Auditing Theory Answer Key 1

CHAPTER 1 PROFESSIONAL PRACTICE OF ACCOUNTANCY Questions 1.

Generally, to be a CPA one must meet certain education requirements, and pass the CPA exam. The CPA examination is prepared and graded twice each year. It is generally recognized as an academic examination. It includes multiple-choice questions in the following subjects namely, Theory of Accounts, Practical Accounting I, Practical Accounting II, Auditing Theory, Auditing Problems, Management Services, Business Law and Taxation.

2.

Refer to page 11 of the textbook.

3.

Refer to page 110 (Section 28 of the Philippine Accountancy Act of 2004) of the textbook.

4.

Competencies include both what individual auditors know and what individual auditors and audit teams do. Competencies are evidenced by auditors applying their skills in the delivery of services to clients or supporting the delivery of those services. These competencies categorized as “High Opportunity Competencies” and “Low Opportunity Competencies” are as follows: High Opportunity Competencies have a high likelihood of being building blocks for selling or delivering new assurance services. •

Analytical Skills

•

Business Advisory Skills

•

Business Knowledge

•

Capacity for Work

•

Comprehension of Client’s Business Processes

•

Communication Skills

•

Efficiency

•

Intellectual Capability

•

Learning and Rejuvenation

•

Marketing and Selling

Solutions Manual – Public Accountancy Profession

1-2

•

Model Building

•

People Development

•

Relationship Management

•

Responsiveness and Timeliness

•

Technology

•

Verification

Low Opportunity Competencies, while important to the delivery of current assurance services, are less likely to be exploited in the development of future services. •

Accounting and Auditing Standards

•

Administrative Capability

•

Managing Audit Risk

5.


6.

The Philippine Accountancy Act of 2004 (R.A. 9298) Article I, Section 4, paragraphs (a) to (d) spell out the scope of the practice of accountancy as follows: •

Practice of Public Accountancy

•

Practice in Commerce and Industry

•

Practice in Education/Academe

•

Practice in the Government

7.

Refer to pages 8 to 10 of the textbook.

8.


9.


10. Refer to pages 14 to 15 of the textbook. 11. Refer to pages 16 to 17 of the textbook.

Professional Practice of Accountancy

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12. This is brought about by the nature of accounting standards and the demand for accounting-related information which have changed in several significant ways. These changes include: •

Global Harmonization of Accounting Standards

•

Expanded Accountability

•

More Detailed Reporting

•

Increased Risk Reporting

•

Global Audit Standards

13. (a) While university-level training is important, it is also necessary that professionals continue their education throughout their careers, as accounting and auditing standards will change. In this particular case, the staff member would need to stay abreast of current developments in order to meet the competence and capabilities element of the responsibilities principle. (b) Auditors need to be both independent in fact and independent in appearance. While a small financial investment might not impair the auditors’ actual state of mind (independence in fact), it is unlikely that financial statement users will perceive the auditor to be independent (independence in appearance). Professional standards would not consider the auditor independent in this case, as no direct financial interests in clients are permitted. Multiple Choice Questions 1. 2. 3. 4.

D C B B

CHAPTER 2 PRACTICE OF PUBLIC ACCOUNTANCY Questions 1.


2.


3.


4.


5.

The following are the most sought - after services among professional accountants. A. Assurance Services. Examples are: 1.

Independent financial statement audit

2.

Reviews

3.

Other assurance services (e.g., CPA Web Trust, Business Performance Measurement Service)

B. Non-Assurance Services. Examples are:

6.

1.

Agreed-upon procedures

2.

Compilation

3.

Tax

4.

Management consultancy/advisory services

5.

Accounting and data processing

6.

Other non-assurance services (e.g., Information Technology System Services)

In an assurance engagement, a practitioner aims to provide a high or moderate level of assurance that an assertion being made by one party for use by another party can be relied upon while in a consulting engagement, the practitioner aims to provide professional advice on how the limited resources of an enterprise can be put into optimal use in order to attain the company’s objectives.


2-2 7.

Examples of assurance engagements on information technology are: a) CPA Web Trust Service b) Information System Reliability Service Refer to page 41 of the textbook for a brief discussion of these services.

8.


9.


10. Refer to page 38 of the textbook. 11. Refer to page 47 of the textbook. 12. Refer to pages 52 to 54 of the textbook. 13. Refer to page 36 of the textbook. 14. Refer to pages 56 and 57 of the textbook.

Multiple Choice Questions 1. 2. 3. 4. 5.

C A D D D

6. 7. 8. 9. 10.

C D D D C

11. 12. 13. 14.

D C D C

Cases 1.

(a) The purpose of CPA reporting on internal control is to provide assurance about whether management’s assertion about internal control is fairly stated in all material respects, based on the control criteria being followed. Thus, for example, an examination provides the highest degree of assurance that information produced by the system will be reliable. (b) When involved in performing an examination on the effectiveness of internal control a practitioner should: • • • •

Plan the engagement. Obtain an understanding of internal control. Evaluate the design and operating effectiveness of internal control. Form an opinion about the fairness of management’s assertion on internal control.

Practice of Public Accountancy 2.

2-3

(a) PSA 100, Assurance Engagements, provide guidance for an engagement such as one on customer satisfaction. They provide guidelines on audits and related services such as examinations and reviews. (b) Suitable criteria are those that are objective and permit reasonably consistent measurements. In addition, the criteria must be sufficiently complete such that no relevant factors are omitted that would affect a conclusion about the subject matter. Finally, the criteria must measure some characteristic of the subject matter that is relevant to a user’s decision. (c)

INDEPENDENT ACCOUNTANTS’ REPORT We have examined the accompanying Schedule of Customer Satisfaction Measures for the three years ended December 31, 2013. This schedule is the responsibility of Gonzales, Inc.’s management. Our responsibility is to express an opinion on this schedule based on our examination. Our examination was conducted in accordance with standards on assurance engagements adopted in the Philippines and, accordingly, included examining, on a test basis, evidence supporting the schedule and performing such other procedures as we considered necessary in the circumstances. We believe that our examination provides a reasonable basis for our opinion. In our opinion, the Schedule of Customer Satisfaction Measures referred to above presents fairly, in all material respects, the levels of customer satisfaction for the three years ended December 31, 2013, in conformity with the measurement and disclosure criteria set forth in Note 1.

Santos & Lopez, LLP March 1, 2014 NOTE TO INSTRUCTOR: If the CPAs believe that the criteria are not understandable by users other than management a paragraph must be added to the report restricting its use.

CHAPTER 3 OVERVIEW OF AUDITING Questions 1.

One definition of auditing is that it is a systematic process by which a competent, independent person objectively obtains and evaluates 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. The Philippine Standards on Auditing (PSA) 120 “Framework of Philippine Standards on Auditing” states the objective of an audit as follows: “The objective of an audit of financial statements is to enable the auditor to express an opinion whether the financial statements are prepared in all material respects, in accordance with an identified financial reporting framework.”

2.

This apparent paradox arises from the distinction between the function of auditing and the function of accounting. The accounting function is the process of recording, classifying and summarizing economic events to provide relevant information to decision makers. The rules of accounting are the criteria used by the auditor for evaluating the presentation of economic events for financial statements and he or she must therefore have an understanding of Philippine Financial Reporting Standards (PFRS), as well as Philippine Standards on Auditing (PSA). The accountant need not, and frequently does not, understand what auditors do, unless he or she is involved in doing audits, or has been trained as an auditor.

Purpose

Audits of Financial Statements To determine whether the financial statements are presented in accordance with PFRS.

Compliance Audits To determine whether the client is following specific procedures set by higher authority.

Operational Audits To evaluate whether operating procedures are efficient and effective.


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Compliance Audits Authority setting down procedures, internal or external Not standardized, but very specific and usually objective

Operational Audits Management of organization

Nature

Audits of Financial Statements Different groups for different purposes – many outside entities. Highly standardized

Performed by: CPAs COA Auditors BIR Auditors Internal Auditors

Almost universally Occasionally Never Frequently

Occasionally Frequently Universally Frequently

Frequently Frequently Never Frequently

Users of Audit Report

4.

The major differences in the scope of audit responsibilities are: 1.

2.

3.

4.

5.

Highly nonstandard; often very subjective

CPAs perform audits in accordance with Philippine Standards on Auditing of published financial statements prepared in accordance with identified and applicable Statements of Financial Accounting Standards. COA auditors perform compliance or operational audits in order to assure the Congress of the expenditure of public funds in accordance with its directives and the law. BIR agents perform compliance audits to enforce the tax laws as defined by Congress, interpreted by the courts, and regulated by the BIR law. Internal auditors perform compliance or operational audits in order to assure management or the board of directors that controls and policies are properly and consistently developed, applied and evaluated.

An independent audit is a means of satisfying the need for reliable information on the part of decision makers. Factors of a complex society which contribute to this need are: 1.

remoteness of information a. owners (stockholders) divorced from management b. directors not involved in day-to-day operations or decisions c. dispersion of the business among numerous geographic locations and complex corporate structures

2.

bias and motives of provider a. information will be biased in favor of the provider when his goals are inconsistent with the decision maker.

3.

voluminous data a. possibly millions of transactions processed daily via sophisticated computerized systems

Overview of Auditing b. c. 4.

6.

3-3

multiple product lines multiple transaction locations

complex exchange transactions a. new and changing business relationships lead to innovative accounting and reporting problems b. potential impact of transactions not quantifiable, leading to increased disclosures

The four primary causes of information risk are remoteness of information, bias in motives of the provider, voluminous data, and existence of complex exchange transactions. The three main ways to reduce information risk are: 1. 2. 3.

User verifies the information itself. The users share the information risk with management. Have audited financial statements provided.

The advantages and disadvantages of each are as follows: User verifies information

Users share information risk with management Audited financial statements are prepared

7.

Advantages 1. User obtains information desired. 2. User can be more confident of the qualifications and activities of the person getting the information. 1. No audit costs incurred.

1. Multiple users obtain the information. 2. Information risk can usually be reduced sufficiently to satisfy users at reasonable cost. 3. Minimal inconvenience to management by having only one auditor.

Disadvantages 1. High cost of obtaining information. 2. Inconvenience to the person providing the information because large number of users would be on premises. 1. Users may not be able to collect on losses.

1. May not meet needs of certain users. 2. Cost may be higher than the benefits in some situations, such as for a small company.

Information risk is the possibility that information upon which a business decision is made is inaccurate. Four causes of information risk are: • remoteness of information, • biases and motives of the provider, • voluminous data, and • complex exchange transactions.


3-4 8.

Three primary ways users of information can reduce information risk are: • users can verify the information themselves, • users can share information risk with management, and • users can obtain audited financial statements.

9.

Four factors that are likely to significantly reduce information risk in the next five to ten years are: • technological advances, • more companies will go on–line, reducing the risk of investors obtaining outdated information, • new accounting and auditing standards, and • auditors will find more efficient and effective audit techniques.

10. Refer to pages 84 and 85 of the textbook. 11. A report by an independent public accountant concerning the fairness of a company’s financial statements is commonly required in the following situations: (1) Application for a bank loan. (2) Establishing credit for purchase of merchandise, equipment, or other assets. (3) Reporting operating results, financial position, and cash flows to absentee owners (stockholders or partners). (4) Issuance of securities by a corporation. (5) Annual financial statements by a corporation with securities listed on a stock exchange or traded over the counter. (6) Sale of an ongoing business. (7) Termination of a partnership. 12. To add credibility to financial statements is to increase the likelihood that they have been prepared following the appropriate criteria, usually the relevant and applicable PAS. As such, an increase in credibility results in financial statements that can be believed and relied upon by third parties. 13. Business risk is the risk that the investment will be impaired because a company invested in is unable to meet its financial obligations due to economic conditions or poor management decisions. Information risk is the risk that the information used to assess business risk is not accurate. Auditors can directly reduce information risk, but have only limited effect on business risk. 14. An operational audit attempts to measure the effectiveness and efficiency of a specific unit of an organization. It involves more subjective judgments than a compliance audit or an audit of financial statements because the criteria of effectiveness and efficiency of departmental performance are not as clearly established as are many laws and regulations or financial reporting standards.

Overview of Auditing

3-5

The report prepared after completion of an operational audit is usually directed to management of the organization in which the audit work was done. 15. The first quoted sentence overstates the case. Although annual audits by CPA firms are universal practice for large corporations, they are not essential to many small businesses. The financial statements of large corporations go to many stockholders (often hundreds of thousands) who demand the assurance of reliability supplied through independent audits by CPA firms. Moreover the SEC and the stock exchanges require that listed companies have annual audits. For a small business concern, the primary need for annual financial statements is to support an application for a bank loan. If a small business does not need to borrow, or can obtain borrowed funds without providing audited statements, the cost of an audit may not be justified. Often a small business can obtain from a CPA firm specialized services other than an audit, which are more useful and may cost less. Examples are the review or compilation of financial statements, installation of a computer based accounting system, or a study of internal control. Thus, the second quoted sentence, as well as the first, is too sweeping to be correct. A decision not to have an audit is not always “false economy.” 16. (a) An example of possible bias on the part of the provider of financial information is the situation in which an individual or business entity applies for a bank loan. In such circumstances, there is an incentive to overstate assets, income, and owner’s equity, and to overlook or minimize liabilities. Distortions of this type give the appearance of greater financial strength. (b) A bank loan officer may insist that a prospective borrower provide audited financial statements. This provides assurance that the data in the financial statements have been examined by independent competent persons. 17. Financial statements audits, operational audits, and compliance audits are similar in that each type of audit involves accumulating and evaluating evidence about information to ascertain and report on the degree of correspondence between the information and established criteria. The differences between each type of audit are the information being examined and the criteria used to evaluate the information. An example of a financial statement audit would be the annual audit of ABS-CBN Corporation, in which the external auditors examine ABSCBN’s financial statements to determine the degree of correspondence between those financial statements and generally accepted accounting principles. An example of an operational audit would be an internal auditor’s evaluation of whether the company’s computerized payroll-processing system is operating efficiently and effectively. An example of a compliance audit would be a BIR

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Solutions Manual – Public Accountancy Profession auditor’s examination of an entity’s tax return to determine the degree of compliance with the National Internal Revenue Code. 18. Refer to pages 83 to 84 of the textbook. 19. The text defines internal auditing as an independent appraisal activity in an entity. Internal auditing is itself a control that operates by examining and evaluating the adequacy and effectiveness of other controls. Independence is such an important aspect of internal auditing that the fourth section of the Statement of Responsibilities of Internal Auditing is devoted to independence. Organizations create internal auditing to serve or benefit the organization. The broad objective of internal auditing is to provide assistance to members of the organization to enable the members to meet their responsibilities effectively. Assistance may involve providing counsel or recommendations, analysis, or information. One goal of internal auditing should be to achieve effective control that is worth the cost. In describing the nature of internal auditing, the Statement of Responsibilities of Internal Auditing indicates that internal auditing functions by examining controls. The scope limits internal auditing’s responsibility for examining and evaluating performance to specific responsibilities that are assigned to individuals or units. Internal auditing examines and evaluates performance to compare the actual performance with plans, specified activities, standards, objectives, policies, and goals. Such evaluations are really evaluations of controls because plans, specified activities, standards, objectives, policies and goals are controls. Internal auditors may be called on to examine areas for which performance criteria have not been specified. When this occurs, internal auditors may select measurable criteria and report their findings in terms of those measurable criteria. For example, if internal auditors were called on to evaluate a credit department, they might present historical information as well as industry information to management as a basis for evaluating the credit department. 20. Independence is the essence of auditing and enables auditors to render impartial and unbiased judgments. The two conditions that contribute to an internal auditor’s independence are organizational status and auditor objectivity. The internal auditors’ status must be such that they are respected throughout the organization. Generally, the more respect management gives to the internal audit function, the greater the attention the whole organization pays to their findings and recommendations. Giving the highest-level person in internal auditing the status of vice president and having that person report to the board of directors’ audit committee give sufficient status to the internal audit function. Objectivity requires that internal auditors have an independent mental attitude and an honest belief in their work product.

Overview of Auditing

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21. COA auditors perform operational or performance audits, compliance audits, and financial audits. 22. An independent auditor is usually a CPA who has received a license to perform the attest function. To be a CPA, one generally must meet certain educational requirements and pass an examination. Internal auditors are employees of the organization for which they do audits. They may perform financial auditing, compliance auditing, or operational auditing. They are not independent in the sense that external auditors are, although they may attain a degree of independence by their position in the organization. Governmental auditors are employees of various government agencies who perform financial, compliance, and operational auditing. For example, local governments employ auditors to verify that businesses collect and remit sales tax as required by law.

Multiple Choice Questions 1. 2. 3. 4. 5. 6. 7. 8. 9. 10.

D A A D B C B C B D

11. 12. 13. 14. 15. 16. 17. 18. 19. 20.

B A C C A D A A D C

21. 22. 23. 24. 25. 26. 27. 28. 29. 30.

D B C B B C D C A A

31. 32. 33. 34. 35. 36. 37. 38. 39. 40.

D B A D C D B C A B

CHAPTER 4 REGULATION OF THE PRACTICE OF PUBLIC ACCOUNTANCY Questions 1.

Refer to pages 110 (Section 28 of the Philippine Accountancy Act of 2004) of the textbook.

2.

Refer to pages 112 (Sections 34 & 35 of the Philippine Accountancy Act of 2004) of the textbook.

3.

Competencies include both what individual auditors know and what individual auditors and audit teams do. Competencies are evidenced by auditors applying their skills in the delivery of services to clients or supporting the delivery of those services. These competencies categorized as “High Opportunity Competencies” and “Low Opportunity Competencies” are as follows: High Opportunity Competencies have a high likelihood of being building blocks for selling or delivering new assurance services. •

Analytical Skills

•

Business Advisory Skills

•

Business Knowledge

•

Capacity for Work

•

Comprehension of Client’s Business Processes

•

Communication Skills

•

Efficiency

•

Intellectual Capability

•

Learning and Rejuvenation

•

Marketing and Selling

•

Model Building

•

People Development

•

Relationship Management

•

Responsiveness and Timeliness


4-2

•

Technology

•

Verification

Low Opportunity Competencies, while important to the delivery of current assurance services, are less likely to be exploited in the development of future services.

4.

•

Accounting and Auditing Standards

•

Administrative Capability

•

Managing Audit Risk

Examples of typical lawsuits against CPAs are a)

Alleged misstatements that the auditor did not detect in the financial statements involving 1) improper or inadequate disclosure 2) inappropriate valuations

b) Alleged failure to detect defalcation as a result of negligence in the conduct of the audit c)

Alleged failure to complete the audit on the agreed-on date

d) Alleged inappropriate withdrawal from an audit 5.

Indications That Noncompliance May Have Occurred Examples of the type of information that may come to the auditor’s attention that may indicate that noncompliance with laws or regulations has occurred are listed below: •

Investigation by government departments or payment of fines or penalties.

•

Payments for unspecified services or loans to consultants, related parties, employees or government employees.

•

Sales commissions or agent’s fees that appear excessive in relation to those ordinarily paid by the entity or in its industry or to the services actually received.

•

Purchasing at prices significantly above or below market price.

•

Unusual payments in cash, purchases in the form of cashiers’ checks payable to bearer or transfers to numbered bank accounts.

•

Unusual transactions with companies registered in tax havens.

Regulation of the Practice of Public Accountancy

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•

Payments for goods or services made other than to the country from which the goods or services originated.

•

Payments without proper exchange control documentation.

•

Existence of an accounting system which fails, whether by design or by accident, to provide an adequate audit trail or sufficient evidence.

•

Unauthorized transactions or improperly recorded transactions.

•

Adverse media comment.

6.


7.

PSA 260 (Clarified), “Communication with Those Charged with Governance” deals with the auditor’s responsibility to communicate with those charged with governance in relation to an audit of financial statements. Although this PSA applies irrespective of an entity’s governance structure or size, particular considerations apply where all of those charged with governance are involved in managing an entity, and for listed entities. This PSA does not establish requirements regarding the auditor’s communication with an entity’s management or owners unless they are also charged with a governance role.

8.

The increase in litigation against auditors seems to be happening for two reasons: a general increase in litigation in society, and the fact that investors and creditors who suffer losses will look for “deep pockets” to pay for those losses. Most accounting firms appear to have “deep pockets.”

9.

Due (professional) care is the standard by which the courts and the profession expect a CPA to practice. A CPA who is found to have exercised due professional care in an engagement should not have any liability to others.

10. The four gradations are none, negligence, gross negligence (sometimes referred to as constructive fraud), and fraud. At one extreme is the auditor who performs an appropriate audit and issues an appropriate report. This auditor’s degree of wrongdoing is “none.” An auditor who commits fraud is at the other extreme, since he or she knows that the financial statements are misstated and yet issues an unqualified opinion. An auditor is negligent if he or she does not do what a reasonably prudent auditor should do in the circumstances. An auditor is grossly negligent if he or she consistently fails to follow the standards of the profession on an engagement. 11. Auditors are responsible to clients for negligence, gross negligence, or fraud. 12. Refer to page 126 of the textbook.

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Solutions Manual – Public Accountancy Profession 13. Most courts have held that an auditor has a higher responsibility to communicate information beyond that required by PFRSs and PSAs. Courts have held that compliance with PFRSs is persuasive but not conclusive evidence. 14. An auditor should (a) follow the Philippine Standards on Auditing, the Code of Ethics for Professional Accountants in the Philippines, and where appropriate, PFRSs; (b) establish and follow appropriate quality control procedures; (c) evaluate whether a client has the necessary integrity and appropriate reputation in the community; (d) evaluate carefully why a client wants an audit; (e) conduct the audit with appropriate professional skepticism; (f) provide for appropriate levels of consultation for issues; and (g) provide for appropriate review of the audit. 15. The prudent man concept states that a man is responsible for conducting a job in good faith and with integrity, but is not infallible. Therefore, the auditor is expected to conduct an audit using due care, but does not claim to be a guarantor or insurer of financial statements.


B C A B A C A C A B

11. 12. 13. 14. 15. 16. 17. 18. 19. 20.

A D C D C A A D B D

21. 22. 23. 24. 25. 26. 27. 28. 29. 30.

B C A A A C C A A C

31.

B

CHAPTER 5 CODE OF ETHICS FOR PROFESSIONAL ACCOUNTANTS IN THE PHILIPPINES Questions 1.

There is a special need for ethical behavior by professionals to maintain public confidence in the profession, and in the services provided by members of that profession. The ethical requirements for CPAs are similar to the ethical requirements of other professions. All professionals are expected to be competent, perform services with due professional care, and recognize their responsibility to clients. The major difference between other professional groups and CPAs is independence. Because CPAs have a responsibility to financial statement users, it is essential that auditors be independent in fact and appearance. Most other professionals, such as attorneys, are expected to be an advocate for their clients.

2.

Independence in fact exists when the auditor is actually able to maintain an unbiased attitude throughout the audit, whereas independence in appearance is dependent on others’ interpretation of this independence and hence their faith in the auditor. Activities which may not affect independence in fact, but which are likely to affect independence in appearance are: (Notice that the first two are violations of the Code of Ethics.)

3.

1.

Ownership of a financial interest in the audited client.

2.

Directorship or officer of an audit client.

3.

Performance of management advisory or bookkeeping or accounting services and audits for the same company.

4.

Dependence upon a client for a large percentage of audit fees.

5.

Engagement of the CPA and payment of audit fees by management.

In return for the faith placed in CPAs by the public, CPAs should continually seek to demonstrate their dedication to professional excellence. The public interest is defined as the community’s collective well-being. CPAs handle ethical conflicts best by acting with integrity, objectivity, and due professional care and by having a genuine interest in serving the public.


5-2 4.

An ethical dilemma is a situation that a person faces in which a decision must be made about the appropriate behavior. There are many possible ethical dilemmas that one can face, such as finding a wallet containing money, or dealing with a supervisor who asks you to work hours without recording them. An ethical dilemma can be resolved using the six-step approach outlined below: 1. 2. 3. 4. 5. 6.

5.

Obtain the relevant facts. Identify the ethical issues from the facts. Determine who is affected by the outcome of the dilemma and how each person or group is affected. Identify the alternatives available to the person who must resolve the dilemma. Identify the likely consequence of each alternative. Decide the appropriate action.

Apparently, in ethical philosophy, the word “conscience” is used to describe the “undefinable mental process that yields moral decisions.” A close kin in the political science terms would be “anarchy.” Conscience might not be a sufficient guide for personal ethics decisions because the individual’s undefinable mental processes may be based on caprice, immaturity, ignorance, stubbornness, or misunderstanding. Conscience may fail to show the consistency, clarity, practicability, impartiality, and adequacy preferred in ethical standards and behavior. Exactly the same can be said about professional ethics decisions because a nonhypocritical individual can no more split his behavior between personal life and professional life than he can voluntarily split his own personality.

6.

A professional accountant must be prepared to be an agent, spectator, advisor, instructor, judge, and critic.

7.

Ethical responsibility for acts of non-CPAs under a CPA’s supervision falls under the latter’s jurisdiction. A CPA shall not permit others to carry out on his behalf, either with or without compensation, acts which, if carried out by the CPA, would place him in violation of the Code of Ethics.

8.

The auditor’s gain from having an audit committee is a direct communication pipeline to the board of directors.

9.

Serving as a purchasing agent places Ben Santos’ father in an “audit sensitive position.” Accordingly, Santos’ independence is impaired. Also, since Santos is a managerial employee, he can no longer work in the Manila office of the CPA firm. The CPA firm may retain its independence if Santos transfers to another office (or resigns).

Code of Ethics for Professional Accountants in the Philippines

5-3

10. The CPA firm’s independence would not be impaired as long as Gary Angeles did not personally participate in the audit of this particular client. Once Gary rises to the position in which he becomes a “managerial employee” of the CPA firm, however, he must be transferred to an office which does not participate in this audit if the firm is to remain independent. 11. Historically, compensation for CPAs serving as expert witnesses had to be based on a standard per diem rate or a fixed sum. However, under certain situations, such contingent fees are allowed only from clients for which the CPA does not also provide to the client financial statement audits, reviews or certain compilations, or prospective financial information examinations. 12. Sanchez may only refer certain clients to his wife or to another life insurance agent who will share such a commission with his wife provided that he does not perform assurance as well as nonassurance services.


D B D A A C A* A* A* A

11. 12. 13. 14. 15. 16. 17. 18. 19. 20.

A A A C C D A C A A

21. 22. 23. 24. 25. 26. 27.

A B D C C B D

*7. A fee for audit clients which is dependent upon the results achieved by the CPA’s efforts is a contingent fee and is prohibited for audit clients. *8. An auditor’s independence would not be considered to be impaired with respect to a financial institution in which the auditor maintains a checking account which is fully insured. *9. The declaration requires the preparer to acknowledge that the return is “true, correct, and complete...based on all information of which the preparer has any knowledge.”


5-4 Cases 1.

a.

Interpretation – Honorary Directorships and Trusteeships Ela will not be considered independent unless: 1. 2. 3. 4.

b.

the position is in fact purely honorary, and listings of directors show she is an honorary director, and she restricts participation strictly to the use of her name, and she does not vote or participate in management functions.

Interpretation – Retired Partners and Firm Independence: Since Monte is still active with the firm as an ex-officio member of the income tax advisory committee, meeting monthly, his situation would impair the appearance of the firm’s independence. Monte should either resign from the Palm board or cease his association with the accounting firm.

c.

Interpretation – Accounting Services CPA Benitez must be careful to know whether outsiders would perceive relationships that would indicate status as an employee, hence impairing the appearance of independence. In particular, CPA Benitez must 1.

2.

3.

4.

d.

Not have any business connection with Hernan Corporation or with Mike Hernan that would in fact impair independence, objectivity and integrity, and Impress Mike Hernan (and the board of directors) that they must be able and willing to accept primary responsibility for the financial statements as their own, and Not take managerial responsibility for conducting operations of the Hernan Corporation (although Benitez’s supervision of the bookkeeper seems to have this characteristics), and Conduct the audit in conformity with PSA and not fail to audit records simply because they were processed under Benitez’s supervision.

Interpretation – Effect of Family Relationships on Independence Jack’s wife’s interest is attributed to him, and he would not be independent. The financial interest is considered direct.

e.

Interpretation Jack is still not independent, so long as the daughter is a dependent child. The financial interest is considered direct.

Code of Ethics for Professional Accountants in the Philippines f.

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Interpretation Still not enough. The grandfather (either Jack’s father or his father-in-law) is considered a nondependent close relative, but the appearance of independence is impaired. The grandfather’s investment is material (50 percent) in relation to his net financial resources.

2.

3.

a.

Pee and Co. / United Furniture, Inc.: This is a judgment call. In this case, the services can be considered temporary, mechanical in nature and performed on a one-time emergency basis. For these reasons, the SEC would probably not consider independence impaired.

b.

Renson & Co. / Spectrum Corporation Laser Division: The SEC would consider independence impaired because of the extent of the bookkeeping services and the relative size of the Division. The only solution that might work is to have another accounting firm audit the Laser Division financials so that Renson & Co. can write a report “in reliance on the work of other independent auditors.”

c.

Reyes & Co. / Valley Bank: The SEC would consider independence impaired because of the family relation of Annabelle, her connection with Valley’s financial statements and the fact that Kris is a “member” (partner) in the audit firm. (The PICPA would probably also consider independence impaired because of the apparent closeness of the two sisters and the “audit sensitivity” of Annabelle’s job).

d.

Cruz & Reyes / Jonas Tomas / Starex Money Market Fund: Jonas is a “member” since he is a manager and will provide audit services to SMMF. Cruz & Reyes’ independence is impaired since Jonas holds a direct financial interest.

Violation of Code of Professional Ethics?

Yes

No

Since Bella had an employment relationship with the client during part of the period covered by the financial statements, her independence is impaired. 4.

Violation of Code of Professional Ethics?

Yes

No

This is a violation. It is a contingent fee agreement. 5.

Although her decision will not be popular with the audit staff, Tracy Ong should thank the client but decline the offer, both for her and for the staff. She should explain that an outsider who had knowledge of all of the relevant facts might view the free use of a condominium as a sizable “gift” to the auditors, which might influence their independent mental attitude. Thus, we believe that to


5-6

maintain an appearance of independence, the auditors should not accept this offer. 6.

No. CPAs may refuse client access to their working papers for any valid business purpose. Therefore, a CPA may require that fees be paid before working papers including such adjusting entries and supporting analysis are provided to the client.

7.

The answers provided in this section are based on the assumption that the traditional legal relationship exists between the CPA firm and the third party user. That is, there is no privity of contract, the known versus unknown third party user is not a significant issue, and high levels of negligence are required before there is liability. a.

False. There was no privity of contract between Tan and Cañada, therefore, ordinary negligence will usually not be sufficient for a recovery.

b.

True. If gross negligence is proven, the CPA firm can and probably will be held liable for losses to third parties.

c.

True. See a.

d.

False. Gross negligence (constructive fraud) is treated as actual fraud in determining who may recover from the CPA.

e.

False. JC is an unknown third party and will probably be able to recover damages only in the case of gross negligence or fraud.

Assuming a liberal interpretation of the legal relationship between auditors and third parties, the answers to a and d would probably both be true. The other answers would remain the same. 8.

Yes. Normally a CPA firm will not be liable to third parties with whom it has neither dealt nor for whose benefit its work was performed. One notable exception to this rule is fraud. When the financial statements were fraudulently prepared, liability runs to all third parties who relied upon the false information contained in them. Fraud can be either actual or constructive. Here, there was no actual fraud on the part of Dantes or the firm in that there was no deliberate falsehood made with the requisite intent to deceive. However, it would appear that constructive fraud may be present. Constructive fraud is found where the auditor’s performance is found to be grossly negligent. That is, the auditor really had either no basis or so flimsy a basis for his or her opinion that he or she has manifested a reckless disregard for the truth. Dantes’ disregard for standard auditing procedures would seem to indicate such gross negligence and, therefore, the firm is liable to third parties who relied on the financial statements and suffered a loss as a result.

Code of Ethics for Professional Accountants in the Philippines 9.

5-7

a.

Yes. Carlos was a party to the issuance of false financial statements and as such is a joint tortfeasor. The elements necessary to establish an action for common law fraud are present. There was a material misstatement of fact, knowledge of falsity (scienter), intent that the plaintiff bank rely on the false statement, actual reliance, and damage to the bank as a result thereof. If the action is based upon fraud there is no requirement that the bank establish privity of contract with the CPA. Moreover, if the action by the bank is based upon ordinary negligence, which does not require a showing of scienter, the bank may recover as a third-party beneficiary (an exception to the strict privity requirement). Thus, the bank will be able to recover its loss from Carlos under either theory.

b.

No. The lessor was a party to the secret agreement. As such, the lessor cannot claim reliance on the financial statements and cannot recover uncollected rents. Even if he or she was damaged indirectly, his or her own fraudulent actions led to his or her loss, and the equitable principle of “unclean hands” precludes him or her from obtaining relief.

c.

Yes. Carlos had knowledge that the financial statements did not follow financial reporting standards and willingly prepared an unqualified opinion. The financial statements were not in accordance with financial reporting standards. That is a criminal act because there was an intent to deceive.

10. a.

Base, Umapas & Cañada is potentially liable to its client because of the possible negligence of its agent, the in-charge accountant on audit, in carrying out duties that were within the scope of his or her employment. Should there be a finding of negligence, liability would be limited to those losses that would have been avoided had reasonable care been exercised. There being no evidence of the assumption of a greater responsibility, the in-charge accountant’s conduct is governed by the usual standard; that is, that the accountant perform his or her duties with the profession’s standards of competence and care. A question of fact arises as to whether the duty of reasonable care was breached when the in-charge accountant failed to investigate further after being apprised by a competent subordinate of exceptions to 6 percent of the vouchers payable examined. Moreover, a question of causation arises as to whether further actions by the in-charge accountant would have disclosed the fraud. If both lack of due care and causation are established, recovery for negligence will be available to the client.

b.

In a properly organized liability partnership, the partner(s) and staff responsible for the engagement and the firm would be liable, as discussed in part a. However, other partners would not be liable.

5-8

Solutions Manual – Public Accountancy Profession 11. Ordinarily, users of financial statements, other than those who contracted for the audit and those known in advance to the auditor, may not recover for ordinary negligence by the auditor in the performance of an audit. Recovery of damages by third parties must usually be based on fraud. Actual knowledge of falsity (scienter) is also generally required for an action based on fraud; however, this requirement may be satisfied by the auditor’s reckless disregard for the truth or gross negligence. It appears that the three deficiencies in the audit by Gonzales & Esteban might be sufficient to satisfy either approach. Failure to check the existence of certain receivables, collectibility of other receivables, and existence of security investments, taken collectively if not individually, appear to show a reckless disregard for the truth by the auditor. In fact, the audit probably lacks sufficient competent evidential matter as a reasonable basis for an opinion regarding the financial statements under examination. The audit appears to have been conducted in a woefully inadequate fashion, without regard to the usual auditing standards and procedures necessary to exercise due professional care. Therefore, the auditors were grossly negligent in the performance of their duties. 12. Corpuz has stated that the CPA firm has “reviewed the books and records of Flores Ventures,” when in fact no such “review” has occurred. A “review” of financial statements consists of limited investigatory procedures designed to provide statement users with a limited degree of assurance that the financial statements are in conformity with financial reporting standards. Corpuz’s actions are similar to issuing an auditors’ report without first performing an audit. Such an action may well be considered an act of criminal fraud, intended to mislead users of the financial statements. If the financial statements of Flores Ventures turn out to be misleading, there is little doubt that any court would find the CPA firm guilty of at least constructive fraud and liable to any third party who sustains a loss as a result of reliance upon the statements. The fact that Corpuz violated Vasquez’s policy of submitting all reports for Vasquez’s review would not lessen the CPA firm’s liability. The concept of mutual agency allows Corpuz, as a partner, to commit the firm to contracts, including auditors’ reports and accountants’ reports. The fact that this report was not submitted for Vasquez’s review might be introduced as evidence against Corpuz in the event he is accused of criminal fraud. 13. (1) Yes, but only to the extent of P70,000. Beta is a third-party beneficiary of the contract between Mega and its auditors, and may therefore recover from the auditors losses caused by the CPAs’ ordinary negligence. However, the original P50,000 loan was made prior to Beta’s reliance upon the negligently audited financial statements. Thus, the auditors’ negligence was

Code of Ethics for Professional Accountants in the Philippines

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not the proximate cause of this portion of Beta’s loss. The auditors’ negligence may, however, be considered the proximate cause of the P70,000 loss incurred as a result of reliance upon the misleading statements. (2) The prospects for Manila’s recovery of its P30,000 loss are substantially less than those of Beta. Manila was not a third-party beneficiary to the contract. Thus, in many jurisdictions following Ultramares, Manila cannot recover losses attributable to the CPAs’ ordinary negligence. Similarly, it is doubtful that Manila would qualify as a foreseen third party as necessary under the Restatement approach. Even in a jurisdiction accepting the Rosenblum precedent, which allows third parties to recover losses caused by the auditors’ ordinary negligence, Manila would have to prove that it was a “foreseeable third party relying upon the financial statements for routine business purposes.” It is questionable whether the loan by Manila was either “reasonably foreseeable” or “routine,” as Manila was a customer of Mega, not a lender.

