Solutions Manual for Auditing & Assurance Services 12th Edition by William Messier,Steven Glover

SOLUTION MANUAL

SOLUTION MANUAL

PART 1: Introduction to Assurance and Financial Statement Auditing Chapter 1: An Introduction to Assurance and Financial Statement Auditing Chapter 2: The Financial Statement Auditing Environment

PART 2: Audit Planning and Basic Auditing Concepts Chapter 3: Audit Planning, Types of Audit Tests, and Materiality Chapter 4: Risk Assessment Chapter 5: Evidence and Documentation

PART 3: Understanding and Auditing Internal Control Chapter 6: Internal Control in a Financial Statement Audit Chapter 7: Auditing Internal Control over Financial Reporting

PART 4: Statistical and Nonstatistical Sampling Tools for Auditing Chapter 8: Audit Sampling: An Overview and Application to Tests of Controls Chapter 9: Audit Sampling: An Application to Substantive Tests of Account Balances

PART 5: Auditing Business Processes Chapter 10: Auditing the Revenue Process Chapter 11: Auditing the Purchasing Process Chapter 12: Auditing the Human Resource Management Process Chapter 13: Auditing the Inventory Management Process Chapter 14: Auditing the Financing/Investing Process: Prepaid Expenses, Intangible Assets, and Property, Plant, and Equipment Chapter 15: Auditing the Financing/Investing Process: Long-Term Liabilities, Stockholders’ Equity, and Income Statement Accounts Chapter 16: Auditing the Financing/Investing Process: Cash and Investments

PART 6: Completing the Audit and Reporting Responsibilities Chapter 17: Completing the Audit Engagement Chapter 18: Reports on Audited Financial Statements Critical Audit Matters: More Information and Insight in the Audit Report

PART 7: Professional Responsibilities Chapter 19: Professional Conduct, Independence, and Quality Management Chapter 20: Legal Liability

PART 8: Assurance, Attestation, and Internal Auditing Services Chapter 21: Assurance, Attestation, and Internal Auditing Services

Solution Manual-Auditing & Assurance Services A Systematic Approach 12e Messier Chapter 1: An Introduction to Assurance and Financial Statement Auditing

Answers to Review Questions 1-1

The study of auditing is more conceptual in nature as compared to other accounting courses. Rather than focusing on learning the rules, techniques, and computations required to prepare financial statements, auditing emphasizes learning a framework of analytical and logical skills. This framework enables auditors to evaluate the relevance and reliability of the systems and processes responsible for financial information as well as the information itself. To be successful, students must learn the framework and then learn to use logic and common sense in applying auditing concepts to various circumstances and situations. Understanding auditing can improve the decision-making ability of consultants, business managers, and accountants by providing a framework for evaluating the usefulness and reliability of information—an important task in many different business contexts.

1-2

There is a demand for auditing in a free-market economy because the agency relationship between an absentee owner and a manager produces a natural conflict of interest due to the information asymmetry that exists between these two parties. As a result, the agent agrees to be monitored as part of his/her employment contract. Auditing appears to be a cost-effective form of monitoring. The empirical evidence suggests that auditing was demanded prior to government regulation. In 1926, before it was required by law, independent auditors audited 82 percent of the companies on the New York Stock Exchange. Additionally, many private companies and municipalities not subject to government regulations, such as the Securities Act of 1933 and Securities Exchange Act of 1934, also purchase various forms of auditing and assurance services. Many private companies seek out financial statement audits in order to secure financing for their operations. Companies preparing to go public also benefit from having an audit.

1-3

The agency relationship between an owner and manager produces a natural conflict of interest because of differences in the two parties’ goals and because of the information asymmetry that exists between them. That is, the manager likely has different goals than the owner, and generally has more information about the "true" financial position and results of operations of the entity than the absentee owner does. If both parties seek to maximize their own self-interest, the manager may not act in the best interest of the owner and may manipulate the information provided to the owner accordingly.

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1-4

1-5

Independence is a bedrock principle for auditors. If an auditor is not independent of the client, users may lose confidence in the auditor’s ability to report objectively and truthfully on the financial statements, and the auditor’s work loses its value. From an agency perspective, if the principal (owner) knows that the auditor is not independent, the owner will not trust the auditor’s work. Thus, the agent will not hire the auditor because the auditor’s report will not be effective in reducing information risk from the perspective of the owner. Auditor independence is also a regulatory requirement.

Auditing (broadly defined) is a systematic process of (1) objectively obtaining and evaluating evidence regarding assertions about economic actions and events to ascertain the degree of correspondence between those assertions and established criteria and (2) communicating the results to interested users.

Attest services occur when a practitioner issues a report on subject matter, or an assertion about subject matter, that is the responsibility of another party.

Assurance services are independent professional services that improve the quality of information, or its context, for decision makers.

1-6

Auditing is a specific form of ―attest service,‖ which in turn is a specific category of ―assurance service.‖ In other words, the phrase ―assurance services‖ constitutes the broadest category of professional services provided by CPAs that serve to improve the quality or context of information for decision making for other parties. Attest services constitute a more specific category of assurance that CPAs can provide. These services are intended to reduce information risk to parties relying on information provided by a party that is creating, or making assertions about, subject matter of interest. CPAs can provide attest services relating to a wide variety of subject matter (or assertions about that subject matter) to reduce the information risk to third parties. One such subject matter is a set of financial statements. When a CPA provides a very in-depth, detailed attest service that follows relevant standards to constitute a complete examination of a set of financial statements and related assertions, this is called a financial statement ―audit.‖

1-7

Audit risk is defined as the risk that the auditor may unknowingly fail to appropriately modify his or her opinion on financial statements that are materially misstated (AS 1101).

Materiality is defined as "the magnitude of an omission or misstatement of accounting information that, in the light of surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information would have been changed or influenced by the omission or misstatement" (FASB Statement of Financial Accounting Concepts No. 8, Chapter 3: Qualitative Characteristics of Useful Accounting Information, which is pending revision at the time of the writing of this book per the Board’s November 2017 decision to revert to a definition of materiality similar to the one found in superseded Concept No. 2).

The concept of materiality is reflected in the wording of the auditor's standard audit report through the phrase "the financial statements present fairly in all material respects."

This is the manner in which the auditor communicates the notion of materiality to the users of the auditor's report. The auditor's standard report states that the audit provides only reasonable assurance that the financial statements do not contain material misstatements. The term "reasonable assurance" implies that there is some risk that a material misstatement could be present in the financial statements and the auditor will fail

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to detect it.

1-8

The major phases of the audit are: • Client acceptance/continuance • Preliminary engagement activities • Plan the audit • Consider and audit internal control • Audit business processes and related accounts • Complete the audit • Evaluate results and issue audit report

1-9

Plan the audit: During this phase of the audit, the auditor uses knowledge about the client and any controls in place to plan the audit and perform preliminary analytical procedures.

The outcome of the planning process is a written audit plan that sets forth the nature, extent, and timing of the audit procedures to be performed. The purpose of this phase is to plan an effective and efficient audit.

1-10 The auditor's standard unqualified report for a public company client includes the following sections: (1) opinion on the financial statements, (2) basis for opinion, and (3) critical audit matters, as illustrated in this chapter.

1-11 The emergence of advanced audit technologies will help remove many of the tedious tasks that are usually performed by junior auditors. Thus, auditors of all positions and experience will be required to spend additional time reasoning through fundamental business, accounting, and auditing concepts. An auditors’ knowledge in these areas will enable them to provide greater benefit to clients by asking the right questions and identifying new, more effective ways to collect, analyze, and interpret results. In using audit data analytics, for example, auditors must understand the client and its industry, as well as the fundamentals of accounting and auditing, in order to ask the right questions in querying the data and in interpreting the results obtained.

1-12 Auditors frequently face situations where no standard audit procedure exists, such as the example from the text of verifying the inventory of cattle. Such circumstances require that the auditor exercise creativity and innovation when planning and administering audit procedures where little or no guidance or precedent exists. Every client is different, and applying auditing concepts in different situations requires logic and common sense, and frequently creativity and innovation.

Answers to Multiple-Choice Questions 1-13 1-14 1-15 1-16 1-17

b b c c c

1-19 1-20 1-21 1-22 1-23

a d d d b

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1-18

c

Solutions to Problems 1-24 There are two major factors that may make an audit necessary for Greenbloom Garden Centers. First, the company may require long-term financing for its expansion into other cities in Florida. Entities such as banks or insurance companies are likely to be the sources of the company's debt financing. These entities normally require audited financial statements before lending significant funds and generally require audited financial statements during the time period the debt is outstanding. There is information asymmetry between the lender of funds and the owner of the business, and this asymmetry results in information risk to the lender. Even if the business could get funding without an audit, a clean audit report by a reputable auditor might very well reduce the lender’s information risk and make the terms of the loan more favorable to the owner. Second, as the company grows, the family will lose control over the day-to-day operations of the stores. An audit can provide an additional monitoring activity for the family in controlling the expanded operations of the company.

1-25

a. Evidence that assists the auditor in evaluating financial statement assertions consists of the underlying accounting data and any additional information available to the auditor, whether originating from the client or externally. b. Management makes assertions about components of the financial statements. For example, an entity's financial statements may contain a line item that accounts receivable amount to $1,750,000. In this instance, management is asserting, among other things, that the receivables exist, the entity owns the receivables, and the receivables are properly valued. Audit evidence helps the auditor determine whether management’s assertions are being met. If the auditor is comfortable that he or she can provide reasonable assurance that all assertions are met for all accounts, he or she can issue a clean audit report. In short, the assertions are a conceptual tool to help the auditor ensure that she or he has ―covered all the bases.‖ c. In searching for and evaluating evidence, the auditor should be concerned with the relevance and reliability of evidence. If the auditor mistakenly relies on evidence that does not relate to the assertion being tested, an incorrect conclusion may be reached about the management assertion. Reliability refers to the ability of evidence to signal the true state of the assertion, i.e., whether it is actually being met or not.

1-26

a. As the chapter explains, a financial statement audit reduces the information risk born by investors and creditors, because an audit reduces the risk that the company’s financial statements are materially misstated. In this example, Community Bank can rely on information in Young’s financial statements to make decisions on whether to provide a loan, with assurance that the information (which is produced by Young Company) is fairly presented. The risk the bank faces in providing a loan is thus reduced by a clean audit opinion on Young’s financials, leading to a lower interest rate.

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b. Young Company has a $15 million loan outstanding at an interest rate of 7%, so its annual interest expense on that loan is $1.05 million. If Young were to go with the option of having a CPA help compile its financial statements (but not provide an external audit of the financial statements), Country Valley Bank is willing to offer a 6% rate, which would entail interest expense of $900,000, or a savings of $150,000 per year. So, unless having a CPA help with the financial statements would cost more than $150,000 per year, which is highly unlikely, this is a better option than Young staying with its current loan. However, Community Bank is willing to offer Young a 4.5% rate if the company has its financial statements audited by an independent auditor, for $375,000 per year in savings relative to its current loan, and $225,000 in annual savings relative to just having a CPA help compile Young’s financial statements. The bottom line is that in this case the reduction in information risk provided by the audit is very likely to produce significant cost savings for Young Company. Young should hire an independent auditor and go with the loan from Community Bank. In the real world, studies show that financial statement audits really do lower the cost of capital for companies that issue financial statements and seek debt or equity capital. c. As the book explains, if an entity’s internal control over financial transactions is effective, this provides indirect information regarding whether the account balances are fairly presented: if controls are effective, then the transactions and other events will more likely be captured and summarized properly, which means in turn that the account balances are more likely to be free of material misstatement. The bank may be interested in knowing whether the controls appear to be designed and implemented appropriately, as this may provide additional comfort that Young’s financial statements will continue to be fairly presented. However, unless the auditor provides an integrated audit on Young’s financial statements and internal control over financial reporting, the auditor will be unable to provide an opinion as to whether Young’s internal control is actually designed and operating effectively. Some companies may find that engaging an auditor to provide an integrated audit provides additional savings in the form of lowering the cost of capital (e.g., lower interest rates on borrowed funds). d. There are reasons Young may decide to consider a financial statement audit, even if it can’t refinance its current loan at a lower rate. For example, if the company were publicly traded, its stock price would likely increase, which would have a similar effect on its cost of capital—in this case equity capital. Of course, Young isn’t public but if it were a public company, it would be required by law to obtain an integrated audit. Even though the company can’t refinance its loan and isn’t public (and thus its common stock is not traded on public exchanges), there may still be reasons to consider an audit. For example, the company may have a number of private owners who have hired managers to run the business. Those owners can reduce the risk that the managers are not appropriately using the company’s resources through an audit of the financial statements. Lastly, the company’s owners or managers may decide for other reasons that they want their financial statements to be as accurate as possible.

An audit provides assurance to any user of financial statements that they are

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presented fairly in all material respects in accordance with a financial reporting framework (e.g. GAAP).

1-27

A search of the homepage of most public companies will include links to their latest financial information or 10-K filings. The SEC’s homepage will also include this information along with any other recent filings. Examining the independent auditor’s report and financial statements will allow the student to have a better idea as to how the chapter’s information is applied in real companies.

1-28

Opinion paragraph: ―…the financial statements present fairly, in all material respects,…‖ This sentence indicates that the financial statements are a ―fair‖, not exact, representation. Also, the idea of materiality is revisited here, indicating that the audit does not provide assurance that there are no immaterial errors in the financial statements.

Basis for Opinion paragraph: ―[These] standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement…‖ The use of the term reasonable assurance indicates that there is no guarantee that the financial statements are correct, only reasonable assurance. Also the statement that the financials are ―free of material misstatement‖ indicates that the audit does not provide assurance that the financials are free of error that is not material. ―Such procedures include examining, on a test basis, evidence…‖ The explanation that the auditor uses a test basis indicates that some of the figures were not fully examined, but rather only a sample of information was taken to gather evidence. ―We believe that our audits provide a reasonable basis for our opinion.‖ This statement indicates that the audit is not ―proof‖ that the financial statements are exact, only that there is reasonable evidence about their fairness in accordance with GAAP. Critical Audit Matter paragraph: ―…involved especially challenging, subjective, or complex audit judgments.‖ This sentence prefaces the entire purpose of the paragraph which is to ensure the public is aware that some financial statement amounts and disclosures require extensive judgment by management and auditors, suggesting that the financial statements inherently are not precisely accurate.

Solution to Discussion Case 1-29 The memo should cite the following facts: • There is a historical relationship between accounting and auditing.

• When parties to the agency relationship (contract) do not possess the same amount of information (information asymmetry) there is a natural conflict of interest between the parties. For example, when an owner and manager are negotiating an employment contract, the owner may assume that the manager likely will use organizational funds for personal uses. Auditing plays an important role in such relationships. The owner and manager will consummate an employment contract only if the manager agrees to be monitored. Auditing can be used to monitor the contract agreed to by the two parties. (As an attorney, Dashawn should be well versed in contract law.)

• Auditing is also used to monitor other types of contracts for which no laws or 17-6 Copyright ©2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

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regulations require an audit, for example, contracts between management and debt holders.

• There is historical evidence of forms of auditing in the early Greek states and in the United Kingdom during the industrial revolution. More relevant evidence is the fact that 82 percent of the NYSE companies were audited prior to the securities acts.

• Additional evidence for the demand for auditing is also provided by the fact that many private companies and municipalities not subject to the securities acts contract for audits.

Solution to Internet Assignment 1-30

There are numerous Internet sites that contain accounting information. Following are some suggested sites: • The AICPA's home page (www.aicpa.org) contains extensive information on the organization's activities. For example, it contains the entire report of the Special Committee on Assurance Services.

• The American Accounting Association’s home page (www.aaahq.org) has numerous links, including professional organizations, accounting journals, and education sites.

• The Association of Certified Fraud Examiners' home page (www.acfe.com) has extensive information on the Association’s certification (CFE) program.

• The Institute of Internal Auditors' home page (www.theiia.org) contains detailed information on internal auditing.

• The International Federation of Accountants' website (www.ifac.org) provides detailed information on international accounting and auditing standards.

• The Government Accountability Office's website (formerly the General Accounting Office, (www.gao.gov) provides detailed information on the GAO’s activities and allows users to obtain copies of GAO reports.

• The SEC’s Edgar website (www.sec.gov) contains all filings by public companies with the SEC. It also contains information on other activities by the SEC. • The PCAOB’s website (www.pcaobus.org) offers detailed information about the PCAOB and the standards it has proposed and established.

• The major public accounting firms and many smaller firms also maintain websites.

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Chapter 2: The financial statement auditing environment

Answers to Review Questions 2-1

Auditors can be classified under four types: (1) external auditors, (2) internal auditors, (3) government auditors, and (4) fraud auditors.

External auditors: provide reasonable assurance that financial statements are fairly stated for publicly traded and private companies, partnerships, universities, and government entities, but are not employees of the entity being audited Internal auditors: employed by companies to provide independent, objective assurance and consulting services designed to add value and improve an organization’s operations Government auditors: employed by federal, state, and local agencies to provide services similar to internal auditors Fraud auditors: employed by corporations, government agencies, public accounting firms, and consulting and investigative services firms to detect, investigate, and deter fraud and white-collar crime

2-2

Examples of compliance audits include (1) internal auditors determining whether corporate rules and policies are being followed by departments within the organization, (2) an examination of tax returns of individuals and companies by the Internal Revenue Service for compliance with the tax laws, and (3) an audit under the Single Audit Act of 1984 to determine whether an entity receiving federal assistance is in compliance with applicable laws and regulations.

Examples of operational audits include (1) an audit by the GAO of the Food and Drug Administration to determine the efficiency and effectiveness of procedures for introducing new drugs to the market, (2) internal auditors examining the effectiveness and efficiency of funds being spent on the entity’s computer resources, and (3) a university hiring an external auditor to examine the effectiveness and efficiency of student advisory services.

Examples of fraud audits include (1) an examination by an external auditor of cash disbursements for payments to unauthorized vendors, (2) assistance by an auditor to a law enforcement agency in tracing laundered monies by organized criminals, and (3) an independent auditor helping identify hidden assets as part of a divorce settlement.

Student answers will likely be less detailed but should capture the general idea of each type of audit.

2-3

During the late 1990s and early 2000s, accounting firms aggressively sought opportunities

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to expand their business in non-audit services such as consulting. This expansion from their core audit practice, combined with allegations of auditors refusing to challenge management’s actions, resulted in conflict between regulators and the accounting profession. Subsequent financial fiascos such as those at Enron, WorldCom, Tyco, and many others caused investors to doubt the fundamental integrity of the financial reporting system. Under pressure to restore the public’s confidence, Congress passed the SarbanesOxley Act and created the PCAOB in 2002.

2-4

The accounting profession’s expansion into new areas, combined with changes in the overall business environment, resulted in new regulations and guidelines. The scandals of the late 1990s and early 2000s brought into question the profession’s ability to selfregulate, resulting in new legislation and regulation. While these changes have caused pain and turmoil, they highlight the essential importance of auditing in our economic system. The independence-related rules the PCAOB and SEC put in place over the auditing profession were intended to enhance the public’s confidence in the quality of audits of public companies. The Sarbanes-Oxley Act and related rules and regulations have various implications for the profession, but they were put in place in recognition of the fact that ―audits conducted by objective and impartial professionals can protect investors and instill confidence in the public markets.‖ One important aspect of these rules and regulations are restrictions on the types of services that can be provided by firms that perform an independent audit of a public company—these restrictions are intended to prevent situations in which auditors’ objectivity and independence might be impaired. The PCAOB also took over the role of audit standard setting for public company audits from the profession, believing that this government regulator would be less biased, more objective steward of these standards. Another example is the required rotation of audit partners, which again was intended to prevent partners from becoming too close to their clients, and possibly losing their objectivity.

2-5

Management is responsible to prepare financial statements that fairly present the company’s financial condition and operations in accordance with established accounting standards. Note that the auditor’s opinion explicitly states that the financial statements are the responsibility of management. The auditor is responsible to issue an opinion in regard to the financial statements prepared by management. In order to issue this opinion, the auditor must plan and perform the audit in accordance with established standards to obtain reasonable assurance that the financial statements are free of material misstatement, whether caused by error or fraud. However, it is important to note that an auditor’s unqualified opinion does not mean that errors or fraud do not exist but rather that there is reasonable assurance that they do not exist in material amounts.

2-6

The essential components of the high-level model of business offered in the chapter include the following: corporate governance, objectives, strategies, processes, controls, transactions, and financial statements. Corporate governance is carried out by management and the board of directors in order to ensure that business objectives are carried out and that company assets are safeguarded. To achieve its objectives, management must formulate strategies and implement various processes which are in turn carried out through business transactions. The entity’s information and internal control

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systems must be designed to ensure that these transactions are properly executed, captured, and processed in order to produce accurate financial statements. It is important that the auditor obtain a firm understanding of these components in order to understand relevant risks and to plan the nature, timing, and extent of the audit so that it is efficient and effective.

2-7

The information system must maintain a record of all businesses transactions. It should be capable of producing accurate financial reports to summarize the effects of the entity’s transactions. Among other things, internal control is required to ensure that a proper environment is established and that transactions are appropriately conducted and recorded by the information system and company employees. Effective internal control provides safeguards to ensure the (1) reliability of financial reporting, (2) compliance with laws and regulations, and (3) the effectiveness and efficiency of operations. Auditing standards require that the auditor obtain an understanding of the client’s environment, including its internal control, in planning the nature, timing, and extent of testing.

2-8

The AICPA issues the following standards: • Statements on Auditing Standards • Statements on Standards for Attestation Engagements • Statements on Standards for Accounting and Review Services • Statements on Quality Control Standards • Standards for Performing and Reporting on Peer Reviews • Statements on Standards for Consulting Services • Statements on Standards for Tax Services

2-9

The PCAOB is a quasi-governmental organization overseen by the SEC. It was formed to provide governmental regulation of the standards used in conducting public company audits because of a perceived failure of the profession to adequately regulate itself.

2-10 The SEC is a governmental regulatory agency. It has congressional authority from the original Securities Acts of 1933 and 1934 to establish accounting and auditing standards for publicly traded companies; however, in the past the SEC has largely delegated this authority to other bodies, including the FASB and the AICPA’s Auditing Standards Board. The Sarbanes-Oxley Act of 2002 gave the SEC the mandate to actively regulate the public accounting profession by establishing and overseeing the PCAOB and its standardsetting process relating to the audits of public companies. The SEC has authority to implement and oversee standards relating to all aspects of the audits of public companies, including standards relating to auditor independence (such as the requirement for audit firms to rotate audit partners off audit engagements every five years).

2-11 The documents most frequently encountered by auditors under the Securities Exchange Act of 1934 are forms 10K, 10Q, and 8K. Forms 10K and 10Q are, respectively, annual and quarterly reports, which include the audited financial statements periodically filed with the SEC by a publicly traded entity. An 8K is filed whenever a ―material corporate event‖ occurs, such as a change of independent auditors.

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2-12 The four categories of Principles Underlying an Audit Conducted in Accordance with GAAS are: Purpose of an Audit and Premise upon which an Audit is Conducted This section explains the purpose and value of a financial statement audit and lays out the responsibilities of management and those charged with governance.

Responsibilities This section describes the responsibilities of the auditor regarding their capabilities, professional skepticism, and ethical behavior.

Performance This section describes the auditor’s responsibilities in performing an effective audit. This includes their reasonable, rather than absolute, assurance that the financial statements are free of material misstatements and the cost versus benefit analysis in determining procedures.

Reporting This section describes the responsibility of the auditor for expressing an opinion and providing a written report of that opinion.

2-13 Auditing standards are important for evaluating whether an auditor has done an adequate audit. Users of financial statements desire consistency between audits of various companies. Standards are a way to hold auditors accountable by ensuring that they fulfill the requirements defining what a good audit entails. If the auditor fails to identify a material misstatement, this does not necessarily mean that the auditor has failed to perform a high-quality audit, since an audit can only provide reasonable, rather than absolute, assurance. If a material misstatement goes undetected, the auditor can defend her or his performance by showing conformance with auditing standards.

2-14 Independence is a fundamental principle for auditors. If an auditor is not independent of the client, users may lose confidence in the auditor’s ability to report objectively and truthfully on the financial statements, and the auditor’s work loses its value. From an agency perspective, if the principal (owner) knows that the auditor is not independent, the owner will not trust the auditor’s work. Thus, the agent will not hire the auditor because the auditor’s report will not be effective in reducing information risk from the perspective of the owner.

Answers to Multiple-Choice Questions 2-15 2-16 2-17 2-18 2-19

b a d d c

2-20 2-21 2-22 2-23

a a c c

Solutions to Problems 2-24

Item Number

Type of Audit

Type of Auditor 17-11

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a.

Operational

Government

b.

Financial statement

External

c.

Compliance or operational or possibly internal control

Internal or external

d.

Fraud/Financial

Internal, external, or fraud

e.

Operational

Government, external, or internal

f.

Operational

Internal or external

g.

Compliance

Government

h.

Compliance or fraud

Government, external, or fraud

2-25 Brief Description of Principles Underlying an Audit

Sally Jones' Actions Resulting in Failure to Comply with Principles Underlying an Audit

Purpose and Premise of an Audit: An audit is to provide an opinion by an auditor on whether financial statements are presented fairly, in all material respects, according to the applicable framework. Management and those charged with governance are responsible for the preparation and fair presentation of the financial statements and for the design, implementation, and maintenance of internal control over financial reporting. They are also responsible for providing the auditor with all information relevant to the preparation of the financial statements.

Jones expressed an opinion regarding the financial statements, but not on whether the financial statements are presented fairly in accordance with generally accepted accounting principles, or any other financial reporting framework. Therefore, she did not fulfill the primary purpose of the audit.

Jones did not ensure that management fulfilled its responsibilities for the fair presentation of the financial statements, since that requires making the appropriate footnote disclosures in the financial statements.

Responsibilities: Auditors are responsible for having appropriate competence and capabilities to perform the audit;

It was inappropriate for Jones to hire the two students to conduct the audit, because they do not

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complying with relevant ethical requirements including independence; and maintaining professional skepticism and exercising professional judgment, throughout the planning and performance of the audit.

have appropriate competence and capabilities.

In order to comply with ethical requirements, Jones must be without bias with respect to the client under audit. Because of the financial interest in whether the bank loan is granted to Boucher, Jones is not independent in either fact or appearance with respect to the assignment undertaken. Independence would also be impaired if Jones was to accept a loan from Boucher as requested.

Neither Jones nor her two assistants exercised professional skepticism or professional judgment in performing the audit.

Performance: The auditor must obtain reasonable assurance about whether the financial statements as a whole are free from material misstatement, whether due to fraud or error. To do so, the auditor must plan the work and supervise any assistants; determine an appropriate materiality level; identify and assess risks of material misstatement based on an understanding of the entity and its environment, including its internal control; and obtain sufficient appropriate audit evidence about whether misstatements exist. The auditor is unable to obtain absolute assurance that the financial statements are free from material misstatements.

Jones failed to supervise the assistants. The work performed was not adequately planned.

Jones did not study the client or its environment, including internal control, nor did the assistants.

Consequently, she could not have identified risks of material misstatements.

Jones acquired little evidence that would support the fairness of the financial statements. Jones merely checked the mathematical accuracy of the records and summarized the accounts. Several standard audit procedures and techniques were neglected.

Reporting: Based on an evaluation of the audit evidence obtained, the auditor expresses an opinion in accordance with the auditor’s findings, or states that an opinion cannot be expressed. The opinion states whether the financial statements are presented fairly, in all material respects, in accordance with the applicable financial reporting framework.

Although Jones' report contains an expression of opinion, her opinion is not based on the results of a proper audit examination. Jones should disclaim an opinion because she failed to conduct an examination in accordance with generally accepted auditing standards.

Jones' opinion made no reference to the applicable financial reporting framework. Also, since the financial statements did not contain adequate disclosures, they could not have been in accordance with any financial reporting framework.

Solutions to Discussion Cases 2-26 Merry-Go-Round Part I.

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a. EY is alleged to have violated the Principles of responsibilities and performance.

• The firm is alleged to have violated the Principle of responsibilities in the sense that it appeared that the staff assigned to the engagement did not have sufficient training or experience for the engagement. EY’s relationship with MGR’s landlords and attorneys likely caused them to violate this Principle, which requires compliance with relevant ethical requirements.

• Poor staff assignments, the leader’s vacation, and the use of inexperienced personnel all suggest that the engagement was not adequately planned and that assistants were not properly supervised, which violates the Principle of performance. Also, the inadequate nature of EY’s recommendations suggests that they likely did not gain a sufficient understanding of the entity and its operations. b. There are arguments both for and against having formal standards for CPAs who consult. Advantages include potential increase in public trust, some assurance that a minimal level of service quality would be attained, and perhaps more guidance for consultants (to allow them to perform more effective consulting engagements). The primary disadvantage would result from the fact that CPAs who consult compete with consulting firms comprised of non-CPAs. If standards were not thought out carefully, perhaps the standards would put CPAs at a disadvantage relative to non-CPAs in the sense that CPAs would be subject to standards that constrain their activities or perhaps result in their not being able to compete with non-CPAs in the area of fees.

Note that CPAs face certain restrictions in providing consulting services to audit clients. These restrictions are covered in a later chapter.

2-27

Merry-Go-Round Part II. a. In one sense, EY acted unethically. That is, it should have disclosed the nature of these relationships to MGR. In another sense, it is difficult to ascertain whether these relationships caused EY to act unethically. Specifically, was EY’s advice affected by its relationship with the landlord? Is this relationship the reason that EY’s cost-cutting suggestions did not go farther? These questions point out the importance of independence in fact and appearance, even when acting in a consulting capacity. Even if EY acted ethically, this relationship creates the appearance of impropriety. b. As mentioned in Part a, the relationship with Rouse could have caused EY to hesitate to suggest that the stores for which Rouse was the landlord be closed for fear of losing business from Rouse. Its relationship with Swidler could have made EY feel that it could not lose the engagement under any circumstances, thereby possibly explaining its apparently lackadaisical attitude towards the engagement.

Solutions to Internet Assignments 2-28

A search of the GAO’s homepage will identify recent audits conducted by this agency.

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2-29

a. According to its website, the AICPA’s mission is to ―provide members with the resources, information, and leadership that enable them to provide valuable services in the highest professional manner to benefit the public as well as employers and clients.‖ b. The SEC’s website states that its mission is ―to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.‖ It goes on to emphasize that its purpose is to promote and sustain economic growth. The site also mentions that the SEC promotes the disclosure of important market information, maintains fair dealings, protects against fraud, and enforces its authority. c. During the 1920s, many people began investing heavily in the stock market without fully thinking about the risk that they were taking upon themselves. As a result of poor investment choices and unreliable information, the stock market crashed in 1929. In an attempt to restore confidence in the capital markets, Congress passed the Securities Act of 1933. One year later, the SEC was created by the Securities Exchange Act of 1934. d. The PCAOB’s website provides information on the Board’s organization, policies, and standards. It also indicates that the Board uses an expert advisory group to help the Board develop standards. Though many observers dispute this claim, the Board asserts that its standards are also developed in an open, public process to allow all parties of interest to comment. Section 103 of the Sarbanes-Oxley Act empowers the PCAOB to set auditing standards for audits of public companies.

The Dodd-Frank Act amended the Sarbanes-Oxley Act to give the PCAOB the authority to establish auditing and related professional practice standards for audits of the financial statements and selected practices and procedures of broker-dealers. The Board's Office of the Chief Auditor is responsible for developing these standards. e. The International Auditing Practices Committee (IAPC) was founded in 1978. During its first meeting, the group agreed to issue its publications as guidelines rather than standards. The IAPC’s initial work focused on three areas: object and scope of audits of financial statements, engagement letters, and general auditing guidelines. During this initial meeting, the IAPC also agreed to respond to a request from the International Accounting Standards Committee (IASC) chairman and Governors of the Central Banks to develop guidance on inter-bank confirmations.

In 1988, the IAPC approved the release of The Auditor’s Report on Financial Statements guidelines. It later developed final guidelines on three key subjects: related parties, going concern, and management representations.

In 1985, Chairman Justin Fryer called on the IAPC to act in the interests of the public. He also called on the IAPC to resolve differences in auditing standards where differences exist in different countries and to establish a single set of international standards. The IAPC recognized that a fundamental way to protect the public interest was to require the application of a core set of internationally recognized auditing and assurance standards.

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IFAC was among the first organizations to refer to international auditing guidelines in its own financial statements. In 1991, the IAPC proposed to IFAC member bodies that the term ―guidelines‖ be replaced with ―standards.‖ With that, International Standards on Auditing, or ISAs, were born.

In 2001, IAPC was renamed as the International Auditing and Assurance Standards Board (IAASB). The IAASB then embarked on its first joint project with a national standard setter, the AICPA, which resulted in the development of the suite of audit risk standards.

In 2003, IFAC approved a series of reforms designed to strengthen the IAASB’s standard-setting processes so that it are properly responsible to the public interest. By 2007, the IAASB had become arguably the most transparent auditing standard setter in the world.

To encourage greater use of its standards and facilitate translation, in 2004 the IAASB launched a project designed to improve the clarity of its pronouncements. It revised its drafting conventions to make the ISAs more readily understood. By the end of 2008, the IAASB had approved all final redrafted auditing standards. The IAASB is currently working on revising its standards for assurance engagements other than audits. f. The IASB is the independent accounting standard-setting body of the IFRS Foundation.

The IASB is composed of 16 experts with an appropriate mix of recent practical experience in setting accounting standards, in preparing, auditing, or using financial reports, and in accounting education. The IASB is advised by the IFRS Advisory Council which, along with the IASB, is overseen by the IFRS Foundation trustees. The IFRS Foundation is overseen by a monitoring board of public capital market authorities.

The IFRS Foundation is a not-for-profit, private sector body that raises funds to support the operations of the IASB as an independent accounting standard setter. Mandatory levies are issued for listed and non-listed companies in a growing number of countries.

The Foundation strives to ensure that its financial support is broad based.

The IASB is responsible for the development and publication of IFRSs and for approving Interpretations of IFRSs as developed by the IFRS Interpretations Committee.

All meetings of the IASB are held in public and are broadcast through the internet. In fulfilling its standard-setting duties, the IASB follows a thorough, open and transparent process of which the publication of consultative documents, such as discussion papers and exposure drafts for public comment is an important component. The IASB engages closely with stakeholders around the world, including investors, analysts, regulators, business leaders, accounting standard-setters, and the accountancy profession.

The SEC has not yet reached a decision as to how, or even whether, the U.S. will adopt IFRS. Currently, the FASB is working to converge many of its standards with those of the IASB. For example, the FASB’s guidance on fair value measurement is largely identical to guidance issued by the IASB. The FASB is currently working on converging

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its standards regarding revenue recognition, financial instruments, and lease accounting to be more in line with IFRS.

CHAPTER 3 AUDIT PLANNING, TYPES OF AUDIT TESTS, AND MATERIALITY Answers to Review Questions 3-1

The auditor should inquire of other firm personnel, the client's bankers and attorneys, credit agencies, and other members of the business community who may have knowledge about the integrity of the prospective client and its management. Such inquiries would include: • the identity and business reputation of the client's principal owners, key management, and those charged with governance; • the nature of the client's operations, including its business practices; • information concerning the attitude of the client's principal owners, key management, and those charged with governance toward such matters as internal control or aggressive interpretation of accounting standards; • indications that the client might be involved in money laundering or other criminal activities.

3-2

The successor auditor is responsible for initiating the communication with the predecessor auditor. However, the successor auditor should request permission of the prospective client before contacting the predecessor auditor. The successor auditor's communication with the predecessor auditor should include questions related to the integrity of management, disagreements with management over accounting and auditing issues, communications to those charged with governance regarding fraud and noncompliance with laws or regulations by the entity, communications to management and those charged with governance regarding significant deficiencies and material weaknesses in internal control, and the predecessor auditor's understanding of the change in auditors.

3-3

An engagement letter is used to formalize the arrangement reached between the auditor and client. It serves as a contract that outlines the responsibilities of both parties and is intended to prevent misunderstandings between the two parties. The letter states the responsibilities of the auditor and management, that the audit will be conducted in accordance with auditing standards, that certain types of audit procedures will be conducted, and written representations will be obtained from management, and that the audit may not detect all material errors and fraud. Exhibit 3-1 in the text contains a sample engagement letter. In addition, the engagement letter might include: • Arrangements involving the use of specialists or internal auditors.

• Any limitation of the liability of the auditor or client, such as indemnification to the auditor for liability arising from knowing misrepresentations to the auditor by

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• • 3-4

management. (Note that regulatory bodies, such as the SEC, may restrict or prohibit such liability limiting arrangements.)

Additional services to be provided relating to regulatory requirements.

Arrangements regarding other services (e.g., assurance, tax, or consulting services).

The following factors can be used to judge the objectivity of the internal audit function: • Whether the organizational status of the IAF, including the function’s authority and accountability, supports the ability of the function to be free from bias, conflict of interest, or undue influence of others to override professional judgments (e.g., the IAF reports to audit committee or an officer with appropriate authority, or if the function reports to management, whether it has direct access to audit committee).

• Whether the IAF is free of any conflicting responsibilities (e.g., having managerial or operational duties or responsibilities that are outside of the IAF).

• Whether audit committee oversees employment decisions related to the IAF. • Whether any constraints or restrictions placed on the IAF by management or audit committee exist, for example, in communicating the IAF’s findings to the external auditor.

• Whether the internal auditors are members of relevant professional bodies and their memberships obligate their compliance with relevant professional standards relating to objectivity or whether their internal policies achieve the same objectives.

The competence of internal audit function can be determined by assessing the following factors: • Whether the IAF is adequately and appropriately resourced relative to the size of the entity and the nature of its operations.

• Whether established policies for hiring, training, and assigning internal auditors to internal audit engagements exist.

• Whether the internal auditors have adequate technical training and proficiency in auditing. (e.g., the internal auditors’ possession of a relevant professional designation and experience).

• Whether the internal auditors possess the required knowledge relating to the entity’s financial reporting and the applicable financial reporting framework and whether the IAF possesses the necessary skills to perform work related to the entity’s financial statements.

• Whether the internal auditors are members of relevant professional bodies that oblige them to comply with the relevant professional standards, including continuing professional development requirements.

3-5

An audit committee is a subcommittee of the board of directors composed of independent members. The audit committee is responsible for the financial reporting and disclosure process. The committee should encourage fair reporting from the perspective of the stockholders, creditors, and employees. The audit committee should meet regularly with the external and internal auditors, providing for the independence of the external and internal auditors.

3-6

The auditor should be guided by the results of the client acceptance/continuance process, 17-18 Copyright ©2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

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procedures performed to gain the understanding of the entity, and preliminary engagement activities. Additional steps that should be performed include the following: • Assess business risks.

• Establish materiality.

• Consider multilocations.

• Assess the need for specialists.

• Consider violations of laws and regulations.

• Identify related parties.

• Consider additional value-added services.

• Document the overall audit strategy, audit plan, and prepare audit programs.

3-7

Auditing standards distinguish the auditor's responsibilities regarding compliance with the following two categories of laws and regulations: • The provisions of those laws and regulations generally recognized to have a direct effect on the determination of material amounts and disclosures in the financial statements, such as tax and pension laws and regulations (direct and material effects).

• The provisions of other laws and regulations that do not have a direct effect on the determination of the amounts and disclosures in the financial statements but compliance with which may be fundamental to the operating aspects of the business, fundamental to an entity's ability to continue its business, or necessary for the entity to avoid material penalties (material but indirect effects).

Circumstances that may indicate an illegal act include the following: • Investigations by regulatory organizations and government departments or payment of fines or penalties.

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

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

• Unauthorized transactions or improperly recorded transactions.

• Noncompliance with laws or regulations cited in reports of examinations by regulatory agencies that have been made available to the auditor.

• Failure to file tax returns or pay government duties or similar fees that are common to the entity's industry or the nature of its business.

3-8

Sources of information that may be used to identify related parties include (see AS18, Appendix A): • Inquires of management.

• Minutes of the board of directors’ meetings.

• Conflict-of-interest statements from management and others.

• Financial and reporting information provided to creditors, investors, and regulators.

• Contracts or other agreements (including side agreements that may not be formally documented between customers and vendors, and management).

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•

Contracts and other agreements representing significant unusual transactions.

3-9

The engagement partner has the overall responsibility for the engagement and its performance and should supervise the audit engagement team so that the work is performed as directed and supports the conclusions reached. The engagement partner and other engagement team members performing supervisory activities should • Inform engagement team members of their responsibilities, including: o the objectives of the procedures that they are to perform; o the nature, timing, and extent of procedures they are to perform; and o matters that could affect the procedures to be performed or the evaluation of the results of those procedures.

• Direct engagement team members to bring any significant accounting and auditing issues they identify to the attention of the engagement partner or other engagement team members performing supervisory activities so they can evaluate those issues and determine appropriate actions.

• Review the work of engagement team members to evaluate whether: o the work was performed and documented; o the objectives of the procedures were achieved; and o the results of the work support the conclusions reached.

3-10 The types of audit procedures are: • Risk assessment procedures are used to obtain an understanding of the entity and its environment, including internal control. Examples include inquiries of management and others, analytical procedures, and observation and inspection. It could also include audit data analytics.

• Further audit procedures, which include: o Tests of controls are audit procedures performed to test the operating effectiveness of controls in preventing, or detecting and correcting, material misstatements at the relevant assertion level. Examples of tests of controls include inquiries of appropriate management, supervisory, and staff personnel; inspection of documents, reports, and electronic files; walkthroughs; and reperformance of the application of the control by the auditor. o Substantive procedures are performed to detect material misstatements (i.e., monetary errors) in a transaction class, an account balance, and disclosure component of the financial statements. Examples of substantive procedures are (1) tests of details (i.e., substantive tests of transactions and test of details of account balances) and (2) substantive analytical procedures.

3-11

Professional standards provide very little specific guidance on how to assess what is material to a reasonable user. As a result, auditing firms should develop policies and procedures to assist their auditors in establishing materiality judgments for clients in order to minimize the variability of such judgments by firm personnel. In other words, firms would prefer to have their auditors establish similar materiality judgments for clients with similar circumstances.

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3-12

The three major steps in applying materiality are: Step 1: Determine overall materiality (planning materiality). The auditor should establish a materiality level for the financial statements taken as a whole. This will be referred to as overall materiality. Overall materiality is the maximum amount by which the auditor believes the financial statements could be misstated and still not affect the decisions of users. Materiality, however, is a relative, not an absolute, concept.

Step 2: Determine tolerable misstatement (performance materiality). This step involves determining tolerable misstatement based on overall materiality. Tolerable misstatement is the amount of overall materiality that is used to establish the scope of audit procedures for the individual account balance or class of transactions.

Step 3: Evaluate audit findings. Based on the results of the audit procedures conducted, the auditor aggregates misstatements from each account or class of transactions. When the aggregated misstatements are less than the overall materiality, the auditor can conclude that the financial statements are fairly presented. Conversely, when the aggregated misstatements are greater than overall materiality, the auditor should request that the entity to adjust the financial statements.

3-13

Total assets or total revenues may be better bases for entities in certain industries. For example, in a not-for-profit entity, total revenues or total expenses might be more appropriate benchmarks, while for asset-based entities (e.g., mutual funds) net assets might be a better benchmark.

3-14

Factors that may affect the identification of an appropriate benchmark include the following: • The elements of the financial statements (for example, assets, liabilities, equity, revenue, or expenses) • Whether items exist on which the attention of the users of the particular entity's financial statements tends to be focused (for example, for the purpose of evaluating financial performance, users may tend to focus on profit, revenue, or net assets) • The nature of the entity, where the entity is in its life cycle, and the industry and economic environment in which the entity operates • The entity's ownership structure and the way it is financed (for example, if an entity is financed solely by debt rather than equity, users may put more emphasis on assets, and claims on them, than on the entity's earnings) • The relative volatility of the benchmark

3-15

Qualitative factors that may affect the establishment of the overall materiality (step 1) include: • Material misstatements in prior years; • High risk of fraud; • The entity is close to violating a covenant in a loan agreement; • Small amounts may cause the entity to miss forecasted revenues or earnings, or affect the trend in earnings; 17-21 Copyright ©2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

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•

3-16

The entity operates in a volatile business environment, has complex operations (multi-locations), or operates in a highly regulated industry.

Factors that would cause the auditor to use a lower percentage for tolerable misstatement: • High risk of misstatement within the account balance, class of transaction, or disclosure; • Increased number of accounting issues that require significant judgment and/or more estimates with high estimation uncertainty; • A history of material weaknesses, significant deficiencies, and/or a high number of deficiencies in internal control; • High turnover of senior management or key financial reporting personnel.

Answers to Multiple-Choice Questions 3-17 3-18 3-19 3-20 3-21

d d a c d

3-22 3-23 3-24 3-25 3-26

b a d d b

Solutions to Problems 3-27 a. Prior to acceptance of the engagement, Tish & Field should obtain the following information from the predecessor auditor: • Information that might bear on the integrity of management.

• Disagreements with management concerning accounting principles, auditing procedures, or other similarly significant matters.

• Communications to those charged with governance regarding fraud and noncompliance with laws or regulations by the entity.

• Communications to management and those charged with governance regarding significant deficiencies and material weaknesses in internal control.

• The predecessor auditor's understanding about the reasons for the change in auditors. b. The additional procedures Tish & Field should perform before accepting the engagement include the following: • Obtain and review available financial information (annual reports, interim financial statements, income tax returns, etc.).

• Inquire of third parties about any information concerning the integrity of the prospective client and its management. (Such inquiries should be directed to the prospective client’s bankers and attorneys, credit agencies, and other members of the business community who may have such knowledge.)

• Consider whether the prospective client has any circumstances that will require special attention or that may represent unusual business or audit risks, such as litigation or going concern issues.

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• • •

Determine if the firm is independent of the client and able to provide the desired service.

Determine if the firm has the necessary technical skills and knowledge of the industry to complete the engagement.

Determine if acceptance of the client would violate any applicable regulatory agency requirements or the Code of Professional Conduct.

3-28 The preliminary engagement and planning activities that Parker needs to complete are: • Reading the current year's interim financial statements.

• Discussing the scope of the examination with management of the client.

• Establishing the timing of the audit work.

• Arranging with the client for adequate working space.

• Coordinating the assistance of client personnel in data preparation.

• Establishing and coordinating staffing requirements, including time budget.

• Holding a brainstorming meeting with assistants assigned to the engagement and discussing possible fraud-related issues.

• Determining the extent of involvement, if any, of consultants, specialists, and internal auditors.

• Considering the effects of applicable accounting and auditing pronouncements, particularly recent ones.

• Preparing documentation setting forth the preliminary audit plan.

• Establish overall materiality and tolerable misstatement.

• Making a preliminary assessment about control risk.

• Updating the prior year's written audit program and possibly developing new procedures as warranted by changes in the business.

3-29

a. In addition to the items shown in the EarthWear engagement letter (Exhibit 3-1), the letter generally may include the following items: • Arrangements involving the use of specialists or internal auditors.

• Any limitation of the liability of the auditor or client, such as indemnification to the auditor for liability arising from knowing misrepresentations to the auditor by management or alternative dispute resolution procedures. (Note that regulatory bodies, such as the SEC, may restrict or prohibit such liability-limiting arrangements.)

• Additional services to be provided relating to regulatory requirements.

• Arrangements regarding other services (e.g., assurance, tax, or consulting services). b. 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

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of opinion expected. In this respect, the letter lessens any problems associated with the first standard of fieldwork, which requires the work to be adequately planned and assistants to be properly supervised. 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 a fraud 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.

3-30

a. The auditor should inquire of management and others within the entity regarding the following: • The identity of the entity's related parties, including changes from the prior period.

• The nature of the relationships (including ownership structure) between the entity and these related parties.

• The business purpose of entering into a transaction with a related party versus an unrelated party.

• Whether the entity entered into, modified, or terminated any transactions with these related parties during the period and, if so, the type and business purpose of the transactions. b. The auditor should inquire of other members of the company concerning related parties to obtain an understanding of controls that management has established to: • identify, account for, and disclose related party relationships and transactions.

• authorize and approve significant transactions and arrangements with related parties.

• authorize and approve significant unusual transactions, and arrangements outside the normal course of business.

Inquiries should also include asking about any related party transactions • that have not been authorized and approved in accordance with the entity's established policies or procedures regarding the authorization and approval of transactions with related parties.

• for which exceptions to the entity's established policies or procedures were granted and the reasons for granting those exceptions.

3-31 a. An audit committee is a subcommittee of the board of directors that is responsible for the financial reporting and disclosure process. Audit committees are required for public companies subject to SOX and may be established by private companies. The audit committee should be composed of independent members of the board. b. Audit committees are formed to satisfy the shareholders' need for assurance that directors are exercising due care in the performance of their duties. For public companies they are required. They may also be formed so that a private company can be more responsive to the needs of those interested in financial reporting. They may 17-24 Copyright ©2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

2023

also be formed to reinforce auditor's independence, particularly the appearance of independence, from the management of a company whose financial statements are being examined by the auditor. c. The functions of an audit committee may include the following: • Selection of the independent auditor, discussion of audit fee with the auditor, and review of the auditor's engagement letter.

• Review of the independent auditor's overall audit plan (scope, purpose, and general audit procedures).

• Review of the annual financial statements before submission to the full board of directors for approval.

• Review of the results of the auditor's examination including experiences, restrictions, cooperation received, findings, and recommendations. Matters that the auditor believes should be brought to the attention of the directors or shareholders should be considered.

• Review of the independent auditor's evaluation of the company's internal control systems.

• Review of the company's accounting, financial, and operating controls.

• Review of the reports of internal audit staff.

• Review of interim financial reports to shareholders before the board of directors approves them.

• Review of company policies concerning political contributions, conflicts of interest, and compliance with federal, state, and local laws and regulations, and investigation of compliance with those policies.

• Review of financial statements that are part of prospectuses or offering circulars; review of reports before they are submitted to regulatory agencies.

• Review of the independent auditor's observations of financial and accounting personnel.

• Participation in the selection and establishment of accounting policies; review the accounting for specific items or transactions as well as alternative accounting treatments and their effects.

• Review of the impact of new or proposed pronouncements by the accounting profession or regulatory bodies.

• Review of the company's insurance program.

• Review and discussion of the independent auditor's management letter.

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3-32

To determine overall materiality based on the information provided, the auditor would make the following calculation for the full year income before taxes: Quarters 1Q 2Q 3Q 4Q Estimated income before taxes

Income before taxes $1,200,000 1,500,000 1,350,000 = 1,500,000 x .90 1,687,500 = 1,350,000 x 1.25 $5,737,500

Using 5% as a benchmark, overall materiality based on the estimated income before taxes would be $287,000 (rounded).

3-33

Scenario 1: a. Because Murphy & Johnson is a profit-oriented entity, income before taxes is likely to be the most appropriate benchmark for determining overall materiality. Murphy & Johnson’s auditor could use 3 – 10% of income before operations for determining overall materiality. If we assume that the auditor uses 5%, overall materiality would be $1.05 million ($21 million  .05). Assume further that the auditor’s firm provides guidance that tolerable misstatement will be set 50% of overall materiality or $525,000. b. In this case, the two detected misstatements exceed overall materiality ($1.25 million versus $1.05 million). Thus, the auditor needs to propose an adjustment to the financial statements. If both of the misstatements are factual (known) misstatements, the auditor should request the client to book both misstatements. If the misstatements are judgmental or projected misstatements, the auditor will have to determine whether the misstatements arose from an accounting estimate or an audit sample. In our example, the auditor’s proposed adjustment would need to be at least $200,000 so that the remaining misstatement would be equal to or less than $1.05 million. The auditor should also understand the cause of the misstatements and determine the impact of the material misstatements on the auditor’s assessment of fraud and control risk. If Murphy & Johnson is a public company, subject to Sarbanes Oxley 404 requirements (see Chapter 7), the material misstatements are strong indicators of material weaknesses in controls.

Scenario 2: a. Delta Investments is in the mutual fund industry and total assets would likely be the most appropriate benchmark for determining overall materiality. Delta’s auditor could use .25 - 2% of total assets (see Table 3-5) for determining overall materiality. If we assume that the auditor uses .5%, overall materiality would be $21.5 million ($4.3 billion  .005). Assume further that the auditor’s firm provides guidance that tolerable misstatement will be set 50% of overall materiality or $10.75 million.

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b. The two detected misstatements are less than both tolerable misstatement and overall materiality so no adjustment to the financial statements would be necessary.

However, the auditor should understand the cause of the misstatement and determine the impact of the misstatements on the auditor’s assessment of fraud and control risk.

If either of the two misstatements were factual misstatements, the auditor would request that the client make an adjustment. If Delta Investments is a public company, subject to Sarbanes Oxley 404 requirements (see Chapter 7), the misstatements may represent significant weaknesses in controls.

Scenario 3: a. Swell Computers is a profit-oriented entity and income before taxes would normally be the most appropriate benchmark for determining overall materiality. However, Swell’s profit ($500,000 income on $7 billion of revenue) is close to breakeven. In this case, Swell’s auditor can use total assets (.25 - 2%) or total revenues (.5 – 5%) for the base. Assume Swell’s auditor decides to use .5% of total assets for determining overall materiality. Thus, overall materiality would be $11.0 million ($2.2 billion  .005). Assume further that the auditor’s firm provides guidance that tolerable misstatement will be set 50% of overall materiality or $5.5 million. Note that other scenario answers are feasible. b. The detected misstatement is less than both tolerable misstatement and overall materiality. However, in this instance the adjustment of $1.5 million turns a profit into a loss. This is one of the qualitative factors that SAB No. 99 requires the auditor to consider (see Chapter 17), so an adjustment to the financial statements would be necessary. In addition, the auditor should understand the cause of the misstatement and determine the impact of the misstatements on the auditor’s assessment of fraud and control risk. If Swell Computer is a public company, subject to Sarbanes Oxley 404 requirements (see Chapter 7), the misstatements may represent significant weaknesses in controls.

Scenario 4: a. Because Emma’s Designs is a for-profit manufacturer and is not close to break even, pre-tax income is a reasonable basis for materiality. The auditor would be justified calculating overall materiality equal to 5% of pre-tax income, or $175,000. Because the client is of moderate risk with some higher risk accounts, it would be appropriate to set tolerable misstatement at 50% of overall materiality, or $87,500. b. The aggregate misstatement ($100k) is less than overall materiality. However, the misstatement in AR ($90k) is higher than the account’s tolerable misstatement ($87.5k). Thus, the auditor should propose an adjusting entry to management.

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3-34

a. Because of the significant drop in income in 2021, the auditor should use some type of ―normalized‖ earnings. One approach would be to use the average of 2018 – 2020 ($584,000,000 + $520,000,000 + $453,000,000 = $1,557,000,000 / 3 = $519,000,000). While the firm allows the use of 3 – 10% for the range of percentages, the loss in the current year might suggest that there is a higher level of risk in 2021.

Thus, a percentage in the 3 – 5% range would seem appropriate. Thus, the amount of overall materiality would be in the range of $16 million ($519,000,000 x .03) and $26 million ($519,000,000 x .05) (rounded). Again because of the higher risk, it would most likely be appropriate to use 50% for the calculation of tolerable misstatement.

The range for tolerable misstatement would then be $8 million to $13 million. b. The auditor could use the amounts for 2021 total assets and total revenues for the calculations. Thus, overall materiality using total assets would be: ($23,422,000,000 x .0025 = $59 million) and ($23,422,000,000 x .02 = $468 million). Using 50% as the multiplier, tolerable misstatement would be $29 million and $234 million, respectively.

When total revenues are used, overall materiality would be: ($20,272,000,000 x .0025 = $51 million) and ($20,272,000,000 x .02 = $405 million). Using 50% as the multiplier, tolerable misstatement would be $26 million and $203 million, respectively. c. If we use overall materiality for comparison purposes, the $50 million in detected misstatements that were ―waived,‖ would be material using the income measures in part a., but not material using total assets or total revenues. The instructor might consider discussing the fact that the $50 million in misstatements is greater than the tolerable misstatement when the lower percentage is applied to total assets and total revenues.

Solutions to Discussion Cases 3-35

a. The current-year audit discovered that Forestcrest Woolen Mills had not completed any construction work on the water treatment facility that must be built to comply with the consent decree from the North Carolina EPA. Failure to complete this facility on time can result in fines and possible plant closure under the consent decree. This situation represents a material uncertainty that is likely to be remote at this point in time. However, the auditor should determine if the client will continue work on the facility and if it can be completed within the remaining three years. If the client provides some assurance that work will start on the facility and that construction can be completed on time, the auditor will likely issue a standard unqualified audit report.

The completion information can be obtained from the company's president and its construction company. If the client will not provide assurance on the future work on the facility and/or the construction cannot be completed on time, the auditor will have to consider what the potential effects of failure to comply with the consent decree might be. At this point, it is probably too early to consider issuing a "going-concern" 17-28 Copyright ©2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

2023

opinion on the company. The auditor might require the client to provide more detailed disclosure of the issue in the footnotes to the financial statements. b. If these facts were noted at the end of the seventh year of the consent decree, the auditor would again need information on the possible timely completion of the facility.

If the facility can be completed, the auditor would most likely issue a standard unqualified report. If, however, the facility cannot be completed on time and the penalties under the consent decree are significant enough to raise doubts about the company's continued existence, the auditor would likely issue a modified report with an explanatory paragraph for going concern.

Solutions to Internet Assignments 3-36

A search of any of these sites should allow the student to identify a company that has recently changed auditors. Once the company has been identified, the student can check the investor relations section on the relevant company’s website. This web page will contain the 8K filed by the company with the SEC. Alternatively, the student can search the SEC website and find the 8K filed by the company and the auditor’s filing for the change.

3-37

The Institute of Internal Auditors (IIA) home page (www.theiia.org) contains detailed information about various activities of the IIA. This includes information on the profession, certification, conferences, products, etc. A search of the website identified information about independence and objectivity.

3-38

A search of the Internet identified a number of potential sources for information on the mail order industry: • The National Mail Order Association (www.nmoa.com) is one site where small to medium-sized organizations can go to get information on education, ideas, resources, and contacts.

• The National Retail Federation (www.nrf.com) maintains historical retail statistics.

• The International Society for Strategic Marketing (www.issm.org) maintains a site that contains economics statistics from the Census Bureau on various SIC codes related to the mail order industry.

• Lastly, a number of the major public accounting firms have industry specialization in retail. The sites of the firms may contain information on the retail industry.

CHAPTER 4 RISK ASSESSMENT Answers to Review Questions 4-1

Audit risk is the risk that the auditor expresses an inappropriate audit opinion when the financial statements are materially misstated. Engagement risk is the risk that the auditor is exposed to financial loss or damage to his or her professional reputation from 17-29 Copyright ©2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

2023

litigation, adverse publicity, or other events arising in connection with financial statements audited and reported on. In simple terms, audit risk is the risk that an auditor will issue an unqualified opinion on materially misstated financial statements, while engagement risk relates to the auditor's exposure to financial loss and damage to his or her professional reputation.

4-2

Inherent risk and control risk differ from detection risk in that inherent risk and control risk exist independent of the audit; that is, the levels of inherent risk and control risk are functions of the client and its environment. The auditor has little control over these risks.

The auditor can control detection risk through the scope (nature, timing, and extent) of the audit procedures performed. Thus, detection risk has an inverse relationship with inherent risk and control risk.

4-3

Sampling risk refers to the fact that, in many instances, the auditor does not examine 100 percent of the class of transactions or account balance. Since only a subset of the population is examined, it is possible that the sample drawn is not representative of the population and a wrong conclusion may be made on the fairness of the account balance.

Professional judgment errors (nonsampling risk) occur because an auditor may use an inappropriate audit procedure, fail to detect a misstatement when applying an appropriate audit procedure, or misinterpret an audit result.

4-4

Standard setters developed the audit risk model as a planning and evaluation tool.

Therefore, the model is only as good as the judgments and assessments used as inputs.

Following are some limitations. First, since the auditor assesses inherent risk and control risk, such assessments may be higher or lower than the actual inherent risk and control risk that exist for the client. Second, the audit risk model does not consider the possibility of judgment or nonsampling risk (auditor error in assessing risk, choosing audit procedures, and evaluating results).

4-5

In understanding the entity and its environment, the auditor gathers knowledge about: (1) the nature of the entity; (2) selection and application of accounting principles; (3) industry, regulatory, and other external factors; (4) objectives strategies, and business risks; (5) entity performance measures; and (6) internal control.

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4-6

Some examples of conditions and events that may indicate the existence of business risks are: • Significant changes in the entity such as large acquisitions, reorganizations, or other unusual events.

• Significant changes in the industry in which the entity operates.

• Significant new products or services or significant new lines of business.

• New locations.

• Significant changes in the IT environment.

• Operations in areas with unstable economies.

• High degree of complex regulation.

4-7

An entity that operates in the coal mining industry faces numerous business risks including the following: General Risks: • • • • • •

Coal prices are subject to change and a substantial or extended decline in prices could materially and adversely affect profitability and the value of coal reserves.

Coal mining operations are subject to operating risks that are beyond the entity’s control, which could result in materially increased operating expenses and decreased production levels and could materially and adversely affect profitability.

Competition within the coal industry could put downward pressure on coal prices and, as a result, materially and adversely affect revenues and profitability.

Decreases in demand for electricity resulting from economic, weather changes, or other conditions could adversely affect coal prices and materially and adversely affect results of operations.

The use of alternative energy sources for power generation could reduce coal consumption by U.S. electric power generators, which could result in lower prices for coal.

Profitability depends upon the long-term coal supply agreements with customers.

Changes in purchasing patterns in the coal industry could make it difficult to extend existing long-term coal supply agreements or to enter into new agreements in the future.

Risks Related to Environmental, Other Regulations and Legislation: •

• •

Extensive environmental regulations, including existing and potential future regulatory requirements relating to air emissions, affect customers and could reduce the demand for coal as a fuel source and cause coal prices and sales of coal to materially decline.

Failure to obtain and renew permits necessary for mining operations could negatively affect business.

Federal or state regulatory agencies have the authority to order certain mines to be temporarily or permanently closed under certain circumstances, which could

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•

4-8

materially and adversely affect the entity’s ability to meet customers’ demands.

Extensive environmental regulations impose significant costs on mining operations, and future regulations could materially increase those costs or limit the entity’s ability to produce and sell coal.

There are three types of misstatements: •

Factual Misstatements. These are misstatements about which there is no doubt. For example, an auditor may test a sales invoice and determine that the prices applied to the products ordered are incorrect. Once the products are correctly priced, the amount of misstatement is known. In such cases, the auditor knows the exact amount of the misstatement.

• Judgmental Misstatements. These are misstatements that arise from the judgments of management, including those concerning recognition, measurement, presentation, and disclosure in the financial statements (including the selection or application of accounting policies) that the auditor considers unreasonable or inappropriate.

• Projected Misstatements. These are the auditor’s best estimate of misstatements in populations, involving the projection of misstatements identified in an audit sample to the entire population from which the sample was drawn.

4-9

Misstatements can result from errors or fraud. The term errors refers to unintentional misstatements of amounts or disclosures in financial statements. The term fraud refers to an intentional act by one or more among management, those charged with governance, employees, or third parties, involving the use of deception to obtain an unjust or illegal advantage. Thus, the primary distinction between errors and fraud is whether the misstatement was intentional or unintentional. Unfortunately, it is often difficult to determine intent. For example, if the auditor detects a misstatement in an account that requires an estimate, such as bad debt expense, it may be difficult to determine whether the misstatement was intentional.

Examples of misstatements due to errors or fraud include: • An error in gathering or processing data from which financial statements are prepared.

• An omission of an amount or disclosure, including inadequate or incomplete disclosures required to meet disclosure objectives of certain financial reporting frameworks as applicable.

• A financial statement disclosure that is not presented in accordance with GAAP. • An incorrect accounting estimate arising from overlooking or clearly misinterpreting facts.

• Judgments of management concerning accounting estimates that the auditor considers unreasonable or the selection or application of accounting policies that the auditor considers inappropriate.

• An inappropriate classification, aggregation, or disaggregation of information.

• The omission of a disclosure necessary for the financial statements to achieve fair presentation beyond disclosures specifically required by the framework.

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4-10

The auditor performs the following steps to identify the risks of material misstatement due to fraud: • Discussion among the audit team members regarding the risks of material misstatement due to fraud.

• Inquire of management, audit committee, and others about their views on the risks of fraud and how it is addressed.

• Identification and assessment of fraud risk factors.

• Consider any unusual or unexpected relationships that have been identified in performing analytical procedures in planning the audit.

• Understand the client’s period-end closing process and investigate unexpected periodend adjustments.

4-11

There are numerous risk factors that can cause an individual to misappropriate assets, such as cash (see Table 4-5). By requiring that an individual take a vacation, another individual will perform that person’s duties. If some type of misappropriation is taking place, there is a strong probability that the misappropriation will be detected. Such a policy is particularly helpful in a small business that does not have sufficient personnel to provide total segregation of duties or where there is poor oversight by personnel responsible for the asset.

4-12

If Jackal determines that a number of the risks of material misstatements are pervasive to the overall financial statement, he should reconsider the overall audit approach and respond to such pervasive risks by: • Assign more experienced personnel or those with specialized knowledge to assess the risks of material misstatement due to fraud; • Evaluate whether the selection and application of accounting policies by the entity, particularly those related to subjective measurements and complex transactions, may be indicative of fraudulent financial reporting resulting from management's effort to manage earnings, or a bias that may create a material misstatement; and • Incorporate an element of unpredictability in the selection of the nature, timing, and extent of audit procedures.

Answers to Multiple-Choice Questions 4-13 4-14 4-15 4-16 4-17

d a c a c

4-18 4-19 4-20 4-21 4-22

c b a c a

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Solutions to Problems 4-23 a. Audit risk is the risk that the auditor expresses an inappropriate audit opinion when the financial statements are materially misstated. b. Inherent risk is the susceptibility of an assertion in an account or disclosure to a misstatement due to error or fraud that could be material, either individually or when aggregated with other misstatements, before consideration of any related controls.

Control risk is the risk that a misstatement that could occur in an assertion about an account or disclosure and that could be material, either individually or when aggregated with other misstatements, will not be prevented, or detected and corrected, on a timely basis by the entity’s internal control. Detection risk is the risk that the procedures performed by the auditor will not detect a misstatement that could be material, either individually or when aggregated with other misstatements. c. Inherent risk and control risk differ from detection risk in that they exist independently of the audit of financial statements, whereas detection risk relates to the auditor's procedures and can be changed at the auditor's discretion. Detection risk has an inverse relationship to inherent and control risk.

4-24 Client No.

Detection Risk

1

25%

2

10%

3

67%

4

25%

Client No. 1

Detection Risk Moderate

2

Low

4-25

3 4

High Low

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4-26 a. A public offering would increase the auditor’s exposure to third party litigation and would, therefore, reduce acceptable audit risk relative to a private company audit. b. Bankruptcy increases the auditor’s reputation and litigation risk and would, therefore, reduce acceptable audit risk relative to a private company audit. c. Significant changes to accounting information systems would typically increase control risk, but would have no effect on the acceptable audit risk relative to a private company audit.

4-27 1.

2.

3.

4.

5.

4-28

a c b a a

6.

7.

8.

9.

10.

b c c c c

a. Two factors are particularly important in assessing the risk of material misstatement for Johnson, Inc. First, one individual, who also has majority control of the stock, dominates the decision making in the company. This factor should lead to a higher assessment for the risk of material misstatement because there is no review of important decisions and actions may be taken that are not in the best interest of the company or its stockholders. Second, Johnson, Inc. is expanding rapidly throughout the southeast. Such expansion may result in material misstatements since decisionmaking may become decentralized without adequate internal control. The increase in the risk of material misstatement due to these two factors will result in a lower determination of detection risk and an increase in the scope of the auditor's work. b. The factors affecting the assessment of the risk of material misstatement for MaxiWrite Corporation all relate to industry characteristics. First, the industry is very competitive, which can lead to price-cutting and its related effects on revenues.

Second, the industry is affected by changes in technology, and MaxiWrite is not one of the industry leaders in technology. Its products usually are not competitive with the industry leaders in terms of performance. Third, the company is not as profitable or financially strong as the major companies in the industry. The industry factors result in an increased assessment of the risk of material misstatement for MaxiWrite Corporation, leading to a lower determination of detection risk and more substantive tests. c. The risk of material misstatement should be increased for the First National Bank of Pond City for the following reasons. First, the audit firm has been the bank's auditors for only two years. Second, there have been contentious accounting issues related to loan loss reserves and the value of collateral. Third, prior audits have indicated the presence of misstatements in the loan loss reserve. Based on all of these risk factors, detection risk should be set lower and increased substantive tests performed.

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4-29

In developing an understanding of the entity and its environment, the auditor obtains information from numerous sources (internal or external) of information about the entity and its environment, including the following: • Procedures performed in client acceptance and continuance process.

• Knowledge obtained from performing interim procedures.

• Consulting, tax, or other engagements performed for the entity.

• Published annual reports and interim reports to shareholders, if applicable.

• Minutes of board of directors and/or audit committee meetings.

• Entity’s business/strategic plans, budgets, or other documentation.

• Reports prepared by analysts, banks, underwriters, rating agencies, and the like.

• Individuals knowledgeable about the industry, such as the engagement team members for clients in a similar business/industry.

• Audit firm-generated industry guidance, databases, and practice aids, where applicable.

• Government statistics.

• Economic and financial journals.

• Industry or trade journals.

• Client press releases, publications, and brochures.

• Internal audit reports.

4-30

a. The entity’s market conditions and competition can be significant sources of business risks. For example, decreasing demand for the entity’s products can affect revenues and the value of inventory. Competition in an industry has a similar affect on prices, and therefore revenues. b.

An industry that is cyclical or seasonal can affect the demand for the entity’s product and the size of its workforce. It can also cause problems with purchasing raw materials or product components. For example, EarthWear’s sales are much higher during the Christmas holiday season than the rest of the year. If EarthWear misestimates the demand for certain types of products or fails to provide products that are in high demand, revenues will decline. In addition, the company may find itself with obsolete or slow-moving products. EarthWear also has to significantly increase its workforce for the holiday season by employing part-time workers.

c.

The speed of technological change in an industry can result in an entity holding products that are not competitive. This can result in reduced revenues and overvalued inventory.

d.

The availability of raw materials or product components and their prices can significantly affect an entity. If an entity is unable to obtain raw materials, revenues are likely to decrease because products are not available for sale. If costs of raw materials increase, either profit margins will decrease due to higher costs of goods sold or demand may decrease due to increasing the sales price of finished product.

One can see these effects in entities that buy and sell commodities (e.g., oil, precious metals, agricultural products).

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4-31

a. An auditor is responsible for obtaining reasonable assurance that the financial statements as a whole are free from material misstatements, whether caused by error or fraud. b. Three conditions are generally present when material misstatements due to fraud occur: 1. Management or other employees have an incentive or are under pressure that provides a reason to commit fraud.

2. Circumstances exist that provide an opportunity for a fraud to be carried out.

3. Those involved are able to rationalize committing a fraudulent act. Some individuals possess an attitude, character, or set of ethical values that allow them to knowingly and intentionally commit a dishonest act. c. The objectives of the brainstorming meeting are to: • Share insights about the entity and its environment and the entity’s business risks.

• Provide an opportunity for the team members to discuss how and where the entity might be susceptible to fraud.

• Emphasize the importance of maintaining professional skepticism throughout the audit regarding the potential for material misstatement due to fraud. d. The documentation should include: • The risks identified, an evaluation of management’s response to such risks, and the auditor’s assessment of the risk of error or fraud after considering the entity’s response.

• The nature, timing, and extent of the procedures performed in response to the risks of material misstatement due to fraud and the results of that work.

• Fraud risks or other conditions that caused the auditor to believe that additional audit procedures or other responses were required to address such risks or other conditions.

• The nature of communications about error or fraud made to management, the audit committee, and others.

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4-32

The following are a sample of the possible business risks that a publicly traded, start-up biotech might have. You might consider having the class examine Item 1A – Risk Factors in a company’s 10-K. a.

Business Risks

b.

Effect on Acceptance Decision

1.

Start-up companies usually have large, accumulated deficits and they usually require large capital infusions until they have a viable product.

Drug development programs are very expensive, time consuming, and difficult to design and implement.

1.

Drug candidates are in various stages of research and development and are prone to the risks of failure inherent in drug development.

4. Drug candidates are subject to extensive regulation (e.g., FDA and similar agencies in other countries), and we may not receive required regulatory approvals, or timely approvals, for any of our drug candidates.

5. Drug discovery and development is intensely competitive.

6. Start-up companies frequently enter into partnerships and other strategic alliances (e.g., marketing arrangements) that may lead to disputes and delays in drug development and commercialization.

7. May incur substantial liabilities from any product liability claims.

3.

Presents a potential going concern problem and might reduce the likelihood of accepting the client.

Potentially affects the long-term (and ultimate) success of the company. The probability of success of the drug(s) would likely affect the auditor’s decision to accept the client.

Same as 2 above.

4.

Same as 2 above.

5.

See 1 and 2 above.

6.

Could lead to lawsuits and might reduce the likelihood of accepting the client.

7.

Same as 1 above.

2.

3.

2.

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Solution to Discussion Case 4-33

Koss Case.

1.

This question can be can answered by looking at the tables (Tables 4-5) that contain the fraud risk factors: the incentives/pressures, opportunity, and attitudes/rationalizations to misappropriate assets.

• Incentives/pressures: Sachdeva’s personal financial obligations due to her excessive spending.

• Opportunity: Inadequate internal controls.

• Attitudes/rationalizations: Disregard for monitoring and internal controls; lack of oversight and segregation of duties; and a change in Sachdeva’s lifestyle.

2.

It is not appropriate for one individual, in this case, Michael Koss to hold 5 seniolevel positions. Even in a smaller public company like Koss Corporation, the demands for each job would be such that none of them would be performed adequately.

Solution to Internet Assignment 4-34

The answers to this Internet assignment will be a function of the company assigned by the instructor. However, the responses to the questions will be found in the sources cited in the problem and will be similar to those in the questionnaire provided by your instructor or downloaded from the book’s website.

See (Messier, W. F., Jr. 2014. An approach to learning risk-based auditing. Journal of Accounting Education 32: 276-287) for a discussion of the use of this case. If you would like more information about the use of this questionnaire, please contact Professor Messier (bill.messier@unlv.edu).

CHAPTER 5 EVIDENCE AND DOCUMENTATION Answers to Review Questions 5-1

Auditors typically divide the financial statements into components or segments in order to make the audit more manageable. A component can be a financial statement account or a business (transaction cycle) process. This approach allows the auditor to gather evidence by examining the processing of related transactions through the accounting system from their origin to their ultimate disposition in the accounting journals and ledgers. Thus, the auditor can examine an accounting transaction from the time it is initiated by the entity until its final recording in the financial statement accounts.

5-2

The financial statements contain management's assertions about the various financial statement components. The auditor tests management’s assertions by conducting audit 17-39 Copyright ©2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

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procedures that provide evidence on whether each relevant assertion is supported. The results from applying audit procedures provide the evidence that supports the fair presentation of management’s assertions and the auditor's report (see Figure 5-1).

5-3 Assertions about classes of transactions and events, and related disclosures, for the period under audit: Assertion Definition Occurrence Transactions and events that have been recorded or disclosed have occurred, and such transactions and events pertain to the entity (sometimes referred to as validity).

Completeness All transactions and events that should have been recorded have been recorded, and all related disclosures that should have been included in the financial statements have been included.

Authorization All transactions and events have been properly authorized.

Accuracy Amounts and other data relating to recorded transactions and events have been recorded appropriately, and related disclosures have been appropriately measured and described.

Cutoff Transactions and events have been recorded in the correct accounting period.

Classification Transactions and events have been recorded in the proper accounts.

Presentation Transactions and events are appropriately aggregated or disaggregated and clearly described, and related disclosures are relevant and understandable in the context of the requirements of the applicable financial reporting framework.

5-4 Assertions about account balances, and related disclosures, at the period end: Assertion Existence Rights and Obligations Completeness

Accuracy, valuation, and allocation

Definition Assets, liabilities, and equity interests exist.

The entity holds or controls the rights to assets, and liabilities are the obligations of the entity.

All assets, liabilities, and equity interests that should have been recorded have been recorded, and all related disclosures that should have been included in the financial statements have been included.

Assets, liabilities, and equity interests have been included in the financial statements at appropriate amounts, and any resulting valuation or allocation adjustments have been 17-40

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Classification Presentation

5-5

appropriately recorded, and related disclosures have been appropriately measured and described.

Assets, liabilities, and equity interests have been recorded in the proper accounts.

Assets, liabilities, and equity interests are appropriately aggregated or disaggregated and clearly described, and related disclosures are relevant and understandable in the context of the requirements of the applicable financial reporting framework.

Audit evidence is the information used by the auditor in arriving at the conclusions on which the audit opinion is based. Audit evidence is information to which audit procedures have been applied and consists of information that corroborates or contradicts assertions in the financial statements.

Information gathered by the auditor to be used as audit evidence can take different forms.

The form of the information can influence the nature of audit procedures used by the auditor to obtain or evaluate the information. Following are forms of information that auditors may obtain: Oral information This information is obtained through a verbal response to an inquiry of management or external information sources. Auditors make numerous oral inquiries throughout the course of the audit. For example, the auditor may inquire of the accounts receivable supervisor about controls that prevent the misclassification of cash receipts to customers’ accounts. Similarly, the auditor makes an oral inquiry about the terms of a sales transaction.

Visual information This includes information obtained through observation or observed by the auditor using remote observation tools. For example, the auditor could observe client personnel conducting a physical inventory (see Chapter 13). The auditor could also observe a message that appears on-screen for a control restricting access to an IT system.

Paper documents This is information obtained in documentary form. On many audits, the information gathered for evidential purposes will be documents. For example, the auditor might examine an original lease contract or obtain a written confirmation from a lender.

Electronic information can include two forms of information. The first form of electronic information is documents obtained in electronic documentary form. For example, an electronic, signed version of an executed sales contract. The second form of electronic information is data stored in the entity’s IT system or obtained electronically from an external information source. Such data may be manually input into the system or may be electronically generated. For example, there may be a transfer of data between the entity and a payroll service organization.

5-6

Sufficiency is the measure of the quantity of audit evidence while appropriateness is a measure of the quality of audit evidence. Evidence is considered appropriate when it provides information that is both relevant and reliable. Sufficiency and appropriateness of audit evidence are interrelated and they affect the persuasiveness

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of audit evidence. Sufficiency and appropriateness are inversely related because if the auditor can obtain higher quality evidence then less evidence will be required.

Conversely, if the evidence is of lower quality then the auditor will need to obtain more evidence.

5-7

The types of audit procedures and their definitions are: (1) Inspection of records or documents consists of examining internal and external records or documents that are in paper form, electronic form, or other media. (2) Inspection of tangible assets consists of physical examination of tangible assets. (3) Observation consists of watching a process or procedure being performed by others. (4) Inquiry consists of seeking information of knowledgeable persons, both financial and nonfinancial, within the entity or outside the entity. (5) Confirmation represents audit evidence obtained by the auditor from a third party in paper form or by electronic or other medium. (6) Recalculation consists of checking the mathematical accuracy of documents and records either manually or electronically. (7) Reperformance is the auditor's independent execution of procedures or controls that were originally performed as part of the entity's internal control, either manually or through the use of CAATs. (8) Analytical procedures consist of evaluations of financial information through analysis of plausible relationships among both financial and nonfinancial data.

5-8

Vouching refers to first selecting an item for testing from the accounting journals or ledgers and then examining the underlying source document. Thus, the direction of testing is from the journals or ledgers back to the source documents. Vouching provides evidence that items included in the accounting journals or ledgers have occurred (are valid). Tracing refers to first selecting an accounting transaction (a source document) and then following it into the journal or ledger. The direction of testing in this case is from the source documents to the journals or ledgers and tests whether transactions that occurred are recorded (completeness) in the accounting records.

5-9

Corroborating evidence is obtained for inquiry and for observation because these audit procedures typically are not from independent sources and therefore are not considered to be highly reliable. For example, the auditor might follow up on the client's responses concerning the internal controls over the raw-material storeroom by conducting tests of the control procedures to verify their existence and effectiveness.

5-10

Inspection of tangible assets, reperformance, and recalculation are generally considered of high reliability because the auditor has direct knowledge about them. Inspection of records and documents, confirmation, and analytical procedures are generally considered to be of medium reliability. The reliability of inspection of records and documents depends primarily on whether a document is internal or external. The form of the confirmation, prior experience with the entity, the nature of the information being confirmed, and the intended respondent affect the reliability of confirmations. The reliability of analytical procedures may be affected by the quality of the client's internal control system. Finally, inquiry and observation are generally low-reliability types of evidence since both require further corroboration by the auditor.

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It should be understood, however, that levels of reliability for the types of evidence should be considered as general guidelines. The reliability of the types of evidence may vary considerably across entities, and it is subject to a number of exceptions.

5-11

The "audit testing hierarchy" starts with tests of controls and substantive analytical procedures because those tests are generally both more effective and more efficient than starting with tests of details (i.e., substantive tests of transactions and substantive tests of account balances and disclosures).

5-12

Some of the buckets are larger than others because certain assertions will be more important or present bigger risks for some accounts than for others. For instance, existence (or validity) is typically more important for accounts receivable than it is for accounts payable. After the auditor has determined the risks associated with the assertions for an account balance, s/he can determine the size of the assurance buckets (i.e., how much assurance is needed) and then begin filling the buckets by applying the "audit testing hierarchy."

5-13

It is important that the audit documentation or working papers be organized or indexed in such a way that members of the audit team or firm can find relevant audit evidence.

When the auditor performs audit work on one working paper and supporting information is obtained from another working paper, the auditor cross-references the information on each working paper. This process of indexing and cross-referencing provides a trail from the financial statements to the individual working papers that can be easily followed by members of the audit team or firm. Today, ―linking‖ the information using electronic working papers facilitates much of this cross-referencing.

5-14

The quality of an expectation is referred to as the precision of the expectation. Precision is a measure of the potential effectiveness of an analytical procedure; it represents the degree of reliance that can be placed on the procedure. Precision is a measure of how closely the expectation approximates the unknown ―correct‖ amount. The degree of desired precision will differ with the specific purpose of the analytical procedure. The precision of the expectation is a function of the materiality and required detection risk for the assertion being tested. If the assertion being tested requires a low level of detection risk, the expectation needs to be very precise. However, the more precise the expectation, the more extensive and expensive are the audit procedures used to develop the expectation, resulting in a cost/benefit trade-off.

The second step in the substantive analytical procedures’ decision process is to define or calculate a tolerable difference. Since the expectation developed by the auditor will rarely be identical to the client's recorded amount, the auditor must decide the amount of difference that would require further investigation. The size of the tolerable difference depends on the significance of the account, the desired degree of reliance on the analytical procedure, the level of disaggregation in the amount being tested, and the precision of the expectation. Auditors often use rules of thumb such as, ―tolerable difference is 10% of the predicted amount.‖

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5-15

Explanations for significant differences observed for substantive analytical procedures must be followed up and resolved through quantification, corroboration, and evaluation.

Quantification: Quantification involves determining whether the explanation or error can explain the observed difference. This may require the recalculation of the expectation after considering the additional information. For example, a client may offer the explanation that the inventory account increased by a certain percentage as compared to the prior year due to a 12 percent increase in raw materials prices. The auditor should compute the effects of the raw materials price increase and determine the extent to which the price increase explains (or does not explain) the increase in the inventory account.

Corroboration: Auditors must corroborate explanations for unexpected differences by obtaining sufficient competent audit evidence linking the explanation to the difference and substantiating that the information supporting the explanation is reliable. This evidence should be of the same quality as the evidence obtained to support tests of details. Common corroborating procedures include examination of supporting evidence, inquiries of independent persons, and evaluating evidence obtained from other auditing procedures.

Evaluation: Evaluation involves the effective use of professional skepticism, combined with the desire to obtain sufficient appropriate audit evidence, similar to other auditing procedures. The auditor should evaluate the results of the substantive analytical procedures to conclude whether the desired level of assurance has been achieved. If the auditor obtains evidence that a misstatement exists and can be sufficiently quantified, the auditor makes note of his or her proposed adjustment to the client’s financial statements.

5-16

There are three types of analytical procedures: 1.

Risk assessment procedures to assist the auditor to better understand the business and to plan the nature, timing, and extent of audit procedures (sometimes referred to as planning or preliminary analytical procedures).

2.

Substantive analytical procedures are used as a substantive procedure to obtain evidential matter about particular assertions related to account balances or classes of transactions.

3.

Final analytical procedures are used as an overall review of the financial information in the final review stage of the audit.

Answers to Multiple-Choice Questions 5-17 5-18 5-19 5-20 5-21 5-22 5-23

b c b b a b b

5-24 5-25 5-26 5-27 5-28 5-29

b c d a c c

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2023

5-30

a. b. c. d.

4 3 1 2

5-31 a. b. c.

d.

e. f. g.

Fictitious revenue.

Revenue recorded, goods not shipped, or services not performed.

Goods shipped or services performed, revenue not recorded.

Goods shipped or services performed for a customer who is a bad credit risk.

Shipments made or services performed at unauthorized prices or on unauthorized terms.

Revenue transaction recorded at an incorrect dollar amount.

Revenue transactions not posted correctly to the sales journal or customers’ accounts in accounts receivable subsidiary ledger.

Amounts from sales journal not posted correctly to general ledger.

Revenue transactions recorded in the wrong period.

Revenue transaction not properly classified as revenue (i.e., improperly recorded as other income or as an offset to expenses).

Revenue transactions not properly presented and disclosed.

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5-32 a. b. c. d. e. f.

5 1 1/7 4 8 2

g. h. i. j.

3 7 5 1/7

a. b. c. d.

Category of Assertion Assertions about account balances Assertions about classes of transactions and events Assertions about account balances Assertions about account balances

e.

Assertions about account balances

f. g. h. i.

Assertions about account balances Assertions about account balances Assertions about account balances Assertions about account balances

j.

Assertions about classes of transactions and events

5-33 Assertion Existence Cutoff Completeness Accuracy, valuation, and allocation Accuracy, valuation, and allocation Existence Completeness/Existence Completeness/Existence Accuracy, valuation, and allocation/Completeness Accuracy

5-34 a. The bank confirmation would be considered more reliable than the observation of segregation of duties because an independent external party provided the information.

Observation is not as reliable because the individuals performing the functions may act differently when someone is observing them. b. The auditor's recalculation of depreciation is more reliable than the examination of the raw material requisitions because the auditor has direct personal knowledge of the outcome. c. The bank statement would be considered more reliable than shipping documents because the bank statement was prepared by an entity that is external to the client. d. The examination of the common stock certificates would generally be considered more reliable than a physical examination of inventory components for a personal computer because the stock certificates are prepared by an entity external to the client.

Additionally, the auditor may not be able to easily determine the quality or value of the computer components.

5-35 a. Type

b. Reliability

1.

1.

Internal

High if internal control is excellent, moderate to low otherwise.

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a. Type

b. Reliability

2.

Internal

2.

High if internal control is excellent, moderate to low otherwise.

3.

External

3.

High because it comes from an external party.

4.

External

4.

High to moderate because the document has been circulated to a party outside the entity.

5.

External

5.

High because it comes from an external party.

6.

Internal

6.

High if internal control is excellent, moderate to low otherwise.

7.

Internal

7.

High if internal control is excellent, moderate to low otherwise.

8.

Internal

8.

High if internal control is excellent, moderate to low otherwise.

9.

Internal

9.

High to moderate because the document has been circulated to a party outside the entity.

10. External

5-36

a.

10. High because it comes from an external party.

The reliability of evidence obtained through confirmations is directly affected by factors such as: • The form of the confirmation.

• Prior experience with the entity.

• The nature of the information being confirmed.

• The intended respondent.

There are two types of confirmation requests: the positive form and the negative form. Positive confirmations are generally considered more reliable because the respondent must reply to the requested information. A nonresponse to a negative confirmation is assumed to be correct. Prior experience with the client in terms of confirmation response rates, misstatements identified, and the accuracy of returned confirmations should be considered when assessing the reliability of confirmations.

If response rates were low in prior audits, the auditor might consider obtaining evidence using alternative procedures. The nature and availability of the information being confirmed may directly affect the competence of the evidence obtained. The intended respondent to confirmations may vary from individuals with little accounting knowledge to highly qualified accounting personnel in large corporations. The auditor should consider the respondent's competence, knowledge, ability, and objectivity when assessing the reliability of confirmation requests.

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5-37

b.

This is a difficult question, but one that is worth discussing with the students, at least preliminarily. AU 500 indicates that even when audit evidence is obtained from sources external to the entity, circumstances may exist that affect its reliability. All responses carry some risk of interception, alteration, or fraud. The auditor's consideration of the reliability of the information obtained through the confirmation process to be used as audit evidence includes consideration of the risks that (a) the information obtained may not be from an authentic source, (b) a respondent may not be knowledgeable about the information to be confirmed, and (c) the integrity of the information may have been compromised.

One of the most important steps is to ensure that the confirmation process is adequately controlled. The auditor is required by AU 500 to determine whether to modify or add procedures to resolve doubts over the reliability of information to be used as audit evidence. The auditor may choose to verify the source and contents of a response to a confirmation request by contacting the confirming party.

c.

The following amounts or information included in EarthWear's financial statements could be confirmed. The source of the confirmation is also included.

Amounts or Information Confirmed

Source of Confirmation

Cash balances

Banks

Accounts receivable

Individual customers

Lines of credit

Banks

Accounts payable

Individual vendors

Lease assets

Leaseholders

Common stock outstanding

Registrar/Transfer agent

Insurance coverage

Insurance company

a. Auditing standards stipulate that working papers have two functions: (1) to provide principal support for the representation in the auditor’s report that the audit was conducted in accordance with GAAS and (2) to aid in the planning, performance, and supervision of the audit. b.

The more common types of working papers include the audit plan and programs, working trial balance, adjusting and reclassification entries, account analysis and listings, and audit memoranda.

c.

The auditor should consider the following factors when determining the form and extent of the documentation for a particular audit area or auditing procedure: • The size and complexity of the entity.

• The nature of the audit procedures to be performed.

• Identified risks of material misstatement.

• The significance of the audit evidence obtained.

17-48

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• • • •

The nature and extent of exceptions identified.

The need to document a conclusion or the basis for a conclusion not readily determinable from the documentation of the work performed or audit evidence obtained.

The audit methodology and tools used.

The extent of judgment involved in performing the work and evaluating the results.

5-38 a. The calculation of the expectation for the reserve for returns account can be made as follows:

Months July August September October November December

Monthly Sales (in 000s) $ 73,300,000 82,800,000 93,500,000 110,200,000 158,200,000 202,500,000

Historical Return Rate 0.004 0.006 0.010 0.015 0.025 0.032

Gross Margin % Auditor expectation

Estimated Returns $ 293,200 496,800 935,000 1,653,000 3,955,000 6,480,000 $13,813,000 x 0.425 $ 5,870,525

b. We can establish a tolerable difference by applying a percentage (50%) to the planning materiality set for EarthWear of $1,800,000. This results in a tolerable difference of $900,000. Alternatively, the auditor might use a rule of thumb like this to determine tolerable difference for account where substantive analytics are being used: Tolerable difference will be 10% of the account balance or 50% of planning materiality, whichever is less. c. The expectation of $5,870,525 is approximately $20,000 less than the book value of $5,890,000. Since this amount is less than the tolerable difference of $900,000 (and also less than 10% of the account balance if the auditor used a lower tolerable difference), the analytical procedure supports the fair presentation of the reserve for returns account. d. If the difference between the auditor’s expectation and the book value is greater than the tolerable misstatement, the auditor should consider performing the following audit procedures: • Review the general journal and general ledger for any unusual entries.

• Reevaluate the historical return rates.

• Reevaluate the gross profit margin.

• Ask the client to adjust the books.

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5-39

The issues and potential risks listed below are based on a real-world situation involving a liquidity crisis and a pending bankruptcy. Because the solution below includes the benefits of the Home Depot insights it is likely to be more complete than answers provided by students.

1. Quick Ratio a. The quick ratio presents a good picture of the client’s liquidity position. A quick ratio greater than 1.0 generally indicates that the entity’s liquid assets are sufficient to meet the cash requirements for paying current liabilities. Home Improvement’s quick ratio has decreased significantly over the past two years and has fallen well below the 1.0 threshold, whereas the industry’s quick ratio has been consistently increasing and above the 1.0 threshold in the last year. Home Improvement appears to be facing serious liquidity issues that are not reflected in the industry. The lack of liquidity presents many risks, including the potential inability to stay current with payments owed to vendors and creditors. A lack of liquidity also increases the risk that the company may face bankruptcy (i.e., may not be able to continue as a going concern). Liquidity pressures also increases the inherent risks on accounting measures related to debt covenants and new financing (i.e., incentive to overstate in order to avoid default and/or acquire new financing). b. 1: Growth. A cash crunch is not uncommon for companies going through rapid growth as appears to be the case with The Home Improvements when you consider the pattern of other ratios and trends (e.g., significant debt to equity, increase in inventory to total assets). As the client expands, it spends large amounts of cash on buying more inventory, building new stores, and incurring other significant start-up costs. The client may also add additional debt during these growth periods to help finance expansion, and this debt also requires repayment as well as interest charges. Although this cash shortage is not uncommon for growth companies, it is vital that sales increase at such a rate as to allow the client to repay future debt and meet all liabilities and/or the client have the ability to acquire additional capital to survive the cash crunch. b.2: Repayment of Debt. The cash crunch in the final year could be the result of repayment of debt (perhaps due to a balloon payment). Note that debt to equity dropped significantly in the last year…indicating that either debt significantly reduced or equity significantly increased. Given the pattern in this case, the former seems more likely.

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2. Days of Inventory on Hand a. This ratio, which is computed as 365 days divided by the inventory turnover, represents how much inventory the entity has on hand to sell to customers. The higher the ratio, the slower the inventory turns and the less able the client is to liquidate inventory and avoid inventory obsolescence. Although the client’s ratio is not much worse than the industry average, the last several years show a large increase, which may represent increasing difficulty in selling its products. This increasing ratio represents an increasing risk of inventory obsolescence and the potential that inventory is being carried at an amount in excess of its market value. b. As the client has grown, it may be that it has established a strategy of maintaining a large volume of inventory on hand in order to meet customer demands. As such, its inventory turnover would naturally decrease. However, the lower inventory turnover may also be a result of a decreased demand for home improvement products or simply that the client has grown too quickly and has increased supply in excess of market demand.

3. Inventory/Current Assets a. This ratio sheds light on how the client is increasing inventory purchases compared to the industry average. Carrying large amounts of inventory on hand can be expensive when carrying, stocking, and storage costs are considered. As mentioned previously, when large amounts of inventory are stored on hand, the risk of inventory obsolescence increases, as does the risk that the client may be poorly investing cash in such a way that materially decreases necessary operating liquidity. Inventory as a percent of current assets has skyrocketed over the past two years, especially when compared to industry averages and deserves further attention indicating that inventory will be an account that should be considered high risk by the auditor. b. This ratio highlights the fact that the client is dramatically increasing inventory purchases to stock new stores and expand rapidly. Although necessary for growth, this increase in inventory can also be dangerous if sales do not support the expansion.

4. Return on Assets (ROA) a. This ratio indicates the return earned on the resources invested by both the stockholders and the creditors. As such, when this ratio dips below the industry average it indicates that the company is not generating as high a return as its competitors and may represent going concern issues. Additionally, if the client feels pressured to keep its ROA higher through higher earnings, the client may engage in earnings management or fraud. ROA over the past three years are quite a bit lower than the earlier years and are quite a bit lower than the industry average and as such deserve further investigation to determine underlying causes and related financial statement risks.

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b. As a growing company, and as shown in other ratios, the client has spent considerable amounts of money expanding its business, including the build-up in inventory, which increases the denominator (Total Assets). At the same time, the company may be experiencing lower profit margins (as they attempt to liquidate inventory at lower prices) and lower net earnings due to higher expenses related to expansion. These factors reduce Net Income, which also reduces ROA. The high amounts of debt to fund expansion also result in higher interest expense, further lowering earnings.

5. Debt to Equity Ratio a. This ratio indicates what portion of an entity’s capital comes from debt. The lower the ratio, the less debt pressure on the entity. The client’s debt has increased dramatically over the last three years and although the ratio drops in the final year in the table, it is still higher than the earliest years as well as the industry ratio over the same timeframe. The fact that the client’s ratio is significantly above the industry average indicates that the client may be too highly leveraged and may not be able to meet its debt obligations on a long-term basis, which increases the risk that the client is a viable going concern. As the amount of debt increases, so does the pressure to meet potentially restrictive debt covenants, putting pressure on the client to be aggressive or even fraudulent in financial statement reports. b. As a growth company, the client has understandably sought out debt as a way to finance its expansion. However, this debt has increased at an alarming rate. As the client has experienced lower than expected earnings, its stock price may have dropped to the point that raising capital through a public offering may have been ineffective and thus debt may have been the client’s only avenue for additional financing.

NOTE: The data used in this problem are based on Home Depot and its industry between 1982 and 1986. Founded in 1978, Home Depot quickly became a major player in its industry. Because of its success, Home Depot sought to rapidly expand during the early 1980’s. Unfortunately, Home Depot tried to expand too quickly. It acquired millions of dollars in debt to purchase large amounts of PP&E and inventory for new stores, but sales did not keep pace with the rapid expansion in assets and debt. As a result, Home Depot had serious cash shortages to the extent that it was having trouble financing operations. Home Depot was forced to restructure its debt and strategy for growth. On the verge of bankruptcy, Home Depot was able to orchestrate a miraculous turnaround and ultimately returned to profitability.

Solution to Discussion Cases 5-40

Part I a. Because of the large increase in sales, both in general and abroad, the auditor primarily would be concerned with occurrence of sales transactions. b. For the same reason given in part a, the auditor would be concerned with the existence of the accounts receivable. In addition, because there is some evidence that

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the increase in accounts receivable is greater than the increase in sales (e.g., greater percentage increase in accounts receivable than for sales, increase in average days outstanding), the auditor also would be concerned with valuation or allocation (i.e., to what extent are the receivables collectible). c. The auditor could vouch sales and receivables. Specifically, to examine the occurrence and existence assertions, the auditor could choose a sample of sales transactions and examine supporting documents, perhaps paying particular attention to the existence of a valid sales order as well as evidence that the products were shipped (i.e., shipping documents).

The auditor also could confirm a sample of accounts receivable with customers, perhaps asking the customers to fill in the dollar amount that they owe as of the balance sheet date. This procedure would help verify existence or occurrence, rights and obligations, and valuation or allocation.

The auditor also could prepare an aging schedule to check for the existence of a significant amount of old receivables. This procedure would be useful primarily for valuation or allocation.

Part II a. The auditors could have examined documentation for sales transactions, particularly searching for valid sales orders and evidence that the products sold were shipped. The auditor also could have considered sending additional confirmations to a larger number of customers, perhaps asking the customer to fill in the dollar amounts because there is so much doubt about the accuracy of L&H’s figures. b. The confirmation responses suggest that management integrity likely is low, especially those that stated they were not a customer of L&H’s. Therefore, the auditor would be unlikely to use inquiry of the client as an audit procedure.

5-41 1. See Development of Auditors' Expectation on the following page.

2. Reported ticket revenue differs from the expectation by approximately 14 percent (($2,200,000 - $1,922,190) / $1,922,190); this difference is material and should be investigated.

One explanation for the larger than expected reported ticket revenue could be that the football team performed better than expected. In addition, perhaps the weather also was better than expected. Auditors can verify ticket sales, perhaps by comparing deposits of ticket revenue with reported attendance. The auditors also could check weather conditions on game days to ascertain whether favorable weather conditions are a plausible explanation for the higher attendance.

3. In a problem such as this, analytical procedures will be most effective when accurate expectations can be developed. From the information provided in this problem, it appears that the auditors' knowledge of Western’s ticket sales is sufficient to allow them to develop a reasonable expectation.

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Development of Auditors' Expectation Four regular games 24,000

Total attendance

Allocation 0.7 0.2 0.1

Total Fans 16,800 4,800 2,400

Less free 16,300 4,800 2,400

Price per Ticket $12 8 5

24,000

Total Revenue $195,600 38,400 12,000 $246,000 X4 $984,000

Four normal games

(30% higher attendance, 20% higher ticket price)

Bloomington University 31,200

Total attendance

Allocation 0.7 0.2 0.1

Total Fans 21,840 6,240 3,120

Less free 21,340 6,240 3,120

Price per Ticket $14.40 9.60 6.00

31,200 Norwalk University

$385,920 (20% more fans, 75% box seats, 25% upper deck) Price per Ticket 4,800 3,600 $12 1,200 5

Extra fans (total): Box Upper Normal game revenue:

Night Games

(10% higher ticket prices, 5% lower attendance)

24,000

Base attendance

0.7 0.2 0.1

Total Revenue $43,200 6,000 49,200 246,000 $295,200

Tickets

16,800 4,800 2,400

Less: 5% and Free Seats 15,485 4,560 2,280

24,000

22,325

Total estimated revenue for the year

Total Revenue $307,296 59,904 18,720

Price per Ticket $13.20 8.80 5.50

Total Revenue $204,402 40,128 12,540 $257,070

$1,922,190

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5-42

a. The auditor can assess the reliability of the client's records for developing the allowance for return of unsold books by testing the number of books sold and the number of books returned. Taking a sample of sales by individual title and tracing them into the client’s internal records could accomplish this. This would verify the sales portion of the internal records. The book return portion of the client's records can be tested by examining a sample of receiving documents used to record the books returned by individual titles from the retail stores. If these tests indicated that the client's records were accurate, the auditor could rely on the client's records for establishing the allowance for return of unsold books. b. The return rate could be estimated for relatively new titles in a number of ways. One possibility is to use the average historical "first-year" return rate for all new titles.

Another possibility is to estimate the first-year return rate by individual author. Thus, if a new title was from an author who had previously published with Bentley Bros., the author's average first-year rate could be tested and used. c. Other than average industry data, there is not likely to be much external evidence that can be gathered on returned books. It might be possible to send a confirmation to the major retail stores and ask for information on current sales activity. Some evidence might also be gathered from the "best-selling" book lists.

Solution to Internet Assignment 5-43

A general search for each term using an Internet browser resulted in a long list of "hits;" most of which did not apply to the material covered in the text. The Institute of Internal Auditors' home page (www.theiia.org) contained some information related to EDI and image processing systems. Using the search function at the AICPA's home page (www.aicpa.org) identified a significant number of references to the three terms. EDI refers to the electronic exchange of data, for example, the electronic exchange of data regarding inventory requirements between a customer and a vendor. Image processing systems capture and store electronic images, usually reproductions of documents. For example, many banks and credit unions now make electronic images of cancelled checks available to their customers online. These technologies have fundamental implications for auditing, especially in terms of the quality of the electronic evidence involved in both. If important audit evidence is stored only in electronic form and controls over the integrity of the electronic records are not adequate, the auditor may not be able to gather sufficient appropriate evidence to express an unqualified opinion on the client’s financial statements.

CHAPTER 6 INTERNAL CONTROL IN A FINANCIAL STATEMENT AUDIT Answers to Review Questions

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6-1

From management's perspective, internal control provides a way to accomplish management’s stewardship or agency responsibilities. Management also needs a control system that generates reliable information for decision-making purposes.

The importance of internal control to the auditor is rooted in the second standard of fieldwork. The controls that are relevant to the entity's ability to initiate, record, process, and report financial data consistent with management's assertions are the auditor's main concern. The auditor needs assurances about the reliability of the data generated within the entity's internal control system in terms of how it affects the fairness of the financial statements and how well the assets and records of the entity are safeguarded. The auditor uses this understanding of internal control to identify the types of potential misstatements, ascertain factors that affect the risk of material misstatement, and design tests of controls and substantive procedures.

6-2

The potential benefits and risks to an entity’s internal control from information technology include (see Table 6-1): Benefits: • Consistent application of predefined business rules and performance of complex calculations in processing large volumes of transactions or data.

• Enhancement of the timeliness, availability, and accuracy of information.

• Facilitation of additional analysis of information.

• Enhancement of the ability to monitor the performance of the entity's activities and its policies and procedures.

• Reduction in the risk that controls will be circumvented.

• Enhancement of the ability to achieve effective segregation of duties by implementing security controls in applications, databases, and operating systems.

Risks: • Reliance on systems or programs that inaccurately process data, process inaccurate data, or both.

• Unauthorized access to data that may result in destruction of data or improper changes to data, including the recording of unauthorized or nonexistent transactions or inaccurate recording of transactions.

• Unauthorized changes to data in master files.

• Unauthorized changes to systems or programs.

• Failure to make necessary changes to systems or programs.

• Inappropriate manual intervention.

• Potential loss of data.

6-3

Internal control is composed of five components (see Table 6-2): 1. Control Environment: The control environment is the set of standards, processes, and structures that provide the basis for carrying out internal control across the organization. The board of directors and senior management establish the tone at the top regarding the importance of internal control and expected standards of conduct.

2. The Entity’s Risk Assessment Process: Risk assessment involves a dynamic and 17-56 Copyright ©2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

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iterative process for identifying and analyzing risks to achieving the entity’s objectives, thereby forming a basis for determining how risks should be managed.

Management considers possible changes in the external environment and within its own business model that may impede its ability to achieve its objectives.

3. Information and Communication: Information is necessary for the entity to carry out internal control responsibilities in support of achievement of its objectives.

Communication occurs both internally and externally and provides the organization with the information needed to carry out day-to-day internal control activities.

Communication enables personnel to understand internal control responsibilities and their importance to the achievement of objectives and allows for upward flow of operating information to management.

4. Control Activities: Control activities are the actions established by policies and procedures to help ensure that management directives to mitigate risks to the achievement of objectives are carried out. Control activities are performed at all levels of the entity and at various stages within business processes, and over the technology environment.

5. Monitoring of Controls: Ongoing evaluations, separate evaluations, or some combination of the two are used to ascertain whether each of the five components of internal control, including controls to implement the principles within each component, are present and functioning. Findings are evaluated and deficiencies are communicated in a timely manner, with serious matters reported to senior management and to the board.

6-4

Principles that underly the control environment include (see Table 6-3): • The organization demonstrates a commitment to integrity and ethical values.

• The board of directors demonstrates independence from management and exercises oversight of the development and performance of internal control.

• Management establishes, with board oversight, structures, reporting lines, and appropriate authorities and responsibilities in the pursuit of objectives.

• The organization demonstrates a commitment to attract, develop, and retain competent individuals in alignment with objectives.

• The organization holds individuals accountable for their internal control responsibilities in the pursuit of objectives.

6-5

A substantive audit strategy means that the auditor has made a decision not to rely on the entity's controls to reduce the risk of material misstatement and to instead audit the related financial statement accounts directly. Control risk is set at the maximum when a substantive audit strategy is followed. With a reliance strategy, the auditor relies on the entity's controls to reduce the risk of material misstatement and sets control risk below the maximum. A reliance strategy requires a more detailed understanding and documentation of internal control than does a substantive strategy. The auditor also plans and performs tests of controls to support the lower assessed level of control risk.

6-6

In addition to planning the audit of the financial statements, the auditor's understanding of the entity's internal control is used to (1) identify the types of potential misstatements, (2) pinpoint factors that affect the risk of material misstatement, and (3) design tests of

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controls and substantive procedures.

6-7

The concept of reasonable assurance recognizes that the cost of an entity's internal control system should not exceed the benefits that are expected to be derived from the system.

Thus, an internal control system will not detect every error that might occur because it would be too costly to design such a system. Management override of internal control, personnel errors or mistakes, and collusion are inherent limitations of internal control.

6-8

A number of tools are available to the auditor for documenting the understanding of the internal control, including copies of the entity's procedures manuals and organizational charts, internal control questionnaires, flowcharts, and narrative descriptions.

6-9

The auditor should document the achieved level of control risk for the controls evaluated.

The auditor’s assessment can be documented using a structured working paper, an internal control questionnaire, or a memorandum.

6-10 The auditor might consider conducting substantive tests at an interim date for a number of reasons. For example, the client may want the auditor to confirm accounts receivable before year-end because of demands on the client’s staff at year-end. Alternatively, the auditor may wish to conduct substantive tests at an interim date to minimize staff overtime at year-end. The auditor should consider the following factors when substantive tests are to be completed at an interim date: • The control environment and other relevant controls.

• The availability of information at a later date that is necessary for the auditor’s procedures (e.g., information stored electronically for a limited period of time).

• The purpose of the substantive procedure.

• The assessed risk of material misstatement.

• The nature of the class of transactions or account balance and relevant assertions.

• The ability of the auditor to perform appropriate substantive procedures or substantive procedures combined with tests of controls to cover the remaining period in order to reduce the risk that misstatement may exist at the period-end will not be detected.

When the auditor conducts substantive tests of an account at an interim date, additional substantive tests might include comparing the year-end account balance with the interim account balance, conducting some analytical procedures, and/or reviewing related journals and ledgers for large or unusual transactions during the remaining period.

6-11 For private companies, auditing standards require that the auditor report to those charged with governance (e.g., audit committee) and management any control deficiencies discovered by the auditor that are serious enough to be considered a significant deficiency or a material weakness. See Chapter 7 for the auditor’s reporting responsibility for reporting on internal control.

Answers to Multiple-Choice Questions 6-12 6-13 6-14

d d d

6-19 6-20 6-21

a b d 17-58

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6-15 6-16 6-17 6-18

d a c b

6-22 6-23 6-24

c d b

Solutions to Problems 6-25 a. The COSO definition is: ―Internal control is designed and carried out by an entity’s board of directors, management, and other personnel to provide reasonable assurance about the achievement of the entity’s objectives in the following categories: (1) reliability, timeliness, and transparency of internal and external, nonfinancial and financial reporting; (2) effectiveness and efficiency of operations, including safeguarding of assets; and (3) compliance with applicable laws and regulations. In Chapter 7, you will find a somewhat similar definition for internal control that is included in the PCAOB’s AS 2201. b. The auditor should obtain an understanding of each of the five components of internal control in order to plan the audit. This understanding includes knowledge about the design of relevant controls and whether they have been placed in operation by the entity. The auditor uses this knowledge to (1) identify the types of potential misstatements, (2) pinpoint factors that affect the risk of material misstatement, and (3) design tests of controls and substantive procedures. c. An auditor should document the understanding of the internal control components obtained to plan the audit. The auditor should also document the assessed (achieved) level of control risk.

6-26 The control environment-related principles that establish, enhance, or mitigate the effectiveness of specific controls, and their components, are: Principle 1: The organization demonstrates a commitment to integrity and ethical values.

The effectiveness of an entity’s controls is influenced by the integrity and ethical values of the individuals who are responsible to create, administer, and monitor the controls.

Integrity and ethical values are essential elements of the control environment, affecting the design, administration, and monitoring of the other components. Integrity and ethical behavior are the product of the entity’s ethical and behavioral standards, how they are communicated, and how they are reinforced in practice.

Principle 2: The board of directors demonstrates independence from management and exercises oversight of the development and performance of internal control.

The board of directors and audit committee significantly influence the control consciousness of the entity. Factors that affect the effectiveness of the board and audit committee include the following: its independence from management, the experience and stature of its members, the extent of its involvement with and scrutiny of the entity's activities, the appropriateness of its actions, the degree to which difficult questions are

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raised and pursued with management, and its interaction with the internal and external auditors.

Principle 3: Management establishes, with board oversight, structures, reporting lines, and appropriate authorities and responsibilities in the pursuit of objectives.

The organizational structure defines how authority and responsibility are delegated and monitored. Establishing a relevant organizational structure includes considering key areas of authority and responsibility and appropriate lines of reporting. It provides a framework for planning, executing, and monitoring operations. An entity develops an organizational structure that depends on its size and the nature of its business.

This principle includes how authority and responsibility for operating activities are assigned and how reporting relationships and authorization hierarchies are established.

It also includes policies regarding acceptable business practices, the knowledge and experience of key personnel, and the resources provided for carrying out duties. It also includes policies and communications directed toward ensuring that all personnel understand the entity's objectives, know how their individual actions interrelate and contribute to those objectives, and recognize how and for what they will be held accountable.

Principle 4: The organization demonstrates a commitment to attract, develop, and retain competent individuals in alignment with objectives.

Management must specify the competence level for a particular job and translate it into the required level of knowledge and skill. Management must then hire employees who have the appropriate competence for a job. The quality of internal control is a direct function of the quality of the personnel operating the system. The entity should have personnel policies for hiring, training, evaluating, counseling, promoting, compensating, and taking remedial action.

Principle 5: The organization holds individuals accountable for their internal control responsibilities in pursuit of objectives.

Management and the board of directors are responsible for establishing mechanisms to communicate and hold individuals accountable for performance of internal control responsibilities across the organization and for implementing corrective action as necessary. Management and the board of directors also establish performance measures, incentives, and rewards appropriate for responsibilities at all levels of the entity, reflecting reasonable expectations for performance and standards of conduct in light of both shortterm and longer-term objectives 6-27

a. The auditor should consider a reliance strategy if evidence is available only in electronic form. However, after developing an understanding of the new system, the auditor would need to test the system to determine whether it is working as intended.

If the system is working effectively, the auditor is more likely to use a reliance strategy. The auditor should also consider whether the firm’s knowledge of IT systems is sufficient to allow it to use a reliance strategy; if not, a substantive strategy may be more appropriate. b. When deciding whether to hire a specialist, the auditor in this case should consider 17-60 Copyright ©2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

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factors such as the complexity of the new system, whether the implementation of the system allows the company to engage in electronic commerce and the extent to which emerging technologies are used and audit evidence is available only in electronic form.

The auditor should ask the IT specialist to communicate information including how IT controls are designed and how data and transactions are initiated, recorded, processed, and reported. c. The control environment likely is not affected to a great extent by the switch to an automated system except inasmuch as the switch might signal management’s commitment to competence and willingness to improve its controls. The entity’s risk assessment is affected because the existence of an automated system creates a new set of risks, such as risks involving the design of the control system. In terms of the information system and communication, the auditor will have to verify that the new system identifies and records all valid transactions and provides information sufficient for preparing accurate and complete financial statements. Control activities are important because new controls regarding the information system will have to be designed and implemented. Monitoring of controls is important because the monitors (including the internal and external auditors) will have to have sufficient knowledge of the system to be able to effectively monitor the use of the system and its outputs.

6-28 a. The strength of using procedures manuals and organizational charts is that they help the auditor document understanding of the internal control system.

The strength of a narrative description is that it provides a simple, written memorandum that documents the understanding of internal control.

The strength of an internal control questionnaire is that it provides a systematic and comprehensive way to evaluate internal control.

A strength of using a flowchart is that it provides a diagrammatic representation of the entity’s internal control system. This facilitates the auditor's analysis of the system's controls. b. On many engagements, auditors combine these tools to document their understanding of the components of internal control. The combination depends on the complexity of the entity’s internal control system. For example, in a complex information system where a large volume of transactions occurs electronically, the auditor may document the control environment, the entity’s risk assessment process, and monitoring activities using a memorandum and internal control questionnaire. Documentation of the information system and communication component, as well as control activities, may be accomplished through the use of an internal control questionnaire and a flowchart.

For a small entity with a simple information system, documentation using a memorandum may be sufficient.

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6-29 a. The internal auditor would have the following concerns with respect to individual entries: • The reasonableness of significant entries (e.g., manual entries in traditionally automated accounts such as inventory), • The review of the appropriateness of the individual who prepared the journal entry (e.g., senior executives or unauthorized personnel), • The review of the frequency of journal entries, particularly those that are relevant to management authorization levels, • The identification of journal entries without descriptions, and • Potentially fraudulent entries. b. The external auditor could rely on the internal audit’s work, but not to the exclusion of reperforming some of the internal audit’s work.

6-30 a. Before applying principal substantive procedures to balance sheet accounts at April 30, 2021, the interim date, Cook should assess the difficulty in controlling incremental audit risk. Cook should consider whether • Cook's experience with the reliability of the accounting records, internal controls, and management's integrity has been good.

• The accounts subject to interim testing have a high risk of misstatement.

• Rapidly changing business conditions or circumstances may predispose General's management to misstate the financial statements in the remaining period.

• The year-end balances of accounts selected for interim testing will be predictable.

• General's procedures for analyzing and adjusting its interim balances and for establishing proper accounting cutoffs will be appropriate.

• General's accounting system will provide sufficient information about year-end balances and transactions in the final two months of the year to permit investigation of unusual transactions, significant fluctuations, and changes in balance compositions that may occur between the interim and balance sheet dates.

• The cost of the substantive tests necessary to cover the final two months of the year and provide the appropriate audit assurance at year-end is substantial.

Assessing control risk at below the maximum would not be required to extend the audit conclusions from the interim date to year-end. However, if Cook assesses control risk at the maximum during the final two months, Cook should consider whether the effectiveness of the substantive tests to cover that period will be impaired. b. Cook should design the substantive procedures so that the assurance from those tests and the tests to be applied as of the interim date, and any assurance provided from the assessed level of control risk, will achieve the audit objectives at year-end. Such tests should include the comparison of year-end information with comparable interim information to identify and investigate unusual amounts. Other analytical procedures and/or substantive procedures should be performed to extend Cook's conclusions relative to the assertions tested at the interim date to the balance sheet date.

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6-31

a.

The following communication is the report on significant deficiencies for Houghton Enterprises: In planning and performing our audit of the financial statements of Houghton Enterprises as of and for the year ended December 31, 2021, in accordance with auditing standards generally accepted in the United States of America, we considered Houghton Enterprises’ internal control over financial reporting (internal control) as a basis for designing our auditing procedures that are appropriate in the circumstance for the purpose of expressing our opinion on the financial statements, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control. Accordingly, we do not express an opinion on the effectiveness of the Company’s internal control.

Our consideration of internal control was for the limited purpose described in the preceding paragraph and would not necessarily identify all deficiencies in internal control that might be significant deficiencies or material weaknesses. However, as discussed below, we identified certain deficiencies in internal control that we consider to be significant deficiencies.

A deficiency in internal control exists when the design or operation of a control does not allow employees, in the normal course of performing their assigned functions, to prevent, or detect and correct, misstatements on a timely basis. A significant deficiency is a control deficiency, or combination of control deficiencies, in internal control, which is less severe than a material weakness; yet important enough to merit attention by those responsible for oversight of the company’s financial reporting. We consider the following items are significant deficiencies: 1. Control activities for granting credit to new customers were inadequate. In particular, the Credit Department did not perform an adequate check of the creditworthiness of the customer with an outside credit agency.

2. There were not adequate physical safeguards over the Company's inventory.

There were no safeguards to prevent employees from stealing high-value inventory parts.

This communication is intended solely for the information and use of management, individuals charged with governance, and others within the organization and is not intended to be and should not be used by anyone other than these specified parties.

b.

If the second item were a material weakness, the following report would be issued: In planning and performing our audit of the financial statements of Houghton Enterprises as of and for the year ended December 31, 2021, in accordance with auditing standards generally accepted in the United States of America, we considered Houghton Enterprises’ internal control over financial reporting (internal control) as a basis for designing our auditing procedures that are appropriate in the circumstance for the purpose of expressing our opinion on the financial statements, but not for the

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purpose of expressing an opinion on the effectiveness of the Company’s internal control. Accordingly, we do not express an opinion on the effectiveness of the Company’s internal control.

Our consideration of internal control was for the limited purpose described in the preceding paragraph and would not necessarily identify all deficiencies in internal control that might be material weaknesses or significant deficiencies. However, as discussed below, we identified certain deficiencies in internal control that we consider to be a material weakness and a significant deficiency.

A deficiency in internal control exists when the design or operation of a control does not allow employees, in the normal course of performing their assigned functions, to prevent, or detect and correct, misstatements on a timely basis. A material weakness is a deficiency, or combination of deficiencies, in internal control, such that there is a reasonable possibility that material misstatement of the entity’s financial statements will not be prevented, or detected and corrected, on a timely basis. We believe that the following deficiency constitutes material weaknesses: There were not adequate physical safeguards over the Company's inventory. There were no safeguards to prevent employees from stealing high-value inventory parts.

A significant deficiency is a control deficiency, or combination of control deficiencies, in internal control, which is less severe than a material weakness; yet important enough to merit attention by those responsible for oversight of the company’s financial reporting. We consider the following item to be a significant deficiency: Control activities for granting credit to new customers were inadequate. In particular, the Credit Department did not perform an adequate check of the creditworthiness of the customer with an outside credit agency.

This communication is intended solely for the information and use of management, individuals charged with governance, and others within the organization and is not intended to be and should not be used by anyone other than these specified parties.

Solution to Discussion Case 6-32 a.

In their complaint against Koss Corporation, the SEC noted the following internal control deficiencies: • • • • •

Lack of segregation of duties over disbursements and bank reconciliations.

Old and weak accounting system, leaving little audit trail and enabling postclosing entries, among other weaknesses.

Lack of documentation for journal entries.

Failure to perform monthly bank reconciliations.

Lack of required review of wire transfers prior to execution (note the distinction 17-64

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• • • •

b.

Koss could have implemented a number of internal controls that might have prevented the misappropriation of assets: •

• •

• •

•

6-33 a.

between a preventive policy and a preventive control).

Lack of an after-the-fact review of journal entries.

Lack of detailed review of financial information by CEO (very cursory).

Insufficient monthly analytical procedures (e.g., no monitoring of even gross margins).

Failure to change passwords on a regular basis, along with other IT security and control deficiencies.

The biggest improvement that Koss could have made was to establish a stronger control environment and better control activities, including better oversight of and segregation of duties over accounting and financial reporting functions. The Company could have assigned someone outside of the accounting function to provide an independent check and balance on employees' integrity and to maintain a sufficiently strong control system. For example, different employees could have performed the separate duties of signing checks, processing cash receipts and cash disbursements, and maintaining the books of original entry.

Koss could have updated its computerized accounting system.

Someone outside the accounting department, such as Michael Koss as the CFO or the Vice President of Operations, review large wire transfers or the recording of payments on accounts payable when not processed through the accounts payable system.

Someone outside of accounting should have reviewed the monthly reconciliations of its bank accounts.

Someone outside of accounting should periodically review documentation to support the general journal entries to verify that the corresponding transactions were being executed in accordance with Koss's accounting policies and recorded as necessary to permit preparation of financial statements in conformity with Generally Accepted Accounting Principles.

Develop an internal audit function. With a well-qualified internal audit function many of the deficiencies in internal control could have been corrected.

Many of the same issues found in the Koss fraud existed in the Dixon, IL fraud.

• • • • •

Lack of segregation of duties.

Little oversight or monitoring by the part-time city administrators.

Ability to deposit funds from one account to another without approval or review.

Lack of review of bank statements and reconciliations.

It does not appear that the city had a mandatory vacation policy where someone performed Crundwell’s job.

b. Note to instructors: There is no correct/incorrect answer to this question, and students will not have access to the information displayed below. There appears that a number of things went wrong on the audits conducted by Clifton, Larson, Allen, LLP (CLA).

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In 2005, CLA resigned from the city ―audit‖ to take on more additional consulting work. However, it appears that they continued to provide information to the small firm (Janis Card Company, LLC) who assumed the audit. Not much information is available publicly about the quality of the audits performed by either firm. The city’s attorney has stated that a number of invoices provided to the firm were fabricated. For example, he pointed to more than 170 phony invoices created by Crundwell, supposedly from the Illinois Department of Transportation. The fake invoices are visibly different from real documents. He stated: ―The invoices that she showed to Clifton auditors were palpably different. They were day and night than the true invoices from the Illinois Department of Transportation. All those are red flags that Clifton should have identified, should have followed up on and it would have simply been a two minute phone call to the Illinois Department of Transportation in Springfield,‖ Bruce said.

CHAPTER 7 AUDITING INTERNAL CONTROL OVER FINANCIAL REPORTING Answers to Review Questions 7-1

Following are management’s and the auditor’s responsibilities under Section 404 of the Sarbanes-Oxley Act of 2002: Management’s Responsibilities • Accept responsibility for the effectiveness of the entity's ICFR. • Evaluate the effectiveness of the entity's ICFR using suitable control criteria.

• Support its evaluation with sufficient evidence, including documentation.

• Present a written assessment of the effectiveness of the entity’s ICFR as of the end of the entity’s most recent fiscal year.

Auditor’s Responsibilities • For large publicly traded companies, the auditor must plan and perform the audit to obtain reasonable assurance about whether the entity maintained, in all material respects, effective internal control as of the date specified in management's assessment.

• The audit of internal control should be ―integrated‖ with the financial statement audit, and should express an opinion on the effectiveness of the entity’s ICFR.

7-2

―Likelihood‖ refers to the probability that a misstatement will not be prevented or detected. For a control deficiency, significant deficiency, or a material weakness to exist, the likelihood of such an occurrence must be either ―reasonably possible‖ or ―probable.‖ ―Magnitude‖ refers to the amount of a potential misstatement that could result from the control deficiency according to the judgment of a prudent official who considers the possibility of further, undetected, misstatements. If the auditor’s likelihood assessment is at least ―reasonably possible‖, the magnitude of the deficiency determines the 17-66 Copyright ©2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

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classification as either a control deficiency, significant deficiency, or material weakness.

7-3

All of the following controls would typically be tested (see Table 7-2): • Entity-level controls (see Table 7-1).

• Controls over initiating, authorizing, recording, processing, and reporting significant accounts and disclosures and related assertions embodied in the financial statements.

• Controls over the selection and application of accounting policies that are in conformity with GAAP. • Antifraud programs and controls.

• Controls, including IT general controls, on which other controls are dependent.

• Controls over significant nonroutine and nonsystematic transactions, such as accounts involving judgments and estimates.

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7-4

Management and the auditor make similar decisions deciding which locations or business units to include for testing. Thus, the choice of which locations to include in the assessment of internal control is based on the presence of entity-level controls and the financial reporting risk at each individual location or business unit.

7-5

The SEC allows considerable flexibility to management in how it should document its assessment. Reasonable support would include the basis for management’s assessment, such as documentation of the methods and procedures it utilizes to gather and evaluate evidence. Such documentation would include the design of the controls management has placed in operation to adequately address identified financial reporting risks, including the entity-level and other pervasive elements necessary for effective ICFR. Management is not required to identify and document every control in a process. Documentation should focus on those controls management concludes are adequate to address the entity’s financial reporting risks. Such evidence for management’s assessment ordinarily includes documentation of how management formed its conclusion about the effectiveness of the company’s entity-level controls and other pervasive elements of ICFR that its control framework describes as necessary for an effective system of internal control.

7-6

The steps in the auditor’s process for an audit of ICFR include (see Figure 7-2): • Plan the audit of ICFR. • Identify controls to test using a top-down, risk-based approach.

• Test the design and operating effectiveness of selected controls.

• Evaluate identified control deficiencies.

• Form an opinion on the effectiveness of ICFR.

7-7

(Refer to Table 3-2). The following factors can be used to judge the objectivity of the internal audit function: • Whether the organizational status of the IAF, including the function’s authority and accountability, supports the ability of the function to be free from bias, conflict of interest, or undue influence of others to override professional judgments (e.g., the IAF reports to audit committee or an officer with appropriate authority, or if the function reports to management, whether it has direct access to audit committee).

• Whether the IAF is free of any conflicting responsibilities (e.g., having managerial or operational duties or responsibilities that are outside of the IAF).

• Whether audit committee oversees employment decisions related to the IAF. • Whether any constraints or restrictions placed on the IAF by management or audit committee exist, for example, in communicating the IAF’s findings to the external auditor.

• Whether the internal auditors are members of relevant professional bodies and their memberships obligate their compliance with relevant professional standards relating to objectivity or whether their internal policies achieve the same objectives.

The competence of internal audit function can be determined by assessing the following factors: • Whether the IAF is adequately and appropriately resourced relative to the size of the 17-68 Copyright ©2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

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• • •

•

7-8

entity and the nature of its operations.

Whether established policies for hiring, training, and assigning internal auditors to internal audit engagements exist.

Whether the internal auditors have adequate technical training and proficiency in auditing. (e.g., the internal auditors’ possession of a relevant professional designation and experience).

Whether the internal auditors possess the required knowledge relating to the entity’s financial reporting and the applicable financial reporting framework and whether the IAF possesses the necessary skills to perform work related to the entity’s financial statements.

Whether the internal auditors are members of relevant professional bodies that oblige them to comply with the relevant professional standards, including continuing professional development requirements.

The steps in the top-down, risk-based approach to obtaining an understanding of ICFR include: • Identify entity-level controls – Because these controls have a pervasive effect on ICFR, the auditor needs a thorough understanding of entity-level controls. The two major categories of controls included here are: (1) the control environment and (2) the period-end financial reporting process.

• Identify significant accounts and disclosures and their relevant assertions - To complete this step, the auditor evaluates risk factors related to the financial statement accounts and disclosures. The risk factors include: • Size and composition of the account.

• Susceptibility to misstatement due to errors or fraud.

• Volume of activity, complexity, and homogeneity of the individual transactions processed through the account or reflected in the disclosure.

• Nature of the account or disclosure.

• Accounting and reporting complexities associated with the account or disclosure.

• Exposure to losses in the account.

• Possibility of significant contingent liabilities arising from the activities reflected in the account or disclosure.

• Existence of related-party transactions in the account.

• Changes from the prior period in account or disclosure characteristics.

• Understand likely sources of misstatement – In order to complete this step, the auditor needs to do the following: • Understand the flow of transactions related to the relevant assertions.

• Identify the points within the entity's processes at which a misstatement – including a misstatement due to fraud – could arise that, individually or in combination with other misstatements, would be material.

• Identify the controls that management has implemented to address these potential misstatements.

• Identify the controls that management has implemented over the prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could result in a material misstatement of the financial statements.

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•

Select controls to test – Table 7-4 shows factors the auditor should consider when identifying controls to test.

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7-9

The period-end financial reporting process controls include procedures used to enter transaction totals into the general ledger; initiate, authorize, record, and process journal entries in the general ledger; record recurring and nonrecurring adjustments to the annual and quarterly financial statements; and draft annual and quarterly financial statements and related disclosures.

The auditor’s evaluation of the period-end financial reporting process includes the inputs, procedures performed, and outputs of the processes the company uses to produce its annual and quarterly financial statements. The auditor should also consider the extent of IT involvement in each period-end financial reporting process element, who participates from management, the number of locations involved, types of adjusting entries, and the nature and extent of the oversight of the process by appropriate parties, including management, the board of directors, and the audit committee.

7-10

Walkthroughs help the auditor to confirm his or her understanding of control design and transaction process flow, to determine whether all points at which misstatements could occur have been identified, to evaluate the effectiveness of the design of controls, and to confirm whether controls have been placed in operation. Walkthroughs typically do not provide evidence of the operating effectiveness of controls. A typical walkthrough involves observation, inquiry, and inspection of documents.

7-11

The circumstances that should be regarded as indicators of a material weakness include (see Table 7-7): • Identification of fraud, whether or not material, on the part of senior management.

• Restatement of previously issued financial statements to reflect the correction of a material misstatement.

• Identification by the auditor of a material misstatement of financial statements in the current period in circumstances that indicate that the misstatement would not have been detected by the entity's internal control over financial reporting.

• Ineffective oversight of the entity's external financial reporting and internal control over financial reporting by the entity's audit committee.

These circumstances are ―red flags‖ for potential problems in the control environment.

Because the nature of the audit report depends on the significance of such weaknesses, the PCAOB does not want them to be overlooked.

7-12

Remediation is when an entity determines that it has a material weakness and takes steps to correct it. If management corrects a material weakness before the ―as of‖ date, and both management and the auditor can adequately test the operating effectiveness of the control, management can assert that ICFR is effective because it will be effective as of the financial reporting date.

7-13

AS 2201 requires that the auditor appropriately document the processes, procedures, judgments, and results relating to the audit of internal control. The auditor’s documentation must include the auditor’s understanding and evaluation of the design of

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each of the components of the entity's ICFR. The auditor also documents the process used to determine, and the points at which misstatements could occur within, significant accounts, disclosures, and major classes of transactions. The auditor must justify and document the extent to which he or she relied upon work performed by others. Finally, the auditor must describe the evaluation of any deficiencies discovered as well as any other findings that could result in a modification to the auditor's report.

7-14

The auditor’s unqualified opinion on the effectiveness of an entity’s internal control signifies that the entity’s internal control is designed and operating effectively in all material respects. Significant deficiencies relate to possible financial statement errors that are less than material, and therefore do not require a departure from an unqualified opinion. A serious scope limitation requires the auditor to disclaim an opinion. An adverse opinion is required if a material weakness is identified. Figure 7-4 illustrates the types of auditor’s reports and the circumstances leading to each.

7-15

The auditor will issue an adverse opinion on the effectiveness of internal control if a material weakness is identified.

7-16

If the scope of the auditor’s work is limited, the auditor may disclaim an opinion, depending on the severity of the limitation and whether or not management intentionally imposes it.

7-17

When a significant period of time has elapsed between the time period covered by the tests of controls in the service auditor's report and the date of management's assessment, additional procedures should be performed. The auditor should consider the results of relevant procedures performed by management or the auditor, how much time has passed since the service auditor's report, the significance of the activities of the service organization, whether errors have been identified in the service organization's processing, and the nature and significance of any changes in the service organization's controls. As these factors increase in significance, the need for the auditor to obtain additional evidence increases.

7-18

Generalized audit software (GAS) is generic software available for purchase by the general public and includes programs that allow the auditor to perform tests on computer files and databases. GAS enables auditors to conduct similar computer-assisted audit techniques in different IT environments. Alternatively, custom audit software is generally written by auditors for specific audit tasks. Such programs are necessary when the entity's computer system is not compatible with the auditor's GAS or when the auditor wants to conduct some testing that may not be possible with the GAS. Some functions that can be performed by GAS are: (1) file or database access, (2) selection of transactions that meet certain criteria, (3) arithmetic functions, (4) statistical analyses, (5) data integrity analyses, and (6) report generation.

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Answers to Multiple-Choice Questions 7-19 7-20 7-21 7-22 7-23 7-24 7-25 7-26

d b c c c b d d

7-27 7-28 7-29 7-30 7-31 7-32 7-33

c a c a c a d

Solutions to Problems 7-34 Control 1: Monthly Manual Reconciliation Nature, Timing, and Extent of Procedures Objective of the Test: To determine whether misstatements in accounts receivable (existence, valuation, and completeness) would be detected on a timely basis.

Test the company's reconciliation control by selecting a sample of reconciliations based upon the number of accounts, the dollar value of the accounts, and the volume of transactions affecting the account.

Perform the following tests on the reconciliation process: a. Make inquiries of personnel performing the control. Ask the employee performing the reconciliation the following questions: • What documentation describes the account reconciliation process?

• How long have you been performing the reconciliation work?

• What is the reconciliation process for resolving reconciling items?

• How often are the reconciliations formally reviewed and signed off?

• If significant issues or reconciliation problems are noticed, to whose attention do you bring them?

• On average, how many reconciling items are there?

• How are old reconciling items treated?

• If need be, how is the system corrected for reconciling items?

• What is the general nature of these reconciling items?

• Who performs this function when you are ill or on vacation? b. Observe the employee performing the control. For nonrecurring reconciling items, observe whether each item included a clear explanation as to its nature, the action that had been taken to resolve it, and whether it had been resolved on a timely basis. c. Reperform the control for two months by inspecting the reconciliations and 17-73 Copyright ©2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

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reperforming the reconciliation procedures. Scan through the file of all reconciliations prepared during the year and note whether they had been performed on a timely basis. d. Make inquiries of company personnel and determine that the reconciliation procedures have not changed from interim to year-end.

Control 2: Daily Manual Preventive Control Nature, Timing, and Extent of Procedures Objective of the Test: To determine whether misstatements in cash (existence) and accounts payable (existence, valuation, and completeness) would be prevented on a timely basis.

Test the control that a cash disbursement is made only after matching the invoice with the receiving report and purchase order.

Select 25 disbursements (voucher packages) from the cash disbursement registers from January through September. Perform the following procedures: a. Examine the invoice to see if it includes the signature or initials of the accounts payable clerk, evidencing the clerk's performance of the matching control. b. Reperform the matching control corresponding to the signature by examining the invoice to determine that (a) its items matched to the receiving report and purchase order and (b) it was mathematically accurate. c. Update the testing through the end of the year by asking the accounts payable clerk whether the control was still in place and operating effectively. Perform a walkthrough of one transaction in December.

Control 3: Programmed Preventive Control and Weekly Information TechnologyDependent Manual Detective Control Nature, Timing, and Extent of Procedures Objective of the Test: To determine whether misstatements in cash (existence) and accounts payable/inventory (existence, valuation, and completeness) would be prevented or detected on a timely basis.

Test the programmed application control of matching the receiving report, purchase order, and invoice as well as the review and follow-up control over unmatched items. To test the programmed application control, perform the following procedures: a. Identify, through discussion with company personnel, the software used to process receipts and purchase invoices. b. Determine, through further discussion with company personnel, that they do not modify the core functionality of the software, but sometimes make personalized changes to reports to meet the changing needs of the business. c. Establish, through further discussion, that the inventory module operated the receiving

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functionality, including the matching of receipts to open purchase orders. d. Identify, through discussions with the entity and review of the supplier's documentation, the names, file sizes (in bytes), and locations of the executable files (programs) that operate the functionality under review. e. Identify the objectives of the programs to be tested; i.e., whether appropriate items are received (for example, match a valid purchase order), appropriate purchase invoices are posted (for example, match a valid receipt and purchase order, non-duplicate reference numbers) and unmatched items (for example, receipts, orders or invoices) are listed on the exception report. f. Determine whether the programmed control is operating effectively by performing a walkthrough in the month of July.

Test the detect control and follow up on the Unmatched Items Report, by performing the following procedures in the month of July for the period January to July: a. Make inquiries of the employee who follows up on the weekly-unmatched items reports and determine why items appear on it. b. Observe the performance of the control. c. Reperform the control. d. Determine that the company had not made significant changes in its controls from interim to year-end by discussing with company personnel the procedures in place for making such changes.

NOTE: In answering Problems 7-35 and 7-36, you should refer to the Audit Policy of Willis & Adams LLP as part of the EarthWear Case on Evaluating Control Deficiencies. A copy of the policy can be downloaded from Connect. The decision chart is included here.

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Box 1. Does the deficiency relate directly to the achievement of one or more financial statement assertions?

NO

YES

Box 2. Is the likelihood of a misstatement resulting from the deficiency (or combination of deficiencies) at least reasonably possible?

NO

YES

Box 3. Is the magnitude of the potential deficiency material to either the interim or annual financial statements?

NO

Box 4. Is the deficiency (or combination of deficiencies) important enough to merit attention by those responsible for oversight of the company’s financial reporting?

NO

Deficiency

YES

YES

Box 5. Do compensating controls exist and operate effectively at a level of precision sufficient to prevent or detect a misstatement that could be material to interim or annual financial statements?

NO

YES

Box 6. Would a well-informed, competent and objective individual (i.e., prudent official) conclude the deficiency is a material weakness?

NO

Significant Deficiency

YES

Material Weakness

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7-35 a. Based only on these facts, this deficiency represents a significant deficiency for the following reasons: First, the deficiency satisfies Box 1 – it relates to a financial statement assertion. Second, the controls do not effectively address the detection of misstatements as evidenced by situations in which transactions that were not material were improperly recorded. Therefore, there is a reasonable possibility that a misstatement could occur. Thus, the answer to Box 2 is ―yes.‖ In addressing Box 3, the magnitude of a financial statement misstatement resulting from this deficiency would reasonably be expected to be significant but not material because individual sales transactions are not material. Furthermore, the risk of material misstatement is limited to revenue recognition errors related to shipping terms as opposed to broader sources of error in revenue recognition. Thus, the answer to Box 3 is ―no.‖ Because the misstatements that could occur from this deficiency are significant, the answer to Box 4 is ―yes.‖ However, the possible misstatements are not material so the answer to Box 6 is ―no,‖ leading to a conclusion of a significant deficiency. It should be noted that there is a compensating detective controls that operates monthly and at the end of each financial reporting period that should reduce the likelihood of a material misstatement going undetected. However, the compensating detective controls are only designed to detect material misstatements. b. Based only on these facts, this deficiency represents a material weakness for the following reasons: First, the deficiency satisfies Box 1 – it relates to a financial statement assertion. Second, the controls do not effectively address the detection of misstatements as evidenced by improper revenue recognition that has occurred.

Therefore, the likelihood of material misstatements occurring is probable. Thus, the answer to Box 2 is ―yes.‖ The answer to Box 3 is ―yes‖ since the magnitude of a financial statement misstatement resulting from this deficiency would reasonably be expected to be material. Individual sales transactions are frequently material and gross margin can vary significantly with each transaction. The answer to Box 5 is ―no‖ since the compensating detective controls based on a reasonableness review are ineffective. Taken together, the magnitude and likelihood of misstatement of the financial statements resulting from this internal control deficiency meet the definition of a material weakness (Box 6). c. Based on only these facts, this deficiency represents a material weakness for the following reasons: First, the deficiency satisfies Box 1 – it relates to a financial statement assertion. Second, the likelihood of material misstatement of the financial statements resulting from this internal control deficiency is reasonably possible (even assuming that the amounts were fully reserved for in the company's allowance for uncollectible accounts) due to the likelihood of material misstatement of the gross accounts receivable balance (Box 2 is answered ―yes‖). The magnitude of a financial statement misstatement resulting from this deficiency would reasonably be expected to be material, because the frequency of occurrence allows insignificant amounts to become material in the aggregate (Box 3 is answered ―yes‖). The answer to Box 5 is ―yes‖ since there are no compensating controls present. It is concluded that a prudent

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official would deem this deficiency to be a material weakness (answer to Box 6 is ―yes‖).

7-36 a. Based only on these facts, the combination of these significant deficiencies represents a material weakness for the following reasons: First, the deficiency satisfies Box 1 – it relates to a financial statement assertion. Second, the combination of these deficiencies was evaluated as representing a reasonably possible likelihood that a misstatement could occur (Box 2 is answered ―yes‖). Third, the gross amount of the transactions totaled an amount greater than materiality, so Box 3 is answered ―yes.‖ Fourth, there are no effective compensating controls, i.e., no timely reconciliations (Box 5 is answered ―no‖). Finally, it is likely that a prudent official would conclude that these deficiencies represent a material weakness (answer to Box 6 is ―yes‖). b. Based only on these facts, the auditor should determine that the combination of these significant deficiencies represents a material weakness for the following reasons: First, the deficiency satisfies Box 1 – it relates to a financial statement assertion. Second, the combination of these deficiencies was evaluated as representing a reasonably possible likelihood that a misstatement could occur (Box 2 is answered ―yes‖). Third, the balances of the loan accounts affected by these deficiencies have increased over the past year and are expected to increase in the future. In addition, the growth in loan balances, coupled with the combined effect of the deficiencies described, results in a reasonably possible likelihood that a material misstatement of the allowance for credit losses or interest income could occur. Thus, Box 3 is answered ―yes.‖ Fourth, there are no effective compensating controls (Box 5 is answered ―no‖). Finally, it is likely that a prudent official would conclude that these deficiencies represent a material weakness (answer to Box 6 is ―yes‖).

7-37

(Note that these cases were taken from disclosures made by companies subject to SOX 404.) a. Case 1 would be deemed a material weakness because the company did not have proper controls over the accounting for and disclosure of derivatives that were associated with warrants. The company’s management acknowledged that it did not have the expertise within the company to properly evaluate the analysis of the warrants under ASC 815. The inability to perform such analysis by entity personnel would suggest that there is a high likelihood that a material misstatement could occur since we can assume that this financial statement account (and it related disclosures) are highly material. b. Case 2 is a material weakness because management acknowledges that its controls over the preparation of the tax provision was not adequate, and resulted in what can be assumed to be material errors. Without proper controls, there is a high likelihood that a misstatement can occur. It is also likely that the tax provision and related accounts are material to the financial statements. c. Case 3 is a material weakness for a number of reasons. First, there was a computational error in the update of the calculation of the allowance for loan losses.

Second, the monitoring controls for reviewing the calculation did not identify the

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error in a timely manner. Finally, an error did occur and the allowance for loan losses account for a bank would be highly material.

7-38 a. If the misstatement resulted in a restatement of the financial statements, the misstatement would likely be considered material. Material misstatements are strong indicators of material weaknesses, thus necessitating an adverse opinion. b. If other controls over financial reporting are present, the auditor may issue an unqualified opinion. However, in most cases when oversight is considered seriously deficient, an adverse opinion would be issued. c. The auditor would most likely issue an adverse opinion because of the importance of the audit committee in the control process. d. If the ineffective monitoring component is a material weakness, then an adverse opinion should be issued. Because the auditor determined that an effective internal audit function was critical to effective monitoring, an adverse opinion would most likely be considered appropriate. e. The significance of financial fraud by the CFO is a material weakness and an adverse opinion should be issued. f. Depending on the amount of risk of material misstatement due to the ineffective control environment, the auditor will issue an adverse opinion or an unqualified opinion. In most cases, an ineffective control environment will result in an adverse opinion because it is considered a pervasive entity-level control. g. Given the lack of management’s concern for internal control, which can be considered a control environment issue, an adverse opinion would most likely be issued, depending on the nature and severity and the combined effect of the significant deficiencies that were left uncorrected.

7-39 a. The auditor would most likely issue an unqualified opinion on the effectiveness of internal control. Significant deficiencies do not necessitate an adverse opinion. In this case, the likelihood is extremely low that the deficiencies taken individually or together will result in a material misstatement, meaning that there is no material weakness. If the significant deficiencies remain uncorrected in future years, the auditor may conclude that management’s attitude toward internal control reflects a poor control environment and may issue an adverse opinion in that future period. b. A disclaimer of opinion on the effectiveness of internal control because the auditor has a scope limitation. The auditor must have sufficient appropriate evidence to conclude that the entity’s ICFR is effective—surmising based on partial results does not constitute a high level of assurance.

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c. Unqualified opinion on the effectiveness of internal control. The audit of internal control is ―as of‖ the report date. In other words, so long as the auditor has sufficient evidence that the entity’s internal control was operating effectively as of the end of the reporting period, an unqualified opinion can be expressed. This gives management an opportunity to remediate weaknesses and avoid an adverse opinion so long as enough time is left for management to reassess and for the auditor to retest controls and obtain sufficient competent evidence that controls were effective as of the report date. d. An adverse opinion with respect to effectiveness of ICFR. The presence of a material weakness as of the report date necessitates an adverse opinion with respect to internal control. e. The auditor would most likely issue a disclaimer on the effectiveness of internal control due to a scope limitation. The auditor’s inability to collect sufficient data to assess the operating effectiveness of the control constitutes a scope limitation, and the opinion should be modified accordingly. However, after the auditor completes testing in the following year and if controls were found to be operating effectively, an interim report on the effectiveness of internal controls could be issued. f. Adverse opinion on the effectiveness of internal control. Because the significant deficiencies identified, taken together, produce a ―moderately low‖ risk of material misstatement in the financial statements, this likelihood assessment is within the range of ―reasonably possible,‖ and thus, this combination of deficiencies is considered a material weakness.

7-40 a. As long as the auditor agrees with company’s assessment of controls, an unqualified report can be issued. However, AS 2201 indicates that controls must operate for a sufficient time period to accommodate management and auditor testing. This does not appear to be possible in the scenario when the changes were made after management’s assessment. The auditor should explicitly disclaim any opinion with respect to the information about corrective actions and plans to implement new controls as disclosed by management. However, after the auditor completes testing in the following year and if controls were found to be operating effectively, an interim report on the effectiveness of internal controls could be issued. b. The auditor should issue an adverse opinion if he or she does not believe sufficient time has passed to gather sufficient, competent evidence that the control deficiencies have been corrected. However, after the auditor completes testing in the following year and if controls were found to be operating effectively, an interim report on the effectiveness of internal controls could be issued.

7-41

The audit report should describe the reason for the material weakness. An example can be found in Exhibit 7-6.

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7-42

The audit report should include the proper title; introductory, scope, definition, limitations, and opinion paragraphs; and should describe the reason for the material weakness. The combined report would be similar to the report in Exhibit 7-5 except that the material weakness explanatory paragraph would be added and the opinion paragraph would be modified to reflect the adverse opinion over ICFR similar to Exhibit 7-6.

7-43

The auditors' report on ICFR would be prepared similar to Exhibit 7-6 for the opinion section because the auditor will issue an adverse opinion over ICFR. The remainder of the report would reflect Exhibit 7-4 as it is a separate report from the report on the financial statements.

7-44

a. 2 b. 4 c. 1

7-45 The substantive auditing procedures Brown may consider performing include the following: Using the perpetual inventory file: • Recalculate the beginning and ending balances (prices x quantities), foot, and print out a report to be used to reconcile the totals with the general ledger (or agree beginning balance with the prior year's working papers).

• Calculate the quantity balances as of the physical inventory date for comparison to the physical inventory file. (Alternatively, update the physical inventory file for purchases and sales from January 6 to January 31, for comparison to the perpetual inventory at January 31, 2021.)

• Select and print out a sample of items received and shipped for the periods (1) before and after January 5 and January 31, 2021, for cutoff testing, (2) between January 5 and January 31, 2021, for vouching or analytical procedures, and (3) prior to January 5, 2021, for tests of details or analytical procedures.

• Compare quantities sold during the year to quantities on hand at year-end. Print out a report of items for which turnover is less than expected. (Alternatively, calculate the number of days' sales in inventory for selected items.)

• Select items noted as possibly unsalable or obsolete during the physical inventory observation and print out information about purchases and sales for further consideration.

• Recalculate the prices used to value the year-end FIFO inventory by matching prices and quantities to the most recent purchases.

• Select a sample of items for comparison to current sales prices.

• Identify and print out unusual transactions. (These are transactions other than purchases or sales for the year, or physical inventory adjustments as of January 5, 2021.)

• Recalculate the ending inventory (or selected items) by taking the beginning balances plus purchases, less sales (quantities and/or amounts), and print out the differences.

• Recalculate the cost of sales for selected items sold during the year.

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Using the physical inventory and test count files: • Account for all inventory tag numbers used and print out a report of missing or duplicate numbers for follow-up.

• Search for tag numbers noted during the physical inventory observation as being voided or not used.

• Compare the physical inventory file to the file of test counts and print out a report of differences for the auditor follow-up.

• Combine the quantities for each item appearing on more than one inventory tag number for comparison to the perpetual file.

• Compare the quantities in the file to the calculated quantity balances in the perpetual inventory file as of January 5, 2021. (Alternatively, compare the physical inventory file updated to year-end to the perpetual inventory file.)

• Calculate the quantities and dollar amounts of the book-to-physical adjustments for each item and the total adjustment. Print out a report to reconcile the total adjustment to the adjustment recorded in the general ledger before year-end.

• Using the calculated book-to-physical adjustments for each item, compare the quantity and dollar amount of each adjustment to the perpetual inventory file as of January 5, 2021, and print out a report of differences for follow-up.

INTERNET ASSIGNMENTS 7-46 The opinion paragraph of the audit report will indicate whether the report is a separate report or a combined report for both audits. Note that even separate reports on each of the audits (of financial statements and ICFR) will refer to the opinion issued on the other audit.

7-47 The opinion paragraph of an audit report for ICFR will provide the definition of a material weakness and will describe the particular material weakness(es) resulting in the adverse opinion.

CHAPTER 8 AUDIT SAMPLING: AN OVERVIEW AND APPLICATION TO TESTS OF CONTROLS Answers to Review Questions 8-1

Audit sampling is the application of audit procedures to less than 100 percent of the items in a population of audit relevance selected in such a way that the auditor expects the sample to be representative of the population and thus likely to provide a reasonable basis for conclusions about the population. When the number of items or transactions in these populations is large and the items cannot be tested via computer assisted audit techniques or audit data analytics (e.g., physical examination, confirmations), it is not economical for auditors to test 100 percent for the population; instead they use sampling to gather sufficient audit evidence. The justification for accepting some uncertainty from sampling is due to the trade-off between the cost to examine all of the data and the cost of making

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an incorrect decision based on a sample of the data.

8-2

Type I and Type II errors are the two types of decision errors an auditor can make when deciding that sample evidence supports or does not support a test of controls or a substantive test based on a sampling application.

In reference to test of controls, Type I and Type II errors are: • Risk of incorrect rejection (Type I): the risk that the assessed level of control risk based on the sample is greater than the true operating effectiveness of the control. Also commonly referred to as the risk of assessing control risk too high or the risk of underreliance.

• Risk of incorrect acceptance (Type II): the risk that the assessed level of control risk based on the sample is less than the true operating effectiveness of the control. Also commonly referred as the risk of assessing control risk too low or the risk of overreliance.

In reference to substantive tests, Type I and Type II errors are as follows: • Risk of incorrect rejection (Type I): the risk that the sample supports the conclusion that the recorded account balance is materially misstated when it is not materially misstated.

• Risk of incorrect acceptance (Type II): the risk that the sample supports the conclusion that the recorded account balance is not materially misstated when it is materially misstated.

The risk of incorrect rejection (Type I) relates to the efficiency of the audit because such errors can result in the auditor’s conducting more audit work than necessary in order to reach the correct conclusion. The risk of incorrect acceptance (Type II) relates to the effectiveness of the audit because such errors can result in the auditor failing to detect a material misstatement in the financial statements. This can lead to litigation against the auditor by parties who relied on the financial statements.

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8-3

Audit evidence types that do not involve audit sampling include: • Analytical procedures • Scanning • Inquiry • Observation Examples of situations where audit sampling would not be used include: • Procedures applied to every item in the account or population (typically due to a small number of large items) • Classes of transactions or account balances not tested • Tests of automated information technology controls

8-4

Nonstatistical sampling is an approach in which the auditor uses a haphazard selection technique or uses judgment in any or all of the following steps: • Determining the sample size • Selecting the sample • Calculating the computed upper deviation rate Nonstatistical sampling doesn’t require the use of statistical theory to determine sample size or in the evaluation of sampling risk, although auditing standards require the extent of testing to be comparable for both types of sampling. Statistical sampling uses the laws of probability to determine sample size, randomly select sampling units, and to evaluate the results of an audit sample. The use of statistical theory permits the auditor to quantify the sampling risk for the purpose of reaching a conclusion about the population.

The major advantages of a statistical sampling application are that it helps the auditor (1) design an efficient sample, (2) measure the sufficiency of evidence obtained, and (3) quantify sampling risk. The disadvantages of statistical sampling include the additional costs of (1) training auditors in the proper use of sampling technique, (2) added complexity in designing and conducting the sampling application, and (3) lack of consistent application across audit teams due to the complexity of the underlying concepts.

An advantage of nonstatistical sampling, particularly for large firms, which is indirectly a disadvantage of a statistical sampling tool like IDEA, is that with a nonstatistical approach a firm can develop firm-specific sampling tools and templates that are based on the knowledge and expertise of national sampling experts. The tools and templates then leverage the expertise of specialists and can make decisions and application associated with audit sampling easier to use and the judgments more consistent for auditors in the field.

8-5

Attribute sampling is used to estimate the proportion of a population that possesses a specified characteristic. For tests of controls, the auditor wants to measure the proportion of a population that possesses a specified characteristic (i.e., a deviation from the control process) to determine whether the control procedure can be relied upon to properly process accounting transactions and therefore support the auditor’s assessed level of control risk.

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8-6

The timing of testing often will determine the period to be covered by the test. For example, interim testing may involve testing transactions from the first nine months of the year. After the population has been defined, (1) the auditor must determine that the physical representation of the population is complete, and (2) if the testing was conducted at an interim date, whether to conduct additional tests in the remaining period.

8-7

The four factors that enter into the sample size decision and their relationship with sample size are:

Factor

Relationship to Sample Size

Desired confidence level

Direct

Tolerable deviation rate

Inverse

Expected population deviation rate

Direct

Population size

Decreases sample size only when population size is small (<1,000 items)

8-8

In conducting the audit procedures for tests of controls, the auditor may encounter voided, inapplicable, or missing documents. The auditor may also stop the test before completion.

Each of these situations should be handled in the following manner for an attributesampling application: • Voided documents: If the transaction has been properly voided, it does not represent a deviation. The item should be replaced with a new sample item.

• Unused or inapplicable documents: Sometimes a selected item is not appropriate for the definition of the control. In such a case, the item is not a deviation and the auditor would simply replace the item with another purchase transaction.

• Missing documents: If the auditor is unable to examine a document or use an alternative procedure to test whether the control was adequately performed, the sample item is a deviation for purposes of evaluating the sample results.

• Stopping the test before completion: If a large number of deviations are detected early in the tests of controls, the auditor should consider stopping the test as soon as it is clear that the results of the test will not support the planned assessed level of control risk. The client should be informed and the exceptions would be considered a control deficiency unless remediation and retesting are successful.

8-9

The auditor’s purposes in evaluating the qualitative aspects of deviations when performing error analysis involves considering (1) the nature of the deviations and their causes and (2) how these deviations may impact the other phases of the audit.

8-10 An auditor using nonstatistical sampling uses judgment to consider the allowance for sampling risk. For example, when the rate of deviation from the prescribed control exceeds the expected rate used to plan the sample, the auditor usually concludes that there is unacceptably high sampling risk and he or she would typically increase the assessed 17-85 Copyright ©2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

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level of control risk or consider further whether to rely at all on the control.

Answers to Multiple-Choice Questions 8-11 8-12 8-13 8-14 8-15

c a a c a

8-16 8-17 8-18 8-19 8-20

b b d d c

Solutions to Problems 8-21 a. The auditor’s justification for accepting the uncertainties that are inherent in the sampling process are based upon the premise that (1) the cost of examining all of the financial data would usually outweigh the benefit of the added reliability of a complete (100%) examination and (2) the time required to examine all of the financial data would usually preclude issuance of a timely auditor’s report. b. The uncertainties inherent in applying auditing procedures are collectively referred to as audit risk. Audit risk is the risk that the auditor may unknowingly fail to appropriately modify the opinion on financial statements that are materially misstated.

Audit risk can be controlled through the scope of the auditor’s test procedures with the audit risk model providing a framework to follow. Detection risk, which is a component of the audit risk model, is composed of two risks or uncertainties: sampling risk and nonsampling risk. c. Sampling risk arises from the possibility that, when a test of controls or a substantive test is restricted to a sample, the auditor’s conclusions may be different from the conclusions he or she would reach if the test were applied in the same way to all items in the population.

Nonsampling risk includes all the aspects of audit risk that are not due to sampling and can occur because the auditor used an inappropriate audit procedure, failed to detect a misstatement when applying an appropriate audit procedure, or misinterpreted an audit result.

When performing a test of controls, the auditor can commit two types of decision errors: (1) the risk of incorrect rejection or of assessing control risk too high, which is the risk that the assessed level of control risk based on the sample is greater than the true operating effectiveness of the control and (2) the risk of incorrect acceptance or of assessing control risk too low, which is the risk that the assessed level of control risk based on the sample is less than the true operating effectiveness of the control.

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8-22 a 6, b 5, c 7, d 1, e 4, f 2, g 3 8-23 1. In this scenario, the stratum of loans greater than $1 million is tested in total. Since the entire population is tested, it does not involve sampling. Sampling is involved in the second stratum because the auditor is only examining 15 of the 450 loans in the stratum.

2. If the analytical procedures used do not include statistical techniques based on a sample (e.g., regression analysis using a subset of data), then the use of analytical procedures does not involve sampling.

3. Since the auditor has haphazardly selected less than 100% of the population’s transactions, sampling is involved in such a test.

4. In this case, the auditor has decided not to audit the account because it is immaterial.

This approach does not involve sampling.

8-24 a. Table 8-2 provides 7 steps in attribute sampling. The list in Table 8-2 includes Jenny’s step 3 within the second step of attributes sampling. The remaining steps of attribute sampling are as follows: 2. Define remaining population characteristics—define the control deviation conditions.

3. Determine sample size, using the following inputs.

• Determine the desired confidence level.

• Determine the tolerable deviation rate.

• Determine the expected population deviation rate.

4. Select sample items.

5. Perform the audit procedures—understand and analyze any deviations observed.

6. Calculate the sample deviation and computed upper deviation rates.

7. Draw final conclusions. b. The advantages of using a statistical sampling methodology are that it helps the auditor (1) design an efficient sample, (2) measure the sufficiency of the evidence obtained, and (3) quantify sampling risk. By using a statistical sampling methodology, the auditor can limit sampling risk to an acceptable level.

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8-25 The sample size for each control procedure is: Control Procedure Parameters

1

2

3

4

Risk of incorrect acceptance

5%

5%

10%

10%

Tolerable deviation rate

4%

5%

7%

8%

Expected population deviation rate

1%

2%

3%

4%

Sample size (using tables)

156

181

94

98

Sample size (using IDEA, large population of 100,000 items)

156

181

94

98

8-26 The computed upper deviation rate and the auditor’s decision for each control procedure are: Control Procedure Results Using Tables 1

2

Number of deviations

3

4

0

5

4

3

Sample size

156

181

94

98

Sample deviation rate

0.0

2.8

4.3

3.1

Computed upper deviation rate

2.0

6.9 Does not support

8.7 Does not support

7.3

Auditor’s decision

Does Support

Does Support

Control Procedure Results Using IDEA (large population of 100,000 items) Number of deviations

1

2

3

4

0

5

4

3

Sample size

156

181

94

98

Sample deviation rate

0.0

2.8

4.3

3.1

1.9 Does Support

5.7 Does not support

8.3 Does not support

6.7 Does Support

1-Sided upper limit Auditor’s decision

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8-27 The sample size for each control procedure is: Control Procedure Parameters

1

2

3

4

Risk of incorrect acceptance

5%

5%

10%

10%

Tolerable deviation rate

6%

7%

4%

3%

Expected population deviation rate

2%

2%

.75%

0%

Sample size using tables

127

88

96

76

Sample size using IDEA (large population of 100,000 items)

127

88

96

76

8-28 The computed upper deviation rate and the auditor’s decision for each control procedure are: Control Procedure Results using Tables 1 Number of deviations

2

3

4

4

2

2

0

Sample size

127

88

96

76

Sample deviation rate

3.1

2.3

2.1

0.0

7.2 Does not support

7.7* Does Support

5.9 Does not support

3.3* Does Support

Computed upper deviation rate Auditor’s decision

* It appears that the computed upper deviation rate exceeds the tolerable deviation rate for both procedures 2 and 4. However, these results are obtained because the evaluation tables do not include evaluations for sample sizes of 88 and 76, and when rounded down to sample sizes of 80 and 70, respectively, the computed upper deviation rate of 7.7% and 3.3% exceed the tolerable deviation rate. In reality, because a statistically derived sample size was determined in problem 8-27 and because the allowed number of deviations was found (see the number in parentheses in tables 8-5 and 8-6), the auditor is guaranteed that the results are acceptable. Note that when using IDEA, rounding is not a potential source for auditor error.

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Using the IDEA, the 1- sided upper limit and the auditor’s decision for each control procedure are: Control Procedure Results using IDEA (large population of 100,000 items) Number of deviations Sample size 1-sided upper limit Auditor’s decision

1

2

3

4

4

2

2

0

127

88

96

76

7.06 Does not support

6.98 Does support

5.45 Does not support

2.98 Does support

The evaluation using IDEA does lead to different upper limits and leads to clearer conclusions that control procedures 2 and 4 are acceptable. Because the tables require auditors to round sample size, the computed upper deviation rates derived from the tables seem to initially suggest that 2 and 4 are not acceptable (see note above). IDEA provides the advantage that exact sample sizes can be evaluated.

8-29 Austen’s conclusion on each item would be as follows: 1. The sample deviation rate is 1.3% (1  75). Since the sample deviation rate is less than the expected population deviation rate of 2%, the control can be relied upon.

2. The sample deviation rate is 3.3% (1  30). Since the sample deviation rate exceeds the expected population deviation rate of 2.5%, the control cannot be relied upon.

8-30 a. The allowance for sampling risk in this situation is the difference between the sample deviation rate 4% (6/150) and the computed upper deviation rate of 7.8%. Therefore, the allowance for sampling risk included in the computed upper deviation rate is 3.8% (7.8% - 4%). We can determine that the desired level of confidence for Nathan Matthews’s tests must have been 95% because we find an upper deviation rate of 7.8% associated with a sample size of 150 and 6 deviations in Table 8-8. b. (1) The tolerable deviation rate, 6%, is greater than the sample deviation rate, but is less than the computed upper deviation rate, 7.8%. Therefore, Matthews could increase the sample size and reevaluate the results based on the larger sample size before determining whether to adjust the preliminary control risk assessment.

(2) Matthews could increase control risk because the upper deviation rate exceeds the tolerable deviation rate and the sample deviation rate exceeds the expected deviation rate.

(3) Matthews could justify not adjusting the preliminary assessment because, even though the upper deviation rate exceeds the tolerable rate, the sample deviation rate from a relatively large sample is less than the tolerable rate and, upon further consideration, Matthews may determine that he can accept a higher tolerable rate than planned. However, he must recognize that this approach does not leave the allowance for sampling risk he originally planned. Looking at Table 8-5, we see that the original 17-90 Copyright ©2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

2023

sample size should have been 195 based on a tolerable deviation rate of 6% and an expected population deviation rate of 3%.

8-31 Iceberge’s conclusion on each item would be as follows: 1. The sample deviation rate is 2.0% (1  50). Since the sample deviation rate is less than the expected population deviation rate of 3%, the control can be relied upon.

2. The sample deviation rate is 4.0% (2  50). Since the sample deviation rate exceeds the expected population deviation rate of 3%, the control cannot be relied upon.

Solution to Discussion Case 8-32 The following are the incorrect assumptions and statements and inappropriate applications of attribute sampling in Baker’s procedures: • Statistical sampling does not eliminate the need for professional judgment.

• The tolerable deviation rate is too high (20%) if Baker plans to assess control risk at a low level.

• The increase in the population size has little or no effect on determining sample size.

• Baker failed to consider the risk of assessing control risk too low in determining the sample size.

• The population from which the sample was chosen (invoices) was an incorrect population.

• The sample was not randomly selected.

• Baker failed to consider the difference of an immaterial amount to be an error.

• The allowance for sampling risk was incorrectly calculated.

• Baker’s reasoning concerning the decision that the sample supported a low assessed level of control risk was erroneous.

CHAPTER 9 AUDIT SAMPLING: AN APPLICATION TO SUBSTANTIVE TESTS OF ACCOUNT BALANCES Answers to Review Questions 9-1

The steps in a statistical sampling application for substantive testing include (by phases): Planning 1. Determine the test objectives.

2. Define the population characteristics: o Define the population. o Define the sampling unit. o Define a misstatement.

3. Determine sample size, using the following inputs: o Desired confidence level or risk of incorrect acceptance. o Tolerable misstatement. o Expected misstatement.

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o Population size.

Performance 4. Select sample items.

5. Perform the audit procedures: o Understand and analyze any misstatements observed.

Evaluation 6. Calculate the projected misstatement and the upper limit on misstatement.

7. Draw final conclusions.

9-2

When monetary-unit sampling (MUS) is used, the sampling unit is defined as an individual monetary unit (e.g., a dollar or other forms of currency). When classical variables sampling is used, the sampling unit is a customer account, an individual transaction, or a line item on a transaction.

9-3

The following table shows how the desired confidence level, tolerable misstatement, expected misstatement, and population size are related to sample size:

9-4

Factor

Relationship to Sample Size

Desired confidence level

Direct

Tolerable misstatement

Inverse

Expected misstatement

Direct

Population size

Direct

The advantages and disadvantages of MUS are: Advantages: • When the auditor expects no misstatements, MUS will normally result in a smaller sample size than classical variables sampling.

• The calculation of sample size and the evaluation of the sample results are not based on the variation (that is, the standard deviation) between items in the population.

• MUS, when applied using a probability-proportional-to-size sample selection procedure as outlined in the text, automatically results in a stratified sample because sampled items are selected in proportion to their monetary amount.

Disadvantages: • Selection of a zero or negative balance generally requires special design consideration.

• When more than one or two misstatements are detected using a MUS approach, the sample results calculations may overstate the allowance for sampling risk.

9-5

Probability-proportional-to-size sample selection gives each individual dollar or monetary unit in the population an equal chance of being selected. Each selected dollar represents a 17-92 Copyright ©2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

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group of dollars (referred to as the sampling interval). The sampling interval is determined by dividing the book value of the population by the sample size. The advantage of using this approach to selecting the sample is that while each dollar in the population has an equal chance of being selected, logical units (e.g., customer accounts) containing more dollars have a higher probability of being selected. Note that all logical units with a book value larger than the sampling interval are certain to be selected using this method.

9-6

The decision rule for determining the acceptability of sample results when MUS is used compares the tolerable misstatement (TM) to the upper misstatement limit (UML). If UML is less than TM, the evidence supports the fair presentation of the account. If UML is greater than TM, the evidence does not support the fair presentation of the account balance.

9-7

Variation in the risk of incorrect acceptance, risk of material misstatement, and tolerable and expected misstatement affect sample size in a nonstatistical sampling application in the following way: • Desired confidence level: Direct-as the desired confidence level increases, the required sample size increases.

• Risk of material misstatement: Direct-as the risk of material misstatement increases, the required sample size increases.

• Tolerable misstatement: Inverse-as tolerable misstatement increases, sample size decreases.

• Expected misstatement: Direct-an increase in expected misstatement results in an increase in sample size.

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9-8

The AICPA’s audit guide describes two acceptable methods of projecting the amount of misstatement found in a nonstatistical sample, ratio projection and difference projection.

Ratio projection applies the misstatement ratio observed in the sample to the population.

Difference projection determines the average misstatement per item found in the sample and projects that using the number of items in the population.

These two methods of projecting misstatements give identical results if the sample includes the same proportion of items in the population as the proportion of the population’s recorded amount included in the sample. If the proportions are different, the auditor chooses between the two methods on the basis of his or her understanding of the magnitude and distribution of misstatements in the population. If the auditor expects that the amount of misstatement relates closely to the size of the item, ratio projection should be used. If the auditor expects the misstatements to be relatively constant for all items in the population, difference projection should be used.

9-9

The advantages and disadvantages of classical variables sampling are: Advantages: • When the auditor expects a relatively large number of differences between book and audited values, classical variables sampling will normally result in a smaller sample size than MUS. • Classical variables sampling techniques are effective for both overstatements and understatements. No special evaluation considerations are necessary if the sample data include both types of misstatements.

• The selection of a zero balance generally does not require special sample design considerations since the sampling unit will not be an individual dollar but rather an account, a transaction, or a line item.

Disadvantages: • When using the approach to evaluate likely misstatements in an account or population, some classical variables sampling techniques (e.g., difference estimation) do not work well when little to no misstatement is expected.

• In order to determine sample size, the auditor must estimate the standard deviation of the audited value or differences.

• If few misstatements are detected in the sample data, the true variance tends to be underestimated and the resulting projection of the misstatements to the population is not likely to be reliable.

9-10 The decision that the evidence supports or does not support the account balance using classical variables sampling is made by determining whether the upper and lower limits are within tolerable misstatement. If both limits are within the bounds of tolerable misstatement, the evidence supports the conclusion that the account is not materially misstated. If either limit is outside the bounds of tolerable misstatement, the evidence does not support the conclusion that the account is materially correct.

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Answers to Multiple-Choice Questions 9-11 9-12 9-13 9-14 9-15

d d b a c

9-16 9-17 9-18 9-19 9-20

b a a c c

Solutions to Problems 9-21

a. The advantages of MUS over classical variables sampling are as follows: • MUS is generally easier to use than is classical variables sampling.

• The calculation of sample size in a MUS sample is not based on an estimate of the standard deviation in the population.

• MUS in conjunction with probability-proportional-to-size selection results in a stratified sample.

• Individually significant items are automatically identified.

• If no misstatements are expected, MUS will usually result in a smaller sample size than classical variables sampling. b. Using Table 8-5 in the text with a desired confidence level = 95%; tolerable misstatement = 5% ($15,000  $300,000); and expected misstatement = 2% ($6,000  $300,000); the sample size is equal to 181 items. The sampling interval is $1,657 ($300,000  181).

Using IDEA with a Desired Confidence Level = 95%; Value of the Sampled Population = $300,000; Tolerable Error = $15,000; and Expected Error = $6,000; the sample size is equal to 157 items. The sampling interval is $1,910.83.

The output from IDEA is provided below:

c. The total projected misstatement for the three misstatements identified is calculated 17-95 Copyright ©2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

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by first computing the tainting factor as follows: Misstatement Number

Book Value

Audit Value

Tainting Factor

1

$400

$320

2

500

0

3

3,000

.20

1.00 2,500 Not applicable, since book value exceeds sampling interval.

The upper misstatement limit is calculated as follows: Misstatement Number

Basic Precision 2 1 Add misstatements detected in logical units greater than the sampling interval:

Tainting Factor

Sampling Interval

1.0

NA

1.0 .20

$1,65 7 1,657 1,657

95% Misstatement Factor or Increment (from Table 9-3) 3.0

1,657 331

1.7 (4.7 - 3.0) 1.5 (6.2 - 4.7)

2,817 497

NA

1,657

500

NA

500

Upper Misstatement Limit

$8,785

Projected Misstatement (column 2 x 3)

Upper Misstatement Limit (column 2 x 3 x 5) $4,971

Misstatem ent 3

NA—Not Applicable

Since the UML ($8,785) is less than the TM ($15,000), the evidence supports the fair presentation of the account balance.

Using IDEA and the IDEA sample size calculated in part (b), the Upper Error Limit is $9,655.64 and the Most Likely Error is $2,611.46. Since the Upper Error Limit is less than the TM ($15,000), the evidence supports the fair presentation of the account balance. The results are based on ―Low Error Rate‖ method with all errors included in one data file.

The output from IDEA is provided below:

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The warning at the bottom of the screen refers to the way ―High Value‖ items are handled in the evaluation. For very large items that can be selected multiple times when using the sampling interval and systematic selection, IDEA’s technical literature provides alternative approaches to handle such situations. Additional examples of applying IDEA in MUS evaluation are included in the Chapter 9 IDEA problems found in Connect. Also, please note that if students use IDEA to calculate the sample size and sampling interval but then calculate the UML by hand using the taint approach, the calculated UML will differ slightly from both solutions shown above.

9-22

a. Using Table 8-5 with a desired confidence level = 95% (risk of incorrect acceptance = 5%); tolerable misstatement = 5% ($212,500  $4,250,000); expected misstatement = 1.5% ($63,750  $4,250,000); the sample size is equal to 124. The sampling interval is $34,274 ($4,250,000  124).

Using IDEA with a Desired Confidence Level = 95%; Value of Sampled Population = $4,250,000; Tolerable Error = $212,500; and Expected Error = $63,750; the sample size is 116 items and the sampling interval is $36,637.93. Note: Remember to uncheck the box ―Use values from database field‖ if it is checked.

The output from IDEA is provided below:

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b. The upper misstatement limit is calculated as follows: Overstatement Errors Error Number

Book Value

Audit Value

1

6,000

1,000

.833

2

24,000

9,000

.625

3

55,000

5,000

Not applicable, since the book value exceeds the sampling interval.

Error Number

Basic Precision

Tainting Factor

Sampling Interval

1.0

$34,2 74 34,27 4 34,27 4

1

.833

2

.625

Tainting Factor

95% Misstatement Factor or Increment (from Table 9-3) 3.0

Upper Misstatement Limit (column 2 x 3 x 5) $102,822

28,550

1.7 (4.7 - 3.0)

48,535

21,421

1.5 (6.2 - 4.7)

32,132

50,000

NA

50,000

Projected Misstatement (column 2 x 3) NA

Add misstatements detected in logical units greater than the sampling interval: Error 3 NA

34,27

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4 Upper Misstatement Limit

$233,489

NA—Not Applicable

Since the UML ($233,489) is more than the TM ($212,500), Zhu cannot accept the inventory account as being fairly stated since there is more than a 5 percent risk that the account contains a misstatement greater than $212,500.

Using IDEA and the sample size calculated by IDEA in part (a), the Upper Error Limit is $220,165.53 and the Most Likely Error is $86,737.

The output from IDEA is provided below:

To compute the upper error limit in IDEA, follow the steps outlined in the Chapter 9 IDEA problems and solutions available on the book’s online learning center, McGraw Hill Connect. The warning at the bottom of the screen refers to the way ―High Value‖ items are handled in the evaluation. For very large items that can be selected multiple times when using the sampling interval and systematic selection, IDEA’s technical literature provides alternative approaches to handle such situations. Additional examples of applying IDEA in MUS evaluation are included in the Chapter 9 IDEA problems found on Connect.

Since the UML ($220,165.53) is more than the TM ($212,500), Zhu cannot accept the inventory account as being fairly stated since there is more than a 5 percent risk that the account contains a misstatement greater than $212,500. Also, please note that if 17-99 Copyright ©2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

2023

students use IDEA to calculate the sample size and sampling interval but then calculate the UML by hand using the taint approach, the calculated UML will differ slightly from both solutions shown above.

9-23

a. Using Table 8-5 with a desired confidence level of 95% (risk of incorrect acceptance = 5%); tolerable misstatement = 4% ($360,000  $9,000,000); expected misstatement = 1% ($90,000  $9,000,000); the sample size is equal to 156. The sampling interval is $57,692 ($9,000,000  156).

Using IDEA with a Desired Confidence Level = 95%; Value of Sampled Population = $9,000,000; Tolerable Error = $360,000; and Expected Error = $90,000; the sample size is equal to 128 items. The sampling interval is $70,312.50.

The output from IDEA is provided below:

b. The upper misstatement limit is calculated as follows: Overstatement Errors Error Number

Book Value

Audit Value

1

10,000

7,500

.25

2

9,000

6,000

.33

3

60,000

0

Not applicable, since the book value exceeds the sampling interval.

4

800

640

.20

Tainting Factor

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Error Number

Tainting Factor

Sampling Interval

Basic Precision 2

1.0

1

.25

4

.20

$57,6 92 57,69 2 57,69 2 57,69 2

.33

Projected Misstatement (column 2 x 3)

95% Misstatement Factor or Increment (from Table 9-3) 3.0

Upper Misstatement Limit (column 2 x 3 x 5) $173,076

19,038

1.7 (4.7 - 3.0)

32,365

14,423

1.5 (6.2 - 4.7)

21,635

11,538

1.4 (7.6 - 6.2)

16,153

60,000

NA

60,000

Upper Misstatement Limit

$303,229

NA

Add misstatements detected in logical units greater than the sampling interval: NA Error 3

57,69 2

NA—Not Applicable

Since the UML ($303,229) is less than the tolerable misstatement ($360,000), Nancy Van Pelt can accept the inventory account as being fairly stated since there is only a 5 percent risk that the account contains a misstatement greater than $360,000.

Using IDEA and the sample size calculated by IDEA in part (a), the Upper Error Limit is $383,790.13 and the Most Likely Error is $125,390.63. Note: To compute the Upper Error Limit, follow the steps outlined in the Chapter 9 IDEA problems and solutions available on the book’s online learning center, Connect. The solution assumes Low Error Rate and in this case there is no need for a separate IDEA data files for Higher Value or errors in items larger than the sampling interval, because there are none larger than the IDEA interval of $70,312.50.

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Since the Upper Error Limit ($383,790.13) is greater than the tolerable misstatement ($360,000), Nancy Van Pelt cannot accept the inventory account as being fairly stated based on the sample evidence. The difference in the evaluation between the manual calculation using the tables and IDEA is driven by the difference in the size of the sample tested and the size of the sampling interval. The larger sample size calculated per Table 8-5 gathers more evidence and results in a smaller sampling interval. The smaller sample suggested by IDEA results in a larger Upper error limit and a larger Basic Precision (IDEA refers to it as Total Precision). Mechanically, this problem also shows the influence of the size of the sampling interval. Because the $60,000 item is smaller than the sampling interval in the IDEA calculation, that error results in an error projection (most likely error) and contributes to the upper error limit or allowance for sampling risk more than just the known error in that sample item. On the other hand, when using the tables, the sample size is larger and the sampling interval is $57,692. As such, all items greater than the interval will be tested and therefore the known error associated with the $60,000 item is added to the UML, but it requires no additional margin for sampling risk when using the tables. Also, please note that if students use IDEA to calculate the sample size and sampling interval but then calculate the UML by hand using the taint approach, the calculated UML will differ slightly from both solutions shown above.

c. The calculation of the adjustment for the understatement errors is as follows: Understatement Errors Error Number

Book Value

Audit Value

Tainting Factor

5

6,000

6,500

-.083

6

750

800

-.067

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Adjustment for Understatement Errors Tainting Factor

Sampling Interval

Projected Misstatement

-.083

57,692

-4,788

-.067

57,692

-3,865

Adjustment to Most Likely Error -8,653 (and UML)* * As noted in the textbook, some auditors adjust down both the Most Likely Error and the UML. Note that IDEA reports both the unadjusted Gross Most Likely Error and the adjusted Net Most Likely Error. Similarly, IDEA reports both the Gross Upper Error Limit and the Net Upper Error Limit.

Using IDEA and the results from parts (a) and (b), the Gross Most Likely Error is $125,390.63 and the Net Most Likely Error is $114,843.75. The Gross Upper Error Limit is $383,790.13 and the Net Upper Error Limit is $373,243.25. Adjustment to the most likely error is -$10,546.88 ($125,390.63 - $114,843.75) and the same adjustment is made to the upper error limit.

The output from IDEA is provided below:

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9-24

a. Remove the 10 accounts greater than $50,000 (total value $750,000) from the sampling population because they will be the subject of 100% testing. Sample size is calculated as follows:   Sample Size= $4,750,000  1.2 = 57  $155,000 − 55,000   b. The projected misstatement for the accounts receivable account is:

Strata

Amount of Misstatement

Ratio of Misstatements in Stratum Tested

Projected Misstatement

>$50,000

$ 3,500

NA 100% of Strata Tested

$ 3,500

>$5,000

15,250

(15,250  910,000) × 3,000,000

50,275

<$5,000

1,550

(1,550  70,000) × 1,750,000

38,750

Total projected misstatement

$ 92,525

Since the projected misstatement, $92,525, is significantly greater than the expected misstatement, $55,000, Gren should conclude that there is an unacceptably high risk that the true misstatement exceeds the tolerable misstatement (i.e., must consider the original allowance for sampling risk of $100,000 ($155,000 – $55,000)).

9-25

a. The calculation of the sample size for Wang’s test of Cougar Goldust is: 2

=  4,000 x1.64 x 25  Sample size 35,000 - 10,000  = 43 .03, round to 44   b. The calculation of the sample results is as follows: The calculation of the mean misstatement per sampling item is: Mean Misstatement per sampling item =

Total audit difference Sample Size

=

400 = 4 100

Thus, the average misstatement in a bin based on the sample data is an overstatement of 4 ounces. Next, the mean misstatement is projected to the population: Projected population = Population size misstatement (in sampling units) 16,000 ounces

=

4,000

x

Mean misstatement per sampling item

x

4

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The allowance for sampling risk is represented by the confidence bound. To calculate the confidence bound, the auditor first calculates the standard deviation and then uses the equation shown below, using the CC value for the level of desired confidence.

SD =

Total squared audit difference - (sample size x mean difference per sampling item2 ) sample size - 1

SD =

17,856 - 100 (4)2 = 12.81 100 - 1

Confidencebound = N(CC)

SD

= 4,000 (1.64)

12.81

= 8, 403

where N = population size (in sampling units) n = sample size CC = Confidence Coefficient SD = Standard Deviation of Audit Differences For Cougar Goldust, the confidence bound is 8,403 ounces and the confidence interval is calculated as follows: Confidence interval = Projected population misstatement + Confidence bound =

16,000

+

8,403

Thus, the Confidence Interval has a lower limit of 7,597 ounces and an upper limit of 24,403 ounces. Since the upper and lower bounds lie within the tolerable misstatement of + 35,000 ounces, the sample evidence suggests that the perpetual records are fairly stated with a 90 percent confidence level.

9-26

The calculation of the sample results for Hipp Supply Company is as follows: The calculation of the mean misstatement per sampling item is: Mean Misstatement per sampling item =

Total audit difference Sample Size

=

$481 = $4.81 100

Thus, the average misstatement for an inventory item based on the sample data is an overstatement of $4.81. Next, the mean misstatement is projected to the population as follows: Projected population = Population size x Mean misstatement misstatement (in sampling units) per sampling item 17-105 Copyright ©2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

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$4,618

=

960

x

$4.81

The allowance for sampling risk is represented by the confidence bound. To calculate the confidence bound, the auditor first calculates the standard deviation and then uses the equation shown below, using the CC value for the level of desired confidence.

SD =

Total squared audit difference - (sample size x mean difference per sampling item2 ) sample size - 1

SD =

8,895 - 100 (4.81)2 = 8.15 100 - 1

Confidencebound = N (CC)

SD

= 960 (1.64)

8.15

=1,283

where N = population size (in sampling units) CC = Confidence Coefficient SD = Standard Deviation of Audit Differences n = sample size For Hipp Supply Company, the confidence bound is $1,283 and the confidence interval is calculated as follows: Confidence interval = Projected Population Misstatement + Confidence bound =

4,618

+

1,283

Thus, the confidence interval has a lower overstatement limit of $3,335 and an upper limit of $5,901. Since the upper limit of $5,901 is greater than tolerable misstatement of $5,000, the sample evidence suggests that the inventory is not fairly stated with a 90 percent confidence level.

Solutions to Discussion Cases 9-27

The incorrect assumptions, statements, and inappropriate applications of sampling are as follows: • Classical variables sampling is not designed for tests of controls.

• MUS uses each dollar in the population, not each account, as a separate sampling unit.

• MUS is not efficient if many misstatements are expected because the sample size can become larger than the corresponding sample size for classical variables sampling as

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• • • • • • •

• •

9-28

the expected amount of misstatement increases.

Each account does not have an equal chance of being selected; the probability of selection of the accounts is proportional to the account’s dollar amount.

MUS requires special consideration for negative (credit) balances.

Tolerable misstatement was not considered in calculating sample size.

Expected misstatement was not considered in calculating sample size.

The standard deviation of the dollar amounts is not required for MUS. The three selected accounts with insignificant balances should not have been ignored or replaced with other accounts.

The account with the $1,000 difference (recorded amount of $4,000 and audited amount of $3,000) was incorrectly projected as a $1,000 misstatement; the projected misstatement for this difference was actually $2,500 ($1,000/$4,000 x $10,000 sampling interval).

The difference in the understated account (recorded amount of $1,900 and audited amount of $2,000) should not have been omitted from the calculation of projected misstatement.

The reasoning (the comparison of projected misstatement with the allowance for sampling risk) concerning the decision that the receivables balance was not overstated was erroneous.

a. While Doug’s selection method is not random, judgmentally ―targeting‖ items for testing is acceptable under auditing standards and it may be preferable if there is reason to think some balances are more likely misstated than others. Doug’s reasoning for selection seems reasonably sound. b. Because the items selected were not identified randomly, Doug cannot use statistical sampling methods to quantify sampling risk or evaluate his results. His ―sample‖ accounts for 66% ($720,000/$1,090,000) of ending inventory and even though it isn’t technically appropriate to project the results from the ―sample,‖ in practice auditors can use their understanding of projection to verify our judgment regarding the sufficiency of the evidence. Projected misstatement using ratio projection would be $121,111 ($80,000/$720,000 x $1,090,000), which is well below the tolerable misstatement of $250,000 ($500,000 x 50 percent).

Doug based his selection on the items that were most risky or most likely to be misstated. Assuming he was successful at identifying the riskiest items and the fact that he obtained relatively high coverage (the remaining items account for only 44% and are less likely to contain misstatements), it appears reasonable to conclude he has sufficient evidence to consider the balance fairly stated.

CHAPTER 10 AUDITING THE REVENUE PROCESS Answers to Review Questions 10-1

FASB ASC 606 ―Revenue from contracts with customers‖ requires the entity to follow a 17-107 Copyright ©2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

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five-step approach: Step 1: Identify the contract(s) with a customer. A contract is an agreement between two or more parties that creates enforceable rights and obligations.

Step 2: Identify the performance obligations in the contract. A contract includes one or more promises to transfer goods or services to a customer.

Step 3: Determine the transaction price. The transaction price is the amount of consideration in a contract to which an entity expects to be entitled in exchange for transferring promised goods or services to a customer.

Step 4: Allocate the transaction price to the performance obligations in the contract. An entity typically allocates the transaction price to each performance obligation on the basis of the relative standalone selling prices of each distinct good or service promised in the contract.

Step 5: Recognize revenue when the entity satisfies a performance obligation. An entity satisfies a performance obligation by transferring a promised good or service to a customer (which is when the customer obtains control of that good or service).

10-2

The credit function has the responsibility for monitoring customer payments. An aged trial balance of accounts receivable should be prepared and reviewed by the credit function. Payment should be requested from customers who are delinquent in making payments for goods or services. The credit function is usually responsible for preparing a report of customer accounts that may require write-off as bad debts. However, the final approval for writing off an account should come from an officer of the company who is not responsible for credit or collections.

10-3

When the entity does not have adequate segregation of duties or if collusion is suspected, the possibility of a theft of cash is increased. An employee who has access to both the cash receipts and the accounts receivable records has the ability to steal cash and manipulate the accounting records to hide the misstatement. This is sometimes referred to as lapping. When lapping is used, the perpetrator covers the cash shortage by applying cash from one customer's account against another customer's account. If the auditor suspects that this has occurred, the individual cash receipts have to be traced to the customers' accounts receivable accounts to ensure that each cash receipt has been posted to the correct account. If the cash receipt is posted to a different account, this may indicate that someone is applying cash to different accounts to cover a cash shortage.

Other possible procedures include custody and authorization of credit memos. Lastly, confirmations that include not only A/R balances, but also total sales and cash receipts are a substantive procedure to address this issue.

10-4

Industry-related factors such as the profitability and health of the industry in which the entity operates, the level of competition within the industry, and the industry's rate of technological change affect the potential for misstatements in the revenue process. The

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level of governmental regulation (e.g., by the Food and Drug Administration) within the industry may also affect sales activity. Finally, most states have consumer protection legislation that may affect product warranties, returns, financing, and product liability.

Such industry-related factors directly impact the auditor's inherent risk assessment for the authorization and valuation assertions.

The presence of misstatements in previous audits is a good indicator that misstatements are likely to be present during the current audit. If material misstatements were present in previous audits, the auditor should assess inherent risk to be high.

10-5

The auditor needs to obtain the following knowledge for each major class of transactions in the revenue process when performing a walkthrough: • How sales, cash receipts, and sales returns and allowances transactions are initiated.

• The accounting records, supporting documents, and accounts that are involved in processing sales, cash receipts, and sales returns and allowances transactions.

• The flow of each type of transaction from initiation to inclusion in the financial statements, including computer processing of the data.

• The process used to prepare estimates for accounts such as the allowance for uncollectible accounts and sales returns.

10-6

Two important controls for processing of credit memoranda for sales returns and allowances transactions are: (1) each credit memorandum should be approved by someone other than the individual who initiated it and (2) a credit for returned goods should be supported by a receiving document indicating that the goods have been returned.

10-7

The analytical procedures that can be used to test revenue-related accounts and the possible misstatements that can be detected by each analytical procedure are (also see Table 10-9): Analytical Procedure

Possible Misstatement Detected

Revenue: Comparison of gross profit percentage by product line with previous years' and/or industry data.

Unrecorded (understated) revenue Fictitious (overstated) revenue Changes in pricing policies Product-pricing problems

Comparison of reported revenue to budgeted revenue.

Accounts Receivable, Allowance for Uncollectible Accounts, and Bad-Debt Expense: Comparison of receivables turnover and days outstanding in accounts receivable to

Under- or overstatement of allowance for uncollectible

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previous years and/or industry data.

accounts and bad-debt expense

Comparison of aging categories on aged trial balance of accounts receivable to previous years.

Comparison of bad-debt expense as a percentage of revenue to previous years and/or industry data.

Comparison of the allowance for uncollectible accounts as a percentage of accounts receivable or credit sales to previous years and/or industry data.

Examination of large customer accounts individually and comparison to previous year.

Sales Returns and Allowances and Sales Commissions:

10-8

Comparison of sales returns as a percentage of revenue to previous years and/or industry data.

Under- or overstatement of sales returns

Comparison of sales discounts as a percentage of revenue to previous years and/or industry data.

Under- or overstatement of sales discounts

Estimation of sales commissions expense by multiplication of net revenue by the average commission rate and comparison to recorded sales commission expense.

Under- or overstatement of sales commission expense and related accrual

The auditor verifies the accuracy of the aged trial balance using the following steps. First, a copy of the aged trial balance of accounts receivable is obtained from the entity and the total balance is compared to the accounts receivable general ledger balance. Second, a sample of customer accounts is selected from the aged trial balance. For each selected customer account, the auditor traces the customer's balance back to the subsidiary ledger detail and verifies the total amount and the amounts included in each column for proper aging. These two steps mainly describe a manual approach to testing accuracy. A second approach would involve the use of computer-assisted audit techniques. If the general controls over IT are adequate, the auditor can use a generalized audit software package to perform the steps described in the first approach to examine the accuracy of the aged trial balance generated by the entity's accounting system.

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10-9

Three factors that affect the reliability of accounts receivable confirmations are: • The type of confirmation request.

• Prior experience on the entity or similar engagements.

• The intended respondent.

The types of confirmations include positive and negative confirmations. Positive confirmations are considered more reliable because the recipient is required to respond to the auditor regardless of whether a misstatement exists or not. Prior experience with the entity in terms of confirmation response rates, misstatements identified, and the accuracy of returned confirmations should be considered when assessing the reliability of accounts receivable confirmations. For example, if response rates were low in prior audits, the auditor might consider obtaining evidence using alternative procedures. Finally, the intended respondents to accounts receivable confirmations may vary from individuals with little accounting knowledge to highly qualified accounting personnel in large corporations. The auditor should consider the respondent's competence, knowledge, ability, and objectivity when assessing the reliability of confirmation requests.

10-10 A positive accounts receivable confirmation requests that the customer indicate whether or not it is in agreement with the amount due to the entity stated in the confirmation.

Thus, a response is required regardless of whether the customer believes that the amount is correct or incorrect. A negative confirmation requests that the customer respond only when it disagrees with the amount due to the entity.

Positive confirmations are generally used when an account contains large individual balances or if errors are anticipated because control risk is assessed to be high. Negative confirmation requests are used when there are a large number of accounts with small balances, control risk is assessed to be low, and the auditor believes that the customers will devote adequate attention to the confirmation.

10-11 Other types of receivables that the auditor should examine include: • Receivables from officers and employees.

• Receivables from related parties.

• Notes receivable.

The auditor would confirm and evaluate each type of receivable for collectibility. The transactions that result in receivables from related parties are examined to determine if they were at "arm's length." Notes receivable would also be confirmed and examined for repayment terms and whether interest income has been properly recognized.

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Answers to Multiple-Choice Questions 10-12 10-13 10-14 10-15 10-16 10-17

c d c b a d

10-18 10-19 10-20 10-21 10-22 10-23

b a c a a b

Solutions to Problems 10-24 1. In applying the 5-step process, the auditor should obtain and review the final contracts. The auditor should determine that recognition of revenue on this transaction is precluded in the current period because Step 1 of the process is to identify the contracts with a customer where a contract is an agreement between two or more parties that creates enforceable rights and obligations. Thomson’s business practice requires a ―signed‖ written sales agreement for this class of customer and the customer has not signed the final sales agreement. Thus, there is no enforceable contract, and no revenue recognition in the current year.

2.

While a clear contract exists with clear performance obligations and agreed-upon transaction prices, Best Products should not recognize revenue from sales of its layaway program until delivery of the merchandise to the customer. Step 5 of the revenue process states that revenue should be recognized when the entity satisfies a performance obligation. An entity recognizes revenue when it satisfies a performance obligation by transferring a promised good or service to a customer (which is when the customer obtains control of that good or service). Until then, the amount of cash received should be recognized as a liability (deferred revenue).

Because Best Products retains the risk of ownership of the merchandise, receives only a deposit from the customer, and does not have an enforceable right to the remainder of the purchase price, revenue cannot be recognized until goods are delivered. The auditor would need to review Best Products’ policies for the layaway plan and review a sample of customer installment notes.

3.

Step 4 of the revenue process requires Dave’s to allocate the transaction price to the performance obligations in the contract. An entity typically allocates the transaction price to each performance obligation on the basis of the relative standalone selling price of each distinct good or service promised in the contract. In this case, Dave’s performance obligation is to provide members with access to shop at its stores throughout the duration of the individual membership. It would not be appropriate for Dave’s to recognize the membership fees as earned revenue upon billing or receipt of initial fee. This conclusion is based on Dave’s remaining and unfulfilled contractual obligation to perform services throughout the remaining period. The auditor would need to review Dave’s membership fee policies and examine the company’s estimate of customer cancellations. Thus, the initial receipt of the fees results in a liability of unearned revenue with the revenue recognized with the 17-112

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passage of time.

10-25 The following weaknesses were identified by Smith in the existing control system over cash admission fees along with the related recommendation for improvement: Weakness

Recommendation

1. There is no segregation of duties between persons responsible for collecting admission fees and persons responsible for authorizing admission.

1. One clerk (the collection clerk) should collect admission fees and issue prenumbered tickets. The other clerk (the admission clerk) should authorize admission upon receipt of the ticket or proof of membership.

2. An independent count of paying patrons is not made.

2. The admission clerk should retain a portion of the prenumbered admission ticket (admission ticket stub).

3. There is no proof of accuracy of amounts collected by the clerks.

3. Admission ticket stubs should be reconciled with cash collected by the treasurer each day.

4. Cash receipts records are not promptly prepared.

4. The cash collections should be recorded by the collection clerk daily on a permanent record that will serve as the first record of accountability.

5. Cash receipts are not promptly deposited. Cash should not be left undeposited for a week.

5. Cash should be deposited at least once each day.

6. There is no proof of accuracy of the amounts deposited.

6. 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.

7. There is no record of the internal accountability for cash.

7. The treasurer should issue a signed receipt for all proceeds received from the collection clerk. These receipts should be maintained and periodically checked against cash collection and deposit records.

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e. 5 f. 2 10-27 a.

In addition to sending second requests, Signoff-On can perform the following audit procedures: • Examination of subsequent cash receipts.

• Examination of the customer orders, shipping documents, and duplicate sales invoices.

• Examination of other entity documentation. b. Of the three procedures listed, examination of subsequent cash receipts provides the highest quality evidence. If the customer has paid the accounts receivable, it provides strong evidence that the receivable was valid.

10-28 The working paper contains the following deficiencies: • The working paper was not initialed and dated by the audit assistant.

• Negative confirmations not returned cannot be considered to be accounts "confirmed without exception."

• The two positive confirmations that were sent but were unanswered are not accounted for.

• There is no documentation of alternate procedures, possible scope limitation, or other working paper reference for the six accounts selected for confirmation that the client asked the auditor not to confirm.

• The dollar amount and percentage of the six accounts selected for confirmation that the client asked the auditor not to confirm is omitted from the "Dollars" columns for the "Total selected for testing."

• There is no indication of follow-up or cross-referencing of the account confirmedrelated-party transaction.

• The tick mark "‡" is used but is not explained in the tick mark legend.

• There is no explanation for proposed disposition of the ten differences aggregating $12,000.

• The overall conclusion reached is not appropriate because there is no notation that a projection from the sample to the population was made.

• There is no reference to second requests.

• Cross-referencing is incomplete, such as the eighteen "Differences reported and resolved, no adjustment" and "Confirmation Requests" to the confirmation control schedule.

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10-29 In order to determine whether lapping exists, Stanley would test the aging of accounts receivable and then: • Mail positive accounts receivable confirmation requests directly to all customers with old balances.

• Investigate all exceptions noted on confirmations.

• Obtain authenticated deposit slips directly from the bank.

• Compare individual customers' names, dates, and amounts shown on the customer's remittance advices with the names, dates, and amounts recorded in the cash receipts journal, individual customer ledger accounts, and deposit slips (if practicable).

• Verify the propriety of noncash credits to accounts receivable (e.g., sales discounts, sales returns, bad-debt write-offs).

• Perform a surprise inspection of deposits.

• Foot the cash receipts journal, the customers' ledger accounts, and the accounts receivable control account.

• Reconcile the total of the individual customers' accounts with the accounts receivable control account.

• Compare information in copies of monthly customers' statements with information in customers' ledger accounts.

10-30 In evaluating proper sales cutoff, three points should be noted: (1) The book-to-physical adjustment has already been made by the client, (2) all sales are made FOB shipping (title passes to the customer at the time the goods are shipped), and (3) goods on hand on December 31 are included in the physical inventory. a. Since the goods were shipped on December 31, they were included in the physical inventory at the end of the fiscal year. