging with international auditing standards, the more than 100 AUs are reorganized into six groups in a new AU codification scheme: (1) AU 200 General Principles and Responsibilities, (2) AU 300-499 Risk Assessment and Response to Assessed Risks, (3) AU 500 Audit Evidence, (4) AU 600 Using the Work of Others, (5) AU 700 Audit Conclusions and Reporting, and (6) AU 800-999 Special Considerations. Audit plan:A description of the nature, timing, and extent of the audit procedures to be performed. Ordinarily, it is documented with an audit program.

Audit Practice and Quality Center (CAQ): The AICPA has established audit practice and quality centers as resource centers to

improve audit practice quality. In addition to these resource centers for CPA firms, the AICPA has established audit quality centers for governmental audits and employee benefit plan audits. Audit procedure:Detailed instruction for the collection of audit evidence. Audit program:Audit procedures for an entire audit consisting of a set of tests of controls procedures, a set of tests of balances


Key Terms procedures, and a set of completing the audit procedures. Audit report:The end product of the auditor’s work, indicating the auditing standards followed, and expressing an opinion as to whether an entity’s financial statements are fairly presented in accordance with established criteria such as the GAAP. Audit report date:The date on which the auditor has obtained sufficient appropriate audit evidence to support the opinion on the financial statements or other financial information being reported upon. Typically, this is the date on which the auditor has completed the field work, and the audit report is ordinarily dated as of this date. Audit report issue date:the date on which the auditor’s report and the client’s financial statements are issued (mailed) to the stockholders in the form of an annual financial report. Audit risk (AR):The risk that the auditor will conclude after conducting an audit that the financial statements are fairly stated and an unqualified opinion can therefore be issued when, in fact, they are materially misstated. Audit risk model:A model reflecting the relationships between audit risk (AR), inherent risk (IR), control risk (CR), and detection risk (DR); AR=IRTesting x CR xless DR.than 100 percent of a population for the purpose of making inferences about that population. Audit sampling: Audit trail:Term used to describe the documents and records that allow an auditor to trace a transaction from its srcination through

B

C

to its final disposition, or vice versa. It may be electronic or paper based. Auditing service:A type of attestation service in which an auditor issues an audit report about the reliability of the financial statements that are the responsibility of the client’s management. Balance-related information assertions/objectivAssertions es: (objectives) about account balances at period end. Bank cutoff statement:A bank statement for a period of time determined by the auditor that is shorter than the regular month-end bank statements. The bank sent it directly to the auditor, who uses it to verify reconciling items on the client’s year-end bank reconciliation. Batch processing:A system in which like transactions are processed periodically as a group. Bill and hold (transactions): Transactions in which sales of merchandise are billed to customers prior to delivery, with the goods being held by the seller. These transactions may overstate revenues and net income if they do not meet specific requirements for recognition as sales. In addition, these transactions may overstate inventory if they were included in the total inventory on hand. Bill of lading:A shipping document issued by a common carrier acknowledging the receipt of goods and setting forth the provisions of the transportation agreement. Blank confirmation request:A request addressed to the debtor, requesting the recipient to fill in the amount of the accounts receivable balance. Board of directors:Persons elected by the stockholders of a corporation to oversee management and to direct the affairs of the corporation. Brainstorming (in audit plan): A required part of every financial statement audit. Conducted at the planning phase of the audit whereby the audit team considers changes in account balances, deficiencies in controls, and motivations to commit fraud to identify areas where fraud is more likely to occur and how it will occur. Breach of contract:Failure to perform a contractual obligation that has not been excused. For CPA firms, the parties to a contact usually involve the audit clients and designated third-party beneficiaries. Business performance measurement (in assurance service): An assurance service that help a client to track performance using a variety of financial and nonfinancial measures. Business risks:Risks that threaten management’s ability to achieve the organization’s objectives. Bylaws: The rules and procedures adopt ed by a corporation’s stockholders, including the corporation’s fiscal year and the duties and powers of its officers. Call privilege for preferred stock: A preferred stock may carry a call privilege option in which case the issuing company will have the right to redeem (call) the preferred stock at a later date for a predetermined price. This call price would be in excess of the srcinal issue price, such as 105 percent of par value. Cash basis framework:A special purpose accounting framework that includes no accruals. Cash equivalent:Excess cash invested in short-term, highly liquid investments such as time deposits, certificates of deposit, and money market funds. Capital expenditure:An expenditure for property, plants, and equipment that is properly charged to an asset account. Capital (finance) lease: A capital (finance) lease is a lease that meets one or more of the following criteria: the lease term is greater than 75% of the property's estimated economic life; the lease contains an option to purchase the property for less than fair market value; ownership of the property is transferred to the lessee at the end of the lease term; or the present value of the lease payments exceeds 90% of the fair market value of the property. A capital lease (finance) lease is recorded and amortized as a purchased asset in the balance sheet by the lessee. The determination of whether a lease is a capital (finance) lease or an operating lease is defined in the United States by Statement of Financial Accounting Standards SFAS No. 13. Capital stock certificate record: A record of the issuance and repurchase of capital stock for the life of the corporation. See also Shareholders’ capital stock master file. Certified public accountant: A person licensed by the state to practice public accounting as a profession, based on having passed the Uniform CPA Examination and having met certain educational and experience requirements. Chart of accounts:A listing of all the entity’s accounts, which classifies transactions into indi vidual balance sheet and income statement accounts. Circumstance-imposed scope limitation: A restriction on auditors from gathering sufficient appropriate evidence because of a situation beyond control of both the auditors and client, such as late appointment of the auditors. Class action suits:Law suits brought on behalf of a large group of plaintiffs to promote consistent judgments and minimize litigation costs.

Classes of transactions in the revenue cycle: The categories of transactions for the revenue cycle in a typical company: sales, cash

receipts, sales returns and allowances. Classification specific audit objective: The specific objective of verifying that financial items have been properly classified in the

financial statements.

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Appendix F

Key Terms Client advisory comment letter (Management letter): A letter written by the auditor to a client’s management containing the auditor’s recommendations for improving any aspect of the client’s control/business. Client-imposed scope limitation: A restriction on auditors from gathering sufficient appropriate evidence because of the client’s deliberate refusal to provide them access to documents or to otherwise limit the auditors’ application of auditing procedures. Client’s inquiry of lawyer letter: A letter sent by auditors to a client’s lawyer requesting a description and evaluation of pending or threatened litigation, unasserted claims, and other loss contingencies. The returned letter from the client’s lawyer is red refer to as the

lawyer representation letter. Close family relative:AICPA defines as a parent, sibling, and non-dependent child. PCAOB defines as a parent (including adoptive parent and step-parent), dependent (i.e., person who received half or more support), non-dependent child (including step-child), and brother and sister (excluding grandchild, grand-parent, parent-in-law, and the spouse of each of these). Cloud computing:A model for enabling on-demand user network access to a shared pool of computing resources (e.g., networks, servers, applications, or(CPC): services), often Internetby browser. Code ofstorage, Professional Conduct A code ofthrough conductan designed the AICPA to provide a framework for providing professional services and responding to other ethical issues in the profession. Cold (concurrent) review:A review of the audit conducted by a partner not otherwise involved in the audit to help assure that the evidence in the documentation adequately supports the audit report. Collateral:An asset or a claim on an asset usually held by a borrower or an issuer of a debt instrument to serve as a guarantee for the value of a loan or security. If the borrower fails to pay interest or principal, the collateral is available to the lender as a basis to recover the principal amount of the loan or debt instrument. Collusion:A fraudulent cooperative effort among employees to steal assets or misstate records. Comfort letter:A letter issued by the independent auditor to the underwriters of securities registered with the SEC under the Securities Act of 1933. Comfort letter deal with such matters as the auditor’s independence and the compliance of unaudited ata with d requirements of the SEC. Commercial paper:Note issued by major corporations, usually for short periods of time and at rates approximating prime lending rates, usually with high credit rating. Its quality may change if the financial strength of the issuer declines. Common law:Law developed through court decisions, custom, and usage without written legislation. It operates on court precedence and it may differ from state to state or by jurisdiction. Committee of Sponsoring Organizations of the Treadway Commission (COSO): In the 1970s, the major accounting organizations (including AICPA) sponsored the National Commission on Fraudulent Financial Reporting (the Treadway Commission) to study and establish a comprehensive framework of internal control for the auditor to assess the quality of internal control over financial reporting. Commission (in ethics):The payment of a fee for selling an item or as a percentage of the fees generated for performing a service to attestation clients, which is prohibited by the Code of Professional Conduct (CPC). However, commission is allowed for performing a non-attestation client, whichhe t auditor must disclose its nature to the user affected by the auditor’s service. Common-size financial statements: Financial statements that present each amount as percentage of some financial statement base. As an example, a common-size income statement presents all revenues and expenses as a percentage of net sales. Compensating (compensatory) control: A control elsewhere in the system that offsets the absence of a key control. Compilation procedure (inventory cycle): A test of balances procedure performed by the auditor to test for the specific audit

objective of mathematic accuracy of inventories. Compilation service (financial statements): A nonaudit engagement in which the accountant under-takes to present, in the form of financial statements, information that is the representation of management, without undertaking to express any assurance on the statements. Completeness assertion:Implicit or explicit assertion made by the management that all accounting transactions and balances that should have been recorded in the financial statements have been recorded. For example, management asserts that there are no unrecorded inventories and that all sales occurred are included in the income statement. Completeness specific audit objective: The specific objective of verifying that the financial items that should be included in the financial statements have actually been included. Compliance audit:(a) A review of an organization’s financial records performed to determine whet her the organization is following specific procedures, rules, or regulations set by some higher authority; (b) An audit performed to determine whether an entity that receives financial assistance from the federal government has complied with specific laws and regulations. Compliance supplement:A publication of the U.S. Office of Management and Budget that specifies audit procedures for federal financial assistance programs. Computed upper exception rate (CUER): The upper limit of exception (the maximum except rate) in the population at a given acceptable risk of overreliance (ARO). Computed upper misstatement rate (CUMR): A statistical estimation of the maximum population misstatement rate. It is the sum of the projected population misstatement (PPM) and the allowance for sampling risk (ASR). Computer-assisted audit techniques (CAATs): Computer programs that allow auditors to test computer files and databases. Confidential information (in ethics): Information obtained during the conduct of an audit related to the client’s business or business plans; the auditor is prohibited from communicating confidential information except in specific instances allowed by the Code of Professional Conduct (CPC) orw ith the client’s permission. Confirmation: The auditor’s receipt of a written or oral response from an independent third party verifying the accuracy of information requested. Consignment (in or out): A transfer of goods from the owner to another person who acts as the sales agent of the owner. Contingent fee (in ethics): A fee established for the performance of any service pursuant to an arrangement in which no fee will be

charged unless a specified finding or result is attained (or achieved), or in which the amount of the fee otherwise depends on the finding or results of such services. For example, an auditor is prohibited from receiving audit fee that is contingent upon issuing an unqualified opinion to the client. Contingent liability (loss contingency): A potential future obligation to an outside party for an unknown amount resulting from activities that have already taken place.


Key Terms Continuous auditing:To provide assurance using a series of reports provided simultaneously or shortly after the related information

is released. Contract law: Law stems from case law, the Uniform Commercial Code, and other state statutes. It establishes the rights and

responsibilities of parties to consensual private agreements. Contributory negligence:An auditor’s legal defense under which the auditor claims that the client failed to perform certain obligations and that it is the client’s failure to perform those obligations that brought about the claimed damages. Control activities:Policies and procedures that help ensure that necessary actions are taken to address risks in the achievement of the entity’s objectives. Typically, they include the following five specific control activities: (1) adequate separation of s, dutie (2) proper authorization of transactions and activities, (3) adequate documentations and records, (4) physical control over assets and records, and (5) independent checks on performance. Control environment:The tone of an organization, which reflects the overall attitude, awareness, and actions of the board of directors, deficiency: management, and ownersininfluencing consciousness its does people. Control A deficiency the designthe or control operation of controls of that not prevent or detect misstatements on a timely basis. A deficiency in design exists when either a control necessary to meet a control objective is missing or the existing control is not designed to operate effectively. A deficiency in operation exists when a properly designed control does not operate as designed, or when the person performing the control does not possess the necessary authority or qualifications to perform the control effectively. Control environment:The actions, policies, and procedures that reflect the overall attitudes of top management and directors about internal control and its importance to the audit client. Control risk:The risk that a material misstatement that could occur in an account will not be prevented or detected on a timely basis by internal control. Convertible bonds:A corporate bond, usually a junior debenture that can be exchanged, at the option of the holder, for a specific number of shares of the company's preferred stock or common stock. Convertibility affects the performance of the bond in certain ways. First and foremost, convertible bonds tend to have lower interest rates than non-convertibles because they also accrue value as the price of the underlying stock rises. In this way, convertible bonds offer some of the benefits of both stocks and bonds. Convertibles earn interest even when the stock is trading down or sideways, but when the stock prices rise, the value of the convertible increases. Therefore, convertibles can offer protection against a decline in stock price. Corporate charter:A legal document granted by the state in which a company is incorporated that recognizes a corporation as a separate entity; it includes the name of the corporation, the date of incorporation, capital stock the corporation is authorized to issue, and the types of business activities the corporation is authorized to conduct. Corporate governance:The oversight mechanisms in place to help ensure the proper stewardship over an entity’s assets. Management, the board of directors, and the audit committee play primary roles, and the independent auditor plays a key facilitating role. Corroborating documents: Documents and memoranda included in the working papers that substantiate representations contained in the client’s financial statements, lawyers’ letters, copies of contracts, copies of minutesdirectors’ of and stockholders’ meetings, and representation letters from the client’s management. Cost Accounting standards Board: A five-member board established by Congress to narrow the options in cost accounting that are available under GAAP. Audit clients that have significant supply contracts with the U.S. government agencies are subject to the cost

D

accounting standard established by the board. Covered member (in ethics):An individual on the attestation engagement team, an individual in a position to influence the attestation engagement, or a partner in the office in which the lead attestation engagement partner primarily practices in connection with the attestation engagement. Cross-sectional analysis: A technique that involves comparing the client’ s ratios for the current year with those of similar firms in the same industry. Cruising (in depletion): The inspection of a tract of forestland for the purpose of estimating the total lumber yield. Current files:All audit files applicable to the year under audit. Cutoff: The process of determining that transactions occurring near the balance sheet date are assigned to the proper accounting period. Cutoff period:The few days just before and after the balance sheet date; the number of days is determined by the auditor, depending on the assessment of potential errors made in recording items in the incorrect period. Cutoff specific audit objective: The specific objective of verifying that transactions occurring near the balance sheet date have been recorded in the proper accounting period. Cutoff tests: Audit testing procedures applied to transactions selected from those recorded during the cutoff period to provide evidence as to whether the transactions have recorded in the proper accounting period. Cutoff bank statement:A partial-period bank statement and the related cancelled checks, duplicate deposit slips, and other documents included in bank statements, mailed by the bank directly to the auditor; the auditor uses it to verify reconciling items on the client’s year-end bank reconciliation. Cutoff misstatements:Misstatement that take place as a result of current period transactions being recorded in a subsequent period or subsequent period transactions being recorded in the current period. Cycle inventory count:Periodic testing ofthe accuracy of theperpetual inventory recorded by counting all inventory on a cyclical basis. Database management systems: Hardware and software systems that allow audit clients to establish and maintain data bases shared by multiple applications. Date of the auditors’ report: The date on which auditors have obtained sufficient appropriate evidence to support their opinion. Debenture (bond):An unsecured bond, dependent upon the general credit of the issuer. Debit memo:A document indicating a reduction in the amount owed to a vendor because of returned goods or an allowance granted. Debit covenant: An agreement between an entity and its lender that places limitations on the entity; usually associated with

debentures or large credit lines. Common limitations include restrictions on dividend payments, requirements for a specified working capital or debt/equity ratio, and annual audits of the entity’s financial statements to be furnished to the lender. Failure o satisfy t the

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Key Terms agreement may result in loans or bonds becoming immediately due and payable or redeemable. Decision support systems:IT information systems that combine models and data in an attempt to solve non-structured problems with extensive user involvement. Defalcation:The theft or embezzlement of funds or other assets from a client. The theft is usually covered up through factitious accounting entries. Asset misappropriation is one type of defalcation. Deficiency in control:A deficiency in the design or operation of a control that does not prevent or detect misstatements on a timely basis. A deficiency in design exists when either a control necessary to meet a control objective is missing or the existing control is not designed to operate effectively. A deficiency in operation exists when a properly designed control does not operate as designed, or when the person performing the control does not possess the necessary authority or qualifications to perform the control effectively. Depletion: Expense associated with the extraction of natural resources. The units of production method are normally used. Unlike depreciation (for tangible assets) and amortization (for intangible assets), which describe the deduction of expenses of tangible assets and the reduction in carrying value of intangible depletion is the actual physical of natural resources companies. Derivatives: Derivatives are financial contracts, assets, or financial instruments, whose valuesreduction are derived from the value ofbysomething else (known as the underlying). The underlying value on which a derivative is based can be an asset (e.g., commodities, equities (stocks), residential mortgages, commercial real estate, loans, bonds), an index (e.g., interest rates, exchange rates, stock market indices, consumer price index (CPI), weather conditions, or other items. Credit derivatives are based on loans, bonds or other forms of credit. The main types of derivatives are forwards, futures, options, and swaps. Derivatives can be used to mitigate the risk of economic loss arising from changes in the value of the underlying. This activity is known as hedging. Alternatively, derivatives can be used by investors to increase the profit arising if the value of the underlying moves in the direction they expect. This activity is known as speculation. Detailed supporting schedule: Detailed schedules prepared by the client or the auditor in support of specific amounts on the financial statements. Detection risk (DR):The risk that the auditors’ procedures will lead them to conclude that a financial statement assertion is not materially misstated when in fact such misstatement does exist. Difference estimation:An audit sampling technique that uses the difference between the audited (correct) values and book values of items in a sample to calculate the estimated total audited value of the population. Difference estimation is used in lieu ratio estimation when the differences are not nearly proportional to book values. Digital signatures:Electronic certificates that are used to authenticate the validity of individuals and companies conducting business electronically. Direct financial interest: A personal investment under the direct control of the investor. Investments made by a CPA’s spouse or dependents also are regarded as direct financial interests of the CPA. Disclaimer opinion (report): A report issued when the auditor is not able to express an opinion on whether the overall financial statements are fairly presented or the auditor is not independent. Discovery sampling:An audit sampling technique for locating at least one deviation (exception), providing that the deviation (exception) occurs in the population with a specified frequency. Distributed data processing: An IT system that uses communication links to share data and programs among various users in remote locations throughout the organization. The users may process the data in their own departments. Dual-dated audit report:The use of one audit report date or f “formal subsequent events” and a later date for “new subsequent events” that come to the auditor’s attention between the field work completion date and the audit report issue date. Dual purpose test (procedure): A concurrent audit procedure that serves as a test of controls and a test of balances of the transactions

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that occurred during the year. For example, a test of controls over equipment acquisitions (tests the control activity of authorization) is combined with a test of balance of whether the dollar amounts of equipment acquisitions are properly recorded (tests the specific audit objective of completeness). Due (professional) care:A legal standard requiring that the auditor performs his/her professional services with the same degree of skill, knowledge, and judgment possessed by other members of the profession. Due diligence:A CPA firm’s contention that its audit work was adequate to support its opinion on financial statements included in a registration statement filed with the SEC under the Securities Act of 1933. Earnings management:A deliberate action taken by management to meet earnings objectives. Earn-out:Earn-out clauses are often included in the business acquisition agreement if the buyer and seller disagree significantly over what the business should be worth. This is especially so if the business financial performance is expected to improve substantially at some future time, after the purchase. In such cases, the acquisition agreement may set an additional amount that the seller will receive in the future if this financial performance expectation is realized. One way to specify the earn-out is as a percentage of revenues in excess of an agreed-upon amount, payable over a certain time period, and limited to some maximum. Effective date (of SEC):The date the SEC indicates to the client that it may begin selling the new securities described in a registration statement that it has filed (filing date) with the SEC. Electronic commerce (e-commerce): An IT system that involves the electronic processing and transmission of business transactions between customer and client. A variety of activities may be included, including electronic trading of goods and services, online delivery of digital products, and electronic funds transfer. Electronic data interchange (EDI): An IT system in which data are exchanged electronically between the computes of different companies. In an EDI system, source documents are replaced with electronic transactions created in a standard format. Electronic funds transfer (EFT) system: An IT system that transmits and processes funds-related cash disbursement and receipt transactions. Elements of Quality Control (AICPA): The Quality Control Standards Committee of the AICPA replaced the previously established A Firm’s five elements of quality control with six elements of quality control in Statement on Quality Control Standards (SQCS No.8), System of Quality Control. A CPA firm’s system of quality control should be designed to provide the firm with reasonable assurance that the firm and its personnel comply with professional, legal, and regulatory requirements and that the partners issue appropriate reports. Elements of Quality Control (PCAOB): The Quality Control Standards Committee previously established five elements of quality


Key Terms control that CPA firms should consider in setting up their policies and procedures in orderconform to to professional standards. The PCAOB adopted and retained the five elements of quality control as part of its interim auditing standards. Embedded audit module:A method of auditing transactions whereby the auditor embeds a module in the client’s application software to identify transactions with characteristics that are of interest to the auditor, which the auditor is then able to analyze them on a real-time, continuous basis as the client transactions are processed. Engagement letter:An agreement between the CPA firm and the client as to the terms of the engagement for the conduct of the audit and related services. Engagement risk:The risk of loss or injury to the auditors’ reputation by association with a client that goes bankrupt or one whose management lacks integrity. Entity-level controls (in ICFR): Controls that have a pervasive effect on the audit client’s system of internal cont rol such as controls related to the control environment; controls over management override; the management’s risk assessment process; and controls over the period-end financial reporting Error: An unintentional mistake ofprocess. the financial statements. Estimation transaction:A transaction involving management’s judgments or assumptions, such as determining the allowance for

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doubtful accounts, establishing warranty reserves, and assessing assets for impairment. Ethics: A system or code of conduct based on moral duties and obligations that indicates how an individual should behave. Ethics Rulings:A set of questions and answers issued by the AICPA that explains the application of Rules and Interpretations of the Code of Professional Conduct to specific ethical situations. Examination:An attestation engagement that results in positive assurance as to whether or not the assertions under examination conform with the applicable criteria. Exception rate:The percent of items in a population that have exceptions in prescribed controls or monetary correctness. Also referred to as occurrence rate or deviation rate. Existence or occurrence assertion: Implicit or explicit assertion made by the management that asset and liability balances stated in the balance sheet actually exist at the balance sheet date and that revenue and expense transactions stated in the income statement actually occurred during the accounting period. For example, management asserts that inventories in the balance sheet actually exist at balance date and that sales in the income statement actually occurred during the accounting period. Existence or occurrence specific audit objective: The specific objective of verifying that the financial items included in the financial statements should actually be included. Expected population exception (deviation) rate (EPER): Exception rate that the auditor expects (estimates) to find in the population before audit testing begins. Explanatory paragraph:A paragraph inserted in an auditor’s report to explain a matter or to describe the reasons for giving an opinion that is other than unqualified. External document:A document, such as a vendor’s invoice, that has been generated by an outside party to the client’s organization. Fidelity bonds:A form of insurance in which a bonding company agrees to reimburse an employer for losses attributable to theft or embezzlement by bonded employees. Fieldwork standards:One of three categories of the GAAS that deals with the actual conduct of an audit. Financial Accounting Standards Board: The Financial Accounting Standards Board is an independent private body that develops generally accepted accounting principles (GAAP). The board consists of seven members who are assisted by a large research staff and an advisory council. It issues Statements ofFinancial Accounting Standards (SFASs) that are officially recognized by the AICPA. Financial audit:An audit of the financial statements of an organization or segment of the organization. This type of service involves obtaining and evaluating evide nce about a client’sfinancial statements. The AICPA’s GAAP and Auditing Standard Board’s Auditing Standard AU 700 require that auditors of private companies in the United States to provide an opinionthe oncompany’s financial statements. Financial forecasts:Prospective financial statements that present an entity’s expected financial positions, results of operations, and cash flows for future periods, to the best of the responsible party’s knowledge and belief, and given one or more underlying assumptions. Financial i nstruments:A broad category of instruments, usually debt securities but also equity or hedges that represents financial agreements between a party (usually an issuer) and counter-party (usually an investor) based on either underlying assets or agreements to incur financial obligations or make payments. These instruments range in complexity from a simple bond to complicated agreements containing put or options. Financial interest:An ownership interest in equity or a debt security issued by an entity, including rights and obligations to acquire such an interest and derivatives directly related to such interest. A direct financial interest is a financial interest that is owned directly by an auditor, or is under the control of the auditor. An indirect financial interest is a financial interest that is owned by an auditor through an investment vehicle, mutual funds, estate, trust, or other intermediary when the auditor does not control the intermediary nor has authority to supervise or participate in the intermediary’s investment decisions. Financial projections:Prospective financial statements that present an entity’s expected financial positions, results of operations, and cash flows for future periods, to th e best of the responsible party’s knowledge and belief, and given one or more underlying and hypothetical assumptions. Financial reporting framework: A set of criteria used to determine the measurement, recognition, presentation, and disclosure of material items in the financial statements. Financial statement assertions: Expressed or implied representations by management about information that is reflected in the financial statements. The tree sets of assertions relate to ending account balances, transactions, and presentation and disclosure. Flowchart:A diagrammatic representation of the client’s documents and records and the sequence in which they are processed. FOB destination:Shipping contract in which title to the goods passes to the buyer when the goods are received. FOB srcin: Shipping contract in which title to the goods passes to the buyer at the time that the goods are shipped. Foreign Corrupt Practices Act of 1977: A federal statute that makes it illegal to offer a bribe to an official of a foreign country for

the purpose of exerting influence and obtaining or retaining business and that requires U.S. companies to maintain reasonably complete and accurate records and an adequate system of internal control.

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Key Terms Forecasts (in prospective financial statements): Prospective financial statements that present an entity’s expected financial positions, results of operations, and cash flows for future periods, to the best of the responsible party’s knowledge and belief, and

given one or more underlying assumptions. Foreseeable third parties : An unlimited class of users that the auditor should have reasonable been able to foresee as being likely users of financial statements. Foreseen third parties:Members of a limited class of users whom the auditor is aware will rely on the financial statements. Forward contract:A forward contract is an agreement between two parties to buy or sell an asset at a specified point of time in the future. The price of the underlying instrument, in whatever form, is paid before control of the instrument changes. The forward price of such a contract is commonly contrasted with the spot price, which is the price at which the asset changes hands on the spot date. The difference between the spot and the forward price is the forward premium or forward discount, generally considered in the form of a profit, or loss, by the purchasing party. This process is used in financial operations to hedge risk, as a means of speculation, or to allow a party to principles take advantage of a quality the underlying instrument which is time-sensitive. Fundamental underlying an of audit in accordance GAAS: The ASB replaced the ten GAAS with four fundamental

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principles underlying an audit that are grouped into four categories: (1) the purpose and premise of an audit, (2) personal responsibilities of the auditor, (3) auditor actions in performing the audit, and (4) reporting. Futures contract:a futures contract is a standardized contract, to buy or sell a specified commodity of standardized quality at a certain date in the future, at a market determined price (the futures price). The price is determined by the instantaneous equilibrium between the forces of supply and demand among competing buy and sell orders on the exchange at the time of the purchase or sale of the contract. In many cases, the items may be such non-traditional "commodities" as foreign currencies, commercial or government paper (e.g., bonds), or "baskets" of corporate equity ("stock indices") or other financial instruments. They are traded on a futures exchange. Fraud: An intentional misrepresentation of the financial statements by management (also known as fraudulent financial reporting), or theft of assets by employees (also known as employee fraud). Fraud also is referred to as irregularities. Fraud Triangle: A diagrammatic representation of the three factors of fraud: incentives/pressures, opportunities, and attitudes/rationalization. Fraudulent financial reporting (management fraud): Intentional misrepresentations or omissions of amounts or disclosures in financial statements to deceive users. Generally accepted accounting principles (GAAP): Accounting principles that are generally accepted for the preparation of financial statements in the United States. GAAP standards are currently issued primarily by the FASB. Generally accepted auditing standards (GAAS): 10 auditing standards, developed by the AICPA, consisting of general standards, standards of field work, and standards of reporting, which are supported by a set of detailed Statements on Auditing Standards (AUs). General cash account/balance (cash on hand): The primary bank account for most organizations; virtually all cash receipts and disbursements flow through this account at some time. General controls:Controls that surround all parts of the audit client’s information technology function. General standards:One of three categories of the GAAS that deals with the qualification of the auditor conducting an audit and the standard of care expected of those conducting an audit. Generalized audit software (GAS): Computer programs used by auditors that provide data retrieval, data manipulation, and reporting capabilities specifically oriented to the audit process. Goodwill: The excess of the net purchase price for an entity over the sum of the fair market values of specifically identifiable tangible and intangible assets of that entity. Goodwill impairment:The decrease in the value of goodwill. It is measured by comparing the fair value of the reporting entity with the carrying value of that entity. If fair value is less than carrying value (including goodwill), the presumption is that goodwill has been impaired. Goodwill should be written down to an amount that would cause fair value to be no more than carrying value. Government Accountability Office (GAO): Government organization directly accountable to the Congress of the United States that performs special investigations for the Congress and establishes broad standards for the conduct of governmental audits. Government audits: Financial, performance, and attestation engagements of government agencies or government –funded institutions. Government Auditing Standards (GAGAS) (or Yellow Book): A publication of the Government Accountability Office (GAO) that is widely used as a reference by government auditors and CPAs who perform governmental audit work. Gross negligence:Lack of even slight care, indicative of a reckless disregard for one’s professional responsibilities. Horizontal analysis:A technique that involves comparing financial statement amounts and ratios for a particular company from year to year. Hedge fund: A hedge fund is an investment fund open to a limited range of investors that is permitted by regulators to undertake a wider range of investment and trading activities than other investment funds and pays a performance fee to its investment manager. Each fund has its own strategy which determines the type of investments and the methods of investment it undertakes. Hedge funds, as a class, invest in a broad range of investments including shares, debt, commodities and so forth. As the name implies, hedge funds often seek to offset potential losses in the principal markets they invest in by hedging their investments using a variety of methods, most notably short selling. However, the term "hedge fund" has come to be applied to many funds that do not actually hedge their investments, and in particular to funds using short selling and other "hedging" methods to increase rather than reduce risk, with the expectation of increasing return. Hedge funds are typically openonly to a limited range of professional orwealthy investors. This provides them with an exemption in many jurisdictions from regulations governing short selling, derivative contracts, leverage, fee structures and the liquidity of interests in the fund. A hedge fund will typically commit itself to a particular investment strategy, investment types and leverage levels via statements in its offering documentation, thereby giving investors some indication of the nature of the fund. The net asset value of a hedge fund can run into many billions of dollars, and this will usually be multiplied by leverage. Hedge funds dominate certain specialty markets such as trading within derivatives with high-yield ratings and distressed debt. Hedging: Hedging is a finance strategy designed to reduce investment risk using call options, put options, short-selling, or futures contracts. A hedge can help lock in profits. Its purpose is to reduce the volatility of a portfolio by reducing the risk of loss.


Key Terms

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Illegal acts:Violations of laws or governmental regulations. Immediate family member: AICPA defines as a spouse, spousal equivalent, and dependent (whether or not related). PCAOB defines

as a spouse, spousal equivalent (including cohabitant), and dependent (i.e., person who received half or more support). Imprest bank account:A bank account that normally carries a zero balance and is replenished by the company when checks are to be written against the account. The imprest payroll account is one type of imprest bank account. Imprest cash account (petty cash): A fund of cash maintained within the company for small cash acquisitions or to cash employees’ checks; the fund’s fixed balance is comparatively small and is periodically reimbursed. Imprest payroll account:A bank account to which the exact amount of payroll for the pay period is transferred by check or wires transfer from the employer’s general cash account. Income smoothing:A form of earnings management in which revenues and expenses are shifted between periods to reduce fluctuations in earnings. Independenc e (in auditing): Being objective and unbiased while performing auditing services. It requires being independent in fact and in appearance. Independent auditors:Certified public accountants or accounting firm that perform audits of commercial and non-commercial financial entities. Independent in appearance: The auditor’s ability to maintain an unbiased viewpoint in the eyes of others. Independent in fact:The auditor’s ability to maintain anunbiased viewpoint in the performance of professional services. Independent registrar:Outside agent engaged by a corporation to make sure that its stock is issued in accordance with capital stock provisions in the corporate charter and authorizations by the board of directors; required by the SEC for publicly held corporations. Indirect financial interest: An investment in which the specific investment decisions are not under the direct control of the investor, for example, an investment in a professionally managed mutual fund. Information and communication: The set of manual and/or computerized procedures that initiates, records, processes, and reports an entity’s transactions and maintains accountability for the related assets. Inherent risk (IR):The risk of material misstatement of a financial statement assertion, assuming there were no related controls. Inquiry (an audit procedure):Seeking information of knowledgeable persons, both financial and non-financial, throughout the client’s entity or outside the client’s entity. Inquiry of the audit client’s attorney: A letter from the client requesting that legal counsel inform the auditor of pending litigation or any other information involving legal counsel that is relevant to financial statement disclosure. Inspection (an audit procedure): Examination of internal or external records or documents that are in paper form, electronic form, or other media. Inspection (by the PCAOB): A process that leads to an assessment of the degree of compliance of each registered public accounting firm and associated persons of that firm with the SarbanesOxley Act of 2002 and the board’s requirements in connection with its performance of audits, issuance of audit reports, and related matters. Inter-bank transfers schedule: A audit working paper that lists all transfers between client bank accounts starting a short period before year end and continuing for a short period after year end. Interest rate swap:An interest rate swap is a derivative in which one party exchanges a stream of interest payments for another party's stream of cash flows. Interest rate swaps can be used by hedgers to manage their fixed or floating assets and liabilities. They

can also be used by speculators to replicate unfunded bond exposures to profit from changes in interest rates. Integrated audit (in ICFR): As required by the Sarbanes-Oxley Act of 2002 and AS 5 of the Public Company Accounting Oversight Board, an audit that includes providing assurance on both the financial statements and internal control over financial reporting. Integrated audits are required of publicly traded companies in the United States. Integrated test facility: A set of dummy records and files included in an IT system enabling test data to be processed simultaneously with live input. Interim audit (work):Those audit procedures that are performed before the balance sheet date. The purpose is to facilitate earlier issuance of the audit report and to spread the auditors’ work more uniformly over the year. Interim financial information: Refers to financial information or statements covering a period less than a full year for a 12-month period ending on a date other than the entity’s fiscal year end. Internal auditors:Auditors employed by a company to audit for the company’s board of directors and management. Internal control:A process designed to provide reasonable assurance regarding the achievement of management’s objectives in the following categories: (a) reliability of financial reporting, (2) effectiveness and efficiency of operations, and (3) compliance with applicable laws and regulations. Internal control over financial reporting (ICFR): A process designed by, or under the supervision of, the audit client’s principal executive and principal financial officers, or persons performing similar functions, and effected by the audit client’s board directors, of management, and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with GAAP. Internal control over financial reporting (ICFR) audit: An attestation engagement in which the auditor reports on the effectiveness of internal control over financial reporting; such reports are required for public companies under Section 404 of the Sarbanes-Oxley Act and PCAOB Standard No.5. Internal control questionnaire: A series of questions about the controls in each audit area used as a means of indicating to the auditor aspects of internal control that may be inadequate. Internal document:A document, such as a sales invoice, that is generated within the client’s organization. International Federation of Accountants (IFAC): A worldwide organization of national accounting bodies (e.g., AICPA) that fosters a coordinated worldwide accounting profession with harmonized standards. International Auditing and Assurance Standards Board (IAASB): A committee of the International Federation of Accountants,

established to issue standards on auditing and reporting practices to improve the degree of uniformity of auditing practices and related services throughout the world. International Standards on Auditing (ISAs): Statements issued by the International Auditing and Assurance Standards Board (IAASB) of the International Federation of Accountants (IFAC) to promote international acceptance of auditing standards. Interpretations of Rules of Conduct: Guidelines issued by the AICPA for the scope and applicability of specific rules in the Rules of

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Key Terms Conduct. Introductory paragraph:The paragraph of an auditor’s report in which the auditor indicates that s/he has audited the financial statements, that the financial statements are the responsibility of management, and that the auditor’sponsibility res is to form an

opinion. Inventory compilation tests:Audit procedures used to verify whether physical counts of inventory are correctly summarized,

inventory quantities and prices are correctly extended, and extended inventory is correctly footed. Inventory pricing tests: Audit procedures used to verify the costs used to value physical inventory. Iron curtain method (approach): A method (approach) that quantifies the total likely material misstatements as of the current yearend based on the effects of reflecting all material misstatements (including projecting material misstatements where appropriate) existing in the balance sheet at the end of the current year, irrespective of whether the material misstatements occurred in the current year or previous years. For example, if expenses were materially misstated by $20,000 in the previous year and $30,000 during the

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current year, the iron curtain method would quantify the misstatement as $50,000. Also see and compare with rollover method (approach). Issuer (Public or publicly traded company): A company that is permitted to offer its registered securities (stock, bonds, etc.) for sale to the general public, typically through a stock exchange, or occasionally a company whose stock is traded over the counter (OTC) via market makers. Job cost system:System of cost accounting in which costs are accumulated by individual jobs when material is used and labor costs are incurred. Job time ticket (job card): A document designed to accumulate the labor and machine time devoted to a particular production order. Joint and several liability: A legal concept that holds a class of defendants jointly responsible for losses attributed to the class as well as liable for any share of losses that cannot be collected from those unable to pay their share. Thus, a financially responsible defendant may be required to pay losses attributed to defendants that do not have the ability to pay. Kiting: The transfer of money from one bank to another and improperly recording the transfer so that the amount is recorded as an asset in both accounts; this practice is used by embezzlers to cover theft of cash. Lack of duty to perform: An auditor’s legal defense under which the au ditor claims that no contract existed with the client; therefore,

no duty existed to perform the disputed service. Lapping (of accounts receivable): The postponement of accounting entries for the collection of receivables to conceal an existing theft of cash. Lawyer representation letter: The auditor sent a client’s inquiry of lawyer letter to a client’s lawyer requesting a description and evaluation of pending or threatened litigation, unasserted claims, and other loss contingencies. The returned letter romf the client’s lawyer is referred to as the lawyer representation letter. Lead schedule:An audit schedule (working paper) with columnar headings similar to those in a client’s working trial balance, set up to combine similar ledger accounts, the total of which appears in the working trial balance as a single amount. Letter of credit:A binding document that a buyer requests from his/her bank in order to guarantee that the payment for goods will be transferred to the seller. Basically, a letter of credit gives the seller reassurance that s/he will receive the payment for the goods. In order for the payment to occur, the seller has to present the bank with the necessary shipping documents confirming the shipment of goods within a given time frame. It is often used in international trade to eliminate risks such as unfamiliarity with the foreign country, customs, or political instability. Leverage (Gearing):leverage is borrowing money to supplement existing funds for investment in such a way that the potential positive or negative outcome is magnified and/or enhanced. It generally refers to using borrowed funds, or debt, so as to attempt to increase the returns to equity. Local area networks (LANs):Networks that connect computer equipment, data files, software, and peripheral equipment within a local area, such as a single building or a cluster of buildings, for intra-company use. Lockbox (system):A post office box controlled by an audit client’s bank at which cash remittances from the client’s customers are received. The bank picks up the remittances, immediately credits the cash to the client’s bank account, and forwards thettance remi advices to the company. Major federal financial assistance program (award): A significant federal assistance program as determined by the auditors based on a risk-based approach. In a single audit, the auditors must provide an opinion on compliance related to major programs. Management assertions:Implicit or explicit representations made by management about classes of transactions, related account balances, and presentation and disclosures in the financial statements. Management integrity:The honesty and trustworthiness of management as exemplified by past and current actions. The auditor assesses the extent to which they can trust management and its representations to be honest and forthright. Management representation (in ICFR): A written representation from an audit client’s management related to the audit of ICFR. It includes statements such as management did not rely on work performed by the audit in forming its assessment of the effectiveness of ICFR; management has disclosed to the auditor all deficiencies in the design or operation of ICFR, and so on. Management representation letter: prepared by officers of the client company at the auditors’ A single letter or separate etters l request setting forth certain representations about the company’s financial position or operations. Management’s discussion and analysis (MD&A): Management’s discussion of a company’s opera ting results, liquidity, and financial position that is required in the regular financial statement filings with the SEC. An auditor may audit MD&A under an audit of specified elements, accounts or items, or review MD&A under a review of interim financial information. Material: Of substantial importance. Significant enough to affect evaluations or decisions by users of financial statements. Information that should be disclosed so that financial statements constitute a fair presentation. Involves both qualitative and quantitative considerations. Material requisition (in inventory cycle): A document that authorizes the release of raw materials for production and updates the raw materials perpetual inventory records. Materiality:The magnitude of an omission or misstatement of accounting information that, in the light of surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information would have been changed or influenced by the


Key Terms omission or misstatement. Alternatively, a common definition of materiality is that a misstatement in the financial statements can be considered material if knowledge of the misstatement will affect a decision of a reasonable user of the financial statements. Material misstatement:A misstatement in the financial statements, knowledge of which would affect a decision of a reasonable user of the statements. Material weakness (in ICFR):A control deficiency, or a combination of significant control deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the company’s annual orrim inte financial statements will not be prevented or detected on a timely basis. Maximum population exception rate (MPER): The upper limit of exception (the highest except rate) in the population at a given acceptable risk of overreliance (ARO). Mean-per-unit estimation:A classical variables sampling plan enabling the auditors to estimate the average dollar value (or other variable) of items in a population by determining the average value of items in a sample. Minutes: A formal record of the issues discussed actions the taken in of meetings of stockholders or the board of directors. Misappropriation of assets (defalcations): theft an entity’s assets. A fraudand involving Misstatement:An instance where a financial statement assertion s not n accordance with the criteria against which it is audited.

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Misstatements may be classified as fraud (intentional), errors (unintentional), and other illegal acts such as noncompliance with laws and regulations (intentional or unintentional). Monetary unit sampling (MUS): A statistical sampling technique that provides upper and lower misstatement bounds expressed in monetary amounts; also known as dollar unit sampling, cumulative monetary amount sampling, and sampling with probability proportional to size. Monitoring: Management’s ongoing and periodic assessments of the quality of internal control performance to determine that controls are operating as intended and are modified when needed. Narrative description:A written description of a client’s internal controls, including the srcin, processing, and disposition of documents and records, and the relevant control procedures. Negative confirmation:A request addressed to the debtor/creditor, requesting a response only if the recipient disagrees with the amount of the stated account balance. Negative goodwill:In a business combination, negative goodwill is accounted for under the purchase accounting method when the fair market value of the net assets of the acquired company exceeds the purchase price paid. Negative (limited) assurance (opinion): A statement (opinion) of what the auditor does not know for sure as opposed to what the auditor does know for sure (positive assurance). For example, a statement (opinion) that the auditor was "not aware of material modifications that should be made to financial statements for them to conform with the U.S. generally accepted accounting principles" is a negative assurance used in a review of financial statements service. Negligence:Failure to exercise reasonable care, thereby causing harm to another person or to a property. Non-issuer (Non-public company): A company other than one whose securities are traded on a public market or one that makes a filing with a regulatory agency in preparation for the sale of securities on a public market. Non-negligent performanceAn : auditor’s legal defense under which the auditor claims that the audit was perfor med in accordance with auditing standards. Non-public company (Non-issuer): A company other than one whose securities are traded on a public market or one that makes a filing with a regulatory agency in preparation for the sale of securities on a public market. Non-routine transaction: A transaction that occurs only periodically, such as counting and pricing inventory, calculating depreciation expense, or determining prepaid expenses. Non-sampling risk:The risk that the auditor fails to identify existing exceptions in the sample. It is caused by either the auditor fails to recognize exception or fails to apply appropriate or effective audit testing procedures. Non-statistical sampling:The auditor uses professional judgment to select the sample items, estimate the population attributes or values, and estimate the sampling risk. Note payable:A legal obligation to a creditor, which may be unsecured or secured by assets. Observation (an audit procedureThe ): process of watching a process or procedure being performed by others. Off balance sheet:Off balance sheet means an asset or debt or financing activity not on the company's balance sheet. It could involve a lease or a separate subsidiary or a contingent liability such as a letter of credit. It also involves loan commitments, futures, forwards and other derivatives. Financial institutions often offer asset management or brokerage services to their clients. The assets in question (often securities) usually belong to the individual clients directly or in trust, while the company may provide management, depository or other services to the client. The company itself has no direct claim to the assets, and usually has some basic fiduciary duties with respect to the client. Financial institutions may report off-balance sheet items in their financial statements, and may also refer to "assets under management," a figure that may include on and offbalance sheet items. The AICPA’s accounting standard determines that an item should appear on the company's balance sheet if it is an asset or liability formally owned by or legally responsible for; uncertain assets or liabilities must also meet tests of being probable , measurable and meaningful. For example, a company that is being sued for damages would not include the potential legal liability on its balance sheet until a legal judgment against it is likely and the amount of the judgment can be estimated; if the amount at risk is small, it may not appear on the company's accounts until a judgment is rendered. Off-the-shelf software : Commercially available software created for a variety of users in the same industry or with the same application. Operating lease:An operating lease is a lease whose term is short compared to the useful life of the asset or piece of equipment (an aircraft, a ship etc.) being leased. An operating lease is commonly used to acquire equipment on a relatively short-term basis. Thus, for example, an aircraft which has an economic life of 25 years may be leased to an airline for 5 years on an operating lease. An operating lease is recorded as rent expense over the lease term in the income statement by the lessee. The determination of whether a lease is a capital (finance) lease or an operating lease is defined in the United States by Statement of Financial Accounting Standards SFAS No. 13. Operational audit:A review of any part of a client’s operating procedures and methods for the purpose of evaluating efficiency and effectiveness. The terms management audit, performance audit, operational audit, and efficiency and effectiveness audit are often

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Key Terms synonymous terms. Opinion paragraph:The paragraph of an auditor’s report that communicated the degree of responsibility that the auditors are taking

for the financial statements. Options: The right, but not the obligation, to buy (for a call option) or sell (for a put option) a specific amount of a given stock, commodity, currency, index, or debt, at a specified price (the strike price) during a specified period of time. For stock options, the amount is usually 100 shares. Each option has a buyer, called the holder, and a seller, known as the writer. If the option contract is exercised, the writer is responsible for fulfilling the terms of the contract by delivering the shares to the appropriate party. In the case of a security that cannot be delivered such as an index, the contract is settled in cash. For the holder, the potential loss is limited to the price paid to acquire the option. When an option is not exercised, it expires. No shares change hands and the money spent to purchase the option is lost. For the buyer, the upside is unlimited. Options, like stocks, are therefore said to have an asymmetrical payoff pattern. For the writer, the potential loss is unlimited unless the contract is covered, meaning that the writer already owns the security

P

underlying option. Options most frequently as shares either would leverage or protection. As leverage, optionselsewhere allow theuntil holder control equity in a the limited capacity for are a fraction of what the cost. The difference can be invested thetooption is exercised. As protection, options can guard against price fluctuations in the near term because they provide the right acquire the underlying stock at a fixed price for a limited time. Ordinary negligence:Violation of a legal duty to exercise a degree of care that an ordinarily prudent person would exercise under similar circumstances. Other comprehensive basis of accounting: Financial statements prepared under regulatory, tax, cash basis, or other definitive criteria having substantial support. Parallel simulation:An audit testing approach that involves the auditor’s use of audit software, either purchased or programmed by the auditor, to replicate so me pare of a client’s application softwares. Payroll master file:A computer file for recording each payroll transaction for each employee and maintaining total employee wages paid and related data for the year to date. Peer review:The review by CPAs ofa CPA firm’s compliance with its quality control system. Periodic inventory system:A system of accounting (usually a manual system) for inventories that does not require a day-to-day record of inventory changes. Costs of materials used and costs of goods sold cannot be calculated until ending inventories, determined by physical count, are subtracted from the sum of opening inventories and purchases (or costs of goods manufactured in the case of a manufacturer). The ending inventories are determined solely by means of a physical inventory count at the end of the accounting period. Permanent files:Auditor’s files that contain data of a historical or continuing nature pertinent to the current audit such as copies of articles of incorporation, bylaws, bond indentures, and contracts. Perpetual inventory system:A system of accounting (usually a computer system) for inventories in which a perpetual inventory master file is used to continuously update computerized record of inventory items purchase, used, sold, and on hand for merchandise, raw materials, and finished goods. The accuracy of the ending inventories is determined periodically by physical count of inventories. Perpetual inventory master file: A continuously updated computerized record of inventory items purchased, used, sold, and on hand for merchandise, raw materials, and finished goods. Persuasiveness of evidence:The degree to which the auditor is convinced that the evidence supports the audit opinion; the two determinants of persuasiveness are the appropriateness and sufficiency of the evidence. Phases of the audit process: The five aspects of a complete audit: (1) audit plan, (2) tests of controls (TOC), (3) tests of balances (TOB), (4) Completing the audit (CTA), and (5) audit report. Physical evidence:Evidence derived by the auditors from physical examination. Plaintiff:The party claiming damages and bringing suit against the defendant. Pledging (of receivables):To assign to a bank, factor, finance company, or other lender an exclusive claim against accounts receivable as security (collateral) for a debt. Positive confirmation:A request addressed to the debtor/creditor, requesting that the recipient indicate that the recipient indicates directly on the request whether the stated account balance is correct or incorrect and, if incorrect, by what amount. Precedent: A legal principle that evolves from a common law court decision and then serves as a standard for future decisions in similar cases. Predecessor auditors:A CPA firm that formerly served as auditor but has resigned from the engagement or has been notified that its services have been terminated. Preferred stock (Preference share): Capital stock which provides a specific dividend that is paid before any dividends are paid to common stock holders, and which takes precedence over common stock in the event of a bankruptcy or liquidation. Like common stock, preferred stocks represent partial ownership in a company, although preferred stock shareholders do not enjoy any of the voting rights of common stockholders. Also unlike common stock, a preferred stock pays a fixed dividend that does not fluctuate, although the company does not have to pay this dividend if it lacks the financial ability to do so. In general, there are four different types of preferred stock: cumulative preferred, non-cumulative, participating, and convertible. Preliminary judgment about materiality (PJAM): The maximum amount by which the auditor believes that the financial statements, taken as whole, could be misstated and still not affect the decision of reasonable users of the financial statements. Presentation and disclosure assertion: Implicit or explicit assertion made by the management that all components of the financial statements are properly classified, described, and disclosed in conformity with GAAP. For example, management asserts that amounts presented as extraordinary items in the income statement are properly classified and described. Presentation-related information assertions/objectives Assertions : (objectives) about presentation and disclosure. Primarily (third-party) beneficiary: A person who was not a party to a contract but is named in the contract as one to whom the contracting parties intended that primary benefits be given. Principal auditor:Auditor who uses the work and reports of other independent auditors who have audited the financial statements of one or more subsidiaries, branches, or other segments of the principal auditor’s client. Ordinarily, the principal auditor ditsauat the client’s headquarter. Principles (in CPC):The part of the AICPA Code of Professional Conduct that presses ex that profession’s responsibilities to the


Key Terms public, clients, and colleagues and provides a framework for the Rules of Conduct. Private (privately held) company (non-issuer): A company whose shares are not traded on the open market as opposite to a public (publicly traded) company. Private Securities Litigation Reform Act of 1995: A federal law passed in 1995 that significantly reduced potential damages in securities-related litigation. Privileged information:Client information that the professional cannot be legally required to provide; information that an auditor obtains from a client is confidential but not privileged. Privity: A relation between parties that is held to be sufficiently close and direct to support a legal claim on behalf of or against another person with whom this relation exists. Privity of contract:Privity of contract is the relationship that exists between two or more parties to an agreement. Process cost system:System of cost accounting in which costs are accumulated for a process, with unit costs for each process assigned to theEthics products passing through the process. Professional Executive Committee (PEEC): The Professional Ethics Executive Committee (PEEC) enforces the Code of Professional Conduct (CPC) and interprets Rules of Conduct. Professional judgment:The application of relevant training, knowledge, and experience in making informed decisions about appropriate course of action during an audit engagement. Professional skepticism:an attitude of the auditor that includes a questioning mind and a critical assessment of audit evidence. Program audit:A government audit to determine the extent to which the desired results or benefits established by the legislature or other authorizing body are being achieved; the effectiveness of organizations, programs, activities, or functions; and whether the entity has complied with laws and regulations applicable to the program. Projected misstatement:An estimate of the most likely amount of monetary misstatement in a population. Projections (in prospective financial statements): Prospective financial statements that present an entity’s expected financial positions, results of operations, and cash flows for future riods, pe to the best of the responsible party’s knowledge and belief, and given one ormore underlying and hypothetical assumptions. Proof of cash:A four-column audit schedule prepared by the auditor to reconcile the bank’s record of the audit client’sginning be balance, cash deposits, cleared checks, and ending balance for the period with the audit client’s records. Proof of cash receipts:An audit procedure to test whether all recorded cash receipts have been deposited in the bank account by reconciling the total cash receipts recorded in the cash receipts journal for a given period with the actual deposits made to the bank. Proportionate liability: A method of allocating damages to each group that is liable according to that group’s pro rata share of any damages recovered by the plaintiff. Prospective financial statements: Financial statements that deal with expected future data rather than with historical data. Ordinarily, it consists of either financial forecasts or projections. Prospectus:The first part of a registration statement filed with the SEC, issued as part of a public offering of debt or equity and used to solicit prospective investors in a new security issue containing, among other items, audited financial statements. The Securities Act of 1933 imposes liability for misstatements in a prospectus. Proximate cause:Damage to another is directly attributable to a wrongdoer’s act. The issue of proximate cause may be raised as a defense by a CPA. For example, A CPA might have been negligent in rendering services, but s/he will not be liable for the intiff’s pla

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loss if his/her negligence was not the proximate cause of the loss. Prudent person concept:The legal concept that a person has a duty to exercise reasonable care and diligence in the performance of obligations to another person. Public (publicly traded) company (Issuer): A company that is permitted to offer its registered securities (stock, bonds, etc.) for sale to the general public, typically through a stock exchange, or occasionally a company whose stock is traded over the counter (OTC) via market makers. Public Company Accounting Oversight Board (PCAOB): Board created by the Sarbanes-Oxley Act to oversee auditors of public companies, including establishing auditing and quality control standards and performing inspections of registered accounting firms. PCAOB standards:Standards regarding the conduct of financial statements for public companies. Currently consist primarily of standards and statements established by the AS, as these statements and standards were adopted by the PCAOB in 2003 on an interim basis, though the PCAOB has added some significant standards. Purchase order:A document prepared by the purchasing department indicating the description, quantity, and related information for goods and services that the company intends to purchase. Purchase requisition (in expenditure cycle): Request by an authorized employee to the purchasing department to place an order for inventory and other items used by an entity. It may be documented on paper or in a computer system. Qualified opinion (report): A report issued when the auditor believes that the overall financial statements are fairly stated but that either the scope of the audit was limited or the financial data indicated a failure to follow GAAP. Quality control:Methods and procedures used by a CPA firm to ensure that the firm meets its professional responsibilities to clients and others. Quality control standards:AICPA standards for establishing quality control policies and procedures that provide reasonable assurance that all of a CPA firm’s engagements are conducted in accordance with applica ble professional standards. Quality Control Standards Committee: The Quality Control Standards Committee monitors a peer (or quality) review program among the CPA firms. Every three years, members of the CPA Firms Division must subject their practice to a Peer (or Quality) Review Program. Questioned costs: Those costs paid with federal assistance that appears to be in violation of a law or regulation inadequately documented, unnecessary, or unreasonable in amount. Random number table:A listing of independent random digits conveniently arranged in tabular form to facilitate the selection of

random numbers with multiple digits. Ratio estimation:A sampling plan that uses the ratio of audited (correct) values to book values of items in the sample to calculate the estimated total audited value of the population. Ratio estimation is used in lieu of difference estimation when the differences are nearly proportional to book values.

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Key Terms Reasonable assurance:The concept that an audit performed in accordance with auditing standards may fail to detect a material misstatement in a client’s financial statements. Reasonable possibility (in ICFR): A reasonable possibility exists when the likelihood of a control deficiency is either “reasonable possible” or “probable” as those terms are used in Financial Accounting Standards Board Statement No.5, Accounting for

Contingencies (FASB No.5). Re-calculation (re-computation): An audit procedure that determines the mathematical accuracy of documents or records. Receiving report: A document prepared by the receiving department at the time tangible goods are received, indicating the

description of the goods, the quantity received, the date received, and other relevant data; it is part of the documentation necessary for payment to be made. Recipient (in government audit): An organization receiving federal assistance directly from the federal agency administering the program. Reclassification journal entry (RJE): of the client’s A transfer workingaccounts paper entry draftedcredit by the auditors presentation theofclient’s financial statements, such as an entry to receivable balances to to theassure currentfair liabilities section balance sheet. Since reclassification entries do not correct misstatements in the client company’s ac counting records, they are not posted to the client’s ledger accounts. Referral fee (in ethics):Fees received or paid for referring business or service to an attestation client, which is allowed by the Code of Professional Conduct, but the auditor must disclose such acceptance or payment to the client. Registered public accounting firm: A public accounting firm registered with the PCAOB in accordance with the Sarbanes-Oxley Act of 2002. Any CPA firm auditing SEC reporting companies must be registered. Registration statement:A document including audited financial statements that must be filed with the SEC by any company in order to sell its securities to the public through the mails or interstate commerce. The Securities Act of 1933 provides liability to security purchasers for material misrepresentations in registration statements. Related party:Affiliate company, principal owner of the client company, or any other party with which the client deals, where one of the parties can influence the management or operating policies of the other. Related party transaction: A transaction in which one party has the ability to influence significantly the management or operating policies of the other party, to the extent that one of the transacting parties might be prevented from pursuing fully its own separate interests. Relevant assertions:Assertions that have a meaningful bearing on whether an account balance, class of transaction, or disclosure is fairly stated. For example, valuation may not be relevant to the cash account unless currency translation is involved; however, existence and completeness are always relevant. Relevant assertions (in ICFR):A financial statement assertion that has a reasonable possibility of containing a misstatement or misstatements that would cause the financial statements to be materially misstated. Relevance of evidence : Whether evidence relates to assertions being tested. Reliability of evidence:The diagnosticity of evidence; that is, whether the type of evidence can be relied on to signal the true state of the assertion being tested. Re-performance (an audit procedure): The auditor’s independent execution of procedures or controls that were srcinally performed as part of the client’s internal control, either manually or through the use of computer-assisted audit techniques. Report on internal control over financial reporting (prepared by auditors): Report that expresses an opinion on the effectiveness of the entity’s internal control over financial reporting. Report on internal control over fi nancial reporting (prepared by management): Report that describes the process through which management assesses its internal control over financial reporting and that provides management’s conclusion with respect to the

effectiveness of its internal control over financial reporting. Reporting standards:One of three categories of the GAAS that deals with the nature of the audit’s report and required communication. Reporting unit (for goodwill impairment): A reporting unit is an operating unit that (1) provides separate accounting; (2) is managed as a separate segment; or (3) could be easily separated from the company, such as by a sale of the segment. Representative sample:A sample with characteristics the same as those of the population. Review: An attestation engagement that results in a negative assura nce as to the CPA’s awareness of any information indicating that the assertions are not presented in conformity with the applicable criteria. Review of financial statements (SSARS review): A review of unaudited financial statements designed to provide limited assurance that no material modifications need be made to the statements in order for them to be in conformity with generally accepted accounting principles or, if applicable, with another comprehensive basis of accounting. Review of interim financial statements: Reviews of interim, unaudited financial information performed to help public companies meet their reporting responsibilities to regulatory agencies. Review of subsequent events: The audit procedures performed by auditors to identify and evaluate subsequent events. Revised judgment about materiality (RJAM): A change in the auditor’s preliminary judgment about materiality made when the auditor determines that the preliminary judgment about materiality was too large or too small. Rights and obligations assertion: Implicit or explicit assertion made by the management that assets stated in the financial statements are actually owned by the client and liabilities stated in the financial statements are actually owed by the client. For example, management asserts that inventories are owned by the company and that accounts payable are owed to other parties. Risk analysis approach (in auditing): An audit approach that begins with an assessment of the types and likelihood of misstatements in account balances and then adjusts the amount and type of audit work to the likelihood of material misstatements occurring in account balances. Risk assessment:Management’s identification and analysis of risks relevant to the preparation of financial statements in accordance

with generally accepted accounting principles. Rollover method (approach): A method (approach) that quantifies the total likely material misstatements as of the current year-end based on the effects of reflecting misstatements (including projecting material misstatements where appropriate) only during the current year. For example, if expenses were materially misstated by $20,000 in the previous year, and $30,000 during the current year, the rollover method would quantify the misstatement as $30,000, ignoring the vious pre year’s misstatement. Also see and compare


Key Terms

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with iron curtain method (approach). Routine transaction:A transaction for a recurring financial activity recorded in the accounting records in the normal course of business, such as sales, purchases, cash receipts, cash disbursements, and payroll. Rules of conduct:Detailed guidance to assist the CPA in applying the broad principles contained in the Code of Professional Conduct (CPC); the rules have evolved over time as members of the profession have encountered specific ethical dilemmas in complying with the principles of the CPC. Safeguarding of assets (a control activity): Those policies and procedures that provide reasonable assurance regarding prevention or timely detection of unauthorizedacquisition, use, or disposition of the audit client’s assets that could have a material effect on the financial statements. Sample exception rate (SER): Number of exceptions in the sample divided by the sample size. Sampling risk:The risk of reaching an incorrect conclusion inherent in tests of less than the entire population because the sample is not representative the population. Sampling risk may be reduced by using an increased sample sizeor a more appropriate method of selecting sampleofitems from the population. Sampling unit:The individual member of the population being sampled. Sarbanes-Oxley Act of 2002: A federal securities law passed in 2002 that provides for additional regulation of public companies and their auditors; the Act established the Public Company Accounting Oversight Board (PCAOB) and requires auditors to attest to management reports on the effectiveness of internal control over financial reporting (ICFR). See Section 404. Scaling the audit:In an integrated audit of ICFR, the auditor takes into consideration the size and complexity of the client, its business processes, and business units that affect the way in which the client achieves effective internal control objectives. Scanning: Reviewing accounting data to identify significant or unusual items; including the identification of anomalous individual items within account balances or other client data through the scanning or analysis of entries in transaction listings, subsidiary ledgers, general ledger control accounts , adjusting entries, suspense accounts, reconciliations, and other detailed reports. Scienter:Intent to deceive, manipulate, or defraud. The U.S. Supreme Court held in the Ernst & Ernst v Hochfelder case that scienter must be proved for the auditors to be held liable under the Securities Exchange Act of 1934. Scope limitation:A restriction that prevents the auditor from being able to apply all of the audit procedures that s/he considers necessary under the circumstances. Scope limitations may be client imposed or may be imposed by other circumstances. Scope paragraph: The paragraph of an auditor’s report in which the auditor describes the characteristics of the audit tests. Second Restatement of the Law of Torts: A summary of tort liability, which when applied to auditor common law liability, expands audits’ liability for ordinary negligence to include third parties of a limited class of known or intended users of the ed audit financial statements. Section 404 (of Sarbanes-Oxley Act of 2002): The primary section of the Sarbanes-Oxley Act dealing with management and auditor reporting on internal control over financial reporting. Section 404(a) requires that each annual report filed with the SEC includes an internal control report prepared by management in which management acknowledges its responsibility for establishing and maintaining adequate internal control and an assessment of internal control effectiveness as of the end of the most recent fiscal year. Section 404(b) requires that the auditor attest to and report internal control. Securities Act of 1933:A federal statute dealing with companies that register and sell securities to the public; under the statute, third parties who are srcinal purchasers of securities may recover damages from the auditor if the financial statements are misstated, unless the auditor proves that the audit was performed with “due diligent” or that the third party’s loss was caused by factorsr othe than misleading financial statements. Securities Exchange Act of 1934: A federal statute dealing with companies that trade securities on national and over-the counter exchanges; auditors are involved because the annual reporting requirements include audited financial statements. The act requires auditors to “act in good faith” and createsivil c and criminal penalties for misrepresentation. Securities and Exchange Commission (SEC): A federal agency that oversees the orderly conduct of the securities markets; the SEC assists in providing investors in public corporations with reliable information upon which to make investment decisions. Separation (segregation) of duties: Separation of the following activities in an organization: (1) custody of assets from accounting, (2) authorization from custody of assets, (3) operational responsibility from record keeping, and (4) IT duties from outside users of IT. Sequential (stop-or-go) sampling: An audit sampling technique in which the sample is selected in stages, with the need for each subsequent stage being conditional on the results of the previous stage. Service organization:An organization or segment of it that provides services to user entities that are likely to be relevant to user entities’ internal control as it related to financial reporting. Shared opinion report (report involving other auditors): An auditor’s report ni which the principal auditor decides to share responsibility with other auditors who have audited some parts (subsidiaries, branches, or segments) of the same audit client. The sharing of responsibility is done by making reference to the other auditors’ork. w Shareholders’ capital stock master file: A record of the issuance and repurchase of capital stock for the life of a corporation. See also Capital stock certificate record. Short selling (Short sales): Short selling or "shorting" is the practice of selling a financial instrument that the seller does not own at the time of the sale. Short selling is done with the intent of later purchasing the financial instrument at a lower price. Short-sellers attempt to profit from an expected decline in the price of a financial instrument. Short selling or "going short" is contrasted with the more conventional practice of "going long", which typically occurs when a financial instrument is purchased with the expectation that its price will rise. Thus, being "long" is just a way of saying that one owns a positive number of the securities; being "short" is just a way of saying that one owns a negative number of the securities. Typically, the short-seller will "borrow" or "rent" the securities to be sold, and later repurchase identical securities for return to the lender. If the security price falls, the short-seller profits from having sold the borrowed securities for more than he later pays for them. However, if the security price rises, the short seller loses by having sold

them for less than the price at which he later has to buy them. The practice is risky in that prices may rise without bound, even beyond the net worth of the short seller. The act of repurchasing a shorted security is known as "closing" or "covering" a position. Significant account or disclosure (in ICFR): An account or disclosure is significant if there is a reasonable possibility that it could contain misstatements that individually, or when aggregated with others, could have a material effect on the financial statements. Significant deficiency (in internal control): A control deficiency, or a combination of control deficiencies, in internal control over

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Key Terms financial reporting that is less severe than a material weakness, yet important enough to merit attention by those responsible for oversight of the company’s financial reporting. Single Audit Act:Federal legislation that provides for a single coordinated audit to satisfy the audit requirements of all federal funding agencies. Sinking fund:A fund into which a company sets aside money over time, in order to retire its preferred stock, bonds or debentures. In the case of bonds, incremental payments into the sinking fund can soften the financial impact at maturity. Investors prefer bonds and debentures backed by sinking funds because there is less risk of a default. Specialist (expert):A person or firm possessing special skill or knowledge in a field other than accounting or auditing, such as an actuary. The auditor engages a specialist to provide evidential matter. For example, a valuation specialist may be engaged by the auditor to determine the fair values of intangible assets. S-1 review: Procedures carried out by auditors at the client’s facilities on or as close as practicable to the effective ated of a registrationbank statement filed under the Securities Act of 1933. form sent to all banks with which the client had business during the year Standard confirmation: A standard bank confirmation to obtain information about the year-end bank balance and additional information about loan outstanding. Standard bank confirmation form: A form approved by the AICPA and American Bankers Association through which the bank responds to the auditor about bank balance and loan information provided on the confirmation. Standard costs:Costs assigned to products based on expected costs, which may differ from actual costs. Standard cost records:Records that indicate variances between projected material, labor, and overhead costs and the actual costs. Standard audit report:The “standard wording” of an unqualified auditor’s report, not including such modifications as emphasis of a matter, substantial doubt about going-concern, lack of consistency in applying GAAP, or a shared opinion audit report. Standard unqualified opinion (report) (unqualified opinion): A report issued when the auditor believes that the overall financial statements are fairly stated in accordance with GAAP and that all auditing conditions have been met and no material misstatements have been discovered or left uncorrected. State Board of Accountancy: Each state has a State Board of Accountancy. A State Board of Accountancy usually consists of five to seven CPAs and at least one public member, who are generally appointed by the governor of each state. The State Board of Accountancy works independently of the AICPA andthe State Society (or Association) of CPAs. It issues, renews, suspends or revokes a CPA's licenses to practice. Statements on Auditing Standards (AUs): Pronouncements issued by the AICPA to interpret generally accepted auditing standards. Statements on Standards for Accounting and Review Services (SSARS): Standards issued by the AICPA Accounting and Review Services Committee that govern the CPA’s associa tion with unaudited financial statements of nonpublic companies. Statements on Standards for Attestation Engagements (SSAE): Statements issued by the AICPA to provide a conceptual framework for various types of attestation services. Statistical sampling:The auditor uses the laws of probability to calculate formal statistical results and quantify sampling risk. Statutory law:Written law created by state or federal legislative bodies, such as the Sarbanes-Oxley Act of 2002. Stock certificate book:A book of serially numbered certificates with attached stubs. Each stub shows the corresponding certificate number and provides space for entering the number of shares represented by the certificate, the name of the shareholder, and the serial number of the certificate surrendered in exchange for the new one. Surrendered certificates are canceled and replaced in the certificate book.

Stock option:An option in which the underlier is the common stock of a corporation, giving the holder the right to buy or sell its

stock, at a specified price, by a specific date. Stock option re-pricing:The exchanging of newly issued incentive stock options priced at the current market price for previously granted options that are out-of-themoney (or “under water”). Re -pricing rewards managers of companies with stock prices that have declined. issuance of a corporation’s stock. Every Stock registrar:An independent institution charged with responsibility for avoiding overnew certificate must be presented to the registrar for examination and registration before it is issued to a stockholder. Stock transfer agent:Outside agent engaged by a corporation to maintain the stockholder records and to disburse cash dividends. Stratification:Dividing a population into two or more relatively homogeneous subgroups (strata). Stratification increases the efficiency of most sampling plans by reducing the variability of items in each stratum. The sample size necessary to evaluate the strata separately is smaller than would be needed to evaluate the total population. Subrecipient (in government audit): An organization receiving federal financial assistance passed through from a recipient. Subsequent discovery of facts: Auditor discovery that the financial statements are materially misstated after the audit report issue date. Subsequent events:Transactions and other pertinent events that occurred after the balance sheet date that affect the fair presentation of disclosure of the financial statements being audited. Subsequent period:The time extending from the balance sheet date to the date of the auditor’s report date and the auditor’s report issue date. Substantive tests: Procedures performed by the auditor to detect material monetary misstatements in account balances and disclosures. Substantive tests of transactions: Procedures performed by the auditor to detect material monetary misstatements in classes of transactions and disclosures. Successor auditors:The auditors who have accepted an engagement or who have been invited to make a proposal for an engagement to replace the CPA firm that formerly served as auditor. Sufficient audit evidence: Sufficient audit evidence is a measure of the quantity of the evidence required. Systematic sample selection:A probabilistic method of sample selection in which the auditor calculates a sample interval (the

population size divided by the sample size) and selects the items for the sample based on the size of the interval and a randomly selected starting point between zero and the length of the interval. SysTrust: An attestation service designed to provide reasonable assurance that a company’s computer system complies with Trust Services principles and criteria.


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Tagging and tracing:A technique for testing programmed control activities in which selected transactions are tagged when they are

entered for processing. A computer program provides a printout of the steps in processing the tagged transactions that may be reviewed by the auditors. Test data:A method of auditing an information technology system that uses the auditor’s test data to determine whether the client’s computer program correctly processes valid and invalid transactions. Tests of (details of) balances (TOB) (substantive tests): Procedures performed by the auditor to detect material monetary misstatements in account balances, classes of transactions and disclosures. It is also known as substantive tests of transactions. Tests of controls (TOC): Procedures performed by the auditor to detect the effectiveness of internal controls in support of an assessed control risk. Third-party beneficiary: A person, not the auditors or their client, who is named in a contract (or known to the contracting parties) with the intention that such person should have definite rights and benefits under the contract. Those charged governance: The of person(s) with responsibility for the overseeing strategic the entity and its obligations relatedwith to the accountability the entity, including overseeing financial the reporting and direction disclosureofprocess. Threats (to independence):Circumstances that could impair independence. The AICPA categorizes seven types of threats- selfreview, advocacy, adverse interest, familiarity, undue influence, financial self-interest, and management participation. Tick mark: A symbol used in working papers by the auditor to indicate a specific step in the audit work performed. Whenever tick mars are used, they should be accompanied by a legend explaining their meaning. Time budget:An estimate of the time required to perform each step in the audit. Time card:A document indicating the time that the employee started and stopped working each day and the number of hours worked. Timing different:A reported difference in a confirmation from a debtor that is determined to be a timing difference between the client’s and debtor’s/creditor’s records and therefore not a misstatement. For example,-transit in shipments or payments. Tolerable exception (deviation) rate (TER): The exception rate that the auditor will tolerate (permit) in the population and still be willing to conclude the control is operating effectively or the amount of monetary misstatements in the balances/transactions is acceptable (also see tolerable misstatement, TM). Tolerable misstatement (TM): The materiality allocated to any given account balance/transaction used in audit planning. Top-down approach (in ICFR): a Top-Down approach starts at the top, the financial statements elements and entity-level controls, and links the financial statement elements and entity-level controls to significant accounts, relevant assertions, and to the major classes of transactions. Tort: A civil wrong. For financial statements audits, the primary tort involved is that of performing the engagement negligently. Tracing:An audit procedure where recorded transactions or amounts are examined to support documentations. Transaction cycle:The sequence of procedures applied by the client in processing a particular type of recurring transaction. The term cycle reflects the concept that the same sequence of procedures applied is to each similar transaction. Ordinarily, an audit clients’ transactions are organized around six major transactions cycles from revenue cycle to general cash and investments. Transaction cycle approach (in auditing): An audit approach that begins with an assessment of controls within each transaction cycle of the client to determine the amount and type of audit work for TOC and TOB. Transaction-related information assertions/objective s: Assertions (objectives) about classes of transactions and events during the period under audit. Treasury stock:Shares of its own stock acquired back by a corporation for the purpose of being reissued at a later date. Trust indenture:The formal agreement between bondholders and the issuer as to the terms of the debt. Trust Services:Engagements that provide assurance on systems. Trust Services provide assurance on one or more of the following

U

V

Trust Principles: (a) security, (b) availability, (c) processing integrity, (d) online privacy, and confidentiality. Ultramares doctrine:A common-law approach to third-party liability, established in 1931 in the case of Ultramares Corporation V. Touche, in which ordinary negligence is insufficient for liability to third parties because of the lack of privity of contract between the third party and the auditor, unless the third party is a primary beneficiary. Unasserted claim:A potential legal claim against an audit client where the condition for a claim exists but no claim has been filed. Understanding specific audit objective: the specific audit objective of verifying that financial and other information in disclosures are expressed clearly. Unqualified opinion (report) (standard unqualified opinion): A report issued when the auditor believes that the overall financial statements are fairly stated in accordance with GAAP and that all auditing conditions have been met and no material misstatements have been discovered or left uncorrected. Unqualified opinion (report) with explanatory paragraph or modified wording: A report issued when the auditor believes that the overall financial statements are fairly stated in accordance with GAAP and that all auditing conditions have been met and no material misstatements have been discovered or left uncorrected, but the auditor believes it is important, or is required, to provide additional information. Valuation and allocation assertion: Implicit or explicit assertion made by the management that asset and liability balances stated in the balance sheet, and revenue and expenses transactions stated in the income statement have all been recorded in the financial statement at the appropriate amount. For example, management asserts that inventories are valued at the lower of cost or market and that depreciation is made to plant and equipment in the appropriate amount. Value-added network (VAN): The intermediary that serves as an electronic mail service for electronic data interchange transactions. Variable sampling:An audit sampling technique designed to estimate a numerical measurement of a population, such as a dollar value. Vouching:An audit procedure where documentations are examined to support recorded transactions or amounts. Vendor’s invoice:A document that specifies the details of an acquisition transaction and amount of money owed to the vendor for an acquisition.

Vendor’s statement: A statement prepared monthly by the vendor, which indicates the customer’s beginning balance, acquisitions,

payments, and ending balance. Vertical analysis:A form of analysis that presents financial statement amounts for a period as a percentage of some financial statement bases. This analysis involves the preparation of common-size financial statements.

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Appendix F

Key Terms Voucher: A document used to establish a formal means of recording and controlling acquisitions, primarily by enabling each

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X Y Z

acquisition transaction to be sequentially numbered. It is usually in the form of a voucher packet. Voucher packet:A cover sheet or folder that contains the purchase order, copy of the packing slip, receiving report, and vendor invoice. After payment, a copy of the check is added to the voucher packet. Voucher register:A recording system that is used instead of a purchase journal. It records all vendor invoices for goods and services purchases srcinating from a voucher (or voucher packet). The debit entries are the cost distribution of the purchases, and the credits are vouchers payable (or accounts payable subsidiary ledger). When a voucher register is used instead of a purchases journal, the total of unpaid vendor invoices in the voucher register is the total accounts payable. Walk-through test:An audit testing procedurethat involves the tracing of a selected few transactions through the accounting system to determine that controls are in place, and to assist in assessing control risk (CR). Walk-through (in ICFR):The auditor traces a transaction from srcination through the client’s processes and information system until it is reflected in the client’s financial reports to understand likely sources of misstatements, and to assist in selecting controls to test (TOC). WebTrust:An attestation service designed to provide reasonable assurance that a company’s Web site complies with Trust Services principles and criteria for business-to-consumer electronic commerce. Wide area networks (WANs): Networks that connect computer equipment, databases, software, and peripheral equipment that reside in many geographic locations, such as client offices located around the country. Working papers:Papers that document the evidence gathered by auditors to show the work they have done, the methods and procedures they have followed, and the conclusions they have developed in an audit of financial statements or other type of engagement. Work order (of plant assets): A serially numbered accounting document authorizing the acquisition of plant assets. A second series of work orders may be used to authorize the retirement or disposal of plant assets, and a third series of work order may be used to authorize repair or maintenance of plan assets. Working trial balance:A listing of the general ledger accounts and their yearend balances. It also provides columns for the auditors’ adjustments and reclassifications and for the final amounts that will appear in the financial statements. anagement to auditors on matters such as the fairness of the entity’s Written representations:Written assertions provided by m financial statements, availability of all financial records and related data, internal control over financial reporting, and other specific representations about the financial statements, XBRL (eXtensible Business Reporting Language): AN international information format designed specifically for business information. It assigns all individual disclose items within business reports unique electronically readable tags that are mapped to taxonomies.

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ACCT 506 - Financial And Integrated Audits

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