CHAPTER 6 MANAGEMENT OF A PUBLIC ACCOUNTANCY PRACTICE Questions 1.

The special function performed by the public accounting profession is the attestation to the fairness of the financial statements of clients. The special function ensures the reliability and integrity of the financial reporting system. Judge Burger described the special function as "certifying the public reports that collectively depict a corporation's financial status," which involves "a public responsibility transcending any employment relationship with the client."

2.

Complexity affects the demand for auditing services in that both users and management need the expertise of professionals who understand the underlying economic substance of transactions and financial instruments and, thus, who have the ability to determine the appropriate accounting best to "fairly" portray the economic substance of an organization's activities and financial condition. The business environment in which the auditor must function is increasingly complex. The major forms of complexity relate to:

3.

a.

Computer systems, which are becoming increasingly interdependent across organizations.

b.

Increased complexity of financial instruments and transactions entered into by organizations.

c.

The economic environment in which we all must operate. The changing environment includes such items as the increased need to have a global outlook in providing goods and services and the need to be attuned to societal regulations in such areas as environmental protection.

For the most part, local CPA firms are subject to the same auditing and accounting standards as the large international CPA firms. The differences relate to whether the audit firms have (a) public clients, or (b) international clients. If a firm has public clients, then the firm is subject to the standards of the PCAOB. If a firm has clients that are domiciled in other countries, then they should utilize international auditing standards. If the audit firm only has non-pubic clients, then they are subject to auditing standards promulgated by the PICPA.


6-2 4.

A network of accounting firms is a body to which individual CPA firms come together to pursue common interests. The services generally provided by the network include: •

centralized staff that provides accounting and auditing expertise to its members on a world-wide basis,

•

a referral service for audit firms that have clients in different parts of the country or world,

•

a referral service for a firm to utilize when clients desire expertise or consulting services that the audit firm does not provide.

•

standard audit programs and/or procedure’s manuals for the member audit firms.

In some cases, the network can be a network of firms that are not otherwise affiliated. In other cases, the network firms all operate under one common name, e.g. Grant Thornton International. 5.

a.

Professional skepticism represents a state of mind that is characterized by appropriate questioning and a critical assessment of audit evidence. When employing professional skepticism, auditors will not simply accept all evidence provided and assume that clients are unquestionably honest. However, the statement that “you really have to question everything the client tells you” is a bit exaggerative and goes beyond the concept of professional skepticism.

b.

It is correct that internal evidence is generally of lower quality than external evidence. However, the necessary quality of evidence depends upon the risk of material misstatement and the effectiveness of the client’s internal control. In this case, the staff auditor’s statement that internal evidence is obtained because of time and cost considerations is not appropriate, unless the risk of material misstatement permits lower quality of evidence because of other reasons.

c.

While appropriate planning will allow audits to be conducted on a timely basis, it is not appropriate for auditors to ignore transactions and events between the interim date (in this case, November 1) and the client’s fiscal year end. Some testing would need to be performed following the year end for transactions occurring between November 1 and December 31.

d.

While the primary purpose of evaluating internal control is to determine the nature, timing, and extent of substantive tests, auditors must still conduct some study of internal control to ensure that the condition of the client’s internal control has not changed from prior years. If it has, the substantive tests performed by auditors may no longer be appropriate. In addition, for

Management of a Public Accountancy Practice

6-3

public companies, auditors are required to study internal control and report on the effectiveness of the client’s internal controls under Auditing Standard No. 5. e.

For departures from PFRS, the choice among opinions would be between a qualified opinion (for less material departures) and an adverse opinion (for more material departures).

f.

While the concept of materiality does consider dollar amounts and their effects on users’ decisions, qualitative factors also need to be considered when assessing materiality. For example, a small dollar amount (in absolute terms) may influence a company’s ability to meet its earnings expectations or report higher earnings than in previous years. Situations such as this need to be considered as well as the absolute dollar amount of an item in assessing materiality.


D D D D A

Cases 1.

(1) Auditing does not involve the creation of goods. However, it does serve a worthwhile purpose in our society because it enhances the flow of reliable financial information needed to conduct commerce in our economy. It also assists in the conduct of government by providing reliable information for tax purposes and regulatory purposes. Audits have been legally mandated to ensure objective information. However, research has indicated that audits would be required even if not mandated. The initial audits performed in conjunction with the settlement of the new world arose because of owners' need to have an independent assessment of the returns earned by their managers. (2) The accounting profession did provide early warning signals of the potential problems within many industries. However, it clearly failed in other areas. Some of the problems were related to the impreciseness of accounting principles (e.g. Enron) while others were more closely related to regulatory failures (e.g. Savings & Loan Industry). However, many of the failures were due to systematic problems in the accounting profession that has been addressed by Sarbanes-Oxley.

6-4

Solutions Manual – Public Accountancy Profession (3) Finding fraud may be important. However, many misstatements that are made in conjunction with an organization's financial statements are not intentional but are simply the result of errors. The audit function is designed to detect material misstatements -- whether they are due to errors or fraud. Thus, the audit function is actually broader than the colleague had desired. Ensuring that a financial statement contains no material misstatements also ensures that the auditor addresses the likelihood that material fraud may also have occurred. (4) There is a potential problem with the auditors being hired by management. The Sarbanes-Oxley Act requires companies that are publicly traded to have an audit committee composed of independent directors (nonmembers of management) that have the responsibility for evaluating the performance of the auditors. The audit committee should exist to present the views and interests of outside owners of the organization and provide effective insulation against undue pressure by management on the audit function. The SEC is very cognizant of independence issues and periodically addresses actions or relationships that they believe may impair the auditor’s independence. (5) PFRS represents rules and conventions that are acceptable at one point in time. Much of the diversity in accounting principles is necessary to reflect real economic differences between organizations and the types of transactions in which the organization is engaged. Beyond this argument, differences such as Weighted Average / FIFO accounting have evolved over the years. The profession attempts to mitigate the potential problems associated with the diversity by providing disclosure of the differences and by developing other procedures to make it difficult for firms to change accounting principles. Thus, the financial statements of a company should be comparable over a period of time. (6) It seems that this individual really wants to have a career in auditing. External auditing has changed; in today's environment, the auditor must thoroughly understand a company's business in order to audit it. A key function of internal auditors is to add value through their recommendations. (7) The external audit is designed to present an opinion on the fairness of a company’s financial statement in accordance with PFRS. It is not directly designed to assess the performance of management, although the financial statements may provide some evidence on the performance of management. (8) Auditors operate in an environment in which they must have a sense of trust with management – at least to the extent that confidential or proprietary information is not made public. Thus, if all recommendations made to management were to be made public, management might simply ask that

Management of a Public Accountancy Practice

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recommendations no longer be made. Further, it must be recognized that many of the recommendations made to improve operations are informal in nature and might not be based on thorough study of a particular area. Auditors may justifiably fear litigation from recommendations made public that were made only on informal observations. (9) Congress, in developing the Sarbanes-Oxley Act believes this statement is true. Maintaining adequate controls is a significant part of corporate governance. Congress believes the owner (shareholder) should receive reports on the quality of controls implemented by management. In the first three years of public reports on internal control, there has been a dramatic change in the quality of controls in many organizations. During the first year of Sarbanes-Oxley, approximately 16% of the companies received adverse reports on the quality of their internal controls. This percentage has gone down dramatically. 2.

(a) There seems to be a misinterpretation on the part of many users that a "clean" audit opinion means that the company is in good health. This, unfortunately, is a miscommunication. A "clean" audit opinion means only that the financial statements are fairly presented, not that they represent a company that is in good financial health. The audit function provides data that are "fairly presented" in accordance with PFRS, but such information alone does not constitute all the information an informed user should know about a company. (b) The auditor is a guarantor only of following auditing standards in determining whether the statements are fairly presented, in all material respects, in accordance with financial reporting standards. Fair presentation is guaranteed only within the context of PFRS. (c) This question and should encourage a widely ranging discussion by users. Topics that might be addressed include these: 1. The potential deficiencies in PFRS. 2. The ability to detect fraud when management has attempted to cover it up. 3. The responsibilities of users to perform their own work and to not expect someone else to make decisions for them. 4. The overall responsibility of management for the integrity of the financial statements. 5. The value of reports on internal control. 6. The difficulty of measuring the economics of complex transactions.

CHAPTER 7 SYSTEM OF QUALITY CONTROL FOR PUBLIC ACCOUNTANCY FIRMS Questions 1.


2.

Refer to pages 293 and 294 of the textbook.

3. Refer to pages 293 and 294 of the textbook. 4.

a.

Leadership responsibilities for quality within the firm

b.

Engagement performance

c.

Human resources

d.

Monitoring

e.

Human resources

f.

Relevant ethical requirements

g.

Acceptance and continuance of clients

h.

Leadership responsibilities for quality within the firm

i.

Engagement performance


A D D B C

6. 7. 8. 9. 10.

B A D B C

11. 12. 13. 14. 15.

D B C C D

16. 17. 18. 19.

C B C D


7-2 Cases 1.

MORALES, CABRERA, & CO., CPAs 1.

a. b. c.

Hiring / Professional requirements To ensure that personnel who will be performing audits have adequate technical training and proficiency. New accountants hired must have an accounting degree from an accredited school.

2.

a. b. c.

Advancement / Professional requirements To ensure personnel are qualified to do the tasks they are assigned. An in-charge accountant must have served as a staff auditor on an audit in the client’s industry.

3.

a. b.

Skills and Competence To ensure that personnel continue to be updated on changes in accounting or auditing standards. Personnel will participate in forty hours of continuing education per year.

c. 4.

a. b. c.

Consultation To ensure that personnel have access to persons with more experience in dealing with problems they have encountered. For each industry for which the office has a client, a specialist will be identified.

5.

a. b. c.

Independence To ensure that personnel meet PICPA guidelines for independence. Firm personnel must list their investments. Personnel must report any stock acquisitions.

6.

a. b. c.

Supervision To ensure that work performed meets the firm’s standard of quality. Staff personnel are to follow firm guidelines for working paper development.

7.

a. b. c.

Inspection / Review To verify that quality control procedures are being followed. Inspect the audit programs for all engagements.

8.

a. b. c.

Acceptance and retention of clients To minimize the risk associated with clients. New clients must be investigated by a private investigative agency.

System of Quality Control for Public Accountancy Firms 9.

a. b. c.

2.

7-3

Assigning personnel to engagements To ensure that personnel posses the degree of technical training and proficiency required for an engagement. To be eligible to be senior on an engagement, a person must have had experience in the industry.

Auditing standards indicate that auditors should report major issues discussed with the entity’s management prior to being retained as auditor, including discussions regarding the application of accounting principles and auditing standards. Discussion of such matters may place pressure on the auditor to yield to management’s view. Making the audit committee members aware of such matters should enable them to better monitor the auditor’s independence. Standards do not preclude clients from making suggestions about audit staff. Clients frequently make requests to have persons on the audit who have experience in the industry. If a client requests that minority persons not be assigned to an audit, however, the auditor must carefully consider the ethical implications of that request.

CHAPTER 8 PHILIPPINE STANDARDS ON AUDITING Questions 1.

Foreign public accounting firms have found that to retain their multinational clients, they have had to develop the capacity to provide services worldwide. Although the roots of at least two of the big firms in the United States are traceable to European ancestry, public accounting firm involvement in international activities has paralleled the gradual involvement of businesses in international activities. In the early 1900s, some public accounting firms established representative offices in foreign countries. As business activity expanded, the firms opened offices in foreign cities. During the 1970s, some countries forced these firms to close their offices. To be able to serve their clients, the firms established correspondent relationships with locally owned accounting firms; in these relationships, local partners remain separate, local, autonomous organizations. Because domestic and foreign partners in a correspondent relationship agree to follow a common code of ethics and practice guidelines, each is able to rely on the work the other performs. A big firm auditing a U.S. business with significant activities in France, for example, would rely on its Paris office to audit the activities of the business in France. The largest firms have organized worldwide partnerships to achieve a greater uniformity of quality, to facilitate management of personnel, and to coordinate research and professional development of personnel. Many small public accounting firms establish correspondent relationships with foreign public accounting firms or join a federation. Firms in a federation call on one another to perform services for clients, following agreed-upon standards in conducting the work they do for one another.

2.

Yes. According to paragraph 10 of the Preface to Philippine Standards on Auditing and Related Services, “an auditor may, in exceptional circumstances, judge it necessary to depart from a PSA in order to more effectively achieve the objective of an audit. When such a situation arises, the auditor should be prepared to justify the departure.”

3.

No. According to paragraph 14 of the Preface to the Philippine Standards on Auditing and Related Services, “PAPSs are issued to provide practical assistance to auditors in implementing the PSAs or to promote good practice. These Statements are not intended to have the authority of the PSAs.”

4.

Refer to page 329, paragraph 6 of PSA 120.


8-2 5.

Refer to page 329, paragraph 6 of PSA 120.

6.

Refer to pages 329 and 330, paragraphs 8, 9 and 10 of PSA 120.


D B B D C

6. 7. 8. 9. 10.

C C D D A*

11.

D

* b and d are also options available to the auditor

Cases 1.

The PICPA currently develops independence and ethical standards, quality control standards, and auditing and attestation standards that apply to its members. However, PICPA standards are applicable to the audits and auditors of nonpublic clients based on general acceptance by the courts, and adoption by state boards of accountancy and other regulatory bodies. The AICPA also has a voluntary peer review program, and enforces its standards on its members. The PCAOB was given the legal authority to develop independence and ethical standards, quality control standards, and auditing and attestation standards that apply to public company auditors and integrated audits. The PCAOB also is charged with performing inspections of registered audit firms, and may sanction the firms for noncompliance with its standards and the provisions of SarbanesOxley Act. The state boards of accountancy regulate CPA firms and CPAs in the various states and jurisdictions. They have the authority to establish their own standards, but have generally adopted the standards of other bodies such as the PICPA and the PCAOB. A state board enforces its standards in its state or jurisdiction and has the authority to revoke a CPA firm or individual CPA’s right to practice in the state.

2.

Applicable Technical and Professional Standards •

It was inappropriate for Arnold to hire the two students to conduct the audit. The audit must be conducted by persons with proper education and experience in the field of auditing. Although a junior assistant has not completed his formal education, he or she may help in the conduct of the audit as long as there is proper supervision and review.

Philippine Standards on Auditing

8-3

•

Because of the financial interest in whether the bank loan is granted, Arnold is not independent.

•

Arnold did not review the work or the judgments of the assistants and clearly failed to adhere to this standard.

•

Arnold accepted the engagement without considering the availability of competent staff. Arnold failed to supervise the assistants and did not adequately plan the work.

•

Arnold and the assistants did not obtain the require understanding of the entity and its environment, including internal control.

•

Arnold acquired no evidence that would support the financial statements. Merely checking the mathematical accuracy of the records and summarizing the accounts is inadequate.

•

Arnold's report makes no reference to applicable reporting framework. Because Arnold did not conduct a proper audit, the report should state that no opinion can be expressed.

•

In this case both the statements and the auditor's report lack adequate disclosures.

Although Arnold’s report contains an expression of opinion, such opinion is not based on the results of a proper audit. Arnold should disclaim an opinion because he failed to conduct an audit in accordance with Philippine Standards on Auditing (PSAs). 3.

(a) When the auditors discover illegal acts by a public client, they should consider three major factors. First, the auditors should consider the effect of the acts on the client's financial statements, including the possibility of fines and loss of business. To comply with the applicable reporting framework, the financial statements must reflect the material effects of illegal acts. Second, the illegal acts may affect the auditors' assessment of the integrity of management. In deciding whether to continue to serve the client, the auditors should consider the nature of the illegal acts and management's response to the acts after they are uncovered. Third, the auditors should consider whether the occurrence of the illegal act indicates that there is a material weakness in the company’s internal control over financial reporting.


8-4

(b) The following courses of action are available to the auditors: (1)

The auditors could issue an unqualified opinion and take no further steps regarding the illegal activities. This course of action could be argued on the basis that the effect of the acts on the financial statements is not material. If the auditors take this course of action, they should also consider whether the illegal act and related actions by management and the board indicate a material weakness exists that would affect their report on internal control over financial reporting.

(2)

The auditors could issue a qualified opinion because the financial statements depart from the applicable reporting framework, in that they fail to disclose the illegal acts. This course of action could be argued on the basis that any illegal activities by the client are material, especially when management fails to take any steps to prevent the acts. If the auditors take this course of action, they should also consider whether the illegal act and related actions by management and the board indicate a material weakness exists that would affect their report on internal control over financial reporting.

(3)

The auditors could withdraw from the engagement, because the client's failure to take actions to prevent such activities indicates that Generic's management lacks sufficient integrity.

(c) We believe that the auditors should consider withdrawing from the engagement. Generic's top management seems far too complacent regarding these activities. Their refusal to take any action to prevent the acts in the future provides a signal to lower level management that top management approves of illegal acts. The auditors clearly should question the integrity of management in this situation. 4.

The following memorandum summarizes the response of Alice Borromeo, CPA, to the request of a client for extension of the attest function to the problem of pollution control. Dear Jenny: As much as I support your strenuous efforts to minimize air and water pollution from the manufacturing operations of your company, there are specific reasons which make it impossible for me as a CPA to attest to the extent of your accomplishments in this area along the lines you have suggested. When we perform the attest function with respect to your financial statements each year, we are expressing our professional opinion that your financial statements are prepared in conformity with certain standards, or applicable reporting framework.

Philippine Standards on Auditing

8-5

In order for us to attest to the effectiveness of your pollution control program, recognized standards would have to be established in this field. No such standards presently exist for a factory to the best of my knowledge. Of course the national government has set standards for exhaust emissions on automobile engines and we could, by retaining independent consulting engineers, obtain a basis for attesting to the compliance of a given automobile engine to those standards. We are quite willing to extend the attest function in various directions if we can find a basis for objective comparison of a given operation with a clearly defined standard. Perhaps your engineering department can develop some specific quantitative data on the industrial waste from your operations. We might then be able to perform the necessary examination of such data to enable us to attest to the validity of your representations as to your operations. Of course, this would not be the same thing as providing your relative position in the industry. After reviewing this possibility with your engineering staff, if you would like to discuss the matter further with us, we will be glad to meet with you. Sincerely, Alice Borromeo

CHAPTER 9 OVERVIEW OF RISK-BASED AUDIT PROCESS Questions 1.

In their investigation of a prospective client, the CPAs should assess the backgrounds and reputations of the prospect and its major shareholders, directors, and officers. Thus, inquiries are made of underwriters, bankers, and attorneys that conduct business with the prospective client. Also, the CPAs are required to make inquiries of the prospect's predecessor auditors to obtain information that might enter into the acceptance decision, such as information regarding the integrity of management. The prospect's financial reports, SEC filings, credit reports, and tax returns are used as sources of financial background information.

2.

An engagement letter is sent to the client by the auditors to make clear the nature of the engagement, any limitations on the scope of the audit, work to be performed by the client's staff, and the basis for computing the auditors' fee. The engagement letter represents the written contract for the engagement, and its primary objective is to prevent possible misunderstandings between the client and the auditors. It constitutes an executory contract between the auditors and the client.

3.

“Shopping for accounting principles” is a practice whereby management changes auditors to a CPA firm that is more likely to allow an accounting principle that has been the subject of dispute with the company’s prior auditors. A number of mechanisms serve to discourage the practice, including: (1) the requirements under PAS No. 84 for the successor auditors to inquire of the predecessors about the reasons for the change in auditors, (2) the SEC 8-K requirements for management to report the reasons for a change in auditors which also require the auditors to express their agreement with the details, and (3) the requirements under PAS No. 97 that require accountants who are being asked to provide a report on the accounting treatment of an prospective or completed transaction to consult with the client’s auditors to ensure that they have a complete understanding of the form and substance of the transaction. In addition, the Sarbanes-Oxley Act of 2002 requires the audit committee to assume responsibility for engaging, compensating, and overseeing the auditors.

4.

The approach described in the statement is not appropriate. Materiality depends on both the dollar amount and the nature of the item. For example, auditors apply a more rigorous standard of materiality in evaluating transactions between


9-2

related parties and potentially illegal acts than they apply to misstatements in accounts. 5.

The two types of misstatements due to fraud are (1) misstatements arising from fraudulent financial reporting, and (2) misstatements arising from misappropriation of assets (sometimes referred to as defalcation). Fraudulent financial reporting is of more concern to the auditors because it typically results in effects that are much more material to the financial statements. Defalcations often are not material to the financial statements.

6. A business risk is a treat to achieving management’s objectives. There are many examples of business risks that may result in a risk of material misstatement of the financial statements. Two are shown below: Business Risk

Risk of Material Misstatement

Rapidly changing technology in the client’s industry may threaten to cause the client’s products to become obsolete.

Inventory may be overvalued because it is not valued at net realizable value.

Economic conditions in the industry may result in significant uncollectible accounts receivable.

Accounts receivable may be overvalued because the allowance for uncollectible accounts is not adequate.

7.

The audit procedures to be followed in a given engagement depend upon such factors as the risks of material misstatement of the financial statements, the assumption about the effectiveness of internal control, the auditors' estimates of materiality, the nature of the accounting records, the caliber of accounting personnel, and any special objectives of the engagement. Consequently, a separate, tailor-made audit program should be prepared for each audit engagement.

8.

The quotation is misleading because it implies that an audit program is no more than a checklist of instructions for inexperienced auditors. Actually, audit programs are essential to assessing that all work is performed and are used on virtually all audit engagements regardless of the amount of experience of the auditor. Also, a written audit program is required for all audits.

9.

The risk of material misstatement is the probability that an account, class of transactions, or disclosure is materially misstated. It consists of inherent risk (the risk of material misstatement without considering internal control) and control risk (the risk that internal control will fail to prevent or detect and correct the material misstatement).

Overview of Risk-Based Audit Process

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10. Significant risks often relate to nonroutine transactions and estimation transactions. Such transactions typically involve more subjective judgment than routine transactions and, therefore, they often have a higher risk of material misstatement. Significant risks may also be fraud risks. 11. Factors which may cause an audit engagement to exceed the original time estimate include the following: (1) Accounting records may not be up to date and complete. (2) Inadequacies in internal control may be discovered necessitating a more detailed audit than anticipated. (3) A significant risk, such as a fraud risk, may be discovered requiring an extension of audit procedures. (4) Fraud may be discovered, and an extended investigation may be authorized by the client to clarify the situation. (5) Inadequate supervision of audit staff may permit unnecessary or misdirected work to be performed. (6) Findings during the course of the audit may cause the client to request extension of the scope of the work. In some engagements, clients are charged at agreed daily or hourly rates for the time used to perform the audit. The difficulty of forecasting time requirements is a principal reason for the use of per diem rates rather than quoting a fee for the entire engagement. For many engagements, a maximum fee is agreed upon; this plan may, of course, force the auditing firm to absorb part of the cost of unexpected amounts of work. A decision as to charging the client for unusual amounts of time will involve consideration of all aspects of the engagement and prior relations with the client. Generally, however, the client should not be billed for excessive time attributed to audit inefficiencies (e.g. item (5) above). 12. Underreporting of time results in the CPA firm not billing the client for all of the time actually involved in rendering the professional services. Thus, the firm's revenue is being restricted. In addition, the underreporting will cause the firm to underestimate the amount of time required for future engagements. Thus, auditors on future engagements will be expected to perform audit procedures in an unrealistically short period of time. This interferes with the performance of an effective audit as well as the realistic evaluation of firm personnel.


9-4 Cases 1.

a.

Prior to acceptance of the engagement, Argante & Tan should have communicated with the predecessor auditor regarding: • • • •

b.

The form and content of engagement letters may vary, but they would generally contain information regarding: • • • • • •

• • • • • • 2.

a.

Facts that might bear on the integrity of management. Disagreements with management concerning accounting principles, auditing procedures, or other significant matters. The predecessor’s understanding about the reason for the change. Any other information that may be of assistance in determining whether to accept the engagement.

The objective of the audit. The estimated completion date. Management’s responsibility for the financial statements. The scope of the audit. Other communication of the results of the engagement. The fact that because of the test nature and other inherent limitations of any system of internal control, there is an unavoidable risk that even some material misstatement may remain undiscovered. Access to whatever records, documentation, and other information may be requested in connection with the audit. Arrangements with respect to client assistance in the performance of the audit engagement. Expectation of receiving from management written confirmation concerning representations made in connection with the audit. Notification of any changes in the original arrangements that might be necessitated by unknown or unforeseen factors. Request for the client to confirm the terms of the engagement by acknowledging receipt of the engagement letter. The basis on which fees are computed and any billing arrangements.

Typical engagement letter generally includes the following: • The name and address of the person or persons who retained the auditor to perform the auditing services. • An opening paragraph that confirms the understanding of the auditor and the client. • A summary of significant events that lead to the retention of the services of the auditor.

Overview of Risk-Based Audit Process • • • • • • • • • b.

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A general description of the CPA firm that will conduct the examination. A statement that the examination will be performed in accordance with auditing standards. A description of the scope of the services to be rendered, which should establish the nature of the engagement. Any scope restrictions or special limitations and their effect on the auditor’s report. A statement regarding the auditor’s responsibility for the detection of fraud. An indication of the possible use of client personnel in connection with the audit work to be performed. A statement that the auditor will provide a management letter if required in the circumstances. The method and timing of billings as well as billing rates and fee arrangements. Space for the client representative’s signature, which indicates “acceptance” of the letter and the understandings, therein.

The benefits of preparing an engagement letter include the avoidance of possible problems between the CPA and the client concerning (1) the scope of the work, (2) the service to be rendered, and (3) the audit fee. In addition, the “in-charge” auditor conducting the examination can avoid misunderstanding the nature and scope of the engagement if the engagement letter is included in the permanent section of the audit working papers. The letter should eliminate misunderstandings and confusion about the type of financial statements to be examined, the estimated report date, and the type of opinion expected. In addition to avoiding possible misunderstandings, any legal problems relating to the auditor’s failure to perform certain procedures can be reviewed with reference to the contractual commitment assumed. (For example, if scope limitations prevent the auditor from performing normal audit procedures, the auditor cannot be legally responsible if an irregularity is not detected when clearly it would have been detected if such procedures were performed.) The engagement letter is also useful as a reference document when preparing for future engagements.

c.

The CPA usually prepares the engagement letter as a follow-up to a verbal understanding that he and his client have reached. It is desirable that the client endorse and return an approved copy of the engagement letter to the CPA. It also is acceptable for the client to prepare his own letter summarizing his understanding of the nature of the engagement.


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3.

d.

Preferably the engagement letter should be sent at the beginning of the engagement so that misunderstandings, if any, can be remedied.

e.

Obviously, the engagement letter will be most useful in clarifying misunderstandings on a first engagement. But it is desirable that the letter be renewed periodically. Client personnel or the nature of the engagement may change, and the resubmission of the letter gives both parties an opportunity to review the circumstances. Accordingly, for recurring examinations of financial statements, it is appropriate to prepare an engagement letter at the start of each examination. For other continuing engagements, the engagement letter also should be updated periodically – probably on a yearly basis.

a.

The procedures that Francis should follow prior to accepting the engagement include the following: (1) Francis should explain to Nikolai the need to inquire of Jo and should request permission to make such inquiries. (2) Francis should request that Nikolai authorize Jo to respond fully to all of Francis’ inquiries since Jo would be prohibited from disclosing confidential information obtained in the course of his professional engagement with Nikolai. (3) Francis should advise Jo of Nikolai’s decision to change auditors as an act of professional courtesy. (4) Francis should make reasonable inquiries of Jo regarding matters that will aid in deciding whether to accept the engagement. (Francis’ inquiries should include questions regarding facts which might bear on the integrity of management, disagreements with management as to accounting principles, auditing procedures or other significant matters, and Jo’s understanding of the reason(s) for the change of auditors.) (5) Francis should weigh all the information received from Jo. If Jo does not respond fully to Francis’ questions, Francis should consider the implications of the limited response in deciding whether to accept the engagement. (6) After weighing all information received from Jo, Francis should inform Nikolai that a first-time audit is more time-consuming than a recurring audit because the new auditor is generally unfamiliar with client’s operations and does not have the benefit of past knowledge of company affairs to use a guide. (7) A discussion with Nikolai of the estimated required audit time and fee arrangement should be coordinated with a clear explanation of the purpose and scope of the audit. Any work that can be done by client

Overview of Risk-Based Audit Process

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personnel should also be discussed so that excess audit time might be eliminated and proposed report deadlines can be reasonably met. (8) To satisfy Francis’ quality control objectives, Francis should use procedures such as reviewing the financial statements of Nikolai; inquiring of third parties such as Nikolai’s banks, legal counsel, investment bankers, and others in the business community as to Nikolai’s reputation; and evaluating his ability to serve Nikolai properly with reference to industry expertise, size of engagement, and available staff. (9) If Francis has no reservations, after all significant factors have been considered, discussed, and agreed to, Francis should accept the engagement and confirm the understanding in an engagement letter. b.

Francis’ procedures on this first-time audit should include the following: (1) Francis should review the workpapers of Jo to obtain information that will help plan the audit work. (2) Francis should make arrangements as early as possible for the initial meeting with “key” company personnel who will be contacted throughout the engagement. (3) Since basic information about the company is not readily available to Francis on this first-time audit, information of a general nature should be obtained as early in the planning stage as possible. (Such information should include company history, nature of the business, credit policies, financing methods, sales methods and terms, seasonal business patterns, products, services, plant locations, internal procedures, accounting policies, tax status, etc. Client procedures manuals and manuals of accounts should be read to obtain such information.) (4) Francis should immediately start obtaining the data needed to create a permanent working paper file. (The file should include items such as articles of incorporation, minutes, internal audit reports, deeds of trust, pension agreements, loan agreements, leases, important contracts, and other pertinent data.) (5) Francis must determine the scope of work necessary to verify the opening balances. Such balances must be reviewed to determine whether they are stated on a basis comparable with those of the period under review. If Francis cannot verify the opening balances, Francis should consider disclaiming an opinion on the earnings statement and statement of changes in financial position. (6) The composition of all important accounts should be reviewed. Francis should limit his examination of prior period accounts to a review or


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survey of such accounts, without a detailed examination, unless the results of Francis’ survey and analyses indicate the need for further investigation of accounting methods in the prior years. (7) Francis must consider whether the financial statements are prepared using financial reporting standards that were consistently applied. If, after performing necessary audit procedures, Francis cannot be satisfied as to consistency, considerations must be given to qualifying the auditor’s report as to consistency. Francis should use professional judgment to determine the extent of reliance that should be placed on the work of Jo. The scope of Francis’ work may be reduced as a result of Francis’ consultation with Jo and a review of the prior-year workpapers of Jo. 4.

a.

A CPA can use the following sources of information to help decide whether to accept a new audit client. Financial information prepared by the prospective client: Annual reports to shareholders Interim financial statements Securities registration statements Annual report on SEC Reports to regulatory agencies Inquiries directed to the prospect’s business associates: Banker Legal counsel Underwriter Other persons, e.g., customers, suppliers Predecessor auditor, if any, communication, re: Integrity of management, Disagreements with management Analysis: Special or unusual risk related to the prospect Need for special skills (e.g., computer or industry expertise) Internal search for relationships that would comprise independence

b.

Students can decide this acceptance question either way, although the brief facts prejudice the conclusion toward nonacceptance. The CPA’s own firm decided to resign only 10 years ago, presumably over matters of ownermanager integrity. Yet, Mr. Sello appears to be a respected member of his new community. Maybe his “fast and loose” accounting past is behind him. Maybe not.

Overview of Risk-Based Audit Process 5.

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Benefits of engagement letters are: •

Helps establish an understanding between client and auditor of the terms of the engagement and the nature of the work.

•

Helps avoid quarrels and misunderstandings between client and auditor.

•

Helps avoid disputes over the audit fee.

•

Helps avoid legal liability assertions based on failure to do work that the CPA may not have contemplated or agreed to do.

CHAPTER 10 UNDERSTANDING THE ENTITY Questions 1.

A business risk is a treat to achieving management’s objectives. There are many examples of business risks that may result in a risk of material misstatement of the financial statements. Two are shown below: Business Risk

Risk of Material Misstatement

Rapidly changing technology in the client’s industry may threaten to cause the client’s products to become obsolete.

Inventory may be overvalued because it is not valued at net realizable value.

Economic conditions in the industry may result in significant uncollectible accounts receivable.

Accounts receivable may be overvalued because the allowance for uncollectible accounts is not adequate.

2.

An audit plan provides essential background information for an audit assignment, and outlines the objectives, timing, staffing, special risks and considerations, and other requirements of the engagement. An audit program is a detailed outline of the auditing work to be performed, specifying the procedures to be followed in verification of each item in the financial statements. Although both the audit plan and the audit program are technically plans, the audit plan serves more as a broad overview of the engagement, while the audit program is more specific and limited in scope.

3.

The purpose of the team meeting on fraud risk is designed to allow the more experienced team members to share insights and exchange ideas about how and where the entity’s financial statements might be susceptible to material misstatement due to fraud, to discuss how to design appropriate tests to detect the misstatements, and to emphasize the importance of maintaining the proper degree of professional skepticism regarding the possibility of fraud.

4.

During the planning process, the auditors make preliminary estimates of both risk and materiality for the engagement. The auditors must plan their engagements to reduce the audit risk of issuing an unqualified opinion on materially misstated financial statements to a relatively low level. At the account balance level, audit risk actually has three components: (1) inherent risk, (2) control risk, and (3) detection risk. On audits where the risk of

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Solutions Manual – Public Accountancy Profession misstatement is relatively high, the auditors must compensate by increasing the effectiveness of their audit procedures. They may design more effective procedures, increase the number of items selected for testing, or perform more procedures at the balance sheet date rather than at an interim date. They may also add an element of unpredictability to the procedures. The auditors' preliminary estimates of levels of materiality also affect the nature, timing, and extent of their planned procedures. Materiality levels determine which accounts are significant enough to require audit, affect the size of the test samples, and determine the dollar amount of individual items that warrant examination.

5.

(a) Auditors must obtain an understanding of the client and its environment in order to determine whether the client should be accepted and to plan the audit. This understanding encompasses the following: (1) The nature of the client, including the client’s application of accounting policies—The auditors’ understanding of this area will include the client’s competitive position, organizational structure, accounting policies and procedures, ownership, capital structure, and product lines. The understanding will also encompass an understanding of the client’s business model and its major business processes. (2) The industry, regulatory, and other external factors—The factors included here are industry conditions, such as the competitive environment, supplier and customer relationships, and technological developments. They also include the regulatory, legal, and political environment, and general economic conditions. (3) Objectives and strategies and related business risks—The auditors obtain an understanding of the operating and financing strategies of management. They also obtain an understanding of management’s risk assessment process. This assists the auditors in identifying significant business risks that may create risks of material misstatement of the financial statements. (4) Methods of measuring and reviewing performance—The auditors obtain an understanding of the methods management uses to measure and review performance at various levels within the organization. These methods are important to determining incentives of management and other employees. The measures may also be used in designing effective analytical procedures. (5) Internal control—The auditors’ understanding of internal control assists them in planning the audit and assessing control risk.

Understanding the Entity

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(b) Sources of information on prospective clients include trade publications, and governmental agency publications. Previous audit reports, annual reports to stockholders, SEC filings, and prior years' tax returns are excellent sources of financial background information. Informal discussions between the auditors and key officers can provide information about the history, size, operations, accounting records, and controls of the enterprise. Inquiries of others within the organization can provide information that confirms inquiries of management, and provides more detailed information about risks and business processes. Inspection of internal documents and records can provide information about the nature of the client’s operations and internal control. The predecessor auditor may also provide information. (c) Knowledge of the client and its environment helps the auditors in: (1) Identifying areas that may need special consideration. (2) Identifying significant business risks that may result in risks of material misstatement of the financial statements. (3) Assessing inherent risk and making preliminary assessments of control risk. (4) Making judgments about the appropriateness of accounting principles in use and the adequacy of disclosures. (5) Evaluating the reasonableness of estimates, such as depreciation lives and the allowance for doubtful accounts. (6) Evaluating the reasonableness of management representations. (7) Developing an efficient audit strategy. (8) Determining the staffing requirements of the engagement. 6.

During the tour of the client's plant facilities, Sison inspects all inventory areas and makes note of the location, types, security, "housekeeping," and general condition of the inventories. He also visits the receiving and shipping departments and reviews the types of documents maintained. His observations in these areas enable him to form a preliminary impression of the adequacy of internal controls for inventories, and possible problems with respect to obsolete or slow-moving inventories. He also can begin formulating plans for staffing and carrying out the physical inventory observation. Sison’s observation of the productive processes will acquaint him with the client's physical plant facilities and layout, the nature of the products and computer applications employed in the production process. He may also obtain information on the client's documentation such as for production orders, raw materials requisitioned to production, direct and indirect labor, and inspection and testing of finished products. He meets the supervisory personnel, engineers, and other key personnel responsible for production, and through inquiries and conversations learns of any unique production problems, including excessive

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Solutions Manual – Public Accountancy Profession spoilage and scrap. As a result, he will be in a position to evaluate the client's cost accounting system during the course of the audit. He will also inquire about the details of the client’s business processes. Throughout the tour, Sison will add to his impression of the client's business processes, control procedures and accounting records. He will notice, for example, what personnel have access to computer terminals and accounting records, whether plant assets have identification tags, and whether documents such as production orders and receiving reports are serially numbered or controlled by the computer.

7.

(a) Misstatements due to fraudulent financial reporting are intentional misstatements or omissions of amounts or disclosures in the financial statements to deceive financial statement users. Misstatements arising from misappropriation of assets (sometimes referred to as defalcation) involve the theft of an entity’s assets where the effect of the theft causes the financial statement not to be presented in conformity with generally accepted accounting principles. (b) The three conditions necessary for the commission of fraud include: (1) some type of incentive or pressure, (2) an opportunity to commit the fraud, and (3) an attitude that allows the individual to rationalize the act. In a case of fraudulent financial reporting, members of top management may have an incentive to commit the act relating to maintaining the value of their stock options. They may have an opportunity based on weaknesses in the corporate governance of the organization. Finally, they may be able to rationalize the act by assuming that the company will make enough income next period to allow them to correct the misstatement. (c) The auditors may respond to fraud risks by (1) a modification in the approach having an overall effect on how the audit is conducted, (2) an alteration in the nature, timing, and extent of the procedures performed, and (3) performance of procedures to further address the risk of management override of internal control.

8.

(a) Shin may respond to fraud risks in the following three ways: (1)

A modification in the overall approach to the audit which might involve: (a) Applying increased professional skepticism and designing procedures that provide more reliable evidence.

(b) Assigning additional staff with specialized skill and knowledge or by assigning more experienced staff to the engagement. Also the

Understanding the Entity

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extent of the supervision of the staff should be adjusted to reflect the fraud risks. (c) Giving further consideration to the appropriateness of the accounting principles used by the client. (d) Incorporating an added element of unpredictability in the selection of auditing procedures. (2) An alteration in the nature, timing and extent of the procedures performed. For example, Shin might apply procedures that provide more reliable evidence, shift more audit tests to year-end, or increase sample sizes for certain substantive tests. (3) Perform procedures to further address the possibility of management override of internal control, including (1) examining journal entries and other adjustments for evidence of fraud, (2) reviewing accounting estimates for biases, and (3) evaluating the business rationale for significant unusual transactions. (b) Whenever the auditors believe that there is evidence that fraud may exist, the matter should be brought to the attention of an appropriate level of management. Fraud involving senior management and fraud that causes a material misstatement of the financial statements should be reported directly to the audit committee. In very serious situations the auditors should consider resigning the engagement. Multiple Choice Questions 1. 2. 3. 4. 5.

d a d d d

6. 7. 8. 9. 10.

d d d d d

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Cases 1.

(1) (a) There is an increased risk of fraudulent financial reporting by subsidiary management. More specifically, subsidiary management would likely attempt to increase revenue or decrease expenses. (b) The auditors would probably respond by performing more procedures at the subsidiary location. Additional tests of revenue would be performed and the auditors would likely decide to observe inventory at year-end. In addition, some of the procedures may be performed on an unannounced basis. (2) (a) There is an increased risk of fraudulent financial reporting by management related to revenue. (b) The auditors would likely respond by utilizing more experienced audit team members. Specifically, audit staff that had experience with complex revenue contracts in the telecommunications industry. They would also likely increase the extent of the substantive tests of revenue. (3) (a) There is an increased risk that the futures traders will fraudulent overstate the value of the contracts to increase their compensation. (b) The auditors would likely respond to this situation by bringing in a specialist to assist in valuing the contracts. In addition, they would do extensive testing of the valuation of the contracts. (4) (a) There is an increased risk that management may be fraudulently overstating income at one or more of the stores. (b) The auditors would likely respond by doing increased testing of revenue and inventory at the stores. The auditors could use the results of the analytical procedures to identify stores that are more likely to have fraudulent reported results (e.g., those with unusually high profit margins). The auditors also may not disclose the locations that they intend to visit for inventory observation.

Understanding the Entity 2.

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Mr. Gian Lee President Palace Corporation Dear Mr. Lee: Our recent tour of Palace's plant was a most pleasant and interesting experience. The information obtained on this tour and during the discussion of your financial statements and accounting records has enabled us to plan the scope of an audit especially suited to your needs. Our fees are based on the time spent on the engagement by various members of our audit staff, and will be billed at our established rates. The total time required for an initial engagement is usually somewhat greater than in repeat examinations, since the latter do not require analysis of past years' transactions. Considerable savings in the cost of the audit may be made by utilizing the services of your accounting staff to help us in certain phases of the work. We can arrange for your employees to prepare for us a number of working papers. If you approve, we shall indicate to your chief accountant the exact nature of the working papers to be prepared. Our audit will be performed in accordance with generally accepted auditing standards and will include all procedures which we consider necessary to provide a basis for expression of our opinion on the fairness of the financial statements. The audit will include: (1) A consideration of the internal control. (2) Tests of the financial statement accounts and balances to the extent we consider necessary, based on our consideration of risks and internal control. (3) Preparation of the federal and state income tax returns. (4) Issuance of our auditor's report upon your financial statements. If our investigation indicates the desirability of any changes in internal control procedures, we shall prepare a report on this subject for your consideration. However, an audit cannot be relied upon to identify all weaknesses in internal control. The purpose of our audit is to enable us to express an opinion on the fairness of the financial statements; the audit is designed to provide reasonable, but not absolute, assurance of detecting material fraud and defalcations, and we will notify you if our audit does bring them to light. Although it is not possible to determine in advance the exact number of days required for the engagement, our estimates indicate that the total fee will be

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Solutions Manual – Public Accountancy Profession between ___________ and _________. The audit will be completed and our report submitted by March 1, 2014. We would like an opportunity during the next few days to discuss with you and your chief accountant the nature of the preliminary work to be done by your staff. We shall also be pleased to answer any further questions which you may have concerning the determination of audit fees. Very truly yours, Chariya, Modena and Company, CPAs

CHAPTER 11 CONSIDERATION OF INTERNAL CONTROL IN A FINANCIAL STATEMENTS AUDIT Questions 1.

An auditor obtains an understanding of a client’s internal control structure as a part of the control risk assessment process in order (1) to plan the nature, timing, and extent of subsequent substantive audit procedures, and (2) to obtain information about reportable conditions (control deficiencies) to report to the client.

2.

The primary reason for conducting an evaluation of a client’s existing internal control system is to give the auditors a basis for finalizing the details of the account balance audit program – to determine the nature, timing and extent of subsequent substantive audit procedures. A secondary purpose for conducting an evaluation of internal control is to be able to make constructive suggestions for improvements. Officially, the profession considers these suggestions a part of the audit function and does not define the work as a MAS consultation. Another purpose of the evaluation is to report to management and the board of directors or its audit committee any discovery of “any reportable conditions” of internal control deficiencies.

3.

Refer to page 590, 1st paragraph of the textbook.

4.

1.

Advantages of control questionnaire: Easy to complete. Checklist of questions. Less chance of overlooking something important. Disadvantages: May contain numerous irrelevant questions. Tendency to treat it like another form to fill out.

2.

Advantages of memorandum documentation: Can explain the precise controls applicable to the particular client. (precise tailoring) Requires penetrating analysis. Minimizes tendency toward perfunctory review.

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Solutions Manual – Public Accountancy Profession Disadvantages: Hard to write. Often lengthy. Hard to revise in subsequent years. 3.

5.

Advantages of flowchart: Graphic presentation of systems. Shows the steps required and the flow of forms and documents. Easy to read and analyze. Easy to update in subsequent years. Disadvantages: Takes some time to draw neatly.

“Observation,” in a test of control procedure, refers to auditors looking to see whether client personnel stamped, initialed, or left other signs that their assigned control procedures had been performed. “Reperformance,” in a test of control procedure, refers to auditors doing again the control that was supposed to have been performed by the client personnel (recalculating, looking up the right price, comparing quantities, and so forth).

6.

Written reports on internal accounting control (IAC) for external use. Type of Engagement Special IAC study

Character of Report Report on IAC with opinion on IAC system taken as a whole.

Service auditor engaged to report for benefit of user auditor and their mutual client.

A special-purpose report on IAC can take special forms, the main feature of which includes an opinion relating to the controls applied by the service organization to the client organization’s transactions.

7.

The auditor must obtain a sufficient understanding of the client’s system of internal financial controls to identify the types of potential material misstatements of financial statement components, and the risks associated with each. Such understanding is obtained by gathering evidence relating to the basic elements of the client’s internal financial controls.

8.

The auditor obtains an initial understanding of the client’s financial controls by studying the organizational structure, inquiring of management, and studying last year’s working papers if a recurring audit.

9.

The documentation of the auditor’s understanding must provide clear evidence of support for the auditor’s conclusions regarding the assessed level of control risk. This is especially necessary if control risk is assessed below the maximum

Consideration of Internal Control in a Financial Statements Audit

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level. The documentation at this point typically consists of some combination of narrative memoranda, questionnaires or checklists, and internal control flowcharts, as well as documentation of the auditor’s conclusions, and the reason(s) for assessing control risk below maximum, if applicable. 10. Testing of internal financial controls may permit the auditor to further reduce the assessed level of control risk. This, in turn, should lead to a decrease in the nature, timing, and/or extent of substantive audit testing in the circumstances. 11. The following factors may cause the auditor to decide not to test the client’s internal financial controls beyond obtaining an initial understanding: a. b.

Controls may already have been evaluated as ineffective; Further testing is not cost effective (i.e., the cost of further testing is greater than the cost savings resulting from reduced substantive testing)

12. Some combination of the following means is typically utilized by the auditor in testing a client’s internal financial controls: a. b. c.

Reprocessing transactions through the client’s system; Observation of controls; and Document examination and testing.

13. Misrepresentation is a form of financial statement misstatement caused by intentional efforts by management to distort reported financial position and/or results of operations. Misappropriation is a form of fraud whereby one or more employees effect a transfer of assets from employer to employee, accompanied by concealment in the form of account or substance alteration. 14. The following are some examples of internal control weaknesses and suggested expanded substantive testing, given the weaknesses: a. b. c.

Perpetual inventory records not maintained: Expand test counts during inventory observation Bank accounts not reconciled: Expand year-end audit of cash accounts Customer exceptions to monthly statements not investigated and cleared: Expand accounts receivable confirmation at year-end.

15. Reportable conditions are matters coming to the auditor’s attention, as a result of his/her study and evaluation of the client’s internal financial controls, relating to significant deficiencies in the design or operation or of the internal controls that could adversely affect the organization’s ability to record, process, summarize, and report financial data consistent with the assertions of management in the financial statements. The purpose of the reportable conditions letter is to inform the audit committee, or similar body within the organization, of weaknesses for which they may not be aware. Such communication increases the likelihood that the weaknesses will be corrected on a timely basis.

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16. Use of any one of the approaches to studying and documenting a client’s internal financial controls, by itself, is inadequate. Each approach adds a needed dimension to the analysis. The memorandum requires depth of analysis not found in the flowchart. The flowchart, on the other hand, promotes ease of understanding and ready identification of strengths and weaknesses in controls. The questionnaires and checklists add the dimension of completeness of coverage. By using the three tools in combination, the auditor is able to gain a deeper and clearer understanding of each of the subsets of the transaction cycles, including major control strengths and weaknesses, thereby permitting more accurate control risk assessments and more useful substantive audit programs based on such assessments. Multiple Choice Questions 1. 2. 3. 4. 5. 6. 7.

b a b d b b b

8. 9. 10. 11. 12. 13. 14.

a b c b a b b

15. 16. 17. 18 19. 20. 21.

d c b b a d a

22. 23. 24. 25. 26. 27. 28.

a a d b d b d

Cases 1.

a.

b.

Given identified financial control weaknesses, the auditor may elect to expand the extent of substantive testing, or search for and test compensating controls. In the present case, the following errors and irregularities may occur, given the control weaknesses in the payroll subset of the expenditure cycle: 1.

Hours may be in error, inasmuch as the time cards are prepared by employees and not reviewed. This could lead to overstatement or understatement of wages expense in the income statement. This could also affect the carrying value of finished goods inventories if Quicky is a manufacturing company.

2.

The payroll could be “padded” inasmuch as signed checks are returned to the department supervisors for distribution. This could result in overstatements of salaries and wages expense on the income statement. It could also cause a finished goods inventory overstatement.

If, based on the initial understanding, controls are thought to be adequate, the auditor should consider the following alternatives:

Consideration of Internal Control in a Financial Statements Audit

c.

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1.

Document the understanding, assess control risk below maximum, as considered appropriate, and document the basis for conclusions; or

2.

Document the understanding and test controls as a means for further reduction in the assessed level of control risk. This alternative would be chosen if the following conditions exist: a.

Controls are thought to be effective; and

b.

Cost reductions through reduced substantive testing exceed cost of further testing of controls.

1.

Auditors must study and evaluate internal control each year because the environment within which the client operates is subject to constant change; and controls must adapt to these changes if the system is to remain effective. The auditor must identify the environmental changes and determine that the relevant control points remain covered after the changes.

2.

A minimum audit is necessary, even under conditions of excellent internal control, because of the following inherent limitations in all internal control systems: Internal control assumes the nonexistence of collusion; Management can override the financial controls; Temporary breakdowns in the control system may occur and produce material errors; Given that these inherent limitations could produce material financial statement misstatements, and given that the audit report provides reasonable assurance that the financial statements do not contain material misstatements, the auditor must perform a minimum audit, even under conditions of excellent internal control if such assurance is to be provided.

11-6


2. ISLANDER DRUG STORE, INC. Processing Cash Collections Internal Control Questionnaire -Question Are customers who pay by check identified via store I.D. card or other means? Does company policy prohibit accepting checks for anything except merchandise sales plus a nominal cash amount? Is a receipt produced by the cash register given to each customer? Is the reading of each cash register taken periodically by an employee who is independent of the handling of cash receipts? Are cash counts made on a surprise basis by an individual who is independent of the handling of cash receipts? Is the reading of each cash register compared regularly to the cash received? Is a summary listing of cash register readings prepared by an employee who is independent of physically handling cash receipts? Are receipts forwarded to an independent employee who makes the bank deposits? Are each day’s receipts deposited intact daily? Is the summary listing of cash register receipts reconciled to the duplicate deposit slips authenticated by the bank? Are entries to the cash receipts journal prepared from duplicate deposit slips or the summary listing of cash register readings? Are the entries to the cash receipts journal compared to the deposits per bank statement? Are areas involving the physical handling of cash reasonably safeguarded? Are employees who handle receipts bonded? Are charged back items (NSF checks, etc.) directed to an employee who does not physically handle receipts or have access to the books?

Yes

No

CHAPTER 12 FRAUD AND ERROR Questions 1.

Holding a belief that a potential conflict of interests always exists causes auditors to perform procedures to search for errors or irregularities that would have a material effect on financial statements. This tends to make audits more extensive for the auditor and more expensive for the client. The situation is not a desirable one in the vast majority of audits where no errors or irregularities exist.

2.

Errors and irregularities: Auditors are required to plan the audit to detect errors and irregularities that would have a material effect on the financial statements. Clients’ illegal acts: Auditors are not required to search for illegal acts, but they are warned to be alert to any that might be detected in the ordinary course of an audit.

3.

Seven major assertions in financial statements: a.

Existence assertion: The practical objective is to establish with evidence that assets, liabilities and equities actually exist and that sales and expense transactions actually occurred. Cut-off can be considered an aspect of the existence assertion.

b.

Occurrence assertion: The practical objective is to establish with evidence that recorded transactions or events that occurred during a given accounting period pertained to the entity.

c.

Completeness assertion: The practical objective is to establish with evidence that all transactions of the period are in the financial statements and all transactions that properly belong in the preceding or following accounting periods are excluded. Another term for these aspects of completeness is cut-off. Completeness also refers to proper inclusion in financial statements of all assets, liabilities, revenue, expense, and related disclosures.

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Solutions Manual – Public Accountancy Profession d.

Rights and Obligations assertion: The practical objectives related to rights and obligations are to establish with evidence that assets are owned (or rights such as capitalized leases are shown) and liabilities are owed.

e.

Measurement assertion: The practical objective is to establish with evidence that a transaction or event is recorded at the proper amount and revenue or expense is allocated to the proper period.

f.

Valuation assertion: The practical objective is to establish with evidence that proper values have been assigned to things (assets, liabilities, equities and related disclosures) and events (revenues, expenses and related disclosures). Auditing Standards refer to the practical objective of obtaining evidence about “valuations” achieved by cost allocations such as depreciation and inventory costing methods.

g.

Presentation and Disclosure assertion: The practical objective is to establish with evidence that accounting principles used by management are appropriate in the circumstances and are applied properly, and that disclosures contain all information required by generally accepted accounting principles.

4.

Benefits of preliminary assessment of materiality: Fine-tune the audit for effectiveness and efficiency. Help auditors avoid surprises related to: Finding out too late about not auditing enough. Finding out later about auditing too much. Is P500,000 material? Maybe. Absolute size. If you think so, it’s material just because it’s a large number. Relative size. No. If P500,000 is less than 5% of a relevant base. Maybe. If P500,000 is between 5% and 10% of a relevant base. Yes. If P500,000 is 10% or more of a relevant base. Nature of the item. Yes, P500,000 is material if it arises from an illegal act.

5.

Yes, auditors have credited discovery of errors and irregularities to analytical review procedures in 27.1% of the cases in a set of audits, and another 18.5% discovery rate was attributed to “prior expectations” and “discussions.”

Fraud and Error 6.

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In assessing inherent risk and control risk, the auditor must consider the types of errors or irregularities that might occur and their impact on the financial statements (materiality.) In evaluating materiality, the auditor should consider the impact of errors and irregularities both individually and in the aggregate. Auditing Standards require that the auditor design the audit to provide reasonable assurance of detecting errors and irregularities that are material to the financial statements. Auditing Standards require that audit risk and materiality be considered both in planning the audit and in evaluating audit results. Control risk and inherent risk are also directly related to the setting of materiality thresholds. If, for example, application of analytical procedures (inherent risk analysis) leads the auditor to suspect earnings inflation, individual item materiality thresholds should be reduced accordingly (i.e., either the materiality percentage or the amount of unaudited income should be decreased.) Similarly, if control risk analysis leads the auditor to suspect numerous errors, aggregate materiality thresholds need to be lowered accordingly.

7.

An auditor’s reaction to an immaterial error may differ from his or her reaction to an immaterial irregularity. Auditors generally accumulate the amount of individual immaterial errors to be sure that the aggregate of all errors is not material. In addition, the auditor is concerned about whether an error came from a misunderstanding or other cause that would have resulted in yet more errors during the period. An auditor is expected to report all irregularities to the audit committee or the board of directors and senior management.

8.


9.


10. Refer to page 430 of the textbook. 11. The factors that should be considered are the peso amount of the account, the likelihood of error, and the cost of auditing the account. 12. The auditor deals with both inherent risk and control risk during the planning phase of the audit. Inquiry of client personnel, study of the business and industry, application of analytical procedures, and documentation of the auditor’s initial understanding of internal control are all performed during the planning phase of the audit. Further study of internal control procedures may occur after the planning phase if the auditor wishes to further reduce the assessed level of control risk, and considers it economically feasible to do so.


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d c c b d a c d c d

11. 12. 13. 14. 15. 16. 17. 18. 19. 20.

d a c c a a a d b d

21. 22. 23. 24. 25. 26. 27. 28. 29. 30.

b d d c d a b a a b

31. 32. 33. 34. 35. 36. 37. 38. 39. 40.

b a d a d d c b a a

41. 42. 43. 44. 45. 46. 47. 48. 49. 50.

b d a c c d d c b d

51. 52. 53. 54. 55. 56. 57. 58. 59. 60.

a a b a c d b d d c

61. a 62. c 63. d

Cases 1.

a.

Antonio’s activity is an irregularity (intentional distortion of financial statements) rather than error (unintentional mistake). It is also an illegal act on Antonio’s individual part.

b.

The problem does not describe the kind of related party transactions discussed in PSA 550.

c.

Yes, a weakness in internal control exists. It may be considered a material weakness because the compensating control (internal auditors’ work on slow-moving inventory) did not operate in a timely enough manner to detect the irregularity before it had gotten large. If a material weakness in internal control exists, Brava & Campos are obligated to report it to management and/or the board of directors.

2.

d.

The problem description indicates that this element of the audit was conducted in a negligent manner. There’s nothing wrong about auditing a sample of the transactions, but Campos’ follow-up and explanation of the missing receiving reports leaves much to be desired. At the very least he could have reviewed the reports produced by Antonio at a later date, and he could have traced the purchases to the inventory records and perhaps noticed an over-stocking condition. The auditors had some evidence that an irregularity might exist, but they failed to apply extended audit procedures properly.

a.

Yes. Nicolas was a party to the issuance of false financial statements and as such is a joint tortfeasor. The elements necessary to establish an action for common law fraud are present. There was a material misstatement of fact, knowledge of falsity (scienter), intent that the plaintiff bank rely on the false statement, actual reliance and damage to the bank as a result thereof. If

Fraud and Error

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action is based upon fraud there is no requirement that the bank establish privity of contract with the CPA. Moreover, if the action by the bank is based upon ordinary negligence, which does not require a showing of scienter, the bank may recover as a third-party beneficiary (an exception to the strict privity requirement). Thus, the bank will be able to recover its loss from Nicolas under either theory. b.

No. The lessor was a party to the secret agreement. As such, the lessor cannot claim reliance on the financial statements and cannot recover uncollected rents. Even if he was damaged indirectly, his own fraudulent actions led to his loss, and the equitable principle of “unclean hands” precludes him from obtaining relief.

c.

Nicolas was not independent. His report is improper and he is probably subject to disciplinary action by the professional organization or regulatory body. According to the ethics interpretation on actual or threatened litigation: “An expressed intention by the present management to commence litigation against the auditor alleging deficiencies in audit work for the client is considered to impair independence if the auditor concludes that there is a strong possibility that such a claim will be filed.”

CHAPTER 13 CORPORATE GOVERNANCE AND AUDITS Questions 1.

Corporate governance is defined as: “a process by which the owners and creditors of an organization exert control and require accountability for the resources entrusted to the organization. The owners (stockholders) elect a board of directors to provide oversight of the organization’s activities and accountability back to its stakeholders.” The key players in corporate governance are the stockholders (owners), board of directors, audit committees, management, regulatory bodies, and both internal and external auditors.

2.

In the past decade, all parties failed to a certain extent. For detailed analysis, see exhibit in the chapter and repeated here: Corporate Governance Responsibilities and Failures Overview of Corporate Governance Failures

Party Stockholders

Overview of Responsibilities Broad Role: Provide effective oversight through election of Board process, approve major initiatives, buy or sell stock.

Board of Directors

Broad Role: the major representative of stockholders to ensure that the organization is run according to the organization charter and there is proper accountability. Specific activities include: • Selecting management. • Reviewing management performance and determining compensation. • Declaring dividends • Approving major changes, e.g. mergers • Approving corporate strategy • Overseeing accountability activities.

Management

Broad Role: Operations and Accountability. Managing the organization effectively and provide accurate and

Focused on short-term prices; failed to perform long-term growth analysis; abdicated all responsibilities to management as long as stock price increased. • Inadequate oversight of management. • Approval of management compensation plans, particularly stock options that provided perverse incentives, including incentives to manage earnings. • Non-independent, often dominated by management. • Did not spend sufficient time or have sufficient expertise to perform duties. • Continually re-priced stock options when market price declined.

•

Earnings management to meet analyst expectations.

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Solutions Manual – Public Accountancy Profession Overview of Corporate Governance Failures

Party

Overview of Responsibilities timely accountability to shareholders and other stakeholders. Specific activities include: • Formulating strategy and risk appetite. • Implementing effective internal controls. • Developing financial reports. • Developing other reports to meet public, stakeholder, and regulatory requirements.

Fraudulent financial reporting. Pushing accounting concepts to achieve reporting objective. • Viewed accounting as a tool, not a framework for accurate reporting.

• •

Audit Committees of the Board of Directors

Broad Role: Provide oversight of the internal and external audit function and the process of preparing the annual accuracy financial statements and public reports on internal control. Specific activities include: • Selecting the external audit firm. • Approving any non-audit work performed by audit firm. • Selecting and/or approving the appointment of the Chief Audit Executive (Internal Auditor), • Reviewing and approving the scope and budget of the internal audit function. • Discussing audit findings with internal auditor and external auditor and advising the Board (and management) on specific actions that should be taken.

• Similar to Board members – did not have expertise or time to provide effective oversight of audit functions. • Were not viewed by auditors as the ‘audit client’. Rather the power to hire and fire the auditors often rested with management.

Self-Regulatory Organizations: AICPA, FASB

Broad Role: Setting accounting and auditing standards dictating underlying financial reporting and auditing concepts. Set the expectations of audit quality and accounting quality. Specific roles include: • Establishing accounting principles • Establishing auditing standards • Interpreting previously issued standards • Implementing quality control processes to ensure audit quality. • Educating members on audit and accounting requirements.

• AICPA: Peer reviews did not take a public perspective; rather than looked at standards that were developed and reinforced internally. • AICPA: Leadership transposed the organization for a public organization to a “trade association” that looked for revenue enhancement opportunities for its members. • AICPA: Did not actively involve third parties in standard setting. • FASB: Became more rule-oriented in response to (a) complex economic transactions; and (b) an auditing profession that was more oriented to pushing the rules rather than enforcing concepts. • FASB: Pressure from Congress to develop rules that enhanced economic growth, e.g. allowing organizations to not expense stock options.

Corporate Governance…

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Overview of Corporate Governance Failures Party Other SelfRegulatory Organizations, e.g. NYSE, NASD

Overview of Responsibilities Broad Role: Ensuring the efficiency of the financial markets including oversight of trading and oversight of companies that are allowed to trade on the exchange. Specific activities include: • Establishing listing requirements – including accounting requirements, governance requirements, etc. • Overseeing trading activities,

Regulatory Agencies: the SEC

Broad Role: Ensure the accuracy, timeliness, and fairness of public reporting of financial and other information for public companies. Specific activities include: • Reviewing all mandatory filings with the SEC, • Interacting with the FASB in setting accounting standards, • Specifying independence standards required of auditors that report on public financial statements, • Identify corporate frauds, investigate causes, and suggest remedial actions. Broad Role: Performing audits of company financial statements to ensure that the statements are free of material misstatements including misstatements that may be due to fraud. Specific activities include: • Audits of public company financial statements, • Audits of non-public company financial statements, • Other accounting related work such as tax or consulting.

• Identified problems but was never granted sufficient resources by Congress or the Administration to deal with the issues.

Broad Role: Perform audits of companies for compliance with company policies and laws, audits to evaluate the efficiency of operations, and audits to determine the accuracy of financial reporting processes. Specific activities include: • Reporting results and analyses to management, (including operational management), and audit committees, • Evaluating internal controls.

• Focused efforts on ‘operational audits’ and assumed that financial auditing was addressed sufficiently by the external audit function. • Reported primarily to management with little effective reporting to the audit committee. • In some instances (HealthSouth, WorldCom) did not have access to the corporate financial accounts.

External Auditors

Internal Auditors

• Pushed for improvements for better corporate governance procedures by its members, but failed to implement those same procedures for its governing board, management, and trading specialists.

• Pushed accounting concepts to the limit to help organizations achieve earnings objectives. • Promoted personnel based on ability to sell “non-audit products”. • Replaced direct tests of accounting balances with a greater use of inquiries, risk analysis, and analytics. • Failed to uncover basic frauds in cases such as WorldCom and HealthSouth because fundamental audit procedures were not performed.

13-4 3.

Solutions Manual – Public Accountancy Profession The board of directors is often at the top of the list when it comes to responsibility for corporate governance failures. Some of the problems with the board of directors included: o o

o o o 4.

Inadequate oversight of management. Approval of management compensation plans, particularly stock options that provided perverse incentives, including incentives to manage earnings. Non-independent, often dominated by management. Did not spend sufficient time or have sufficient expertise to perform duties. Continually re-priced stock options when market price declined.

Some of the ways the auditing profession was responsible were: • Too concerned about creating “revenue enhancement” opportunities for the firm, and less concerned about their core services or talents • Were willing to “push” accounting standards to the limit to help clients achieve earnings goals • Began to use more audit “shortcuts” such as inquiry and analytical procedures instead of direct testing of account balance. • Relied on management representations instead of testing management representations. •

Were too often ‘advocates’ of management rather than protectors of users

5.

Users should expect auditors to have the expertise, independence, and professional skepticism to render an unbiased and justified opinion on the financial statements. Auditors are expected to gather sufficient applicable evidence to render an independent opinion on the financial statements.

6.

Management is responsible for issued financial statements. Although other parties may be sued for what is contained in the statements, management is ultimately responsible. Ownership is important because it establishes responsibility and accountability. Management must set up and monitor financial reporting systems that help it meet its reporting obligations. It cannot delegate this responsibility to the auditors.

7.

An audit committee is a subcommittee of the board of directors that is composed of independent, outside directors. The audit committee has oversight responsibility (on behalf of the full board of directors and its stockholders) for the outside reporting of the company (including annual financial statements); risk monitoring and control processes; and both internal and external audit functions.

Corporate Governance… 8.

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An outside director is not a member of management, legal counsel, a major vendor, outside service provider, former employee, or others who may have a personal relationship with management that might impair their objectivity or independence. The audit committee is responsible for assessing the independence of the external auditor and engage only auditors it believes are independent. Auditors are now hired and fired by audit committee members, not management. The intent is to make auditor accountability more congruent with stockholder and third-party needs.

9.

The external auditor should discuss any controversial accounting choices with the audit committee and must communicate all significant adjustments made to the financial statements during the course of the audit. In addition, the processes used in making judgments and estimates as well as any disagreements with management should be communicated. Other items that need to be communicated include: • • • • • •

All adjustments that were not made during the course of the audit, Difficulties in conducting the audit, The auditor’s assessment of the accounting principles used and overall fairness of the financial presentation, The client’s consultation with other auditors, Any consultation with management before accepting the audit engagement, Significant deficiencies in internal control.

10. The auditor might utilize the following procedures in determining the actual level of governance in an organization: • •

• • •

observe the functioning of the audit committee by participating in the meetings, noting the quality of the audit committee questions and responses, interactions with management regarding issues related to the audit, e.g. o providing requested information on a timely basis, o quality of financial personnel in making judgments, o accounting choices that tend to ‘push the limits’ towards aggressiveness or creating additional reported net income, o the quality of internal controls within the organization. review the minutes of the board of directors meetings to determine that they are consistent with good governance, review internal audit reports and especially determine the actions taken by management concerning the internal auditor’s findings and recommendations, review the compensation plan for top management,


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review management expense reimbursements to determine (a) completeness of documentation, (b) appropriateness of requested reimbursement, and (c) extent of such requests. review management’s statements to the financial press to determine if they are consistent with the company’s operations.

•

•


d d a d d

Cases 1.

a.

The auditor might use the following approaches to determine whether a corporate code of ethics is actually followed: observe corporate behavior in tests performed during the audit, e.g. approaches the company takes to purchasing goods, promoting personnel, and so forth, • observe criteria for promoting personnel; for example does performance always take on greater importance than how things are done, • observe corporate plans to communicate the importance of ethical behavior, e.g. webcasts, emails, and so forth to communicate the importance of ethics, • review activity on the client’s whistleblowing website, or a summary of whistleblowing activities reported by the internal auditor, • read a sample of self-evaluations by corporate officers, the board, and the audit committee and compare with the auditor’s observations of behavior, • examine sales transactions made during the end of quarters to determine if the sales reflect ‘performance goals’ as opposed to the company’s code of ethics. Are auditors equipped to make subjective judgments? This should be a great discussion question because many young people are attracted to the accounting profession because there are rules and relative certainty as to how things are done. However, as the profession is evolving, more judgments are required in both auditing and accounting. Audit personnel need to be equipped to make judgments on whether the company’s governance structure operates as intended and whether there are deficiencies •

b.


13-7

in internal control when it does not operate effectively. The profession believes that auditors can make such judgments. c.

Assessing the competence of the audit committee can occur in a number of ways. Fortunately, the most persuasive evidence comes from the auditor’s direct interaction with the audit committee on a regular basis. The auditor can determine the nature of questions asked, the depth of understanding shared among audit committee members, and the depth of items included in the audit committee agenda. Many audit committees have self-assessment of their activities using criteria developed by CPA firms, or by the National Association of Corporate Directors. The auditor should also review the minutes of the audit committee meetings and determine the amount of time spent on important issues. An external auditor should be very reluctant to accept an audit engagement where the audit committee is perceived to be weak. There are a number of reasons including: •

• •

d.

Internal auditing is an integral part of good corporate governance. contributes to corporate governance in three distinct ways: •

•

• 2.

a.

The lack of good governance most likely influences the organization’s culture and is correlated with a lack of commitment to good internal control. The auditor has less protection from the group that is designed to assist the auditor in achieving independence. The company may be less likely to be fully forthcoming in discussions with the auditor regarding activities that the auditor might question. It

It assists the audit committee in its oversight role by performing requested audits and reporting to the audit committee, It assists senior management in assessing the continuing quality of its oversight over internal control throughout the organization, It assists operational management by providing feedback on the quality of its operations and controls.

Corporate governance is defined as: “a process by which the owners and creditors of an organization exert control and require accountability for the resources entrusted to the organization. The owners (stockholders) elect

13-8

Solutions Manual – Public Accountancy Profession a board of directors to provide oversight of the organization’s activities and its accountability to stakeholders.” The key players in corporate governance are the stockholders (owners), board of directors, audit committees, management, regulatory bodies, and auditors (both internal and external). b.

In the past decade especially, all parties failed to a certain extent. For detailed analysis, see exhibit 2.2 in the chapter and reproduced below: Corporate Governance Responsibilities and Failures Overview of Corporate Governance Failures Focused on short-term prices; failed to perform long-term growth analysis; abdicated all responsibilities to management as long as stock price increased.

Party Stockholders

Overview of Responsibilities Broad Role: Provide effective oversight through election of Board process, approve major initiatives, buy or sell stock.

Board of Directors

Broad Role: the major representative of stockholders to ensure that the organization is run according to the organization charter and there is proper accountability. Specific activities include: • Selecting management. • Reviewing management performance and determining compensation. • Declaring dividends • Approving major changes, e.g. mergers • Approving corporate strategy • Overseeing accountability activities.

• Inadequate oversight of management. • Approval of management compensation plans, particularly stock options that provided perverse incentives, including incentives to manage earnings. • Non-independent, often dominated by management. • Did not spend sufficient time or have sufficient expertise to perform duties. • Continually re-priced stock options when market price declined.

Management

Broad Role: Operations and Accountability. Managing the organization effectively and provide accurate and timely accountability to shareholders and other stakeholders. Specific activities include: • Formulating strategy and risk appetite. • Implementing effective internal controls. • Developing financial reports. • Developing other reports to meet public, stakeholder, and regulatory requirements.

• Earnings management to meet analyst expectations. • Fraudulent financial reporting. • Pushing accounting concepts to achieve reporting objective. • Viewed accounting as a tool, not a framework for accurate reporting.


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Overview of Corporate Governance Failures • Similar to Board members – did not have expertise or time to provide effective oversight of audit functions. • Were not viewed by auditors as the ‘audit client’. Rather the power to hire and fire the auditors often rested with management.

Party Audit Committees of the Board of Directors

Overview of Responsibilities Broad Role: Provide oversight of the internal and external audit function and the process of preparing the annual accuracy financial statements and public reports on internal control. Specific activities include: • Selecting the external audit firm. • Approving any non-audit work performed by audit firm. • Selecting and/or approving the appointment of the Chief Audit Executive (Internal Auditor), • Reviewing and approving the scope and budget of the internal audit function. • Discussing audit findings with internal auditor and external auditor and advising the Board (and management) on specific actions that should be taken.

SelfRegulatory Organizations: AICPA, FASB

Broad Role: Setting accounting and auditing standards dictating underlying financial reporting and auditing concepts. Set the expectations of audit quality and accounting quality. Specific roles include: • Establishing accounting principles • Establishing auditing standards • Interpreting previously issued standards • Implementing quality control processes to ensure audit quality. • Educating members on audit and accounting requirements.

• AICPA: Peer reviews did not take a public perspective; rather than looked at standards that were developed and reinforced internally. • AICPA: Leadership transposed the organization for a public organization to a “trade association” that looked for revenue enhancement opportunities for its members. • AICPA: Did not actively involve third parties in standard setting. • FASB: Became more rule-oriented in response to (a) complex economic transactions; and (b) an auditing profession that was more oriented to pushing the rules rather than enforcing concepts. • FASB: Pressure from Congress to develop rules that enhanced economic growth, e.g. allowing organizations to not expense stock options.

Other SelfRegulatory

Broad Role: Ensuring the efficiency of the financial markets including oversight of trading

• Pushed for improvements for better corporate governance procedures by its

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Solutions Manual – Public Accountancy Profession Overview of Corporate Governance Failures members, but failed to implement those same procedures for its governing board, management, and trading specialists.

Party Organizations, e.g. NYSE, NASD

Overview of Responsibilities and oversight of companies that are allowed to trade on the exchange. Specific activities include: • Establishing listing requirements – including accounting requirements, governance requirements, etc. • Overseeing trading activities,

Regulatory Agencies: the SEC

Broad Role: Ensure the accuracy, timeliness, and fairness of public reporting of financial and other information for public companies. Specific activities include: • Reviewing all mandatory filings with the SEC, • Interacting with the FASB in setting accounting standards, • Specifying independence standards required of auditors that report on public financial statements, • Identify corporate frauds, investigate causes, and suggest remedial actions. Broad Role: Performing audits of company financial statements to ensure that the statements are free of material misstatements including misstatements that may be due to fraud. Specific activities include: • Audits of public company financial statements, • Audits of non-public company financial statements, • Other accounting related work such as tax or consulting.

• Identified problems but was never granted sufficient resources by Congress or the Administration to deal with the issues.

Broad Role: Perform audits of companies for compliance with company policies and laws, audits to evaluate the efficiency of operations, and audits to determine the accuracy of financial reporting processes. Specific activities include: • Reporting results and analyses to

• Focused efforts on ‘operational audits’ and assumed that financial auditing was addressed sufficiently by the external audit function. • Reported primarily to management with little effective reporting to the audit committee.

External Auditors

Internal Auditors

• Pushed accounting concepts to the limit to help organizations achieve earnings objectives. • Promoted personnel based on ability to sell “non-audit products”. • Replaced direct tests of accounting balances with a greater use of inquiries, risk analysis, and analytics. • Failed to uncover basic frauds in cases such as WorldCom and HealthSouth because fundamental audit procedures were not performed.

Corporate Governance… Party

• c.

Overview of Responsibilities management, (including operational management), and audit committees, Evaluating internal controls.

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Overview of Corporate Governance Failures • In some instances (HealthSouth, WorldCom) did not have access to the corporate financial accounts.

There is an inverse relationship between corporate governance and risk to the auditor i.e. the better the quality of corporate governance, the lower the risk to the auditor. This relationship occurs because lower levels of corporate governance implies two things for the auditor: •

•

There is more likelihood that the organization will have misstatements in its financial statements because the commitment to a strong organizational structure and oversight is missing, There is greater risk to the auditor because the governance structure is not designed to prevent/detect such misstatements, and will likely not be as forthcoming when the auditor questions potential problems.

3.

Element of Poor Corporate Governance

The company is in the financial services sector and has a large number of consumer loans, including mortgages, outstanding.

The CEO and CFO’s

Audit Activity to Determine if Governance is actually Poor This is not necessarily poor governance. However, the auditor needs to determine the amount of risk that is inherent in the current loan portfolio and whether the risk could have been managed through better risk management by the organization.

This is a rather common compensation package and,

Risk Implication of Poor Governance The lack of good risk management by the organization increases the risk that the financial statements will be misstated because of the difficulty of estimating the allowance for loan losses. The auditor will have to focus increased efforts on estimating loan losses, including a comparison of how the company is doing in relation to the other companies in the financial sector. In combination with other things, the use of

13-12



compensation is based on three components: (a) base salary, (b) bonus based on growth in assets and profits, and (c) significant stock options.

The audit committee meets semi-annually. It is chaired by a retired CFO who knows the company well because she had served as the CFO of a division of the firm before retirement. The other two members are local community members – one is the President of the Chamber of Commerce and the other is a retired executive from a successful local manufacturing firm.

Audit Activity to Determine if Governance is actually Poor by itself, is not necessarily poor corporate governance. However, in combination with other things, the use of ‘significant stock options’ may create an incentive for management to potentially manage reported earnings in order to boost the price of the company’s stock. The auditor can determine if it is poor corporate governance by determining the extent that other safeguards are in place to protect the company.

There is a strong indicator of poor corporate governance. If the audit committee meets only twice a year, it is unlikely that it is devoting appropriate amounts of time to its oversight function, including reports from both internal and external audit. There is another problem in that the chair of the audit committee was previously employed by the company and would not meet the definition of an independent director. Finally, the problems with the other two members is

Risk Implication of Poor Governance ‘significant stock options’ may create an incentive for management to potentially manage reported earnings in order to boost the price of the company’s stock. The auditor should carefully examine if the company’s reported earnings and stock price differs broadly from companies in the same sector. If that is the case, there is a possibility of earnings manipulation and the auditor should investigate to see if such manipulation is occurring. This is an example of poor governance because (1) it signals that the organization has not made a commitment to independent oversight by the audit committee, (2) the lack of financial expertise means that the auditor does not have someone independent that they can discuss controversial accounting or audit issues that arise during the course of the audit. If there is a disagreement with management, the audit committee does not have the expertise to make independent judgments on whether the auditor or

Corporate Governance… Element of Poor Corporate Governance

Audit Activity to Determine if Governance is actually Poor that there is no indication that either of them have sufficient financial expertise.

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Risk Implication of Poor Governance management has the appropriate view of the accounting or audit issues.

The company has an internal auditor who reports directly to the CFO, and makes an annual report to the audit committee.

The good news is that the organization has an internal audit activity.

The bad news is that a staff of one isn’t necessarily as large or as diverse as it needs to be to cover the major risks of the organization. The external auditor will be more limited in determining the extent that his or her work can rely on the internal auditor.

The CEO is a dominating personality – not unusual in this environment. He has been on the job for 6 months and has decreed that he is streamlining the organization to reduce costs and centralize authority (most of it in him).

A dominant CEO is not especially unusual, but the centralization of power in the CEO is a risk that many aspects of governance, as well as internal control could be overridden. The auditor should look at policy manuals, as well as interview other members of management and the board – especially the audit committee.

The centralization of power in the CEO is a risk that many aspects of governance, as well as internal control could be overridden. This increases the amount of audit risk.

The Company has a loan committee. It meets quarterly to approve, on an ex-post basis all loans that are over $300 million (top 5% for this institution).

The auditor should observe the minutes of the loan committee to verify its meetings. The auditor should also interview the chairman of the loan committee to understand both its policies and its attitude towards controls and risk.

There are a couple of elements in this statement that carries great risk to the audit and to the organization. First, the loan committee only meets quarterly. Economic conditions change more rapidly than once a quarter, and thus the review is not

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The previous auditor has resigned because of a dispute regarding the accounting treatment and fair value assessment of some of the loans.

Audit Activity to Determine if Governance is actually Poor

The auditor should contact the previous auditor to obtain an understanding as to the factors that led the previous auditor to either resign or be fired. The auditor is also concerned with who led the charge to get rid of the auditor.

Risk Implication of Poor Governance timely. Second, the only loans reviewed are (a) large loans that (b) have already been made. Thus, the loan committee does not act as a control or a check on management or the organization. The risk is that many more loans than would be expected could be delinquent, and need to be written down. This is a very high risk indicator. The auditor would look extremely bad if the previous auditor resigned over a valuation issue and the new auditor failed to adequately address the same issue. Second, this is a risk factor because the organization shows that it is willing to get rid of auditors with whom they do not agree. This is a problem of auditor independence and coincides with the above identification of the weakness of the audit committee. This action confirms a generally poor quality of corporate governance.

4.

a&b.

Cookie jar reserves are essentially funds that companies have “stashed away” to use when times get tough. The rationale is that the reserves are then used to “smooth” earnings in the years when earnings needs a


13-15

boost. “Smooth” earnings typically are looked upon more favorably by the stock market. An example of a cookie jar reserve would be overestimating an allowance account, such as allowance for doubtful accounts. The allowance account is then written down (and into the income statement) in a bad year. Auditors may have allowed cookie jar reserves because they are known to smooth earnings, and smooth earnings are rewarded by the market. On the flip side, fluctuating earnings are penalized, and present more risk to the company of bankruptcy or other problems.

The Sarbanes-Oxley Act addressed the issue by creating an oversight body, the PCAOB, but also addressed the issue in other ways. For example, Congress felt that creating more effective Boards would decrease the use of earnings management. Allowing improper revenue recognition is one thing that auditors may have done in their unwillingness to say “no” to clients. For example, companies shipped out goods to customers at the end of the year for deep discounts and allowed returns at the beginning of the next year. This practice is known as channel stuffing. Since the goods had a great chance of being returned, it would be improper to recognize all as revenue. Again, auditors were unwilling to say “no” to clients. Greed is probably the reason here. If companies claim more revenue, their stock would grow in the short-term, making management richer, and making management more willing to give pay raises to their auditors. With the establishment of stronger audit committees and certification of financial statements in the Sarbanes-Oxley Act, this kind of accounting trickery will certainly decrease. Creative accounting for M&A included the use of the “pooling” method of accounting. Pooling allowed acquiring companies to value existing assets at historical costs and did not require the recognition of goodwill for the acquisition. Because true costs (values) were not shown on the financial statements, management was often encouraged to bid up prices for acquisitions with the result that many of them were not economic. The creative accounting also shielded the income statement from charges that would have otherwise hit income including: goodwill amortization, depreciation, and depletion expenses. Greed, the same reasons as the revenue recognition issue, was most likely the motivation for this creative accounting.

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Solutions Manual – Public Accountancy Profession Discussion between an educated audit committee and auditor plus certification of financial statements required by Sarbanes-Oxley will certainly address this issue. Assisting management to meet earnings. Too often, auditors confused ‘financial engineering’ with value-adding. In other words, auditors often sought to add value to their clients by finding ways to push accounting to achieve earnings objectives sought by management. These earnings objectives then played a major role in escalating stock prices – all desired because of the heavy emphasis of management compensation on stock options. Incentives were misaligned. Most of management compensation came in the form of stock options.

5.

a.

This is intended to be an open-ended discussion. There are a number of factors that have been mentioned in the discussions regarding auditor independence. The following is representative of some issues discussed: • •

• • •

• • •

•

The audit firm’s policy for rotating auditors in charge of the engagement, Whether or not the client has hired personnel from the audit firm for significant financial or management positions in the company, such as the Chief Financial Officer was the former partner in charge of the audit engagement, The nature of non-audit services provided by the audit firm, The existence of any social or other relationships with management, Audit committee experience with the audit firm in other situations, such as the auditor provides services for other entities with which the audit committee member has an association, The existence of any charges brought against the auditing firm by the SEC, The audit firm’s involvement in significant lawsuits where their judgment has been questioned, The amount of fees charged by the auditing firm. If the audit fees are too low, the audit committee should question the thoroughness and independence of the work. If fees from non-audit work are high, the audit committee will want to question that relationship and possible effect on judgments made by the auditor. The manner in which individual audit partners are compensated by the public accounting firm. For example, if an audit partner’s compensation is determined significantly by whether or not a client


• • • •

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is retained, then there might be questions about what the auditor would do to retain the client. The general reputation of the firm. The firm’s policies and procedures for attracting and retaining talented audit personnel. The process of assigning personnel to an audit. The firm’s expertise in the industry.

b.

The main way that the audit committee can influence the independence of the internal audit department is by choosing who is in charge of the department. The “tone at the top” in the internal audit department will go a long way. Further, the audit committee ought to approve the scope of the internal audit charter, approve annual audit plans, as well as annual budgets.

c.

1. Tax Return for Company: Approval argument. The auditor is already aware of all the information, so can efficiently prepare the return. Tax accounting is different than audit accounting, so accounting treatments can be different in both settings and will not affect each other. Non-Approval: On the other hand, some argue that tax preparation is a consulting activity, i.e. the auditor would need to be a client advocate and thereby should not prepare the tax return. 2. Tax Return for Management and Board Members: Approval: The auditor is an expert. The services can be viewed as a benefit for management and the board. Not Approve: Performance of the tax services too closely aligns the auditor with management and the board. The auditor has to be a client advocate in developing the tax returns. This may mentally conflict with the auditor’s need to be objective in all other work involving the client. 3. Tax Return paid for by Managers, not company: Approval: This is an independent service not paid for by the company. Not Approve: The argument is the same as #2 above. Although paid for by the individuals, there is still the possibility of conflict. 4. Overseas Assistance for Internal Audit Department: Do not approve. It is the responsibility of management to prepare a review of internal control, and the auditor does an independent analysis.

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Solutions Manual – Public Accountancy Profession Further, the performance of internal audit work is one of the areas that have been explicitly prohibited by the SEC. 5. Security Audit of Information Systems: Approve. This is not a conflict of interest as it is an audit or assurance service. 6.

Train Operating Personnel on Internal Controls: Approve. Auditors are experts on this area. There is no direct conflict with the performance of the audit. Better trained personnel should imply better internal controls – beneficial for both management and the auditor. Not Approve. The PCAOB is explicit that management has the responsibility to design, implement, and evaluate internal control. Thus, training personnel is a management task that cannot be performed by the auditor. It could, however, be performed by a different public accounting firm.

7.

Perform Internal Audit Work for the Company: Do not approve. It is the responsibility of management to prepare a review of internal control, and the auditor does an independent analysis. Usually internal audit is responsible for “management’s” end of assessing internal controls. The audit of effectiveness and efficiency is akin to consulting and would be interpreted by most people as compromising the auditor’s independence.

8.

Provide, at no cost, Seminars to Audit Committee Members. Approve. The audit committee can make a decision as to whether a particular member will attend the seminar. It is one way that an audit committee member can keep up on the profession. The only potential problem would occur if the audit committee only relied on the audit firm for updates on accounting and audit issues.

9.

Seminars for both Audit and Non-Audit Clients. Recommend Approval. The key is whether the audit committee feels that it may lose some of its objectivity in performing its oversight role.

CHAPTER 14 DESIGNING AN EFFECTIVE RESPONSE TO ASSESSED RISKS Questions 1.

Inspection techniques include physical examination of assets, examination of documents and records, performance of mechanical accuracy tests, and analytical procedures.

2.

Vouching and tracing are two types of commonly performed documentation. Vouching involves the examination of documents that served as a basis for recording the transaction. Vouching usually starts with a recorded transaction and works back to the documents and addresses existence. Tracing involves determining whether source documents have been recorded properly in the accounting records. By tracing, an auditor can obtain evidence that the recording of the transaction is complete.

3.

An inquiry involves requesting information from client personnel and receiving their response. The request and response may be either written or oral. A confirmation is a response a third party makes directly to the auditor on the request of a client. The response includes information about certain transactions, relationships, and/or balances that have an impact on a specific financial statement assertion.

4.

Confirmations are usually considered more reliable because they are from outside parties, while inquiries are made of client personnel.

5.

When equivalent procedures are available to satisfy the need for evidence, an auditor may consider cost in selecting among the alternatives.

6.

Vouching is relevant to testing the existence of sales; tracing is not. Tracing is relevant to testing the completeness of sales, but vouching is not.

Multiple Choice Questions 1. 2.

c d

3. 4.

c a

5. 6.

c c

7. 8.

a d

9.

d

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Cases 1.

2.

Types of procedures used by auditors in general, with examples: 1.

Recalculation by the auditor * recomputing the client’s calculation of depreciation expense

2.

Observation by the auditor * observation, test-counting of client’s physical inventory-taking

3.

Confirmation by letter * obtaining accounts receivable confirmations * obtaining client’s lawyer’s letter

4.

Inquiry and written representations * ask client personnel about accounting events * complete an internal control questionnaire * obtain written client representation letter

5.

Vouching * find brokers’ invoices and cancelled checks showing agreement with record amounts for securities investments

6.

Tracing * select a sample of shipping documents and trace them to sales invoices, sales journal recording and posting to general ledger

7.

Scanning * scan expense accounts for credit entries * scan payroll check lists for unusually large checks

8.

Analytical procedures – any example that fits one of these: * compare financial information with prior periods * compare financial information with budgets and forecasts * study predictable financial information patterns (e.g., ratio analysis) * compare financial information to industry statistics * study financial information in relation to nonfinancial information

a.

A material decline in sales may indicate unrecorded sales; a decrease in cost of goods sold may be due to unrecorded purchases; and an increase in cost of good sold may be the result of omissions from the ending inventory. An increase or decrease in gross profit will result from any one or a combination of the above omissions.

b.

A decline in the miscellaneous revenue account balance, or the absence of a previously existing source of miscellaneous revenue, could be attributable to a failure to record miscellaneous revenue.

Designing an Effective Response…

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c.

Unrecorded accounts payable at year-end would cause an increase in calculated accounts payable turnover.

d.

An apparent increase in accounts receivable turnover may, in fact, be the result of failure to record credit sales transactions.

e.

A higher than average operating return may be indicative of unrecorded purchases or operating expenses; a lower than average return could result from unrecorded sales.

CHAPTER 15 AUDIT EVIDENCE Review Questions 1.

Refer to page 614, 2nd and 4th paragraphs of the textbook.

2.

Refer to page 614, 3rd paragraph of the textbook.

3.


4.

Refer to page 6177, 1st paragraph of the textbook.

5.

Refer to page 617, 2nd paragraph of the textbook.

6.

Refer to page 618, 4th paragraph of the textbook.

7.

External documentary evidence is evidential matter obtained from the other party to an arm’s-length transaction or from outside independent agencies. External evidence reaches the auditor directly and does not pass through the hands of the client. External-internal documentary evidence is documentary material that originates outside the bounds of the client’s data processing system but which has been received and processed by the client. Internal documentary evidence consists of documentary material that is produced, circulates, and is finally stored within the client’s information system. Such evidence is not touched by outside parties at all or is several steps removed from third-party attention.

8.

Auditors can help the effectiveness of confirmation requests by: a. b.

c.

Having the confirmation letters printed on the client’s letterhead and signed by a client officer. Being careful to be assured of reliable addresses for recipients; that is, being assured that the confirmations are not misdirected (for example, to a client’s accomplices in fraud). Asking confirmation of information that recipient can supply, like the amount of a balance or the amounts of specified invoices or notes (not the balances of homeowners’ mortgages or financial amounts, like certificates of deposit with accrued interest, for which people usually do not keep their own accounting records).

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Solutions Manual – Public Accountancy Profession d. e.

9.

Controlling the mailing and return of confirmations so the client cannot tamper with them. Receiving the reply directly, so the client cannot intercept and alter them.

Factual evidence is direct evidence, in that conclusions may be drawn from the evidence without further corroboration. An example of factual audit evidence is physical observation of inventory for existence. Inferential evidence is indirect, in that direct conclusions cannot be drawn from the evidence. The auditor typically examines other evidence to further corroborate the inferences drawn. An oral statement by a product manager that one or more products are fully saleable and not obsolete is an example of inferential evidence. The auditor may perform inventory turnover tests and/or determine the date of last sale of the product to further corroborate the product manager’s statement.

10. Sufficiency of audit evidence is a matter of audit judgment. Materiality and the quality of internal control are important ingredients in determining sufficiency. If internal control produces over sales processing and cash receipts, for example, are effective, the auditor may elect to confirm fewer customers’ accounts receivables than under conditions of weak internal control. 11. Physical evidence tests the existence assertion. Examples of physical evidence are inventory observation, examination of securities, inspection of plant asset additions, and count of cash on hand. 12. The quality of existing internal control is the major factor supporting the strength of documentary evidence. A voucher produced under conditions of strong internal control over the processing of vendors’ invoices, for example, possesses greater validity and is therefore stronger evidence than vouchers produced under weak control conditions. 13. Auditing standards define an accounting estimate as “an approximation of a financial statement element, item or amount.” Estimates are used because (1) an amount is uncertain pending specific future events or (2) relevant data cannot be accumulated on a timely, cost-effective basis. Examples of accounting estimates include allowance for uncollectible accounts, obsolete inventory, useful lives and residual values of fixed assets, natural resources and intangibles, accruals for taxes on real and personal property, accruals based on actual assumptions in pension plans, contract revenue using percentage of completion method, litigation losses, fair values in nonmonetary exchanges, and current values in personal financial statements. 14. In evaluating the reasonableness of accounting estimates, an auditor should consider the internal controls related to the estimates in order to reduce the likelihood of material misstatements in the estimates, whether the accounting

Audit Evidence

15-3

estimates are reasonable given the situation, and whether the accounting estimates are presented in accordance with appropriate accounting principles. 15. Evidence is persuasive if the auditor considers the evidence to be sufficient and competent enough to afford a reasonable basis for an opinion. Multiple Choice Questions 1. 2. 3.

d d c

4. 5. 6.

c a d

7. 8. 9.

d b d

10. d 11. a 12. b

13. b

Cases 1.

2.

a.

Evidential matter obtained from independent sources outside an enterprise provides greater assurance of reliability (competency) than that which is secured solely within the enterprise.

b.

Accounting data and financial statements developed under satisfactory conditions of internal control are more reliable (competent) than those which are developed under unsatisfactory conditions of internal control.

c.

Direct personal knowledge obtained by the independent auditor through physical examination, observation, computation, and inspection is more persuasive than information obtained indirectly.

1.

Types of evidence Evidential items/sources d. Letter from creditor a. Monthly statements b. Voucher register c. Audit computation of discounts

in reliability rank 1. External 2. External-internal 3. Internal 4. Mathematical (based on unaudited data)

2. c. a. d. b.

Audit computation of expense amounts Letter from bond trustee Cancelled checks Minutes of directors’ meetings

1. 2. 3. 4.

Mathematical (based on unaudited data) External External-internal Internal

CHAPTER 16 BASIC AUDIT SAMPLING CONCEPTS Review Questions 1.


2.


3.


4.

Audit conclusions can be made only about the population from which the sample was drawn, and a conclusion can only be valid if the sample on which it is based actually shows the characteristics of the population. Auditors can attempt to achieve representativeness, but they cannot guarantee it. Sampling risk – the probability that the sample does not adequately reflect the population – always exists.

5.

Refer to page 656, 2nd paragraph; page 657, 1st paragraph of the textbook.

6.


7.

Refer to page 662, paragraphs 1 to 4 of the textbook.

8.

Refer to page 662, paragraphs 3 and 4 of the textbook.

9.

Refer to page 663, 4th paragraph & page 664, 1st to 3rd paragraph of the textbook.

10. Sampling risk is the probability that the auditor’s conclusions concerning the population will be in error. In terms of conclusions regarding internal control, sampling risk consists of two subsets: Alpha risk, the risk that the auditor will assess control risk too high and perform more substantive testing than is necessary under the circumstances; and Beta risk, the risk that the auditor will assess control risk too low and perform less substantive testing than is necessary. For control testing purposes, the auditor is more concerned with beta risk than alpha risk, because beta risk poses the threat of underauditing and is therefore the basis for the audit opinion. The auditor controls this risk by setting beta risk sufficiently low as to maintain overall audit risk at a level less than or equal to 10%.

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11. Refer to pages 675 of the textbook. 12. Refer to pages 670 of the textbook. Multiple Choice Questions 1. 2.

b c

3. 4.

d c

5. 6.

d b

7. 8.

a d

9. a 10. c

Comprehensive Cases 1.

a.

Areas requiring the auditors to make judgment decisions when statistical sampling techniques are employed (only four required): (1) Defining population, characteristics to be tested, and deviations. Unless a relationship is defined between the occurrence rate of deviations in the population and either the validity of the client’s financial statement or the strength of internal control, little useful information is gained by estimating the occurrence rate. (2) Determining the appropriate statistical selection techniques for drawing a random sample. The auditors must recognize the advantages and disadvantages of stratified selection, unstratified selection, and systematic selection, and determine which technique is appropriate for selecting an economical random sample. (3) Establishing the required maximum tolerable deviation rate and the risk of assessing control risk too low for the procedure. This requires judgment decisions regarding materiality, time, cost, and the planned assessed level of control risk. (4) Interpreting sample results. This requires a decision as to whether the results support the auditors’ planned assessed level of control risk, or whether additional sampling is necessary to reach a conclusion. (5) Following up on the discovery of critical errors or unacceptable deviation rates. (6) Determining the circumstances under which statistical sampling is appropriate, and those in which other techniques should be used in lieu, of or to supplement, the statistical sampling techniques. This is an open-ended question. The student may identify numerous other areas in which the auditors must make judgment decisions.

b.

If the CPAs’ sample shows an unacceptable deviation rate, they may take the following actions: (1) They may enlarge their sample to increase the precision of their estimate.

Basic Audit Sampling Concepts

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(2) They may isolate the type of deviation and expand examination as it relates to the transactions that give rise to that type of misstatement. (3) The auditors’ usual response to an unacceptably high deviation rate is to increase their assessed level of control risk. Accordingly, the auditors would increase the intensity of their substantive tests. c.

Techniques for selecting an unstratified random sample of accounts payable vouchers include the following: Random Sample. A random sample is a sample of a given size drawn from a population in a manner such that every possible sample of that size is equally likely to be drawn. Items may be selected randomly by: (1) Table of Random Numbers. Use one of a number of published tables. Using four columns in the table, select the first 80 numbers which fall within the range of 1 to 3,200. The starting point in the table should be selected randomly and the path to be followed through the table should be set in advance and followed consistently. (2) Random Number Generator: Using generalized audit software, generate a list of 80 random numbers. Systematic Sample. A systematic sample is drawn by selecting every nth item beginning with a random start. (1) Every nth item. Select every 40th voucher after selecting the initial voucher (from 1 to 40) randomly. (2) Several random starting points. For example, use two random starting points and select 40 of the 80 vouchers from each of the two sequences. Select every 80th voucher (3,200/40) after each of the two random starting points between 1 and 80 for each of the two sequences.

2.

a.

(1) Since the results of tests of controls typically play a significant role in determining the nature, timing, and extent of other audit procedures, the auditors usually specify a low level of risk of assessing control risk too low. It is usually set at 5 or 10 percent. (2) In determining the tolerable deviation rate, an auditor should consider the planned assessed level of control risk and the extent of assurance desired from the evidential matter included in the sample. (3) In determining the expected population deviation rate, an auditor should consider the results of prior years’ tests, the overall control environment, or utilize a preliminary sample.

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Solutions Manual – Public Accountancy Profession b.

(1) There is a decrease in sample size if the acceptable level of the risk of assessing control risk too low is increased. (2) There is a decrease in sample size if the tolerable deviation is increased. (3) There is an increase in sample size if the population deviation rate is increased.

c.

Using a statistical sampling approach, Figure 17.4 reveals that 7 deviations in a sample of size 100 results in an achieved upper deviation rate of 12.8%, well in excess of the tolerable deviation rate (8%). The sample results should thus be interpreted as not supporting the planned assessed level of control risk. Using a nonstatistical sampling approach, the 7% estimated population deviation rate identified in the sample (7 deviations / 100 sample items) approaches the tolerable deviation rate of 8%. Therefore, using a nonstatistical approach, the sample result would also be interpreted as not supporting the planned assessed level of control risk.

d.

Statistical sampling allows the auditors to quantify sampling risk. As described in part (c), only when statistical sampling is used do the auditors know that the achieved upper deviation rate is 12.8%.

CHAPTER 17 AUDIT SAMPLING FOR TESTS OF CONTROLS Questions 1.

A test of control procedure is a statement of a. b.

2.

Identification of a population from which sampling units are to be drawn. Expression of an action taken to produce evidence about a client control procedure.

Compliance deviations should be defined in advance so auditors will know what to look for and will know one when they see it. Seven Examples – Based on Seven General Control Objectives:

3.

Objective

Example

1.

Validity

1.

Sale recorded without supporting shipping orders.

2.

Authorization

2.

Lack of credit manager approval for a credit sale.

3.

Accuracy

3.

Mathematical errors in sales invoice calculations.

4.

Classification

4.

Sales classified in wrong product line revenue account.

5.

Proper Period

5.

Sales recorded in month (quarter, year) before the actual shipment.

6.

Accounting

6.

Sales charges fail to be posted to a customer’s account.

7.

Completeness

7.

Shipments fail to be billed to customers and recorded as sales and receivables.

Judgments affecting sample size for test of controls auditing. Judgment 1.

Acceptable risk of assessing control risk too low

Influence on sample size Inverse.

The greater the acceptable risk, the smaller the sample.

17-2

Solutions Manual – Public Accountancy Profession 2.

Acceptable risk of assessing control risk too high

Inverse.

The greater the acceptable risk, the smaller the sample.

3.

Tolerable deviation rate

Inverse.

The higher the tolerable rate, the smaller the sample.

4.

Expected population deviation rate (an estimate rather than a judgment)

Direct.

The higher the expected rate, the larger the sample.

The sample size is also directly related to the population size, although the influence is generally minor. The larger the population, the larger the sample, but not much. 4.

The risk of assessing the control risk too low has the potential of affecting audit effectiveness, thus damaging the quality of the audit for users. Professionally, in light of responsibility to users, effectiveness is more important than efficiency, which is affected by the risk of assessing the control risk too high.

5.

Expanded risk model: AR = IR x CR x AP x TD Solve for TD, when: .048 = 1.0 x .4 x .6 x TD

TD

=

.048 1.0 x .4 x .6

=

.2

The tolerable misstatement (P10,000) and estimated standard deviation (P25.00) are “noise” in the question. 6.

The “connection” is a direct relationship between control risk and the tolerable deviation rate. (1) When larger values are planned for control risk (say, 0.95, 0.90) in an audit plan, more analytical procedure and test of detail work will be done. Auditors will not rely very much on internal controls. Therefore, not much help is expected from the controls anyway, so the tolerable deviation rate can be larger. The direct relation is: The higher the control risk, the higher the tolerable deviation rate can be. (2) When lower values are assigned to control risk (say, 0.10, 0.20) in an audit plan, less analytical procedure and test of detail work will be done. Auditors intend to rely on internal accounting controls. Therefore, effective compliance with control policies and procedures is important, and the tolerable deviation rate ought to be low. The direct relation is: The higher the planned control risk, the higher the tolerable deviation rate can be.

Audit Sampling for Tests of Controls

17-3

7.

Based on the specifications of risk of assessing control risk too low, tolerable deviation rate and expected population deviation rate, sample sizes would be determined independently for the two populations in the subdivision. If the criteria are at least as stringent for each of the two as they would be for the undivided population, the sum of the two sample sizes would be at least twice the size of the sample figured for the single population (provided both subdivided populations have 1,000 or more units).

8.

Further reduction of the assessed level of control risk is justified only when the upper occurrence limit is <= the tolerable occurrence rate. Recall that the tolerable occurrence rate is that rate of error beyond which the auditor cannot justify further reduction in the assessed level of control risk. A calculated rate which exceeds the tolerable rate, therefore, would suggest a level of error which precludes any lowering of assessed control risk.

9.

Expected occurrence rate is the anticipated error rate in a population. It is set on the basis of one or a combination of: The prior year’s audit; the auditor’s initial understanding of internal control policies and procedures relative to the transaction cycle subset; or a pilot sample of documents. The expected occurrence rate has a positive effect on sample size. The tolerable occurrence rate is the maximum error rate which the auditor would accept while still lowering assessed control risk below maximum. The auditor bases the tolerable rate on materiality of the attribute being tested. The more critical an attribute to effective internal control, the lower the tolerable occurrence rate. The tolerable occurrence rate has an inverse effect on sample size.

10. Inherent risk is the risk that, in the absence of internal control, material errors or irregularities will occur. Control risk is the risk that internal financial control policies and procedures will fail to prevent or detect material errors and irregularities. Detection risk is the risk that material errors and irregularities, which are not prevented or detected by internal financial control policies and procedures, will not be detected by the independent audit. Multiple Choice Questions 1. 2. 3. 4. 5.

d b a d c

6. 7. 8. 9. 10.

a a b c b

11. 12. 13. 14. 15.

b d c a b

16. 17. 18. 19. 20.

d d b d b

21. d 22. c

17-4


Cases 1.

2.

a.

Control testing may be approached in three different ways, depending on the nature of the controls. If a visible audit trail exists in the form of documentation, the auditor examines documents, as appropriate, for the purpose of evaluating the operating effectiveness of internal control procedures. Evidence as to whether transactions have been executed in accordance with management’s authorization and recorded in accordance with GAAP is gathered through such examination. In the absence of a visible audit trail, the auditor tests controls through observation or reprocessing. The auditor observes the control environment and control procedures, such as physical safeguards. In the presence of complex EDP systems, the auditor may find transaction reprocessing the most effective means for testing selected controls. Statistical sampling methods, involving attribute sampling, are commonly applied to the first form of control testing. Observation and reprocessing ordinarily do not require the use of statistical sampling, although reprocessing may involve judgment sampling in developing hypothetical transactions to process through the system.

b.

1. 2.

attribute sampling application; observation to determine effectiveness of the data processing function, and to support accuracy of financial data; possibly reprocess a sample of transactions through the system to test effectiveness; 3. observation and inquiry to determine separation of functional responsibilities necessary to prevent employee fraud; 4. attribute sampling application; 5. observation (inspection of bank reconciliations) to support accuracy of cash balances; 6. attribute sampling application; 7. observation (inspect client workpapers evidencing periodic check) to support adequate safeguarding of documents and periodic inventories and comparisons; 8. observation (inspect voided documents) to support document retention control and prevent unauthorized use of documents to conceal fraud; 9. attribute sampling application; 10. observation (observe cash receipts processing) to support adequate separation of functional responsibilities and prevent employee fraud.

a.

Effect on sample size: 1. Positive effect (but only in population sizes under 2,000) 2. Positive effect 3. Inverse effect 4. Inverse effect.

Audit Sampling for Tests of Controls

3.

17-5

b.

How determined: 2. Prior year’s audit; initial understanding of internal control; pilot sample. 3. Materiality; 4. Materiality (but normally not to exceed 10%).

a.

The remaining steps are as follows: 4. Define the attributes (characteristics) of interest to be tested (including the criteria for establishing the existence of errors or deviant conditions). 5. Set the tolerable occurrence rate that would support the initial assessment. 6. Select a confidence level (quantify the risk of underassessment). 7. Estimate the population error rate (expected occurrence rate). 8. Determine the sample size. 9. Choose a method for randomly selecting a sample. 10. Perform the tests of control procedures.

b.

Statistical sampling methodology helps the auditor (a) to design an efficient sample, (b) to measure the sufficiency of the evidential matter obtained, and (c) to evaluate the sample results. By using a statistical sampling methodology, the auditor can quantify sampling risk to assist in limiting it to an acceptable level.

CHAPTER 18 AUDIT SAMPLING FOR SUBSTANTIVE TESTS Questions 1.

An incorrect acceptance decision directly impairs the effectiveness of an audit. Auditors wrap up the work and the material misstatement appears in the financial statements. An incorrect rejection decision impairs the efficiency of an audit. Further investigation of the cause and amount of misstatement provides a chance to reverse the initial decision error.

2.

The two methods of projecting the known misstatement to the population are the average difference method and the ratio method. Refer to Chapter 19 for formula expressions of each.

3.

The important thing is to audit all the sample units. You cannot simply discard one that is hard to audit in favor of adding to the sample a customer whose balance is easy to audit. This action might bias the sample. If considering the entire balance to be misstated will not alter your evaluation conclusion, then you do not need to work on it any more. Your evaluation conclusion might be to accept the book value, as long as the account counted in error is not big enough to change the conclusion. Your evaluation conclusion might already be to reject the book value, and considering another account to be misstated just reinforces the decision. If considering the entire balance to be misstated would change an acceptance evaluation to a rejection evaluation, you need to do something about it. Since the example seems to describe a dead end, you may need to select more accounts (expand the sample) and perform the procedures on them (excluding confirmation) and reevaluate the results.

4.

Two main reasons for stratifying a population when sampling for variables (peso) measurement: a. b.

Some units may be individually significant (e.g., large) and taking sampling risk with respect to them is not a good idea. Auditors may want to achieve audit coverage of a large proportion of pesos in the balance by choosing the largest units (a protective sampling objective, which is closely related to avoiding sampling risk).

18-2 Solutions Manual – Public Accountancy Profession 5.

The tolerable misstatement (judged for the audit of a particular account balance) must be less than the monetary misstatement considered material to the overall financial statements. Also, the aggregation of multiple tolerable misstatement amounts for several different balances under audit must be equal to or less than the amount of monetary misstatement considered material to the overall statements.

6.

The appropriate general set of objectives is the objective(s) of obtaining evidence about each of the client’s assertions in the financial balance. In general, the assertions are about: Existence (and cutoff) Occurrence (and cutoff) Completeness (and cutoff) Rights and obligations (ownership, owership) Valuation Measurement Presentation and disclosure

7.

Influence on sample size: Sample Size Relationships: Audit of Account Balances

Sample Size Influence 1. Risk of incorrect acceptance 2. Risk of incorrect rejection 3. Tolerable misstatement 4. Expected misstatement 5. Population variability 6. Population size 8.

Predetermined Sample Size Will Be: High Rate or Low Rate or Large Amount Small Amount Smaller Larger

Sample Size Relation Inverse

Smaller

Larger

Inverse

Smaller

Larger

Inverse

Larger

Smaller

Direct

Larger

Smaller

Direct

Larger

Smaller

Direct

The three basic steps in quantitative evaluation are these: 1. 2. 3.

Figure the total amount of actual misstatement found in the sample. This amount is called the known misstatement. Project the known misstatement to the population. The projected amount is called the likely misstatement. Compare the likely misstatement (also called the projected misstatement) to the tolerable misstatement for the account, and consider the

Audit Sampling for Substantive Tests a.

b.

9.

18-3

Risk of incorrect acceptance that likely misstatement could be less than tolerable misstatement even though the actual misstatement in the population is greater, or the Risk of incorrect acceptance that likely misstatement could be greater than tolerable misstatement even though the actual misstatement in the population is smaller.

Nonstatistical measurements described in Chapter 19 (page 718) leave only one avenue for “accounting for further misstatement”: Apply experience and professional judgment to decide if further misstatement could be large enough to prevent an acceptance decision. If the projected likely misstatement is a great deal less than the amount considered material, an auditor could judge that further misstatement, if known, would not affect acceptance. If projected likely misstatement is close to the amount considered material, maybe acceptance is not warranted.

10. Account balances also can be audited, at least in part, at an interim date. When account balance audit work is done before the company’s year-end date, auditors must extend the interim-date audit conclusion to the balance-sheet date. The process of extending the audit conclusion amounts to nothing more (and nothing less) than performing substantive-purpose audit procedures on the transactions in the remaining period and on the year-end balance to produce sufficient competent evidence for a decision about the year-end balance. Additional considerations include: a.

b. c.

If the company’s internal control over transactions that produce the balance under audit are not particularly strong, you should time the substantive detail work at year-end instead of at interim. If control risk is high, then the substantive work on the remaining period will need to be extensive. If rapidly changing business conditions might predispose managers to misstate the accounts (try to slip one by the auditors), the work should be timed at year-end. In most cases, careful scanning of transactions and analytical review comparisons should be performed on transactions that occur after the interim date.

As an example, accounts receivable confirmation can be done at an interim date. Subsequently, efforts must be made to ascertain whether controls continue to be strong. You must scan the transactions of the remaining period, audit any new large balances, and update work on collectibility, especially with analysis of cash received after the year-end. 11. Classical variables sampling estimates the value of a population by calculating the mean and standard deviation of a sample and imputing the results to the population. Probability proportional to size sampling uses the results of

18-4 Solutions Manual – Public Accountancy Profession sampling to calculate an estimated upper error limit and compares this with a preset tolerable error limit. Although used for substantive testing purposes, PPS sampling is actually a variation for attribute sampling. 12. Detection (or beta) risk affects sample size inversely for substantive testing purposes. That is, the higher the acceptable detection risk, the smaller the sample size; and the lower the acceptable detection risk, the larger the sample size. 13. Precision is the range + – within which the true answer most likely falls. It is set by the auditor as a function of materiality and those levels of beta and alpha risk deemed acceptable. Reliability is the likelihood that the sample range contains the true value. Also referred to as the confidence level, reliability is set by the auditor on the basis of overall audit risk. 14. PPS sampling is restricted to populations for which the auditor suspects a few errors of overstatement only. 15. Several statistical software packages are available to facilitate audit sampling applications. In addition to calculating sample size and evaluating sample results, these packages can also assist in the following sampling areas: a. b. c.

Stratify populations for sampling purposes; Generate random numbers to facilitate sample selection; Draw the sample, given computerized data bases.

Multiple Choice Questions 1. 2. 3. 4.

b a c&d b

5. 6. 7. 8.

c b b d

9. 10. 11. 12.

d a a c

13. 14. 15. 16.

a a c d

17. 18. 19. 20.

d b c d

Supporting Computations: 3.

c.

d.

Audited Value Book Value P480 120

=

47,520 48,000

P 17,500 P500,000

0.99 ;

P4

1,200 x P4 = 7.

=

=

P4,800 3.5%

P450,000 x 3.5% =

P157,500

490,000 x 0.99 = 485,100 490,000 – 485,100 = P4,900

Audit Sampling for Substantive Tests

18-5

Cases 1.

2.

a.

Alpha risk is the risk of rejecting a population that is essentially correct. Beta risk is the risk of accepting a population that is materially incorrect. Alpha risk affects audit efficiency because overauditing results from incorrectly rejecting a population. Beta risk impacts audit effectiveness because underauditng results from incorrectly accepting a population. Collectively, alpha and beta risk comprise sampling risk, defined as the probability that the auditor will draw erroneous conclusions about a population.

b.

Attention to, and quantification of, alpha and beta risk assist the auditor in applying an audit risk approach to substantive testing. During the audit planning stage, the auditor identifies areas of high audit risk and sets detection (beta) risk low for these areas. The result is that more substantive testing is devoted to the high risk areas relative to the lower risk areas. This approach enhances both audit efficiency and audit effectiveness.

c.

Because it is closely related to the basis for the auditor’s opinion, alpha risk is usually set equal to overall audit risk. Beta risk is set on the basis of the auditor’s evaluation of inherent risk and control risk. The greater these risk factors, as determined by the auditor during the audit planning stages, the lower the beta risk set by the auditor. The lower the acceptable beta risk, the larger the sample sizes for substantive testing purposes. Alpha and beta risk, therefore, provide the necessary link between audit risk analysis and substantive audit testing.

a.

(1) Mean-per-unit estimates the total value of a population by (1) using the sample mean as an estimate of the true population mean, and (2) extending this estimated population mean by the number of items in the population. The computations are as follows: (1) Estimated population mean = P582,000 / 200 lots = P2,910 per lot (2) Estimated total value = P2,910 per lot x 2,000 lots = P5,820,000 (2) Ratio estimation estimates total population value by (1) using the ratio of the sample audited values to book values as an estimate of the ratio of population audited value to book value, and (2) applying the estimated ratio to the population book value. The computations are as follows:

18-6 Solutions Manual – Public Accountancy Profession (1) Estimated ratio of audited to book value = P582,000 / P600,000 = 97% (2) Estimated total value = 97% x P5,900,000 = P5,723,000 (3) Difference estimation estimates total population values by (1) using the average difference between the audited and book values of sample items as an estimate of the average difference for all population items, (2) extending the estimated average difference by the number of items in the population, and (3) using the resulting estimate of the total difference between audited and book value to compute the estimated total value. The computations are as follows: (1) Estimated average difference in audit and book values: (P582,000 - P600,000) / 200 lots = - P90 per lot (2) Estimated total difference = - P90 per lot x 2,000 lots = - P180,000 (3) Estimated total value = P5,900,000 - P180,000 = P5,720,000 b.

The sample contains an element of sampling error with respect to the average peso value of production lots. The mean book value of the population is P2,950 (P5,900,000 / 2,000 lots), while the mean book value in the sample is P3,000 (P600,000 / 200 lots). Mean-per-unit estimation uses the mean value of the sample as the basis for estimating total value. Thus, if the sample contains a disproportionate number of higher (or lower) priced items, this sampling error will affect the estimate of the total population value. The estimate of total value developed in ratio estimation is based upon the ratio of audited values to book values, rather than upon mean peso value. If this ratio has no tendency to vary with the peso value of the lot, the estimate of total value is not affected by the mean value of items in the sample. However, sampling error may still be present if the sample lots are not representative of the population with respect to the ratio of audited values to book values.

Audit Sampling for Substantive Tests 3.

18-7

The auditors would project the misstatement found in the sample to the population using either the ratio or difference approach. The ratio approach would result in a projected misstatement of P65,500. This may be computed by first calculating the ratio of the audited to book value as 1.0131 [P23,100 / P22,800 (since there is a net understatement of P300, the audited value is P23,100)] and estimating the audited value of the population as: 1.0131 x P5,000,000 = P5,065,500 (rounded) The projected misstatement is thus P65,500 under the ratio method. The difference approach results in an average difference of P1.50 (P300 net difference divided by 200 items). Multiplying by the 100,000 invoices indicates a projected misstatement of P62,400 (P1.50 x 41,600).

4.

The audit risk (ultimate risk) of material misstatement in the financial statements (AR) is the product of: (1) Inherent risk (IR), the risk of material misstatement in an assertion, assuming there were no related internal controls. (2) Control risks (CR), the risk of material misstatement occurring in an assertion, and not being prevented or detected on a timely basis by the internal control structure. (3) Detection risk (DR), the risk that the auditors’ procedures will lead them to conclude an assertion is not materially misstated, when in fact such misstatement does exist. In equation form, this relationship is expressed as follows: AR = IR x CR x DR This equation may be restated to solve for the allowable detection risk as follows: DR = AR / (CR x IR) Using the risk levels set forth in the problem, the allowable risk of reliance upon substantive tests is computed as illustrated below: DR = .02 / (.2 x .5) = .20 Thus the risk of incorrect acceptance should be limited to 20 percent if the auditors are to achieve their objective of holding audit risk to 2 percent.


a.

(1) Required sample size is calculated as follows: Recorded amount of population x Reliability factor Tolerable misstatement – (Expected misstatement x Expansion factor)

Sample size =

P500,000 x 3

Sample size =

P25,000 – (P2,000 x 1.6)

=

69

Note: The reliability factor is from the zero misstatements row of the PPS sampling table given in the case. (2) The sampling interval is calculated simply by dividing the book value of receivables by the sample size, as follows: Sampling interval = Recorded receivables / Sample size = P500,000 / 69 = P7,246 b.

The results may be evaluated as follows: (1) Projected misstatement = Book Value P 50 800 8,500

Audited Value P 47 760 8,100

(2) Basic precision

Misstatement P 3 40 400

=

Tainting % 6% 5% NA

Sampling Interval P7,246 7,246 NA

Projected Misstatement P 435 362 400 P1,197

Reliability factor x Sampling interval

=

3.0

x

P7,246

=

P21,738

(3) Incremental allowance = Reliability Factor 3.00 4.75 6.30

Projected Increment (Increment – 1) Misstatement 1.75 1.55

.75 .55

P435 362

Incremental Allowance P326 199 P525

Audit Sampling for Substantive Tests (4) Upper limit on misstatement

18-9

= P1,197 + P21,738 + P525 = P23,460

NOTES: Projected misstatement (a) Tainting percentages are calculated as the difference between book and audited value divided by book value (e.g., (P50 – P47) / P50 = 6%). (b) No tainting percentage is calculated for items in excess of the sample interval and the actual misstatement is extended to projected misstatement (as for the third error). Basic precision is always the reliability factor for zero misstatements multiplied times the sampling interval. Incremental allowance (a) Reliability factors are read from the PPS sampling table given in the case, starting at zero misstatements. (b) “Increment – 1” is the difference in the two adjacent reliability factors minus 1 (e.g., 4.75 – 3.00 – 1.00 = .75). (c) Misstatements in excess of the sampling interval are not considered in the incremental allowance. This is because the nature of the process requires that all items in excess of the sampling interval be included in the sample – therefore no allowance for items not in the sample is necessary.

6.

c.

The results obtained in part b would indicate that the auditors may accept the population as not containing a tolerable misstatement at the 5 percent level of risk of incorrect acceptance. The auditors would also consider the results obtained in conjunction with other audit tests.

a.

The advantages of probability-proportional-to-size (PPS) sampling over classical variables sampling are as follows: • • • • •

PPS sampling is generally easier to use than classical variables sampling. The size of a PPS sample is not based on the estimated variation of audited amounts. PPS sampling automatically results in a stratified sample. Individually significant items are automatically identified. If no misstatements are expected, PPS sampling will usually result in a smaller sample size than classical variables sampling.

18-10 Solutions Manual – Public Accountancy Profession • b.

A PPS sample can be easily designed and sample selection can begin before the complete population is available.

Sampling interval = Recorded receivables / Sample size =

c.

P300,000

/ 60

=

P5,000

Projected misstatement = Book Value P 400 500 3,000

Audited Value P 320 0 2,500

Misstatement P 80 500 NA

Tainting % 20% 100% NA

Sampling Interval P1,000 1,000 NA

Projected Misstatement P 200 1,000 500 P1,700

CHAPTER 19 TESTS OF CONTROLS Questions 1.

Directly. Higher levels of control risk induce auditors to audit larger samples of receivables, with confirmation date closer to the fiscal year end date. As for nature of the procedures: higher levels of control risk induce auditors to use positive confirmations instead of negative confirmations, and to consider vouching subsequent payments by the customers.

2.

A “walk through” is the process of following a transaction from its initiation (customer order in the Revenue Cycle) through all the various processing steps until it is recorded in the formal accounting records (accounts receivable and sales). Usually samples of all documents are collected (sales order, sales invoices, sales return slip, credit memo, shipping document, remittance advice and daily remittance report) and notes are made of procedures each person performs. The purpose of the “walk through” is to obtain an understanding of the transaction flow, the control procedures and populations of documents that may be utilized in test of controls auditing.

3.

The review (obtaining an understanding) of the control structure is primarily a process of identifying control procedures (strengths) and lack of controls (weaknesses) which will affect subsequent substantive procedures.

4.

The internal auditors should, through periodic checks, ensure that the control account is periodically reconciled to the customer subsidiary accounts, bank statements are reconciled and that all prenumbered documents, especially invoices, have all numbers accounted for. Some internal auditors also confirm accounts receivable. Internal auditors also might review and evaluate customer complaints for signs of weaknesses in the procedures leading to errors in accounts receivable.

5.

The features of a cash receipts internal control system which would be expected to prevent an employee from absconding with company funds and covering with funds from the employee pension fund is the prohibition against one employee having custody of company funds and noncompany funds. The auditor can detect such transfers by controlling and counting both funds simultaneously. To prevent the cash receipts journal and recorded cash sales from reflecting more than the amount shown on the daily deposit slip, the internal control

19-2 Solutions Manual – Public Accountancy Profession system should provide that receipts be recorded daily and intact. A careful bank reconciliation by an independent person could detect such errors. 6.

The evaluation after the review phase was to determine which controls appeared adequate as a basis for justifying a low control risk assessment. The final assessment after test of controls auditing is to determine if the controls are actually operating as well as they appeared to be.

7.

The objectives of internal control relate to transactions, and by category are: validity, completeness, authorization, accuracy, classification, accounting and proper period. The objectives expensed in general terms and specific terms applied to cash receipts are as follows: Example of Cash Receipts General Objective Specific Objective 1. Recorded transactions are valid and documented. 2. All valid transactions are recorded and none omitted.

3. Transactions are authorized by company policy.

4. Transaction peso amounts are properly calculated. 5. Transactions are properly classified in the accounts. 6. Transaction accounting is complete. 7. Transactions are accounted in the proper period.

1. Recorded cash receipts are supported by remittance advices. 2. All cash receipts are entered in the daily remittance list, deposited intact and recorded in the accounts receivable control account. 3. Cash receipts for transactions other than merchandise sales (scrap sales, sales of fixed assets) are properly authorized. 4. Cash receipts are compared to invoice terms to determine proper cash discounts. 5. Cash receipts for nonmerchandise sales are posted to proper accounts. 6. All cash receipts for credit sales are posted to customer individual accounts. 7. Cash receipts are deposited daily intact and recorded as of date received.

8.

If the credit limits are set and entered incorrectly, the credit approval process will be systematically deficient.

9.

The functions which should be separated to maintain internal control in a purchasing system include (1) custody of the goods (receiving and stores departments), (2) authority to initiate a transaction (purchasing department) and

Tests of Controls

19-3

(3) bookkeeping (accounts payable department, inventory record-keeping department). 10. The “walk through” of a purchase transaction would begin with the preparation of the requisition by the Stores department, through the bidding process and preparation of the purchase order by the purchasing agent, to receipt of vendor’s invoices and receiving report by the purchasing agent and finally to accounts payable voucher preparation. Procedures would be observed and notations made on document samples of procedures followed. Documents are collected to note where documentary evidence exists or control procedures being followed. The following documents would be collected: requisition, purchase order, receiving report and voucher. The “walk through” and sample documents would assist the auditor in understanding the flow of transactions. 11. a. b.

c. d. e. f.

Blank vouchers kept in secure location available only to authorized personnel. Blank supporting documents (invoices, receiving reports, requisitions, purchase orders) kept in secure locations available only to authorized personnel. Supporting documents canceled by Cash Disbursement function when checks are prepared. Separation of duties of preparers of supporting documents, preparation of vouchers, check preparation, and check signing. Vouchers and other supporting documents reviewed by check signers. Checks mailed directly by signer and not returned to accounts payable.

12. Authorization for vouchers payable recording mainly consist of an approved purchase order, a receiving report, and an accurate vendor invoice. Auditors should look for purchase approval signatures, receiving approval signatures, and approval of the vendor invoice – checks by client for proper quantity, price, and discount. 13. The point of this quotation is to generate discussion on the source of errors and therefore the controls necessary when an accounting process is computerized. Discussion items might include the following: 1. 2. 3. 4.

People have bad days and make mistakes; computers do not have bad days. Murphy’s Law – If it is possible to make an error, someone will find a way to do it. People initiate the transactions and will make errors. All controls should be considered together (manual and computer). Excellent computer controls cannot be relied upon if the related manual controls are weak.


6. 7. 8.

In computer systems, it is extremely important to establish extensive input validation controls to prevent people errors from getting into the processing (GIGO – garbage in, garbage out). People can prevent a good computer system from working well if they are not convinced it is in their best interests. People will rarely question computer printed output, even though it may not be correct. Most computer controls are to prevent, detect, or correct errors made by people.

14. The purpose of the auditor’s search for unrecorded liabilities is to gather evidence as to whether the liability assertion is true. The same concern exists in the internal control objective “all valid transactions are recorded and none are omitted.” From an evidence gathering perspective, it is much more difficult to gather evidence on unrecorded transactions than to gather evidence that recorded transactions (and account balances) are proper. The search for unrecorded liabilities includes procedures in other audit areas such as questions on bank and insurance confirmations and vouching the source of funds for asset additions. Specific audit procedures in the search for unrecorded liabilities include: 1.

2.

3. 4. 5.

Obtain vendor’s invoices (or accounts payable vouchers) recorded for several days after the balance sheet date to determine if the liability relates to the balance sheet period under audit. Scan cash disbursements for several days subsequent to year-end and vouch to support to determine if cutoff was proper. Scan all cash disbursements until the end of field work for unusual amounts and payees to determine if amounts paid represent liabilities of the balance sheet period. Examine BIR tax reports and correspondence and the audit reports of tax authorities and trace additional tax assessments to the accounts. Confirmation of accounts payable. Use analytical procedures such as trend comparisons of accounts payable to sales, sales taxes to sales, payroll taxes to gross payroll and interest expense to average notes payable.

15. A “walk through” involves following a transaction from initiation through the various steps until the transaction is recorded in the formal accounting records. In the conversion cycle, the following would constitute a complete “walk through:” Step Documents Collected Controls Noted Prepare production Production Order (P.O.) Support for P.O. orders Prepare bill of materials and manpower needs

Bill of materials (B.M.) Manpower needs (M.N.)

Separation planning from production.

Tests of Controls Assign job order and foreman

19-5

Note separation production supervisor from foreman duties.

Job tickets and material requisitions prepared

Job tickets (JT) Production foreman Material requisition (MR) duties separated from authorization.

Raw material records updated, issue slips prepared

Issue slip (IS)

Observe time entered and foreman approval on JT Direct labor report prepared

Approval by foreman of hours. Labor report (LR)

Observe timekeeping, compare job tickets to clock cards Material used report prepared

Materials not issued without MR. IS prepared for all materials released.

Job tickets support L.R. Reconciliation hours per clock cards to hours per J.T.

Material used report (MUR)

Issue slips and requisitions support MUR.

Observe matching issue slips and material used report

Records from sources reconciled.

Observe matching job time tickets (or labor distribution) to labor report

Records from separate sources reconciled.

Enter costs in job cost sheets

Job cost sheets (JCS)

Support for all entries in JCS.

Summary entry prepared.

Summary entry form

Job cost sheets support summary entries.

Trace summary entry to General Ledger posting Preparation of completion report Observe units compared to RUC, post finished records

Separation of duties; cost accounting and general ledger. Report of units completed (RUC)

Independent report of production completed. Independent check of RUC.

19-6 Solutions Manual – Public Accountancy Profession Products received report prepared

Products received report (PRR)

Observe comparison RUC and PRR Job sheets closed out, summary entry prepared Trace summary entry to General Ledger posting

Independent records of units put into finished goods inventory. Records from separate sources reconciled.

Summary entry form

Closed job sheets, RUC and PRR support summary entries. Separation of duties; cost accounting and general ledger.

16. Weaknesses (lack of control where auditors believe one is necessary) are not audited because auditors do not rely upon weaknesses to prevent, detect or correct material errors. Auditors must consider the financial impact of weaknesses on financial statements and plan substantive tests accordingly. A control strength may be identified in interviews during the review phase (or in preparing the flowcharts or questionnaires), but during test of controls auditing, found to be nonexistent or operating ineffectively. For example, in the conversion cycle the production management may state that foremen approve workers’ job time tickets. However, when a sample of job time tickets are examined by auditors for evidence of approval, none is found. Thus, a weakness is not found until the control is tested. Therefore, control risk should not be assessed low until evidence is gathered that the control is operating effectively. 17. The purpose of this review question is to foster discussion toward what information an independent auditor needs to know. Items relevant to the quotation might include: 1. 2. 3. 4. 5.

Reference to the standard regarding “adequate technical training and proficiency as an auditor.” Reference to the standard regarding “due professional care.” Obviously, the auditor must be knowledgeable about cost accounting to audit a manufacturing company. In a manufacturing company, the inventories most likely will be a major asset which will require substantial audit work. A proficient auditor must be knowledgeable in all phases of the business, including production, marketing, finance as well as accounting data processing.

18. The surprise observation enables the auditor to see how the distribution system really works and increases his chances of detecting fraud. Such an observation involves taking control of paychecks, then accompanying a client representative

Tests of Controls

19-7

as the distribution takes place. The auditor checks to see that each employee is identified and that only one check is given to each individual. Unclaimed checks are controlled and examined to detect any fictitious persons on the payroll. 19. A “walk through” of a personnel and payroll transaction would include discussions with each person handling personnel and payroll records. The following illustrates the steps and documents collected. Steps Hiring – personnel dept. Deductions – personnel dept. Timekeeping Shops Cost distribution Accounts payable Cash disbursement

Document(s) Collected Authorization to hire and rate assignment Personnel forms, employee authorization for deductions Clock card Job time ticket Labor distribution sheet Payroll voucher Payroll checks

If the payroll is processed by computer, the clock cards and job time tickets would be traced to batch control in the timekeeping and production departments, to data preparation (keying to machine sensible form), to edit and validation error reports and other computer output indicating control and finally to computer prepared checks, labor distribution reports and summary general ledger entries. Multiple Choice Questions 1. 2. 3. 4.

c c b c

5. 6. 7. 8.

a c c b

9. 10. 11. 12.

d b a a

13. 14. 15. 16.

b a c d

17. 18. 19. 20.

d d c b

Cases 1.

1.

Controlled access to blank sales invoices. a. Observation. Visit the storage location yourself and see if unauthorized persons could obtain blank sales invoices. Pick some up yourself to see what happens. b. Someone could pick up a blank and make out a fictitious sale. However, getting it recorded would be difficult because of the other controls such as matching with a copy from the shipping department. (Thus a control access deficiency may be compensated by other control procedures.)

19-8 Solutions Manual – Public Accountancy Profession

2.

2.

Sales invoices check for accuracy. a. Vouching and Recalculation. Select a sample of recorded sales invoices and vouch quantities thereon to bills of lading, vouch prices to price lists, and recalculate the math. b. Errors on the invoice could cause lost billings and lost revenue or overcharges to customers which are not collectible (thus overstating sales and accounts receivable).

3.

Duties of accounts receivable bookkeeper. a. Observation and Inquiry. Look to see who is performing bookkeeping and cash functions. Determine who is assigned to each function by reading organization charts. Ask other employees. b. The bookkeeper might be able to steal cash and manipulate the accounting records to give the customer credit and hide the theft. (Debit a customer’s payment to Returns and Allowances instead of to cash, or just charge the control total improperly).

4.

Customer accounts regularly balanced with the control account. a. Recalculation. Review the client’s working paper showing the balancing/reconciliation. Do the balancing yourself. b. Accounting entries could be made inaccurately or incompletely and the control account may be overstated or understated.

The discussion could take several directions, including some or all of the following: 1.

Material Weakness. The facts seem to suggest “a condition in which specific control features (few or none are described) or the degree of compliance with them do not reduce to a relatively low level the risk that errors or irregularities in amounts that could be material to the financial statements may occur and not be detected within a timely period by employees in the normal course of performing their assigned functions.” Castro has authority and influence over too many interrelated activities. Nothing he does seems to be subject to review or supervision. He even is able to exclude the internal auditor. An identification of the potential irregularities will illustrate the misdeeds he can perpetrate almost single-handedly.

2.

Potential irregularities include: a. b.

Castro can collude with customers to rig low bids and take kickbacks, thereby depriving the company of legitimate revenue. Castro can direct purchases to favored suppliers, pay unnecessarily high prices and take kickbacks. He might even set up a controlled

Tests of Controls

c.

d. e.

3.

dummy company to sell overpriced materials to the company. No competitive bidding control prevents these activities. Castro, through the control of physical inventory, can (i) remove materials for himself, and (ii) manipulate the inventory accounts to conceal shortages. Castro can order truck shipping services for his own purposes and cause the charges to be paid by the company. Castro can manipulate the customer billing (similar to a above) to deprive the company of legitimate revenue while taking an unauthorized commission or kickback.

Almost every desirable characteristic of good internal control has been circumvented: a. b.

c. d.

3.

19-9

Segregation of Functional Responsibilities. Castro has authorization and custodial responsibilities. Authorization, Supervision. Castro is apparently subject to no supervision or review. The accounting staff is probably powerless to challenge transactions because of Samuel’s apparent approval of Castro’s powers. Controlled Access. The whole situation gives Castro access to necessary papers, records, and assets to carry out his one-man show. Periodic Comparison. No one else apparently has any access to the materials inventory in order to conduct an actual count for comparison to the book value (recorded accountability) of the inventory.

The purpose of this question is to get the student to consider where the functions that are considered incompatible in a manual system occur in a computer system. The functions should be separated in a manual or computer accounting system such that different people authorize the sales transactions, record the transactions, have custody to the assets (inventory) and reconcile the books to the assets. Different people should: indicate the sales order source document (authorize), prepare the computer program (authorize and record), operate the computer (record), have custody of inventory and correct errors (reconciliation).

4.

If the credit limits are set and entered incorrectly, the credit approval process will be systematically deficient.


Memorandum TO: FROM: DATE: SUBJECT:

Board of Directors, The Potter Art League (Student’s name) Control weaknesses related to Cash Admission Fees

You requested a report which identifies the weaknesses in the existing system of cash admission fees and my recommendations. Below are the weaknesses that exist and my recommendations for procedures that overcome these weaknesses. I will be pleased to discuss these at the next board meeting and offer further explanations that may be necessary. Weakness: There is no segregation of duties between persons responsible for collecting admission fees and persons responsible for authorizing admission. Recommendation: One clerk (hereafter referred to as the collection clerk) should collect admission fees and issue prenumbered tickets. The other clerk (hereafter referred to as the admission clerk) should authorize admission upon receipt of the ticket or proof of membership. Weakness: An independent count of paying patrons is not made. Recommendation: The admission clerk should retain a portion of the prenumbered admission ticket (admission ticket stub). Weakness: There is no proof of accuracy of amounts collected by the clerks. Recommendation: Admission ticket stubs should be reconciled with cash collected by the treasurer daily. Weakness: Cash receipts are not promptly prepared. Recommendation: The cash collections should be recorded by the collection clerk daily on a permanent record that will serve as the first record of accountability. Weakness: Cash receipts are not promptly deposited. Cash should not be left undeposited for a week. Recommendation: Cash should be deposited at least once each day. Weakness: There is no proof of accuracy of amounts deposited. Recommendation: Authenticated deposit slips should be compared with daily cash collection records. Discrepancies should be promptly investigated and resolved. In addition, the treasurer should establish a policy that includes an analytical review of cash collections. Weakness: There is no record of the internal accountability of cash. Recommendation: The treasurer should issue a signed receipt of all proceeds received from the collection clerk. These receipts should be maintained and should be periodically checked against cash collection and deposit records.

Tests of Controls 6.

a.

b.

19-11

The purposes of these audit procedures are: 1.

To substantiate the validity of the asset “cash” in the balance sheet, as it may substantially consist of “cash in transit” from several sales divisions.

2.

To determine proper cash “cutoff”, i.e., to detect any unintentional errors overstating or understating cash between the current and the following accounting period.

3.

To disclose “kiting” (if any), e.g., perpetrated by the home office cashier in collusion with one or more sales divisions employees.

Audit Program for Sales Divisions – Audit Steps 1.

Prepare a schedule of transfer payments made by the branch for a period covering two weeks prior and two weeks after the end of the fiscal period showing: Check number Date of entry in cash disbursements book Amount of check Date of perforation by paying bank Transfer checks outstanding at the date of cutoff Transfer checks outstanding at the date of reconciliation.

2.

Compare dates of issue on canceled checks and of entries.

3.

Trace and compare dates of perforation and dates of payment on the bank statement and the “cutoff” statement.

4.

Compare dates of issue of checks to date of perforation looking for: a. b.

5.

unusual delays in payment discrepancy in accounting periods for the two dates.

Scan cancelled checks and cash disbursements records during the year for: a. b.

names of payees, consecutive numbers of checks to determine whether any payments other than regular transfers to main office were made from this account.

6.

Reconcile individually several transfers during the year to corresponding collections presumed to be transferred as of each individual date.

7.

Reconcile total collections for the year to total transfers.


1.

a. b.

Recorded payroll transactions are valid (no fictitious employees). Paychecks might be delayed and terminated workers might continue to be “paid” (with theft of check by someone else) if payroll is not promptly notified of new hires and terminations.

2.

a. b.

Recorded payroll deductions are valid. Incorrect amounts might be deducted from pay.

3.

a. b.

Recorded payroll transactions are valid and authorized. If payroll department personnel were also responsible for time records, they would have effective control over transaction authorization (i.e., hours worked approval) and could overpay themselves or friends.

4.

a. b.

Payroll and labor cost transactions are complete. Cost accounting records might contain more or fewer pesos than actually paid (per payroll data). Simple errors in cost analyses might occur.

CHAPTER 20 SUBSTANTIVE TESTS OF TRANSACTIONS AND BALANCES Questions 1.

The cutoff bank statement is a bank statement sent by the bank directly to the auditor, and it is usually for a fifteen or twenty day period following the reconciliation date. The basic use of the statement by the auditor is to determine whether outstanding checks were actually mailed before the reconciliation date.

2.

All cash funds (and negotiable investment stock and bond certificates) should be counted at the same time (simultaneously) so that money (or securities) cannot be shifted from one location to another to conceal a shortage. If simultaneous count cannot be made, as each fund (or each negotiable asset) is counted, it should be locked and sealed until all are counted.

3.

Kiting is the practice of recording a deposit of an interbank transfer in one period, but delaying the recording of the disbursement until the next period – thus double counting the amount of the transfer. It is used to cover up a cash shortage. Auditors schedule all bank transfers around the year-end and examine the dates deposited and disbursed per books and the dates deposited and disbursed per bank. Thus, the auditors can determine if both sides of the transfers are recorded in the same period and the proper period.

4.

A “positive” confirmation is a request for a response from an independent party who the auditor has reason to expect is able to reply. A “negative” confirmation is a request for a response from the independent party only if the information is disputed. Negative confirmations should also be sent only if the recipient can be expected to detect error and reply accordingly.

5.

Generally, vouching of documentation underlying receivables balances is deferred until after confirmation. Then vouching is performed in regard to accounts for which confirmations were mailed but no replies received. Additionally, vouching may be used to gather evidence about account discrepancies and disputes indicated on confirmation responses.

6.

Sales cutoff is audited by selecting sales invoices, shipping documents, and contracts created in the period (usually 10 days to two weeks) before and after the fiscal year-end. The transactions are traced to the sales and receivables accounts to prove whether they were recorded in the proper period. Similarly,

20-2 Solutions Manual – Public Accountancy Profession recorded sales in this period may be vouched to underlying documents to determine whether recording was in the proper period. 7.

Refer to pages 458 to 460; 824 to 825; 827 to 828.

8.

To prevent embezzlement through creation of fictitious credit memos, the internal control system should provide that all credit memos be prenumbered, controlled, and approved by a party independent of the preparer. Additionally, credit memos should be approved only with proper supporting documentation, e.g., a receiving report or correspondence.

9.

Auditors get in the most trouble by missing overstated assets and understated liabilities. Therefore, they need to audit for the existence of assets and the completeness of liabilities.

10. Notes payable audit evidence obtained from a standard bank confirmation used in the audit cash. Sales tax liability derived partially from the audit of sales revenue (also commissions payable and excise taxes payable). Income tax liability is derived from the net income number (audit of all revenue and expense accounts). 11. The types of fraud and material misstatement with respect to cash disbursements include: 1. 2. 3. 4.

The sending of checks to a fictitious person or company to accomplices outside (coupled with internal record alterations). The increasing (altering) of amounts payable to outside accomplices. The intercepting of payments to a bank (coupled with internal record alterations). The drawing of checks payable to cash or bearer for one’s own use.

The procedures auditors use most frequently to detect cash disbursement embezzlement schemes include: 1.

2. 3.

4.

A proof of cash – a recalculation – which reconciles cash receipts and disbursements per the bank statement with receipts and disbursements recorded in the accounts. The auditor will satisfy himself as to the propriety of all checks payable to “cash” or bearer, NSF checks, and checks drawn to officers and other employees. The confirmation with all bank creditors of amounts owed, terms and activity during the period. The auditor’s test of purchase transactions – vouching, tracing and recalculation in regard to purchase orders, supplier invoices, cash disbursement journal and voucher register. The auditor’s obtaining satisfaction of the proper separation of functions: To establish that a proper separation exist, the auditor will not only examine

Substantive Tests of Transactions and Balances

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internal records purporting a proper separation, he will also examine documents for compliance and observe personally the flow of operations and activities. 12. The characteristics that the auditor is looking for in his review of the client’s inventory-taking instructions include: 1. 2. 3. 4.

Names of client personnel responsible for the count. Dates and times of inventory-taking. Names of client personnel who will participate in the inventory-taking. Detail instructions for recording accurate descriptions of inventory items, for count and double-count, and for measuring or translating physical quantities. 5. Detail instructions for making notes of obsolete or worn items. 6. Detail instructions for the use of tags, punched cards, count sheets, or other media devices, and for their collection and control. 7. Plans for shutting down plant operations or for taking inventory after store closing hours, and plans for having goods in proper places. 8. Plans for counting or controlling movement of goods in receiving and shipping areas if those operations are not shut down during the count. 9. Detail instructions for compiling the count media (e.g., tags and punched cards) into final inventory listings or summaries. 10. Detail instructions for pricing the inventory items. 11. Detail instructions for review and approval of the inventory count, notations of obsolescence, or other matters by supervisory personnel. 13. As is true in other areas of a financial audit, verbal inquiry is a valuable tool for obtaining preliminary evidence in the audit of inventory and cost of sales. For example, the auditor can gain information such as the locations of inventory, dates for the physical count, inventory held by consignees and public warehouses, the cost-flow assumption used to price cost of goods sold and inventories, and the pledging of inventory as collateral on loans. In addition to providing preliminary evidence, verbal inquiry frequently provides information about the status and value of slow-moving inventory, apparently worn, damaged or obsolete inventory, and the existence of large inventory stockpiles. 14. Cost of goods sold is generally audited through a combination of limited vouching and extensive analytical procedures. Inventory balances are generally audited through heavy reliance on observation, vouching and recalculation, with much less emphasis on analytical procedures. 15. The auditor can obtain preliminary evidence through physically observing plant facilities and making verbal inquiries; for example, evidence can be obtained

20-4 Solutions Manual – Public Accountancy Profession regarding the quantity and size of assets, their location and apparent physical condition, the activity surrounding them, and ownership of the facilities. Further preliminary evidence of existence may be gained by a review of internal management reports. Examples of such reports include capital expenditure proposals, capital budgets, construction cost or acquisition cost postanalysis, maintenance and repair reports, reports of sales or retirements, and insurance and property tax analyses. The preliminary evidence should be corroborated by auditor tracing to the detailed records to ascertain that existing assets are recorded. Further, new asset acquisitions should be traced to directors’ authorizations for expenditures and to the capital budget. 16. To obtain relevant audit data about investment securities, auditors’ procedures include: 1. 2. 3. 4.

Inspecting the securities in the presence of a responsible client officer. Personally examining the securities while other negotiable fund sources are sealed off or are being examined simultaneously. Obtaining a written statement from the client’s representative that the securities were returned intact. Obtaining the information by confirmation from an independent party (e.g., trustee) who holds the securities.

17. Investment cost can be vouched to brokers’ advices, monthly statements and canceled checks. The auditors can similarly vouch the price of securities sold and investment income to this documentary evidence and then trace amounts to income, gain and loss, and cash accounts. 18. If investments are sold at substantial losses early in the period following yearend, there is evidence that the securities were overvalued at the balance sheet date. Accordingly, the auditor will consider whether such securities should be written down in the financial statements of the period under audit. 19. The long-term liabilities (and fixed assets and owners’ equity) are characterized by a few large transactions, unlike the current assets and liabilities which have numerous small transactions. Except for the initial year of an audit, the entire balance is not verified each year. Only the changes in the account that occurred in the current period need to be audited. The results of the audit of prior year’s changes are recorded in “carry-forward” working papers for these accounts. 20. By vouching open purchase orders, inquiry of purchase personnel, and confirmation with suppliers, the auditor is seeking to learn of commitments to purchase inventories at fixed prices. If the client faces significant losses on


20-5

fixed-price purchase commitments, appropriate provision for the losses should be made in the period’s financial statements. 21. “Off-balance sheet information” refers to information that relates to obligations and commitments assumed by the clients that do not appear on the balance sheet as current or long-term liabilities. Such information should be disclosed by the client in the footnotes to the financial statements. Therefore, the auditors must be alert to these items and gather evidence that will allow the auditors to determine if the footnote disclosure is adequate. Such information includes: leases, endorsements on discounted notes or others’ obligations, guarantees, repurchase or remarketing agreements, commitments to purchase at fixed prices, commitments to sell at fixed prices, legal judgment, litigation, pending litigation. 22. The following matters are usually covered during the conference with the client at audit completion: a. b. c. d.

Proposed audit adjustments; Material internal financial control weaknesses; Recommended footnote disclosures; Type of audit report to be rendered.


b b d d

5. 6. 7. 8.

c c c b

9. 10. 11. 12.

b c&d b b

13. 14. 15. 16.

c d d c

17. 18. 19. 20.

d a a c

Cases 1.

a.

The CPA’s test of the sales cutoff at June 30 should include the following steps: 1. 2.

3.

4.

Determine what JETO’s cutoff policy is, review the policy for reasonableness, and compare it to the prior year for consistency. Select a sample of sales invoices (including the last serial invoice number) from those recorded in the last few days of June and the first few days of July. Trace these sales invoices to shipping documents and determine that sales have been recorded in the proper period in accordance with company cutoff policy. Determine that the cost of goods sold has been recorded in the period of sale.


6.

b.

Select a sample of shipping documents for the same period and trace these to the sales invoice. Determine that the sale and the cost of goods sold have been recorded in the proper period. Review the cutoff for sales returns and allowances, determine that it has been based upon a consistent policy and that there have not been abnormal sales returns and allowances in July; this might indicate either an overstatement of sales during the audit period or the need for a valuation account at June 30 to provide for future returns and allowances.

(1) The CPA will use the July 10 cutoff bank statement in his review of the June 30 bank reconciliation to determine whether: (a) The opening balance on the cutoff bank statement agrees with the “balance per bank” on the June 30 reconciliation. (b) The June 30 bank reconciliation includes those canceled checks that were returned with the cutoff bank statement and are dated or bear bank endorsements prior to July 1. (c) Deposits in transit cleared within a reasonable time. (d) Interbank transfers have been considered properly in determining the June 30 adjusted bank balance. (e) Other reconciling items which had not cleared the bank at June 30 (such as bank errors) clear during the cutoff period. (2) The CPA may obtain other audit information by: (a) Investigating unusual entries on the cutoff bank statement. (b) Examining canceled checks, particularly noting unusual payees or endorsements. (c) Reviewing other documentation supporting the cutoff bank statement.

2.

The procedure followed appears to be appropriate except that the examination of detail transactions for three months might be considered to be excessive in view of the exceptionally good internal control. A lighter test of such transactions, designed to test the effectiveness of the control procedures, might be devised. The procedures followed should be supplemented by the following: 1.

2. 3.

Review the company’s method of sales cutoff at year-end and test billings and shipments (including returns) for an adequate period before and after year-end to establish that cut-off procedures have been adhered to. Examine collections in early part of subsequent period to determine if a substantial portion of the receivables has been collected. Examine agreements entered into with the distributors. If price protection clauses are included, review the current price position and distributor


4. 5.

3.

1.

inventory positions to determine whether a reserve for such protection is needed. When a company deals with a limited number of customers, it is dependent upon the continued solvency of all such customers. Obtain a representation letter from appropriate company officials covering the receivables. a. b. c.

2.

a. b. c.

3.

a. b. c.

4.

a. b. c.

4.

a.

20-7

Notes payable are authorized according to company policy (proper authorization). For each note outstanding or paid during the year, vouch to written authorizing document. Funds might be borrowed in the company’s name without the knowledge of responsible officers. Recorded notes payable are valid and documented (separation of duties). Observe the client personnel record-keeping duties. Someone might intercept a check made out to a bank and convert company funds to his or her own use. Notes payable records could be falsified for a short time to hide the theft. Valid liabilities are recorded and none omitted (sound error checking practices). Observe client personnel making comparisons. Review correcting journal entries that result from the comparison. Purchases or other liabilities may fail to be recorded and the error not detected by any other means. Recorded liabilities and cash disbursements valid and documented (sound record keeping). Inspect notes to see if they are marked “paid.” Notes may get “paid” a second time if put back through the cash disbursements system (intentionally or inadvertently).

The fact that the client made a journal entry to record vendors’ invoices which were received late should simplify the CPA’s audit for unrecorded liabilities and reduce the possibility of a need for a further adjustment, but the CPA’s audit is nevertheless required. If the client has not journalized late invoices, the CPA is compelled in his testing to substantiate what will ultimately be recorded as an adjusting entry. In this examination the CPA should audit entries in the 2004 voucher register to ascertain that all items which according to dates of receiving reports or vendors’ invoices were applicable to 2004 have been included in the journal entry recorded by the client.

20-8 Solutions Manual – Public Accountancy Profession b.

No. The CPA should obtain a letter in which responsible executives of the client’s organization represent that to the best of their knowledge all liabilities have been organized. However, this is done as a normal audit procedure to afford additional assurance to the CPA and it does not relieve him of the responsibility for doing his own audit work.

c.

Whenever a CPA is justified in relying on work done by an internal auditor, he should curtail (but not eliminate) his own audit work. In this case, the CPA should have ascertained early in his examination that Ozone’s internal auditor is qualified by being both technically competent and reasonably independent. Once satisfied as to these points, the CPA should discuss the nature and scope of the internal audit program with the internal auditor and review his working papers in order that the CPA may properly coordinate his own program with that of the internal auditor. If the Ozone internal auditor is qualified and has made tests for unrecorded liabilities, the CPA may limit his work in this audit area.

d.

In addition to the 2005 voucher register, the CPA should consider the following sources for possible unrecorded liabilities: 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12.

5.

Unentered vendors’ invoice file. Status of tax returns for prior years still open. Discussions with employees. Representations from management. Comparison of account balances with preceding year. Examination of individual accounts during the year. Existing contracts and agreements. Minutes. Attorney’s bills and letter of representation. Status of renegotiable business. Correspondence with principal suppliers. Audit testing of cutoff date for reciprocal accounts, e.g., inventory and fixed assets.

a.

Lourdes should find in the audit working papers a planning memo describing the client’s inventory-taking plan and notes about the auditor’s first-hand observation of the instructions being given to counters, along with a memo about the auditors’ observation of the counting. This memo should tell about supervision of the audit staff, and the working papers (test counts) should show the review signatures of the supervising auditors.

b.

Working papers should document performance of these substantive procedures for the existence and completeness assertions: 1.

Conduct an observation of the company’s physical inventory count.

Substantive Tests of Transactions and Balances 2. 3.

4.

20-9

Scan the inventory compilation for items added from sources other than the physical inventory count. . . At year end, obtain the number of the last shipping and receiving documents . . . Use these to scan the sales, inventory/cost of sales, and accounts payable entries for proper cutoff. Confirm or inspect inventories held in public warehouses.

6.

The three categories of major losses or manipulations in the area of investments are: theft of diversion of funds, manipulation of accounting, and business espionage. Business espionage is generally outside the sphere of independent auditors’ interest.

7.

a.

The objectives (specific assertions) for the audit of non-current investment securities are to obtain evidence regarding the: • • • • • •

b.

Existence of the investment securities at the balance sheet date. Ownership of the investment securities. Cost and carrying value of the investment securities. Proper presentation and disclosure of the investment securities in the financial statement. Proper recognition of interest income. Proper recognition of investment gains and losses.

The following audit procedures should be undertaken with respect to the audit of Tess’ investment securities: • • • • • • • • • • •

Inspect and count securities in the company’s safe and safe deposit box. Examine brokers’ statements to obtain assurance that all transactions were recorded. Examine documents in support of purchases and sales of investment securities. Inspect the minutes of the board of directors meetings. Review the audited financial statements of the (25 percent) investee. Verify the equity method of accounting was used for carrying value of the investment in Dee Industrial. Obtain a client representation letter that confirms the client’s representations concerning the noncurrent investment securities. Verify the calculation of interest income. Review the propriety of the presentation and disclosure of the securities in the financial statements. Make certain that the client representation letter includes the proper assertions concerning accounts payable. Investigate and resolve confirmation exceptions and other matters requiring follow-up.


a.

The audit objectives in the examination of long-term debt are to determine that: 1. 2. 3. 4. 5. 6. 7.

b.

All liabilities were properly recorded. Items recorded as liabilities are bona fide obligations. Interest expense and/or amortization was properly computed and recorded. The client is not in violation of restrictions or requirements imposed on it by the terms of the loan agreement. Satisfactory authority existed to enter into long-term obligation agreements. All long-term obligations are properly classified in the balance sheet. Assets pledged as security are adequately disclosed.

The following procedures should be included in an audit program for the examination of the long-term note between Odette and First National Bank: 1. 2.

3. 4. 5.

Confirm the loan and terms of the agreement with the bank. Review the agreement between Odette and the bank to determine that: a. The debt is long-term (by reference to dates). b. Provisions of the agreement have not been violated, e.g., that Odette is complying with any restrictions on the payment of dividends, on the amount of working capital to be maintained, or on the uses to which the funds may be employed and is maintaining the plant pledged as security for the loan. c. The agreement was signed by person(s) having authority. Trace the receipt of funds into the bank account and cash receipts book. Check the computation of interest expense for the period May 1 to June 30, and trace the recording of the expense and the accrual on the books. Determine that authority to borrow was granted and is recorded in the board of directors’ minutes.

CHAPTER 21 AUDIT DOCUMENTATION Questions 1.


2.

The major function of audit workpapers is to provide evidence of conformance with auditing standards. As a body, the workpapers are the principal record of the evidence which the auditor has gathered and evaluated in support of the audit opinion.

3.


4.


5.

With electronic spreadsheets, audit adjustments need only be entered once – in the supporting schedule. The adjustments are then automatically reflected in lead schedules and in the working trial balance through equations entered in appropriate cells. The cell equations “link” the workpapers such that an adjustment need be entered only once in order for all affected workpapers to be automatically updated.

6.

Permanent files contain information that is of a continuing interest to the auditor. A permanent file typically contains (1) copies or abstracts of significant company documents and (2) auditor- or client-prepared information on accounts. Current-year files contain working papers prepared to support the assertions embodied in the financial statements.

7.

Client personnel may prepare working papers to reduce the time spent by the auditor on the engagement. When client personnel prepare working papers, the auditor should give the client personnel detailed instructions. Working papers prepared by the client should be identified as PBC (prepared by client) and should involve no decision making. The auditor should test completed working papers against underlying documentation.

8.

The lead schedule, especially on larger engagements, is designed to bridge the gap between the working trial balance and the general ledger by listing all general ledger accounts that are reported as one account in the financial statements. Supporting schedules is a term for working papers that support the amounts presented in the financial statements by providing support for a detailed account on a lead schedule. Supporting schedules represent the bulk of working papers.

21-2 9.

Solutions Manual – Public Accountancy Profession In general, a properly prepared working paper should meet firm policy, have a proper heading, clearly indicate the work performed, clearly meet the audit objective for which it was designed, and clearly state the auditors’ conclusion.

10. The prior year’s audit working papers are a useful guide to staff assistants because the audit procedures performed in the prior year usually are similar to those of the current year. By referring to last year’s working papers, the assistant can see how the procedures were documented and is given a possible format for organizing the current year’s working paper. In addition, exceptions noted in last year’s working papers may alert the assistant to possible problems in the current year. Finally, the prior year’s working papers contain information substantiating the beginning balances for the current year. 11. The more common types of audit working papers and their principal purposes may be summarized as follows: (1) Audit administrative working papers – aid the auditors in planning and administration of the audit, and include such items as the audit programs, questionnaires and flowcharts, decision aids, time budgets, and engagement letters. (2) Working trial balance – represents the backbone of the auditors’ working papers, for it contains the balances of the ledger accounts, the adjustments and reclassifications deemed necessary by the auditors, and the adjusted amounts that appear in the financial statements. It also contains references to all supporting schedules and analyses, thus serving to control the other types of working papers. (3) Lead schedules – working papers that serve to combine similar general ledger accounts, the total of which appears on the working trial balance. (4) Adjusting journal entries – material misstatements in the accounts disclosed by the auditors’ investigation are corrected by means of adjusting journal entries. These appear on the auditors’ working trial balance, and in addition, a list of such entries is turned over to the client at the conclusion of the audit with the request that they be approved and entered in the accounting records. (5) Reclassification entries – entries necessary to properly reflect financial results but not representing misstatements in the financial records of the client. (6) Supporting schedules – although the term schedule is at times applied to various types of working papers, the preferred usage is to designate a listing of the details or elements comprising the balance in an account at a specified date. Preparation of such a listing is often an essential step in determining the nature of an account.

Audit Documentation

21-3

(7) Analyses – consist of working papers showing the changes which occurred in an account during a given period. By analyzing an account, the auditors determine its nature and contents. (8) Reconciliations – working papers that prove the relationship between two amounts obtained from different sources. (9) Computational working papers – used to verify such data as interest expense, income taxes, and earnings per share. (10) Corroborating documents – working papers that provide support for specific representations made in the financial statements, such as letters of representations from clients, lawyers’ letters, audit confirmations, and copies of the contracts. 12. Audit working papers are the property of the auditor; however, they must not violate the confidential relationship between client and auditors by making the papers available to outsiders or even to the client’s employees without specific permission from the client. 13. Refer to page 820 of the textbook. 14. Refer to pages 820 to 822 of the textbook.

Multiple Choice Questions 1. 2. 3. 4. 5. 6. 7. 8.

d d c a d c c d

9. 10. 11. 12. 13. 14. 15. 16.

b b a d d b d d

17. 18. 19. 20. 21. 22. 23. 24.

d c c d b d a b

25. 26. 27. 28. 29. 30. 31. 32.

b d d c d c d d

Cases 1.

a.

(1) The functions of audit working papers are to aid the CPA in the conduct of his work and to provide support for his opinion and his compliance with auditing standards. (2) Working papers are the CPA’s records of the procedures performed, and conclusions reached in the audit.

21-4


The factors that affect the CPA’s judgment of the type and content of the working papers for a particular engagement include: 1. The nature of the auditor’s report. 2. The nature of the client’s business. 3. The nature of the financial statements, schedules or other information upon which the CPA is reporting and the materiality of the items included therein. 4. The nature and condition of the client’s records and internal controls. 5. The needs for supervision and review of work performed by assistants.

c.

Evidence which should be included in audit working papers to support a CPA’s compliance with generally accepted auditing standard includes: 1.

2.

3. 4. 5.

d.

2.

Evidence that the financial statements or other information upon which the auditor is reporting were in agreement or reconciled with the client’s records. Evidence that the client’s system of internal control was reviewed and evaluated to determine the nature, timing, and extent of audit procedures. Evidence of the auditing procedures performed in obtaining evidential matter for evaluation Evidence of how exceptions and unusual matters disclosed by auditing procedures were resolved or treated. Evidence of the auditor’s conclusions on significant aspects of the engagement with appropriate commentaries.

The CPA should perform an adequate examination at minimum cost and effort and the preceding year’s programs will aid in doing this. The preceding year’s audit programs ordinarily contain information useful in the current examination (such as descriptions of the unique features of a client’s operations or records, a formalized sequence of audit steps in logical order, and approximate time requirements to perform various phases of the work). The auditor should decide whether to use the old program or prepare a new one.

In general, the working paper is not set up in a logical manner to show what the auditor wants to accomplish. The primary objective of the working paper is to verify the ending balance in notes receivable and interest receivable. A secondary objective is to account for all interest income, cash received and cash disbursed for new notes, collateral as security, and other information about the notes for disclosure purposes.

Audit Documentation

21-5

Specific deficiencies of the working paper presented in the question are:

1.

2. 3. 4.

a. DEFICIENCY Tick mark explanation “tested” does not indicate specifically what was done.

Explanation of some tick marks is not given. Classification of long-term portion indicates no verification. Paid-to-date row is confusing.

5.

Due dates are missing for C.C. Co., P. Pablo and Tetra Co.

c.

SPREADSHEET SOLUTION

b. IMPROVEMENT Should have separate tick marks meaning: Agreed to confirmation Footed Traced to cash receipts journal Recomputed, etc. Explain all tick marks on the same page of the working paper. Recompute portions of notes which are long-term. Column should say “date paid to” and this should be confirmed. Include due dates on working paper for these notes.

The purpose of using an Excel spreadsheet in this problem is to give the student some experience in preparing a simple working paper using an Excel spreadsheet. It should be explained to students that this type of working paper may or may not be prepared in actual practice, and that often templates are used to prepare more time-consuming working papers. Also, whether or not tick marks are computerized is a matter to be decided. The advantage is that the completed audit work can then be stored and reviewed electronically, a direction many firms are going. On the other hand, it may be more efficient to indicate audit work manually as it is performed, and a contrast in the color of the tick marks through use of a colored pencil may be desirable. The formulas used are self-evident, so no listing is provided. Two items deserve comment: 1.

An advantage of using a spreadsheet program for these types of analyses is that footing and crossfooting are done automatically.

2.

When auditor tick marks are done by computer, a problem arises as to how to place them on the worksheet. One could use narrow columns inserted between the scheduled client data, or, as done here, the tick marks are placed in blank rows beneath the related data.

21-6


FOURTH PACIFIC COMPANY A/C # 110 – NOTE RECEIVABLE 12/31/13

Schedule Prepared by Approved by Account # 110 – Notes Receivable

Maker Alba Co.

c*

Barrios, Inc.

c*

C.C. Co.

c*

P. Pablo

c*

Martin Cruz

c*

Tetra Co.

c*

Date Interest Made / Rate / Due Date Paid to 6/15/12 / 5% / 6/15/14 None pd. 11/21/12 / 5% / Demand 12/31/13 11/1/12 / 5% / 4/1/18 12/31/13 (P200/Mo.) 7/26/13 / 5% / 8/1/15 9/30/13 (P1000/Mo.) 5/12/12 / 5% / Demand 12/31/13 9/3/13 / 6% / 2/1/16 11/30/13 (P400/Mo.)

Balance 12/31/12 4000 tp 3591 tp 12780 tp

Value of Security None

3591

None

13180

24000

25000

50000

0

25000 r

5000 r

20000

2100

None

0

10000

12000 r

2100 r 1600 r

0

12000

2100 tp 0 22471

37000

f tp

f

0 0

Payments 1000 r 3591 r 2400 r

Date 1/21/14 2/15/14

Interest

Face Amount 5000

Additions 0

N-1 JD PP

Balance 12/31/13 3000

Receivable 12/31/12 114 tp 0 tp 24 tp

Receivable 12/31/13 279

Earned 175 < 112 < 577 <

Received 0 112 r 601 r

0

0

468 <

200 r

268

105 < 162 <

105 r 108 r

0

11400

0 tp 0

15691

43780

128

1589

1116

601

f

f, cf wtb

f tb

f op

f

f, cf wtb

0 11380

Legend of Auditor’s Tick Marks f Footed cf Crossfooted tp Traced to prior year working papers wtb Traced total to working trial balance op Traced total to operations working paper – OP6 * Examined note for payee, made and due dates, interest rate, face amount, and value of security. No exceptions noted. c Received confirmation, including date interest paid to, interest rate, interest paid during 2013, note balance, and security. No exceptions noted. r Traced to cash receipts journal < Recomputed for the year

0

54

21-7


CHAPTER 22 AUDIT EVIDENCE EVALUATION Questions 1.


2.


3.

The objective of evaluating misstatements is to determine the effect on the audit and whether there is a need to perform additional audit procedures. Revisions to the audit strategy and detailed audit plans may be required when:

4.

a. b.

c.

d.

e.

f.

g.

•

The nature of circumstances of identified misstatements indicate that other misstatement(s) may exist that, when aggregated with known misstatements, could exceed performance materiality; or

•

The aggregate of identified and uncorrected misstatements come close to or exceeds performance materiality.

Omissions or Fraud – Some transactions may not be recorded, either by mistake or deliberately, the latter of which would constitute fraud. Significant Transactions – A lack of business rationale for significant transactions (unusual or outside the normal course of business) could be intended to manipulate the financial statements or to conceal misappropriation of assets. Journal Entries – Inappropriate or unauthorized journal entries may have occurred throughout the period or at period end. These could be used to manipulate amounts reported in the financial statements. Errors in Estimates – Management estimates may calculate incorrectly, overlook or misinterpret certain facts, use faulty assumptions, or contain some element of bias if the entity’s estimate falls outside an acceptable range. Estimates could also be deliberately misstated to manipulate financial statement results. Errors in Fair Values – There may be disagreements with management’s judgments with respect to the fair value of certain assets, liabilities, and components of equity required to be measured or disclosed at fair values in accordance with the financial framework. Selection and Application of Accounting Policies – There may be disagreements with management with regard to the selection and use of certain accounting policies. Uncorrected Misstatements in Opening Equity – Uncorrected misstatements from prior periods would be reflected in opening equity. If not adjusted, they may also cause a misstatement in the current period financial statements.

20-2 Solutions Manual – Public Accountancy Profession

5.

h.

Revenue Recognition – Overstatement or understatement of revenues (e.g., premature revenue recognition, recording fictitious revenues, or improperly shifting revenues to a later period).

a.

Materiality of Misstatements – How significant is a misstatement in the assertion being addressed, and what is the likelihood of it having a material effect (individually or aggregated with other potential misstatements) on the financial statements? Management Responses – How responsive is management to audit findings, and how effective is the internal control in addressing risk factors? Previous Experience – What has been the previous experience in performing similar procedures, and were any misstatements identified? Results of Performed Audit Procedures – Do the results of performed audit procedures support the objectives, and is there any indication of fraud or error? Quality of Information – Are the source and reliability of the available information appropriate for supporting the audit conclusions? Persuasiveness – How persuasive (convincing) is the audit evidence? Understanding the Entity – Does the evidence obtained support or contradict the results of the risk assessment procedures (which were performed to obtain an understanding of the entity and its environment, including internal control)?

b. c. d.

e. f. g.

6.

Audit matters that should be communicated by the auditor to those charged with governance are: •

Accounting policies

•

Prior period communications

•

Risks of material misstatement

•

Material uncertainties

•

Concerns

•

Significant difficulties encountered

•

Comments on entity management

•

Audit adjustments

•

Uncorrected misstatements

•

The auditor’s report

•

Agreed-upon matters

•

Other matters

CHAPTER 23 COMPLETING THE AUDIT AND POST-AUDIT RESPONSIBILITIES Questions 1.

Many of the revenue and expense accounts are not material in relation to the financial statements and may be combined with other accounts in the financial statements. These accounts can be audited through analytical procedures. Such procedures compare the account balance to related statement of financial position accounts, to sales, to industry averages or to a multiple-year trend to ascertain whether any unusual fluctuations are present. Unusual or unexpected items would have to be investigated and material items vouched to supporting documents.

2.

The primary purpose of the client representation letter is to impress upon management its ultimate responsibility for the adequacy of the financial statements and related disclosures. With respect to receivables, such letters typically state that all receivables are valid and include proper amounts; also stated is the amount written off in the past year and the current provision for uncollectibles. In connection with inventories, the client represents that the peso amount of inventories reflects physical quantities determined by a count and priced by a stated accounting method. The client also represents that provision has been made by the company for all obsolete and damaged inventory. In regard to minutes, the client represents that all minutes of meetings of stockholders, directors, and executive committees which have been transmitted to the auditor are complete and authentic records for the period under audit (including the subsequent period). The client letter of representation should state whether any events occurred subsequent to the date of the financial statements that, in the client’s opinion, require adjustment or disclosure in the statements.

3.

In addition to the attorney’s letter, other procedures that are used to gather evidence regarding contingencies include: • • • •

Standard bank confirmation. Inquiry of client management. Reading of the minutes of the board of directors. Vouching to purchase and sales contracts.


• Vouching to lease agreements, confirmation with lessor or lessee. There are two types of subsequent events: 1.

The first type consists of those events that provide additional evidence with respect to conditions that existed at the date of the statement of financial position and affect the estimates inherent in the process of preparing financial statements. The use of the evidence requires an adjustment to the financial statements.

2.

The second type consists of those events that provide evidence with respect to conditions that did not exist at the date of the statement of financial position being reported on but arose subsequent to that date. These events should not result in an adjustment of the financial statements. However, disclosure may be required to prevent the financial statements from being misleading. In some cases, pro forma financial statements may be required to ensure adequate disclosure.

5.

The purpose of dual dating is twofold: (1) To provide a means of inserting important information in the financial statements even when learned after field work is complete, while at the same time (2) to inform users that the auditor takes full responsibility for subsequent events only up to the end of the field work and for the specifically identified later event, but does not take responsibility for other events which may have occurred after the end of field work and before the date of the specifically identified subsequent event.

6.

Loss contingencies from litigation, claims, and assessments can be accrued or disclosed, depending on the event’s likelihood. When a loss contingency involves an unasserted claim or assessment, disclosure is not required if no evidence exists that the assertion of a claim is probable. When an unasserted claim probably will be asserted and an unfavorable outcome is a reasonable possibility, disclosure is required. When a loss contingency is likely and the amount can be estimated, the contingency should be accrued.

7.

When substantial doubt exists about the ability of an entity to continue in operation for a year following the financial statements, an auditor should add a paragraph calling attention to the fact that the statements have been prepared assuming that the entity will continue as a going concern. If an auditor fails to modify the report, however, and an entity ceases to exist as a going concern within one year following the date of the audit, this does not in itself indicate inadequate performance by the auditor.

8.

Management’s refusal to sign a representation letter would typically result in a disclaimer of opinion because audit evidence was restricted by management.

Completing the Audit and Post-Audit Responsibilities 9.

23-3

At the completion of the audit, an auditor must reconsider materiality and determine an amount for materiality to be used in evaluating the estimated errors in the financial statements. Also, an auditor should reconsider the audit risk. As errors are found during the audit, the auditor generally shares them with the client, and the client makes adjusting entries for material errors. If the client refuses to correct a material error, the auditor must consider the materiality of the combined known errors and likely errors. Known errors are individual errors specifically identified by an auditor, whereas likely errors are an auditor’s best estimate of other errors based on a projection of errors detected during sampling. An auditor should compare projected error to materiality, both on an account level and in the aggregate.

10. A financial statement disclosure checklist is a checklist an auditor uses to review the financial statements to check that all necessary disclosures have been included. In contrast, the auditor uses an engagement checklist to determine that all auditing procedures have been performed. 11. “Subsequent events” are material events that occur after the statement of financial position date but before the end of field work (and thus, before the audit report date) that require disclosure in the financial statements and related notes. Auditors (and management) are responsible for gathering evidence on these subsequent events and evaluating the proposed disclosure. “Subsequent discovery of facts existing at the audit report date” is knowledge gained after the audit report is issued about an event or condition that existed at the audit report date. Auditors have no responsibility to search for these facts (as they do for subsequent events); however, once brought to the auditors’ attention, their responsibility is to determine if the financial statements (and thus their report) are misstated and take appropriate action. 12. The actions the partner should take if the client consents to disclose the information (which existed at the audit report date and materially impacts the financial statements) is to determine the method and timing of disclosure. The actions the partner should take if the client refuses to make disclosure are: • Notify the client that the auditors’ report must no longer be associated with the financial statements. • Notify regulatory authorities that the auditors’ report should no longer be relied upon. • Notify users known to be relying on the financial statements that the auditors’ report should no longer be relied upon. Such notification may be to the SEC and the stock exchanges.

23-4 Solutions Manual – Public Accountancy Profession 13. Once auditors have reported on audited financial statements, they have no responsibility to carry out a retroactive review of their work. However, postissuance review may be made in connection with a firm’s internal quality control monitoring program, peer review or otherwise, and the omission of an auditing procedure may be discovered. If an omitted procedure is found, the auditors should consult legal counsel and take the following actions: • Assess the importance of the omitted procedure to the present ability to support the previously expressed opinion. • Determine if there are persons currently relying or likely to rely on their report. • If the omitted procedure impairs present ability to support the previously expressed opinion, the omitted procedure should be applied or alternative procedures applied that would provide a satisfactory basis for the opinion. • If, as a result of subsequent application of the omitted procedure or alternative procedures, the auditors become aware of facts that existed at the date of their report, they should refer to page 927 (Subsequent Discovery of Facts Existing at the Date of the Auditor’s Report) for guidance. 14. In a “cold review,” a partner not otherwise associated with an engagement will take the report (in draft copy) and all working papers and review the entire engagement with a fresh start. The purpose of the review is to obtain the unbiased view of a professional expert who is not committed to a particular engagement or its problems. It is performed to aid in maintaining high standards of professional practice. 15. A management letter is an extra audit service. Auditors write to the management their recommendations about control, tax matters, operating efficiencies, and other consulting subjects to impress on managers the benefits of audits in addition to “just an audit.” The letter also serves to promote and sell CPAs’ consulting services. 16. A good management letter can show the client some profit potential, and the CPA may be hired to do the consulting work. 17. When the auditor learns of information existing at the date of a previously issued audit report, that it, if known, would have altered the audit opinion, the following steps are in order: a. Determine whether the information is reliable and whether the facts existed at the date of the audit report; b. Request the client to make necessary disclosure to persons known to be relying on the statements; c. If the client refuses, the auditor has a duty to notify those known to be relying on the audit report that such reliance is no longer justified (notifying

Completing the Audit and Post-Audit Responsibilities

23-5

board of directors, SEC, and stock exchange usually satisfies this requirement). 18. An auditor should investigate the new information as soon as practicable. When an auditor determines that the information is reliable, that the facts existed at the date of the report, and that the nature of the information and its effect on the financial statements are such that the report would have been affected, the auditor should consider whether persons are relying on the report. If the auditor must take steps to prevent future reliance on the report, the preferred resolution is for the client to issue revised financial statements and the auditor to issue a revised report, unless the issuance of statements for a subsequent period is imminent. When the effect on the financial statements of the subsequently discovered information cannot be determined without a prolonged investigation, the client should notify persons who are known to be relying on or who are likely to rely on the financial statements and the related report. The client’s notification should state that (1) the statements should not be relied on and (2) revised financial statements and auditor’s report will be reissued on completion of an investigation. If applicable, the client should discuss the matter with the Securities and Exchange Commission, stock exchanges, and appropriate regulatory agencies. 19. If the client refuses to disclose the newly discovered facts, the auditor should consult with his or her attorney and notify each member of the board of directors of such refusal and of the fact that, in the absence of such disclosure, the auditor will take steps to prevent future reliance on the audit report. These steps may include • notifying the client that the audit report must no longer be associated with the financial statements. • notifying the appropriate regulatory agencies that the audit report should no longer be relied on. • notifying each person known to the auditor to be relying on the financial statements that the audit report should no longer be relied on. If such notification is impracticable, the auditor may request a regulatory agency having jurisdiction over the client to take whatever steps it deems appropriate. 20. When an auditor concludes that an auditing procedure considered necessary at the time of the audit was omitted, auditing standards require the auditor to assess the importance of the omitted procedure to his or her present ability to support the previously expressed opinion. An auditor may review the working papers and discuss the matter with other engagement personnel to evaluate whether other applied procedures compensate for the omitted procedure. If the auditor concludes that omission of the procedure impairs his or her present ability to support the previously expressed opinion, and if persons are currently relying on or are likely to rely on the report, the auditor should promptly undertake to apply

23-6 Solutions Manual – Public Accountancy Profession the omitted procedure or alternative procedures that would provide a satisfactory basis for the opinion. If the auditor is unable to do so, he or she should consult a lawyer to determine the proper course of action. When performing the omitted procedures supports the opinion that was previously released, the auditor has no further responsibility. However, if while performing the procedures the auditor becomes aware that facts regarding the financial statements existed at the date of the report that would have affected the report had he or she had been aware of them, the auditor should follow notification procedures to prevent further reliance on the report. Multiple Choice Questions 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11.

c b a c d b d d d c d

12. 13. 14. 15. 16. 17. 18. 19. 20. 21. 22.

b c a b b b c a b d a

23. 24. 25. 26. 27. 28. 29. 30. 31. 32. 33.

a c a a b a a c d c a

Cases 1.

a.

(1) The objectives of the engagement letter are to: a. b. c.

Make sure that the CPA and his client are in agreement about the nature of the engagement. Inform the client about the scope of the CPA’s work and what may be expected to result. Provide a written record of the responsibilities assumed by the CPA and those retained by the client. (This understanding protects both the CPA and his client).

(2) The CPA usually prepares the engagement letter as a follow-up to a verbal understanding that he and his client have reached. It is desirable that the client endorse and return an approved copy of the engagement letter to the CPA. It also is acceptable for the client to prepare his own letter summarizing his understanding of the nature of the engagement. (3) Preferably, the engagement letter should be sent at the beginning of the engagement so that misunderstandings, if any, can be remedied.


23-7

(4) Obviously, the engagement letter will be most useful in clarifying misunderstanding on a first engagement. But it is desirable that the letter be renewed periodically. Client personnel or the nature of the engagement may change, and the resubmission of the letter gives both parties an opportunity to review the circumstances. Accordingly, for recurring examinations of financial statements, it is appropriate to prepare an engagement letter at the start of each examination. For other continuing engagements, the engagement letter also should be updated periodically – probably on a yearly basis. b.

(1) The objectives of the client’s representation letter are to: confirm oral representations given to the auditors, indicate and document the appropriateness of such representations, and reduce the possibility of misunderstandings. (2) The client’s representation letter should be prepared by the auditors (to ensure all items are included) and signed by members of management whom the auditors believe are responsible for and knowledgeable about matters covered by the representations. Normally, the chief executive officer and chief financial officer should sign. (3) The client’s representation letter should be obtained at the end of the audit work and should be dated as of the date of the auditors’ report (the date of the end of field work). (4) The client’s representation letter should be prepared for each examination as the representations apply to one period’s financial statements. The items that need representation will change from one period or another, as will the people who should sign the letter.

c.

(1) The CPAs should obtain an engagement letter when performing accounting services involving unaudited financial statements, such as in a compilation or review engagement. The engagement letter is probably more important in unaudited engagements that in audited engagements because as there is more likelihood of misunderstanding. The engagement letter should include: a description of the nature and limitations of the services to be performed, a description of the report, a statement that the engagement cannot be relied upon to disclose errors, irregularities or illegal acts, and that the CPAs will inform the client of any matters that come to their attention. (2) The CPAs are not required to obtain a client’s representation letter when performing engagements involving unaudited financial statements. However, the CPAs may wish to obtain such a letter.


a.

A subsequent event is an event or transaction that occurs subsequent to the statement of financial position date but prior to the issuance of the financial statements and auditor’s report that has a material effect on the financial statements and therefore requires adjustment or disclosure in the financial statements.

b.

The occurrence of subsequent events that provide additional evidence regarding conditions that existed at the date of the statement of financial position and affect the estimates inherent in the process of preparing financial statements necessitate financial statement adjustment. Those events that provide evidence regarding conditions that did not exist at the date of the statement of financial position being reported on but arose subsequent to that date ordinarily would not result in adjustment of the financial statements. Some of these latter events, however, may be such that disclosure of them is required to keep the financial statements from being misleading. Occasionally such an event may be so significant that disclosure can best be made by supplementing the historical financial statements with pro forma financial data giving effect to the event as if it had occurred on the statement of financial position date.

c.

The specific procedures that should be performed in order to ascertain the occurrence of subsequent events are these: •

Read the latest available interim financial statements, compare them with the financial statements being reported upon, and make any other comparisons considered appropriate in the circumstances. Inquire of officers and other executives having responsibility for financial and accounting matters whether the interim statements have been prepared on the same basis as that used for the statements under examination.

•

Inquire of and discuss with officers and other executives having responsibility for financial and accounting matters (limited, where appropriate, to major locations) regarding: a.

b. c.

Whether any substantial contingent liabilities or commitments existed at the date of the statement of financial position being reported on or at the date of inquiry. Whether there was any significant change in the capital stock, long-term debt, or working capital to the date of inquiry. The current status of items in the financial statements being reported on that were accounted for on the basis of tentative, preliminary, or inconclusive data.

Completing the Audit and Post-Audit Responsibilities d.

3.

a.

23-9

Whether any unusual adjustments have been made during the period from the statement of financial position date to the date of inquiry.

•

Read the available minutes of meetings of stockholders, directors, and appropriate committees; inquire about matters dealt with at meetings for which minutes are not available.

•

Obtain from the client’s legal counsel a description and evaluation of any litigation, impending litigation, claims, and contingent liabilities (of which counsel has knowledge) that existed at the date of the statement of financial position being reported on, together with a description and evaluation of any additional matters of such nature that have come to counsel’s attention up to the date the information is furnished.

•

Obtain letter of representation, dated as of the date of the auditor’s report, from appropriate officials (generally the chief executive officer and chief financial officer) regarding whether any events occurred subsequent to the date of the financial statements being reported on by the independent auditor that, in the officer’s opinion, would require adjustment or disclosure in these statements.

•

Make such additional inquiries or perform such procedures as considered necessary and appropriate to dispose of questions that arise in carrying out the foregoing procedures, inquiries, and discussions.

(1) A contingent liability is an existing condition situation, or set of circumstances, involving uncertainty as to a possible loss to an enterprise that will ultimately be resolved when one or more future events occur or fail to occur. The business enterprise must have already sustained an event which exposed it to a loss but all aspects of the event have not yet been concluded. The ultimate effect of the event will not be known with certainty until the occurrence of some future event which will conclude the transaction and resolve the current contingency. (2) A loss contingency should be accrued only if the information available prior to issuance of the financial statements indicates that it is probable that a liability has been incurred at the date of the financial statements, and the amount of the loss can be reasonably estimated.

23-10 Solutions Manual – Public Accountancy Profession A loss contingency should be disclosed in a footnote when it is probable that a liability has been incurred but the amount cannot be estimated. A loss contingency for which it is only reasonably possible that a liability has been incurred and for which no amount can be estimated should be disclosed in a footnote. Where the probability that a liability has been incurred is remote, no disclosure is required. b.

4.

Subsequent events may provide new and important information about known or unknown contingency losses as of the statement of financial position date. The subsequent event may very well modify the circumstances surrounding the contingent loss thereby changing the reporting method from no disclosure to footnote disclosure or accrual. For example, a contingent loss may have been recorded as a footnote disclosure because, at the statement of financial position date, the company had only a reasonable possibility that a loss may be incurred. A subsequent event occurs which in the accountants’ judgment makes it probable that a contingent liability has been incurred. The contingent liability will now have to be accrued in the financial statements (provided an amount can be estimated).

Other matters that J. Cee’s representation letter should specifically confirm include whether or not – a.

b. c. d. e. f.

g. h.

Management acknowledges responsibility for the fair presentation in the financial statements of financial position, results of operations, and cash flows in conformity with financial reporting standards (or other comprehensive basis of accounting). All material transactions have been properly reflected in the financial statements. There are other material liabilities or gain or loss contingencies that are required to be accrued or disclosed. The company has satisfactory title to all owned assets, and whether there are liens or encumbrances on such assets or any pledging of assets. There are related party transactions or related amounts receivable or payable that have not been properly disclosed in the financial statements. 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. Events have occurred subsequent to the statement of financial position date that would require adjustment to or disclosure in, the financial statements. The accountant has been advised of all actions taken at meetings of stockholders, board of directors, and committees of the board of directors (or other similar bodies) that may affect the financial statements.


23-11

i.

Management is aware of irregularities that could have a material effect on the financial statements or that involve management or employees who have significant roles in the system of internal control. j. All financial records and data were made available. k. Provision, when material, has been made to reduce excess or obsolete inventories to their estimated net realizable value. l. Provision has been made for any material loss to be sustained in the fulfillment of, or from inability to fulfill, any sales commitments. m. Provision has been made for any material loss to be sustained as a result of purchase commitments for inventory quantities in excess of normal requirements or at prices in excess of the prevailing market prices. 5.

The auditor’s search for subsequent events is an important set of auditing procedures because certain events, occurring after the statement of financial position date, may have a significant impact on the audited financial statements. Litigation in progress at the statement of financial position date, for example, may be settled following the statement of financial position date, but prior to completion of the audit field work. If the litigation is decided to the detriment of the client, and if the judgment against the client is material and not subject to appeal, an audit adjustment recognizing the loss is in order. Only by communicating with the client’s legal counsel near the end of audit field work, concerning the current status of litigation, will the auditor become aware of the settlement. Otherwise, a material loss pertaining to the year under audit will be incorrectly omitted from the income statement. A Type I subsequent event (like the one described above) provides further evidence of conditions that existed at the statement of financial position date, and, if the related amounts are material, may require adjustment of the financial statements. Type II subsequent events provide evidence of conditions which did not exist at the statement of financial position date, and, therefore, do not require adjustment, but may require footnote disclosure, if considered material. The following procedures assist the auditor in locating subsequent events: a.

Obtaining a letter from the client’s legal counsel – Added information concerning litigation pending at the statement of financial position date may provide a basis for an audit adjustment recognizing a loss contingency or a footnote describing uncertainty.

b.

Reading the minutes of directors’ meetings held subsequent to the statement of financial position date may reveal the following subsequent events: 1. 2. 3. 4.

Approval of bonus applicable to year under audit (Type I) Decision to dispose of a segment (Type II) Approval of restructuring agreement (Type II) Approval of major recapitalization plan (Type II)

23-12 Solutions Manual – Public Accountancy Profession c.

Reading the latest interim financial statements may disclose events such as the following: 1.

2. 3.

6.

Major adjustments correcting for prior year’s earnings inflation (e.g., reversal of fabricated revenue through abnormal sales returns entries) (Type I) Major uninsured casualty loss occurring after the statement of financial position date (Type II) Reappearance of officers’ loans purported to have been paid or collected prior to the statement of financial position date (Type I)

(1) If an omitted procedure is found, the auditors should consult legal counsel and take the following actions: •

Assess the importance of the omitted procedure to the present ability to support the previously expressed opinion.

•

Determine if there are persons currently relying or likely to rely on their report.

•

If the omitted procedure impairs present ability to support the previously expressed opinion, the omitted procedure should be applied or alternative procedures applied that would provide a satisfactory basis for the opinion.

•

If as a result of subsequent application of the omitted procedure or alternative procedures, the auditors become aware of facts that existed at the date of their report, they should refer to page 927 (Subsequent Discovery of Facts Existing at the Date of the Auditor’s Report) for guidance.

(2) If after reevaluating the scope of the examination and reviewing the completed audit workpapers, procedures were found that tend to compensate for the omitted procedure, the omitted procedure would not have to be performed. The auditors should document their decision and their support for this decision. (3) If in subsequently applying the omitted procedure, the auditors become aware of material new information that should have been disclosed in the financial statements, they should follow the provisions of auditing standards (refer to page 927 – subsequent discovery of a fact existing at the date of the auditor’s report). 7.

a.

The following accounting changes require a fourth paragraph explaining the lack of inconsistency, given the change: 1. 2. 3.

Change in accounting principle; Change in reporting entity; Correction of an error in principle;

Completing the Audit and Post-Audit Responsibilities 4.

8.

23-13

Change in principle inseparable from change in estimate.

b.

To be in conformity with PFRS, management must demonstrate that the new principle is preferable to the old. The auditor, therefore, must establish preferability in evaluating whether the change is justified. If preferability cannot be established, the auditor should render an “except for” qualification on the basis that the financial statements contain a departure from PFRS.

1.

d. The management representation letter documents management’s acknowledgment of responsibility for the assertions made in the financial statements. Typically, one of management’s assertions is a statement that all material transactions have been recorded properly. This statement relates to the completeness and valuation categories of management assertions.

2.

i. The audit inquiry letter to legal counsel seeks to confirm with the client’s lawyer assertions furnished by management about pending or threatened litigation, unasserted claims and assessments, and other contingencies.

3.

d. The management representation letter documents management’s acknowledgement of responsibility for the assertions made in the financial statements. One of management’s assertions may be that a provision has been made for any material loss to be sustained in the fulfillment of, or from the inability to fulfill, any sales commitments. This statement relates to the valuation and presentation and disclosure categories of management assertions.

4.

c. The audit engagement letter documents the contract between the client and the auditor. This documentation also includes the basis of fees for services to be provided.

5.

c. The audit engagement letter documents the contract between the client and the auditor. The letter should indicate the objective of the engagement.

6.

d. Management’s assertions, as documented in the management representation letter, often deny the existence of any irregularities, such as those caused by employees, that may cause the financial statements to be materially misstated.

7.

b. The successor auditor should make specific and reasonable inquiries of the predecessor auditor regarding matters that the successor believes will assist him or her in determining whether to accept the engagement. The inquiries should include specific questions regarding, among other things, facts that might bear on the integrity of management.


a. The partner’s engagement review program is designed to confirm that the audit was conducted in accordance with PSA. This review program is also designed to identify any problems that may have arisen during the audit, such as differences of opinion between an auditor and a specialist or other consultant.

9.

e. The standard financial institution confirmation request asks the institution to confirm the accounts and account balances of the client. The form also allows the institution to include exceptions to management’s assertions, such as the existence of an undisclosed outstanding loan.

10. c. The auditor’s engagement letter outlines the auditor’s expectations of management, including compliance with requests for written representations. 11. d. Management assertions, as documented in the management representation letter, often deny the existence of any plans or intentions to materially alter the financial statements. 12. g. An additional paragraph may be added to the otherwise unmodified audit report to emphasize a matter, for example, significant transactions with related parties. 13. f. Any serious difficulty encountered in completing the audit, such as management’s delays in providing information, should be communicated to the audit committee. 14. j. Accounts receivable confirmations seek to confirm account balances with a client’s debtors and customers. This excerpt is from a negative confirmation, which requests a reply from a debtor or customer only if a discrepancy exists. 15. g. Substantial doubt on the part of an auditor about an entity’s ability to continue as a going concern is presented in an explanatory paragraph of the auditor’s report.

CHAPTER 24 FORMING AN OPINION AND REPORTING ON FINANCIAL STATEMENTS Questions 1.

The entire audit process culminates in the preparation of the auditor’s report. The auditor’s report is the primary product of the audit. The auditor should review and assess the conclusions drawn from the audit evidence obtained as the basis for the expression of an opinion on the financial statements. This review and assessment involves considering whether the financial statements have been prepared in accordance with an acceptable financial reporting framework. It may also be necessary to consider whether the financial statements comply with statutory requirements. The auditor’s report should contain a clear written expression of opinion on the financial statements taken as a whole.

2.

In order to form that opinion, the auditor shall conclude as to whether the auditor has obtained reasonable assurance about whether the financial statements as a whole are free from material misstatement, whether due to fraud or error. That conclusion shall take into account: (a) The auditor’s conclusion, in accordance with PSA 330 (Clarified), whether sufficient appropriate audit evidence has been obtained; (b) The auditor’s conclusion, in accordance with PSA 450 (Clarified), whether uncorrected misstatements are material, individually or in aggregate; and (c) The evaluations required by paragraphs 12 to 15.

3.

The auditor shall evaluate whether the financial statements are prepared, in all material respects, in accordance with the requirements of the applicable financial reporting framework. This evaluation shall include consideration of the qualitative aspects of the entity’s accounting practices, including indicators of possible bias in management’s judgments.

4.

In particular, the auditor shall evaluate whether, in view of the requirements of the applicable financial reporting framework: (a) The financial statements adequately disclose the significant accounting policies selected and applied; (b) The accounting policies selected and applied are consistent with the applicable financial reporting framework and are appropriate;

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Solutions Manual – Public Accountancy Profession (c) The accounting estimates made by management are reasonable; (d) The information presented in the financial statements is relevant, reliable, comparable and understandable; (e) The financial statements provide adequate disclosures to enable the intended users to understand the effect of material transactions and events on the information conveyed in the financial statements; and (f) The terminology used in the financial statements, including the title of each financial statement, is appropriate.

5.

When the financial statements are prepared in accordance with a fair presentation framework, the evaluation required by paragraphs 12 to 13 of PSA 700 (Clarified) shall also include whether the financial statements achieve fair presentation. The auditor’s evaluation as to whether the financial statements achieve fair presentation shall include consideration of: (a) The overall presentation, structure and content of the financial statements; and (b) Whether the financial statements, including the related notes, represent the underlying transactions and events in a manner that achieves fair presentation. The auditor shall evaluate whether the financial statements adequately refer to or describe the applicable financial reporting framework.

6.

The auditor shall express an unmodified opinion when the auditor concludes that the financial statements are prepared, in all material respects, in accordance with the applicable financial reporting framework.

7.

If the auditor: (a) concludes that, based on the audit evidence obtained, the financial statements as a whole are not free from material misstatement; or (b) is unable to obtain sufficient appropriate audit evidence to conclude that the financial statements as a whole are free from material misstatement. The auditor shall modify the opinion in the auditor’s report in accordance with PSA 705 (Clarified). If financial statements prepared in accordance with the requirements of a fair presentation framework do not achieve fair presentation, the auditor shall discuss the matter with management and, depending on the requirements of the applicable financial reporting framework and how the matter is resolved, shall determine whether it is necessary to modify the opinion in the auditor’s report in

Forming an Opinion and Reporting on Financial Statements

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accordance with PSA 705 (Clarified). 8.


9.

The introductory paragraph in the auditor’s report shall: (a) Identify the entity whose financial statements have been audited; (b) State that the financial statements have been audited; (c) Identify the title of each statement that comprises the financial statements; (d) Refer to the summary of significant accounting policies and other explanatory information; and (e) Specify the date or period covered by each financial statement comprising the financial statements.

10. “Management’s responsibility for the financial statements” paragraph in the audit report is important because it describes the responsibilities of those in the organization that are responsible for the preparation of the financial statements. The auditor’s report need not refer specifically to “management,” but shall use the term that is appropriate in the context of the legal framework in the particular jurisdiction. In some jurisdictions, the appropriate reference may be to those charged with governance. 11. The auditor’s report shall include a section with the heading “Auditor’s Responsibility.” The auditor’s report shall state that the responsibility of the auditor is to express an opinion on the financial statements based on the audit. The auditor’s report shall state that the audit was conducted in accordance with PSAs. The auditor’s report shall also explain that those standards require that the auditor comply with ethical requirements and that the auditor plan and perform the audit to obtain reasonable assurance about whether the financial statements are free from material misstatement. 12. The auditor’s report shall be dated no earlier than the date on which the auditor has obtained sufficient appropriate audit evidence on which to base the auditor’s opinion on the financial statements, including evidence that: (a) All the statements that comprise the financial statements, including the related notes, have been prepared; and (b) Those with the recognized authority have asserted that they have taken responsibility for those financial statements.

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B A D D C

6. 7. 8. 9.

C B D B

Cases 1.

You must determine whether an unqualified opinion satisfies the PSA reporting standard, in particular: a.

Determine whether the financial statements are presented in conformity with PFRS. 1.

Read the footnote description of accounting policies.

2.

Use a PFRS checklist.

3.

Review the working papers for any indication of accounting policies not described in the footnote or ones apparently not in conformity with PFRS.

4.

Determine if: (i) The accounting principles are generally acceptable, having authoritative support. (ii) The accounting principles are appropriate in the circumstances. (iii) The financial statements are informative. (iv) The information is reasonably summarized. (v) Material adjustments have not been waived without good reasons.

2.

b.

Determine whether any accounting changes have been made and whether accounting principles have been applied consistently.

c.

Determine whether the footnote disclosures are adequate to inform users of any material information evident in the working papers.

1.

Title. The report needs a title referring to Rose as the independent auditor or independent accountant.

2.

Notice of audit. The report does not give the proper declaration of an audit of the financial statements, especially the part about “in accordance with your instructions,” which suggest that Rose surrendered some audit independence. The reference to a “complete audit” is ill advised because it

Forming an Opinion and Reporting on Financial Statements

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suggests a 100% investigation, which is contradicted by the sentence about “tests of the sales records.” 3.

Responsibilities. The report says nothing about the auditor’s responsibility for the audit report.

4.

Opinion. The opinion sentence should not be modified with the phrase “with the explanation given above.”

5.

Opinion. The opinion sentence should not mention “minor errors we consider immaterial,” but it should contain the phrase “presents fairly in all material respects.”

6.

Opinion/Identification of Financial Statements. The opinion should not include reference to cash flows because the introductory paragraph did not state that the cash flow statement was audited. This may be a deficiency in the identification of the financial statements that were actually audited.

7.

Opinion. The opinion paragraph refers improperly to ASC pronouncements. It should refer to “generally accepted accounting principles.”

8.

Date. The date accompanying Rose’s signature should be September 23 – the day the field work was completed – not the company’s fiscal year-end date.

9.

Other. The commentary on the economy and the strike are not generally appropriate for an audit report. Even if the auditor wanted to draw attention to these matters, their relevance for understanding the financial statements and their manner of expression are both questionable.

10. Other. The negative assurance (concerning the recording of sales) is not permitted in audit reports.

CHAPTER 25 MODIFICATIONS TO THE INDEPENDENT AUDITOR’S REPORT Questions 1.

Major reasons for departure from the standard unqualified report 1.

2. 3. 4. 5. 6. 7. 8. 2.

Students may identify more than one description of the “most important” distinction between an opinion and a disclaimer. All the following are valid, although (a) is intended to be the “Most Important:” a.

b. c. d.

3.

Disagreement with management regarding the acceptability of the accounting policies selected, the method of their application or the adequacy of financial statement disclosure. Limitation on scope of the audit (resulting in a lack of evidence). Using extra paragraph(s) to emphasize significant matters. Different opinion on prior year comparative statements. Relying on the work and reports of other independent auditors. Required supplementary data omitted or departs from guidelines. “Other information” inconsistent with financial statements or contains material misstatement of fact. Auditor is not independent.

An opinion (unqualified, qualified or adverse) is an explicit statement of the auditor’s conclusion(s), while a disclaimer is an (empty) assertion of “no conclusion.” An (unqualified) opinion is the highest level of assurance, while a disclaimer is the lowest level (no assurance). An opinion requires evidence as a basis, while a disclaimer results from lack of evidence. Auditors must be independent to give an opinion, while a disclaimer can result from a CPA’s lack of independence.

A material scope restriction occurs when the auditor is unable to gather sufficient competent evidence to support an unqualified opinion on the financial statements. Scope restrictions may be client-imposed or they may result from other circumstances, e.g., appointment of the auditor after the client’s physical inventory has been taken. A material scope restriction need not result in a modification of the auditor’s opinion provided the auditor can obtain satisfaction by alternate means.

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4.

The principal auditor’s reference in his report to another auditor is not a qualification in scope. The reference only shows the divided responsibility for the audit work.

5.

When an auditor is not independent with respect to a client, a disclaimer of opinion must be rendered. The disclaimer must be issued because the statements cannot be audited in accordance with auditing standards. (An accountant, not an auditor, is the person associated with compiled and reviewed financial statements. An accountant can give a compilation – disclaimer – report on compiled unaudited financial statements).

6.

The auditor may decide to disclaim an opinion when confronted by a material scope limitation that precludes gathering sufficient evidence to support an opinion as to overall fairness of financial presentation. The auditor may also disclaim an opinion if his/her name is associated with financial statements for which an audit was not intended (e.g., compilations and reviews), or if the auditor is not independent.

7.

The audit opinion does not extend to the other information, and therefore, the opinion is not affected by omission or inconsistency or incorrect supplemental information.

8.

Upon learning of a change in accounting principle, the auditor should first determine the materiality and appropriateness of the change. If material and the auditor agree with the client’s justification for the change, an explanatory paragraph should be added following the opinion paragraph. The paragraph will refer to the footnote describing the change. If the change is not properly accounted for or is inadequately disclosed, the auditor should consider issuing a qualified or adverse opinion.


C D C D A B C C C A

11. 12. 13. 14. 15. 16. 17. 18. 19. 20.

D C A A C C B B C B

21. 22. 23. 24. 25. 26.

C D D A D B

Modifications to the Independent Auditor’s Report

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Cases 1. Independent Auditor’s Report To the shareholders and board of directors of Various Fabrics, Inc.: We have audited the accompanying statement of financial positions of Various Fabrics, Inc. as of January 31, 2013 and 2012 and the related statements of income, retained earnings, and cash flows for the years 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 audits in accordance with auditing standards. 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 Various Fabrics, Inc. as of January 31, 2013 and 2012 and the results of its operations and its cash flows for the years then ended in conformity with generally accepted accounting principles. Aya de Jesus, CPA March 2, 2013

2.

1. 2. 3. 4.

F, L B, I B, Q A, J

3.

A. B. C. D. E. F. G.

1, 2, 4. 1. 6. 5. 2

H. 3,

5. 6. 7.

B, I B, I E, J

7c. 7a.

(Note: The change in principle should be described in the descriptive paragraph following the scope paragraph.) 7c.

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Solutions Manual – Public Accountancy Profession I. J. K. L. M.

2, 3, 6. 1, 1,

7b. 7d. (given the materiality of property, plant, and equipment) 7e. 7b and 7e.

CHAPTER 26 THE COMPUTER ENVIRONMENT Questions 1.

In a batch processing system, documents evidencing transactions and events are gathered and processed by groups. The day’s sales invoices, for example, may be converted to machine-readable form and processed the next morning. In a real time system, transactions are input into the system and processed as they occur. A branch sale, for example, may be input into the system via a terminal at a remote location. The computer checks for product availability, customer authenticity, customer credit approval, and shipping terms; and if all conditions are met, the sale is processed immediately and the sales invoice and shipping order are produced.

2.

In a real-time system, much of the data are stored internally and documentation is often not as extensive as in a batch system. Retrieval and audit of transaction data, therefore, are often more difficult in a real-time system. Also, controls are more likely to be programmed in real-time systems, and for this reason, are more difficult to test.

3.

Inasmuch as computer processing requires increased dependence on the computer systems and software for the accuracy and completeness of processing, documentation assumes major significance relative to effective control. Documentation facilitates reviewing and updating systems and programs as the environment changes; and it also minimizes the probability of unauthorized system and program changes which could result in loss of control and decreased reliability of financial data.

4.

In a batch system, files are stored off-line for the most part, and access control assumes the form of safeguarding the programs, transaction files, and master files by assigning responsibility for the files to a librarian and instituting a formal checkout system. Only those persons authorized to process transactions (computer operators) are permitted access to transaction and master files; and programmers are permitted access to programs only for testing and “debugging” purposes. In an on-line, real-time system, transactions and master files are stored internally, often in a system of integrated data bases. Access control in this type of data environment assumes the form of controlling access to data bases and fixing of responsibility for the data base components. Assigning a password to an individual who is responsible for the data base component accessible by that password, canceling passwords of former employees, and frequent changing of existing employees’ passwords are examples of access controls in a real-time system.

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5.

Recording forms and transaction logs assure consistency and completeness of data inputs. The form or log should include codes describing such transaction components as employee number, customer number, vendor number, department number, stock number, purchased part number, or job number. The form should also provide for quantities, prices, dates, and usually a short narrative description of products, parts, materials, or services for purchase and sales transactions.

6.

A transaction file is the batch of entered data that has been converted into machine-readable form. A transaction file may contain payroll information for a specific period of time. It is similar to a journal in a manually prepared system. A master file contains updated information through a particular time period. It is similar to a ledger in a manual system.

7.

Small businesses have found that microcomputers or personal computer systems are cost effective for processing accounting data. In small businesses, one would expect to find microcomputers (or personal computers) using commercially available software.

8.

In the computerized system, documents to support a transaction may not be maintained in readable form, requiring associated performance of controls. However, the computerized system will enable processing of transactions to be done more consistently, duties to be consolidated, and reports to be generated more easily.


d c a a

5. 6. 7. 8.

c c c b

9. 10. 11. 12.

c c d c

13. 14. 15. 16.

c d a a

17. 18. 19. 20.

c a b a

Cases An auditor should have the following concerns about the Box system: •

Does the system have any flaws or incompatibilities? (No one appears to have tested the software or found out about others’ satisfaction with it.)

•

The computer sits out in the open. (Anyone could have access to and damage the hardware.)

•

Anyone could come up with the password by guessing.

•

The backup disks are not stored in a safe place.

•

Was the conversion appropriately executed, with no data lost or added?

CHAPTER 27 INTERNAL CONTROL IN THE COMPUTER INFORMATION SYSTEM Questions 1.

The proper installation of IT can lead to internal control enhancements by replacing manually-performed controls with computer-performed controls. ITbased accounting systems have the ability to handle tremendous volumes of complex business transactions cost effectively. Computer-performed controls can reduce the potential for human error by replacing manual controls with programmed controls that apply checks and balances to each transaction processed. The systematic nature of IT offers greater potential to reduce the risk of material misstatements resulting from random, human errors in processing. The use of IT based accounting systems also offers the potential for improved management decisions by providing more and higher quality information on a more timely basis than traditional manual systems. IT-based systems are usually administered effectively because the complexity requires effective organization, procedures, and documentation. That in turn enhances internal control.

2.

When entities rely heavily on IT systems to process financial information, there are new risks specific to IT environments that must be considered. Key risks include the following:

Reliance on the functioning capabilities of hardware and software. The risk of system crashes due to hardware or software failures must be evaluated when entities rely on IT to produce financial statement information. Visibility of audit trail. The use of IT often converts the traditional paper trail to an electronic audit trail, eliminating source documents and paperbased journal and records. Reduced human involvement. The replacement of traditional manual processes with computer-performed processes reduces opportunities for employees to recognize misstatements resulting from transactions that might have appeared unusual to experienced employees. Systematic versus random errors. Due to the uniformity of processing performed by IT based systems, errors in computer software can result in incorrect processing for all transactions processed. This increases the risk of many significant misstatements.

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Unauthorized access. The centralized storage of key records and files in electronic form increases the potential for unauthorized on-line access from remote locations. Loss of data. The centralized storage of data in electronic form increases the risk of data loss in the event the data file is altered or destroyed. Reduced segregation of duties. The installation of IT-based accounting systems centralizes many of the traditionally segregated manual tasks into one IT function. Lack of traditional authorization. IT-based systems can be programmed to initiate certain types of transactions automatically without obtaining traditional manual approvals. Need for IT experience. As companies rely to a greater extent on IT-based systems, the need for personnel trained in IT systems increases in order to install, maintain, and use systems.

3.

General controls relate to all aspects of the IT function. They have a global impact on all software applications. Examples of general controls include controls related to the administration of the IT function; software acquisition and maintenance; physical and on-line security over access to hardware, software, and related backup; back-up planning in the event of unexpected emergencies; and hardware controls. Application controls apply to the processing of individual transactions. An example of an application control is a programmed control that verifies that all time cards submitted are for valid employee ID numbers included in the employee master file.

4.

The most significant separation of duties unique to computer systems are those performed by the systems analyst, programmer, computer operator, and data base administrator. The idea is that anyone who designs a processing system should not also do the technical work, and anyone who performs either of these tasks should not also be the computer operator when real data is processed.

5.

Typical duties of personnel: a. b. c.

d.

Systems analysis: Personnel will design and direct the development of new applications. Programming: Other personnel will actually do the programming dictated by the system design. Operating: Other people will operate the computer during processing runs, so that programmers and analysts cannot interfere with the programs designed and executed, even if they produce errors. Converting data: Since this is the place where misstatements and errors can be made – the interface between the hardcopy data and the machinereadable transformation, people unconnected with the computer system itself do the data conversion.

Internal Control in the Computer Information System e.

f.

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Library-keeping: Persons need to control others’ access to system and program software so it will be used by authorized personnel for authorized purposes. Controlling: Errors always occur, and people not otherwise connected with the computer system should be the ones to compare input control information with output information, provide for correction of errors not involving system failures, and distribute output to the people authorized to receive it.

6.

Documentation differs significantly as to inclusion of program flowcharts, program listings, and technical operating instructions. File security and retention differs because of the relatively delicate form of the magnetic media requiring fireproof vault storage, insulation from other magnetic fields, safeguards from accidental writing on data files, and so forth.

7.

Auditors review documentation to gain an understanding of the system and to determine whether the documentation itself is adequate for helping manage and control the computer processing.

8.

Responsibilities of the database administrator (DBA) function are: • •

• •

• 9.

Design the content and organization of the database, including logical data relationships, physical storage strategy and access strategy. Protect the database and its software, including control over access to and use of the data and DBMS and provisions for backup and recovery in the case of errors or destruction of the database. Monitor the performance of the DBMS and improve efficiency. Communicate with the database users, arbitrate disputes over data ownership and usage, educate users about the DBMS and consult users when problems arise. Provide standards for data definition and usage and documentation of the database and its software.

Five things a person must have access to in order to facilitate computer fraud are: a. b. c. d. e.

The computer itself. Data files. Computer programs. System information (documentation). Time and opportunity to convert assets to personal use.

10. Because many companies that operate in a network environment decentralize their network servers across the organization, there is an increased risk for a lack of security and lack of overall management of the network operations. The decentralization may lead to a lack of standardized equipment and procedures.

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Solutions Manual – Public Accountancy Profession In many instances responsibility for purchasing equipment and software, maintenance, administration, and physical security, often resides with key user groups rather than with features, including segregation of duties, typically available in traditionally centralized environments because of the ready access to software and data by multiple users.

Multiple Choice Questions 1. 2. 3. 4. 5. 6.

c a d b d d

7. 8. 9. 10. 11. 12.

b b c a b a

13. 14. 15. 16. 17. 18.

c c c a b a

19. 20. 21. 22 23. 24.

c c a c b c

25. 26. 27. 28. 29. 30.

b c c d b d

Cases 1.

Does access to on-line files require specific passwords to be entered to identify and validate the terminal user? POSSIBLE ERRORS OR IRREGULARITIES – unauthorized access may be obtained to processing programs or accounting data resulting in the loss of assets or other company resources. Are control totals established by the user prior to submitting data for processing? POSSIBLE ERRORS OR IRREGULARITIES – sales transactions may be lost in data conversion or processing, or errors made in data conversion or processing. Are input totals reconciled to output control totals? POSSIBLE ERRORS AND IRREGULARITIES – (same as above). Control totals are useless unless reconciled to equivalent controls created during processing.

2.

a.

1.

Input control objectives Transactions have been recorded properly (neither double-counted nor omitted – that is, control over validity and completeness) Transactions are transmitted from recording point to processing point Transactions are in acceptable form

2.

Processing control objectives Loss or nonprocessing of data is detected Arithmetic functions are performed accurately Transactions are posted properly Errors detected in the processing of data are controlled until corrected and processed

Internal Control in the Computer Information System

b.

3.

a.

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3.

Output control objectives Processed data are reported correctly and without unauthorized alteration Output is required by the user Output is distributed only to persons authorized to receive it

1.

Control procedures – input source data Registration at point of entry Sequential numbering Grouping (batching) with control totals Key verification Programmed edits Edits for completeness and reasonableness Checklists to ensure input arrived and on time

2.

Control procedures – processing controls Prevention of loss or nonprocessing of data (e.g., control totals) Performance of arithmetic functions Assurance of proper posting (sample test of postings) Correction of errors Exclusion of unauthorized persons from operating areas (e.g., programmers)

3.

Control procedures – output controls Review performed by originating area of the reports and other output data Sampling and testing of individual transactions Use of control totals obtained independently from prior processing or original source data Distribution lists used to route output only to authorized persons Making inquiries as to whether the output is desired by the recipient

The primary internal control objectives in separating the programming and operating functions are achieved by preventing operator access to the computer or to input or to output documents, and by preventing operator access to operating programs and operating program documentation, or by preventing operators from writing or changing programs. Programmers should not be allowed in the computer room during production processing. They should submit their tests to be scheduled and run by the operators as any other job. Operators should not be allowed to interfere with the running of any program. If an application fails, the operators should not be allowed to attempt to fix the programs. The failed application should be returned to the programmers for correction.

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Compensating controls usually refer to controls in user departments (departments other than computer data processing). In a small computer installation where there are few employees, segregation of the programming and operating functions may not be possible (as in a microcomputer or minicomputer environment). An auditor may find compensating controls in the user department such as: (1) manual control totals compared to computer output totals and (2) careful inspection of all output. Such compensating controls in a simple processing system could provide reasonable assurance that all transactions were processed, processing was proper and no unauthorized transactions were processed. An auditor may find the following compensating controls that are particularly important when the programming and operating functions are not separate: 1. 2. 3. 4. 5. 6. 7.

4.

Joint operation by two or more operators. Rotation of computer duties. Comparison of computer times to an average or norm. Investigation of all excess computer time (errors). Adequate supervision of all computer operations. Periodic comparison of a program code value to a control value. Required vacations for all employees.

a.

Input editing is the process of including, in EDP systems, programmed routines for computer checking as to validity and accuracy of input. Types of input editing controls are: tests for valid codes; tests for reasonableness; completeness tests; check digits; and tests for consistency of data entered in numeric and alphabetic fields.

b.

Examples of payroll input editing controls are: Test for validity of employee number; Test for proper pay rate; Test for reasonableness of hours worked. Examples of sales input editing controls are: Test for validity of customer number; Test for credit approval; Credit limit test; Sales price list.

c.

As EDP system complexity increases, documentation, as well as manual checking decreases. To provide reasonable assurance as to completeness, existence, and accuracy of processed transactions under these circumstances, input editing becomes increasingly necessary.

Internal Control in the Computer Information System 5.

27-7

a.

Most commonly associated with supervisory programs contained in on-line real-time systems, design phase auditing involves the auditor in system design. The goal is to ensure inclusion of controls that will detect exceptions or unusual conditions and record and log information about the initiating transactions. Once the necessary controls have been designed and incorporated into the system, frequent visits by the auditor to the client’s premises are necessary to determine that the controls are functioning properly.

b.

Some individuals and groups have suggested that independence may be impaired, given auditor monitoring and reviewing a system which he/she has helped to design. The PICPA has taken the position that making control recommendations during system design is no different from auditor recommendations for control improvements after the fact and documented in the management letter.

c.

In some complex EDP systems, a computer audit specialist may be needed to assist in designing the necessary controls, as well as monitoring and reviewing the control functions. A computer audit specialist is an employee of the CPA firm who, typically, will have served on the audit staff for a period of time, followed by specialized training in computer system design and control, and EDP auditing.

d.

The auditor may rely on the computer audit specialist to whatever degree considered necessary to assure proper control installation and implementation. The in-charge field auditor must keep in mind, however, that use of a computer audit specialist does not compensate for the field auditor’s lack of understanding of the internal control, including the EDP applications.

CHAPTER 28 AUDITING IN A COMPUTER INFORMATION SYSTEMS (CIS) ENVIRONMENT Questions 1.

Additional planning items that should be considered when computer processing is involved are: • • • • • •

2.

The extent to which the computer is used in each significant accounting application. The complexity of the computer operations used by the entity, including the use of an outside service center. The organizational structure of the computer processing activities. The availability of data. The computer-assisted audit techniques to increase the efficiency of audit procedures. The need for specialized skills.

Understanding the control environment is a part of the preliminary phase of control risk assessment. Computer use in data processing affects this understanding in each of the parts of the control environment as follows: The organizational structure – should include an understanding of the organization of the computer function. Auditors should obtain and evaluate: (a) a description of the computer resources and (b) a description of the organizational structure of computer operations. Methods used to communicate responsibility and authority – should include the methods related to computer processing. Auditors should obtain information about the existence of: (a) accounting and other policy manuals including computer operations and user manual and (b) formal job descriptions for computer department personnel. Further, auditors should gain an understanding of: (a) how the client’s computer resources are managed, (b) how priorities for resources are determined and (c) if user departments have a clear understanding of how they are to comply with computer related standards and procedures. Methods used by management to supervise the system – should include procedures management uses to supervise the computer operations. Items that are of interest to the auditors include: (a) the existence of systems design and documentation standards and the extent to which they are used, (b) the existence and quality of procedures for systems and program modification, systems

28-2 Solutions Manual – Public Accountancy Profession acceptance approval and output modification, (c) the procedures limiting access to authorized information, (d) the availability of financial and other reports and (e) the existence of an internal audit function. 3.

The “audit trail” is the source documents, journal postings and ledger account postings maintained by a client in order to keep books. These are a “trail” of the bookkeeping (transaction data processing) that the auditor can follow forward with a tracing procedure or back ward with a vouching procedure. In a manual system this “trail” is usually visible to the eye with posting references in the journal and ledger and hard-copy documents in files. But in a computer system, the posting references may not exist, and the “records must be read using the computer rather than the naked eye.” Most systems still have hard-copy papers for basic documentation, but in some advanced systems even these might be absent.

4.

The audit trail (sometimes called “management trail” as it is used more in daily operations than by auditors) is composed of all manual and computer records that allow one to follow the sequence of processing on (or because of) a transaction. The audit trail in advanced systems may not be in a human-readable form and may exist for only a fraction of a second. The first control implication is that concern for an audit trail needs to be recognized at the time a system is designed. Techniques such as integrated test facility, audit files and extended records must be specified to the systems designer. The second control implication is that if the audit trail exists only momentarily in the form of transaction logs or master records before destructive update, the external auditor must review and evaluate the transaction flow at various times throughout the processing period. Alternatively, the external auditor can rely more extensively on the internal auditor to monitor the audit trail.

5.

Major characteristics: 1. 2. 3.

Staff and location of the computer – operated by small staff located within the user department and without physical security. Programs – supplied by computer manufacturers or software houses. Processing mode – interactive data entry by users with most of the master file accessible for inquiry and direct update.

Control Problems: 1. 2.

Lack of segregation of duties. Lack of controls on the operating system and application programs.

Auditing in a Computer Information Systems (CIS) Environment 3. 4. 5. 6. 7.

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Unlimited access to data files and programs. No record of usage. No backup of essential files. No audit trail of processing. No authorization or record of program changes.

6.

Auditing through the computer refers to making use of the computer itself to test the operative effectiveness of application controls in the program actually used to process accounting data. Thus the term refers only to the proper study and evaluation of internal control. Auditing with the computer refers both to the study of internal control (the same as “auditing through”) and to the use of the computer to perform audit tasks.

7.

Both are audit procedures that use the computer to test controls that are included in a computer program. The basic difference is that the test data procedure utilizes the client’s program with auditor-created transactions, while parallel simulation utilizes an auditor-created program with actual client transactions. In the test data procedure the results from the client program are compared to the auditor’s predetermined results to determine whether the controls work as described. In the parallel simulation procedures the results from the auditor program are compared to the results from the client program to determine whether the controls work as described.

8.

The test data technique utilizes simulated transactions created by the auditor, processed by actual programs but at a time completely separate from the processing of actual, live transactions. The integrated test facility technique is an extension of the test data technique, but the simulated transactions are intermingled with the real transactions and run on the actual programs processing actual data.

9.

User identification numbers and passwords prevent unauthorized access to accounting records and application programs. The transaction log does not prevent unauthorized access but may be reviewed to detect unauthorized access. Even then, responsibility could not be traced to a particular individual without user identification numbers and passwords. The transaction log is more important to establish the audit trail than to detect unauthorized access.

10. Generalized audit software is a set of preprogrammed editing, operating, and output routines that can be called into use with a simple, limited set of programming instructions by an auditor who has one or two weeks intensive training.

28-4 Solutions Manual – Public Accountancy Profession 11. 1. 2. 3. 4. 5. 6. 7.

Phases Define the audit objectively Feasibility Planning Application design Coding Testing Processing

8. Evaluation

Noncomputer auditor involvement Primary responsibility Evaluate alternatives Review with computer auditor none none Review final test results, compare to plan Actual computer processing – none Use of results – depends on application 8. Full responsibility

1. 2. 3. 4. 5. 6. 7.

12. Automated microcomputer work paper software generally consists of trial balance and adjustment worksheets, working paper (lead schedule) forms, easy facilities for adjusting journal entries, and electronic spreadsheets for various analyses. 13. A microcomputerized electronic spreadsheet can be used instead of paper and pencil to create the form of a bank reconciliation, with space provided for text lists of outstanding items (using the label input capability), and math formulas inserted for accurate arithmetic in the reconciliation. Printing such a reconciliation is easy (and much prettier than most accountants’ handwriting!). 14. With either data base or spreadsheet software packages, macros (sets of instructions) can be developed for retrieving data from the working trial balance and converting this data into classified financial statements. If one or more subsidiaries are to be included, the consolidated process can also be automated by the inclusion of special modules designed for that purpose. The standard audit report, as well as recurring footnotes, can be included in the data base, and modified to fit the circumstances of the current year’s audit results. 15. Relational data base packages have all the advantages of spreadsheets, and, in addition, have the capacity to store and handle larger quantities of data. They are especially useful in manipulating large data bases, such as customer accounts receivable, plant assets, and inventories. Multiple Choice Questions 1. 2. 3. 4.

a c c d

5. 6. 7. 8.

d d c b

9. 10. 11. 12.

b d b b

13. 14. 15. 16.

c a d b

17. b 18. c 19. d

Auditing in a Computer Information Systems (CIS) Environment

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Cases 1.

a.

Auditing “around” the computer generally refers to examinations of transactions in which a representative sample of transactions is traced from the original source documents, perhaps through existing intermediate records in hard copy, to output reports or records, or from reports back to source documents. Little or no attempt is made to audit the computer program or procedures employed by the computer to process the data. This audit approach is based on the premise that the method of processing data is irrelevant as long as the results can be traced back to the input of data and the input can be validated. If the sample of transactions has been handled correctly, then the system outputs can be considered to be correct within a satisfactory degree of confidence.

b.

The CPA would decide to audit “through” the computer instead of “around” the computer (1) when the computer applications become complex or (2) when audit trails become partly obscured and external evidence is not available. Auditing “around” the computer would be inappropriate and inefficient in the examination of transactions when the major portion of the internal control system is embodied in the computer system and when accounting information is intermixed with operation information in a computer program that is too complex to permit the ready identification of data inputs and outputs. Auditing “around” the computer will also be ineffective if the sample of transactions selected for auditing does not cover unusual transactions that require special treatment.

c.

(1) “Test data” is usually a set of data in the form of punched cards or magnetic tape representing a full range of simulated transactions, some of which may be erroneous, to test the effectiveness of the programmed controls and to ascertain how transactions would be handled (accepted or rejected) and if accepted, the effect they would have on the accumulated accounting data. (2) The auditor may use test data to gain a better understanding of what the data processing system does, and to check its conformity to desired objectives. Test data may be used to test the accuracy of programming by comparing computer results with results predetermined manually. Test data may also be used to determine whether errors can occur without observation and thus test the system’s ability to detect noncompliance with prescribed procedures and methods. Assurance is provided by the fact that if one transaction of a given type passes a test, then all transactions containing the identical test characteristics will – if the appropriate control features are functioning

28-6 Solutions Manual – Public Accountancy Profession – pass the same test. Accordingly, the volume of test transactions of a given type is not important. d.

In addition to actually observing the processing of data by the client, the CPA can satisfy himself that the computer program tapes presented to him are actually being used by the client to process its accounting data by requesting the program of a surprise basis from a computer librarian and using it to process test data. The CPA may also request, on a surprise basis, that the program be left in the computer at the completion of processing data so that he can use the program to process his test data. This procedure may reveal computer operation intervention. If, so, ensures that a current version of the program is being audited, an important procedure in computer installations newly installed and undergoing many program changes. To gain further assurance about this matter, the CPA should inquire into the client’s procedures and controls for making program changes and erasing superseded program tapes, and should examine log tapes where available.

2.

a.

Document retention IMPACT ON THE INTERNAL CONTROL SYSTEM: In on-line real time systems and EDI systems, the audit trail is frequently modified in the form of reduced documentation. To compensate, internal controls should provide for adequate input editing, as well as some form of transaction log as documentation at the input stage. IMPACT ON THE INDEPENDENT AUDIT: In examining internal control, under these circumstances, the auditor must rely more on observation, inquiry, and reprocessing of transactions for control testing purposes, and less on document testing. If documents are retained for only a short period, the auditor should also consider the feasibility of frequent visits for both substantive and control testing purposes.

b.

Uniformity of processing IMPACT ON THE INTERNAL CONTROL SYSTEM: The impact of this internal control characteristic is to generally strengthen control by increasing the consistency of processing. Once the proper controls are installed and tested, processing consistency increases the accuracy of transaction processing over that which exists in manual systems. IMPACT ON THE INDEPENDENT AUDIT: The auditor must emphasize control study and testing at the point of transaction input and processing to determine that the necessary controls exist and are functioning. Upon determining that the necessary input and processing controls are in place


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and functioning properly, the auditor may elect to perform little or no document testing. c.

Concentration of functions IMPACT ON THE INTERNAL CONTROL SYSTEM: In manual systems, separation of functional responsibilities provides a double-check for the purpose of enhancing processing accuracy. In EDP accounting systems, consistency of processing removes the need for double-check. IMPACT ON THE INDEPENDENT AUDIT: The auditor must determine that the necessary input editing controls are in place and functioning to ensure that transactions are accurately introduced into the processing stream. Moreover, to ensure checks and balances within the electronic data processing function, the auditor should study the organizational structure of the EDP group to ascertain proper separation among the following functions: Systems analysis and design Program design, development, and testing Computer operations involving data processing Distribution of EDP output and reprocessing of errors

d.

Access to data bases IMPACT ON THE INTERNAL CONTROL SYSTEM: The greater the number of input terminals providing access to data bases, and the more integrated the data base, the greater the danger of unauthorized access. To protect the data bases under these circumstances, the internal control policies and procedures should provide for effective control over identification codes and passwords permitting access to data bases; and the control policies should also fix responsibility in designated individuals for specified elements of data bases. In batch systems, access to magnetic tape and disk files and programs should be secured by assigning responsibility over these files to one or more individuals designated as “librarians,” and instituting a formal “checkout” system for releasing and reacquiring files and programs. IMPACT ON THE INDEPENDENT AUDIT: The auditor should determine that proper control over I.D. codes and passwords exists, that codes and passwords are changed frequently and voided upon termination of employment, and that responsibility for elements of data bases has been appropriately fixed. In batch systems, the auditors should determine that tape and disk files and programs stored off-line are properly secured.

28-8 Solutions Manual – Public Accountancy Profession 3. a.

Test data approach: The auditor prepares simulated input data (both valid and invalid transactions) that are processed, under the auditor’s control, by the client’s processing system. Advantage: A good way of testing existing controls for proper functioning. Disadvantage: Difficulty in designing comprehensive test data; Difficulty in ascertaining whether the programs tested are the same programs used by the client in processing actual transactions and events during the year. ITF approach: The auditor creates a fictitious entity within the client’s actual data files, and processes simulated data during live processing by client. The auditor then compares the results of processing with anticipated results. Advantage: Greater assurance that programs tested are programs used by the client (the approach can be applied at different points in time during the year). Disadvantage: Difficult to remove test data from the system without harming client’s files. Tagging and tracing: This is a technique whereby an identifier or “tag” is affixed to a transaction record; and the tag triggers “snapshots” during the processing of transactions. Following the tagged transactions through the system permits the auditor to evaluate the logic of the processing steps and the adequacy of programmed controls. Advantage: The use of actual data eliminates the need for removing data from the client’s processing system. Disadvantage: The auditor analyzes the transactions only after processing is completed. SCARF: A systems control audit review file is an audit log used to collect information for subsequent analysis and review. An imbedded audit module monitors selected transactions as they pass by specific processing points. The module then captures the input data so that relevant information, accessible only by the auditor, is displayed at key points in the processing system. Advantage: Utilizes real- rather than simulated-transaction data, and does not require reversing the entries. Disadvantage: Does not necessarily capture erroneous data.


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Surprise audit: The auditor, on an unannounced basis, requests copies of client’s programs, and compares them with auditor’s copy of authorized versions. Advantage: Assists the auditor in determining whether client personnel are using authorized versions of programs in processing data. Disadvantage: Auditor may not always be notified by the client when program changes are made, thus making the comparison irrelevant. b.

Inasmuch as each of the above alternatives have distinct advantages and disadvantages, a combination approach overcomes the disadvantages resulting from using a single approach. Using ITF, for example on a few simulated transactions, while applying the tagging and tracing or SCARF approach for numerous actual transactions, provides effective testing of control procedures for error prevention and detection, without requiring the reversal of a large number of simulated transactions from the client’s system.

c.

In auditing around the computer, the auditor predetermines the processing results (output) of selected input data, and compares the predetermined results with actual computer output. The advantage of this approach is its ease of application; a significant disadvantage is that the auditor gains no understanding of how the computer processes data, nor of the controls which have been incorporated into the computer programs. In auditing through the computer, the auditor actually tests the programmed controls used in processing specific applications. Such techniques as design phase auditing, ITF, tagging and tracing, SCARF, test data, and surprise audit are examples of auditing through the computer.

d.

Parallel simulation is an automated version of auditing around the computer in that the auditor creates a set of application programs that simulate the processing system, and compares output from the real and simulated systems. Comparison of input with output ignores the essential characteristics of the processing system and assumes that if the outputs are identical, the system is processing transactions accurately. The auditor might elect to use parallel simulation in combination with design phase auditing. Design phase auditing ensures that the necessary controls are installed during system design. By permitting the auditor to test large volumes of transactions, parallel simulation helps to confirm whether these controls are working.


(a) Test decks, also called “test data,” are sets of computer input data which reflect a variety of auditor-identified transactions for verification through actual computer processing to detect invalid processing of results (i.e., existing programs run test data). Ideal test data should present the application under examination with every possible combination of transactions, master file situations, and processing logic which could be encountered during actual comprehensive processing. Test data are usually processed separately from actual data using copies of master files. Test decks are most feasible when the variety of transactions processing and controls is relatively limited (i.e., fairly simple files). Uses include checking and verifying: (1) input transaction validation routines, error detection, and application system controls, (2) processing logic, and controls associated with creation and maintenance of master files, (3) computational routines such as interest and asset depreciation, and (4) incorporation of program changes. (b) Parallel simulation consists of the preparation of a separate computer application that performs the same functions as those used by the actual application programs. The simulation programs read the same input data as the application programs, use the same files, and attempt to produce the same results (e.g., real data run through test programs). These simulated results are matched with those from the live programs, providing a means for testing through comparison. Uses include all those cited for test decks. (c) The integrated test facility approach permits the introduction of auditorselected test data into a computer system with actual or “live” data and then traces the flow of transactions through the various system processing functions for comparison to predetermined actual results. An ITF involves the creation or establishment of a “dummy” entity (e.g., a branch or division) to receive the results of the test processing. Therefore, transactions are processed against the test entity together with actual transactions. Test data must be removed from the entity’s records upon completion of the test. Uses are identical to the test deck technique. (d) Tagging and tracing and SCARF are forms of transaction tracking provided only for auditor selected computer inputs carrying a special code. If the capability is provided in the application system in advance, the attachment of a code to any input transaction can be made to generate a printed transaction trail for that item following each step of the application processing.


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Uses include: (1) determining the impact of specific transactions on master records or calculations in high volume systems, (2) “flagging” unusual or abnormal transactions, and (3) “debugging” application programs. 5. In an audit of a computer-based system, adequate training and experience must be directly related to EDP. In particular, the auditor should be knowledgeable of what computer systems do, how to test the operations of an EDP system, and how to use EDP-unique documentation. The training and proficiency standard contributes to satisfaction of the independence standard by enabling the auditor to make his own decisions and judgments. Otherwise, he might tend to subordinate his judgment to other persons, possibly to client personnel. When the auditor lacks training and proficiency, it is virtually impossible to maintain an operational independence over audit decisions. An independence of mental attitude is futile if actual decisions are subordinated to others. The exercise of due audit care requires a critical review at every level of audit supervision of the work done and the decisions made by auditors. Lacking the requisite skills and lacking independent decisions, the due care expected of an auditor at operational, supervisor, and review levels cannot be delivered. The Philippine Standards on Auditing require adequate planning and supervision of assistants. Training and proficiency in computer systems auditing is necessary in order to plan access to computerized records, programs, and to obtain machine time for conducting audit procedures. The planning should provide for an early examination of the computer system so that further procedures involving non-computer control and accounting features may be planned should they depend upon computer control procedures. Training and proficiency are very important for being able to obtain an understanding of the internal control structure in a computer system. Client personnel will expect audit personnel to be capable of working with a computer system. The Philippine Standards on Auditing also require the auditor to obtain sufficient competent evidential matter to provide a basis for an opinion on financial statements. Documentary evidence relating to a computer system includes program flow charts, logic diagrams, and decision tables that are not normally used in non-computer systems. Since these types of documentation are a part of the evidence, they must be understood by the auditor, and understanding of them comes through training and proficiency in their use.

CHAPTER 29 PROCEDURES AND REPORTS ON SPECIAL PURPOSE AUDIT ENGAGEMENTS Questions 1.

The report simply states: “The financial statements are not intended to be presented in conformity with financial reporting standards.” The opinion expression thereafter refers to a description of the comprehensive basis used. Non-PFRS accounting bases include:

2.

3.

1.

Statutory or regulatory accounting requirements

2.

Tax basis accounting

3.

Cash and modified cash bases

4.

General price level-adjusted statements

5.

Any other basis having “substantial support” (Auditing standards do not explain how non-PFRS accounting can have “substantial support.” In practice, accountants will report on any reasonable accounting basis, which explains why reports exist on diverse types of current value financial statements.)

The following are four comprehensive bases of accounting other than PFRS: 1.

A basis of accounting to comply with the requirements of a governmental regulatory agency (for example, insurance companies use a basis of accounting pursuant to the rules of the insurance commission)

2.

A basis of accounting used to file an income tax return

3.

The cash receipts and disbursements basis of accounting (cash basis) and modifications to the cash basis, such as recording depreciation on fixed assets or accruing income tax.

4.

A definite set of criteria having substantial support that is applied to all material items in the financial statements, such as the price-level basis of accounting.

A CPA may be asked to report on the application of PFRS by another auditor’s client who disagrees with the auditor’s view of proper accounting for the transaction. Auditing standards apply when a CPA in public practice, either in connection with a proposal to obtain a new client or otherwise, provides oral or written advice on the application of accounting principles to a specific

29-2

Solutions Manual – Public Accountancy Profession transaction or the type of opinion that may be rendered on an entity’s financial statements. In forming a judgment, the CPA should perform the following procedures:

4.

•

Obtain an understanding of the form and substance of the transaction(s).

•

Review applicable PFRS.

•

If appropriate, consult with other professionals or experts.

•

If appropriate, perform research or other procedures to ascertain and consider the existence of creditable precedents or analogies.

•

The reporting CPA is required to consult with an entity’s continuing CPA to ascertain all the relevant facts. The continuing CPA can provide information about the form and substance of the transaction, how management has applied accounting principles to similar transactions, and whether the method of accounting recommended by the continuing CPA is disputed by management.

The following difficulties might arise: Prior-year statements were unaudited: The auditor should label the prior-year columns “Unaudited” and modify the report by adding a paragraph that disclaims an opinion on the statements. Audited by another auditor: •

Alternative 1: Predecessor auditor reissues report.

•

Alternative 2: If predecessor’s report is not presented, the auditor indicates in the introductory paragraph (1) that the financial statements of the prior period were audited by another auditor (but does not name the predecessor auditor), (2) the date of the report, (3) the type of report issued by the predecessor auditor, and (4) if the report was not a standard unqualified report, the substantive reasons therefor. When the predecessor auditor’s report is not presented, the audit report would have an added sentence at the end of the first paragraph, and the opinion paragraph would refer only to the current-year statements.

Different reports on comparative statements: An auditor may issue modified reports on either of the financial statements reported on comparatively. In this situation, the auditor must exercise care to relate the opinion to the appropriate year’s financial statements.

Procedures and Reports on Special Purpose Audit Engagements

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b a c a

5. 6. 7. 8.

b a a a

9. 10. 11. 12.

a a d d

13. 14. 15. 16.

d a a a

17. 18. 19. 20.

b c b a

Cases 1. To the Board of Directors of Neiny Ltd.: We have reviewed the accompanying statement of financial position of Neiny Ltd. as of December 31, 2014, and the related statements of income, retained earnings, and cash flows for the year then ended, in accordance with standards established by the Auditing Standards and Practices Council. All information included in these financial statements is the representation of the management of Neiny Ltd. A review consists principally of inquiries of company personnel and analytical procedures applied to financial data. It is substantially less in scope than an examination in accordance with auditing standards, 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 2014 financial statements in order for them to be in conformity with financial reporting standards. The financial statements for the year ended December 31, 2013, were audited by us, and we expressed an unqualified opinion on them in our report dated February 27, 2014, but we have not performed any auditing procedures since that date. Modelle & Co. March 3, 2016

2.

a.

The assertions that are incorrect and should otherwise be deleted are the following: 1. Report should be addressed to Ms. Clean Corporation’s Board of Directors. 2. Delete the entire paragraph describing the scope except for the reference to cash in banks and accounts receivable. 3. Delete the opinion rendered on cash in banks and accounts receivable. 4. Delete the recommendation to acquire Ajacks.

b.

The assertions that are missing and should be inserted are the following: 1. Date of the report. 2. Statement limiting the distribution of the report to Ms. Clean’s management.

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Solutions Manual – Public Accountancy Profession 3. 4. 5. 6. 7.

Description of the procedures performed. Statement that the agreed-upon procedures applied are not adequate to constitute a PSA audit. Description of the accountant’s findings. Disclaimer of an opinion concerning cash in banks and accounts receivable. Statement limiting the report only to cash in banks and accounts receivable and indicating that the report does not extend to the financials taken as a whole.

3. Independent Auditor’s Report [Addressee] We have audited the statement of assets, liabilities, and capital (income tax [cash] basis) of Vanda & Corona, a partnership, as of December 31, 2014, and the related statements of revenue and expenses (income tax [cash] basis) and statement of changes in partners’ capital accounts (income tax [cash] basis) 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 audits in accordance with auditing standards. 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 X, the partnership’s policy is to prepare its financial statements on the accounting basis used for income tax purposes; consequently, certain revenue and related assets are recognized when received rather than when earned, and certain expenses are recognized when paid rather than when the obligation is incurred. Accordingly, the accompanying financial statements are not intended to present financial position and results of operations in conformity with financial reporting standards. In addition, the company is involved in continuing litigation relating to patent infringement. The amount of damages resulting from this litigation, if any, cannot be determined at this time. In our opinion, the financial statements referred to above present fairly the assets, liabilities, and capital of the Vanda & Corona partnership as of December 31, 2014, and its revenue and expenses and changes in its partners’ capital accounts for the year then ended, on the income tax (cash) basis of accounting as described in Note X, which basis has been applied in a manner consistent with that of the preceding year. [Sterling & Co.] [Date]

CHAPTER 30 NONAUDIT ENGAGEMENTS: PROCEDURES AND REPORTS Questions 1.

Examples of using “what has held true in the past will hold true in the future:” (a) evaluating the collectibility of accounts receivable based on past collection history, (b) evaluating inventory obsolescence on the basis of past usage patterns, (c) assessing the economic usefulness and useful lives of fixed assets based upon experience with similar assets, (d) relying on a control risk assessment for a period between the time of the original assessment at interim and the fiscal year-end, and (e) expecting to encounter classification and evaluation errors when management has been known to have acted without sufficient decision planning in the past.

2.

Financial statements are unaudited if the CPA has not applied any auditing procedures or has not applied procedures which produced sufficient evidence upon which to base an opinion on the financial statements as a whole. With respect to unaudited statements, in addition to a disclaimer of opinion (public companies), the following guides should be followed: 1.

2. 3. 3.

If the CPA should learn that the statements are not in conformity with financial reporting standards (including adequate disclosures), he should explain the departures in the disclaimer. If prior years’ unaudited statements are present, the disclaimer should cover them as well as the current year statement. Each page of the statements should be clearly labeled as unaudited.

Prospective financial statements are defined as complete financial statements in the same form as traditional income statements, statement of financial positions and statements of changes in financial position. However, an abbreviated presentation constitutes prospective financial statements if its contains all of these items (if applicable): 1. 2. 3. 4. 5.

Sale or gross revenue Gross profit Unusual or infrequently occurring items Provision for income taxes Discontinued operations or extraordinary items

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Solutions Manual – Public Accountancy Profession 6. 7. 8. 9. 10.

Net income Primary and fully diluted earnings per share Summary of significant changes in financial position Summary of significant assumptions Summary of significant accounting policies

Omission of any items 1–8 makes the presentation a partial presentation. Omission of 9 or 10 makes it a deficient presentation. 4.

Similarities and Differences Examination Report on a Forecast a. Identification of financial statements and what they intend to represent. b. Warning about ultimate attainment of prospective results. c. Statement about review in accordance with ASPC standards. d. Opinion / assurance about presentation and reasonable assumptions. e. Statement about no responsibility to update the report. Compilation Report on a Forecast a. Identification of financial statements and what they represent. b. Warning about ultimate attainment of prospective results. c. d. e.

5.

Statement about compilation in accordance with ASPC standards. Disclaimer of opinion / assurance. Statement about no responsibility to update the report.

Audit Report on Historical Statements a. Identification of statements audited.

c. d.

Statement that audit was in accordance with PSA. Opinion about conformity with PFRS.

Compilation Report on Historical Statements a. Identification of statements compiled. b.

c. d.

Statement / warning that information is the representation of management (owners). Same kind of statement about compilation and ASPC standards. Disclaimer of opinion / assurance.

Both review service and compilation service engagements are less than an audit. A comparison of the three amounts to a hierarchy of assurance: 1.

Audit engagement

Auditor obtains sufficient competent evidence that serves as a basis for an opinion on financial statements. The auditor obtains reasonable assurance within the inherent limitations of the audit

Nonaudit Engagements: Procedures and Reports

30-3

process. 2.

Review engagement

Accountant obtains limited assurance through analytical procedures that there are no material modifications that should be made to financial statements.

3.

Compilation engagement

Accountant puts client information in financial statement form without obtaining any assurance (because no procedures are performed) that material modification should or should not be made to the financial statements.

Additionally, an accountant who is not independent may report on a compilation service (providing that lack of independence is disclosed), but not on a review service or audit engagement. 6.

7.

8.

A state of association exists whenever: a. b.

The CPA’s name is used in a document containing the statements; or The CPA has prepared or assisted in preparing the statements.

a.

Compilation: In compiling financial statements for a client, the CPA presents information that is the representation of management without undertaking to express any assurance on the statements.

b.

Review: More than a compilation, but less than an audit, a review consists mainly of performing inquiry and analytical procedures. Such procedures provide the CPA a basis for expressing limited assurance concerning conformance with PFRS.

c.

Audit: An audit provides reasonable assurance concerning conformance of financial statements with PFRS. In addition to inquiry and analytical procedures, an audit involves a study of the client’s internal controls and application of such evidence gathering procedures as confirmation, observation, inspection, vouching, and examination.

The major procedures applied in a review consist of reading the financial statements, inquiry as to accounting procedures, and analytical procedures. A compilation, in contrast to a review, consists of obtaining an understanding of industry accounting principles and practices and reading the financial statements.


30-4 9.

A CPA who lacks independence may compile financial statements; but may not perform an audit, review, or any other form of attestation service.

10. Procedures to be applied in compiling prospective financial statements should include the following: a. b. c. d. e. f.

Inquire about the accounting principles used in preparing the statements. Ask how the key factors are identified and how the assumptions are developed. Obtain a list of assumptions and consider whether there are any omissions or inconsistencies. Test the mathematical accuracy of computations. Read the statements for conformity with PSA presentation guidelines. Obtain client representations concerning compliance with the guidelines.


c c b b

5. 6. 7. 8.

a b a c

9. 10. 11. 12.

a d a b

13. 14. 15. 16.

b b a b

17. 18. 19. 20.

c d a b

Comprehensive Cases 1. a.

Liability to Delcee and other stockholders: Delcee in its own right may bring an action, or the other stockholders may bring a derivative action against Canada and Canada on behalf of the corporation, for negligent performance in failing to detect the fraud (embezzlement). A lawsuit based on constructive fraud might be asserted against C & C, because the conduct of the review may be characterized as gross negligence with reckless disregard for the truth. Individual shareholders and lending institutions will claim this is the case, and if upheld, privity of contract will not be a valid defense.

b.

Liability to financial institutions: Third-party financial institutions have rights to sue accountants for negligence in performing review engagements. As a general rule, third parties, even though not direct parties to an audit contract, may successfully assert negligence if they can show that they are members of a class of persons intended to benefit from the services performed by the CPA and that their use of the statements was reasonably foreseeable by the CPA.


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2. Assumption

Evidence Sources and Procedures

a. Sale of real estate

1. Determine market value of real estate: * Review appraisals (if any), inquire of real estate broker for the selling price of similar pieces of land. 2. Determine cost and tax basis of land: * Examine underlying documents (use financial statement cost presentations, if previously audited) – deeds, purchase contracts. * Review National Internal Revenue Code and appropriate publications to determine proper tax basis, tax rates, treatment. 3. Determine after-tax profit and proceeds: * Based on above information, compute profit and proceeds. Compare amounts to client representations to determine reasonableness. 4. Determine authority for use of proceeds: * Examine minutes of directors’ and officers’ meetings for evidence of authority to sell the real estate and a formal plan for using the proceeds to retire bonds.

b. Retire outstanding debentures.

1. Determine probable cost of repurchasing bonds: * Examine amount, terms of bonds outstanding. * Review current forecasted market for bonds, in light of terms, amount. * Compute estimated cost of repurchase. 2. Determine adequacy of funding for repurchase: * Compare amount of proceeds [computed in (a)] to amount estimated for repurchase. 3. Determine authority for retirement: * Examine minutes of executives’ and officers’ meetings for evidence of approval of retirement.

c. Labor contract

1. Determine probable wage increase: * Examine prior contract settlements, including subjective analysis of labormanagement relations. Confer with union officials.

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Solutions Manual – Public Accountancy Profession * Examine documents, memos, and minutes regarding upcoming labor negotiations. * Examine management’s proposed contract. 2. Determine effect of higher than predicted wage settlement: * Recompute effect of percent change in wage increase to net income and correlate to management’s figures. d. Sales projections

1. Determine estimated completion date of Tarlac facility: * Examine contract plans, consult with contractor, observe facility. * Examine contracts for machinery, installation; consult with vendor – dates, type of equipment, product capacity. * Compare auditor-estimated completion date to management’s for reasonableness. * Consider if company can meet personnel requirements of the new facility. 2. Estimate financial impact of Tarlac production: * Compare productive capacity to forecasted sales figure (presumed determined reasonable by the auditor). * Recompute probable effect of delay in Tarlac’s completion date and compare to management’s figures.

3. Nicky has no accounting staff and has little expertise in preparing financial statements himself. However, he needs them occasionally, apparently for credit purposes. Three kinds of compiled financial statements are available: 1.

2.

3.

Compilation Without Independence. Brother Kian can prepare the compiled financial statements (with or without all disclosures), but he will need to disclose in this report his lack of independence. Compilation With Full Disclosure. CPA Bryan can compile the statements and present them in the complete form used for audited financial statements. Compilation That Omits Substantially All Disclosures. CPA Bryan can compile statements without footnote disclosures, but his report will indicate the lack of disclosure and will warn users.

Nonaudit Engagements: Procedures and Reports 4.

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a.

Yes, this is a negative assurance.

b.

Negative assurance is generally prohibited in audit reports because the profession wishes such reports to contain positive assertions based on evidence instead of negative statements based on “what did not come to my attention.”

c.

A review service is less than an audit, hence the report can be less than positive assurance. Clients get what they paid (less) for.

5. To the Board of Directors of Francisco Company I have reviewed the accompanying statement of financial position of Francisco Company as of December 31, 2014, and the related statements of income, retained earnings, and changes in financial position for the year then ended, in accordance with standards established by the Auditing Standards and Practices Council. All information included in these financial statements is the representation of the management of Francisco 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 examination in accordance with auditing standards, the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, I do not express such an opinion. Based on my review, I am not aware of any material modifications that should be made to the 2014 financial statements in order for them to be in conformity with financial reporting standards. The accompanying 2013 financial statements of Francisco Company were compiled by other accountants whose report dated January 11, 2014, stated that they did not express any opinion or any other form of assurance of those statements.

Jo Cee, CPA January 15, 2015

Note:

This report presumes: 1. Jo Cee is independent. 2. Francisco and Associates, CPAs made no modifications in their 2003 compilation report. 3. Francisco and Associates, CPAs was independent. 4. The 2003 statements contained all necessary disclosures.


30-8 6.

a. b. c. d.

7.

Service Compilation Agreed upon procedures Review

Report Compilation Review

Examination (attestation)

Opinion

Review

Procedures Read and inquire As agreed and applied to specified elements Read, inquire, and apply analytical procedures Evaluate preparation Examine and evaluate underlying assumptions Determine whether presentation is in conformity with PSA guidelines.

a. Nature of Engagement

Type of Report

Principal Procedures

a.

Audit

Opinion; positive

Study and evaluate internal control; observe, examine, confirm, reconcile, calculate, and vouch.

b.

Comprehensive basis other than PFRS

Opinion; positive

Same as (a)

c.

Review; nonpublic entity

Review; limited

Inquiry; analytical procedures

d.

Compilation; nonpublic entity

Compilation; none

Understand industry accounting practices; read the financial statements

e.

Agreed-upon procedures

Review; limited

As specified by engagement letter

f.

Letter for underwriter

Review; limited

Inquiry-as specified by agreement; read the financial statements


30-9

g.

Examination of prospective financial statementsprojection

Opinion; positive

Examine evidence supporting assumptions; determine whether assumptions provide a reasonable basis for the projection; evaluate preparation and presentation of projected financial statements.

h.

Review of interim financial information

Review; limited

Inquiry; analytical procedures

b. a. b. c. d. e. f. g. h.

General. Restricted to management, the board of directors, and the regulatory commission. General. General (but a fourth paragraph must be added which states that the CPA is not independent.) Restricted to the parties named in the agreement. Restricted to the underwriters, Candy and Lolli. Restricted to management, the board of directors, and the prospective lender. General.

Auditing Theory Answer Key 1

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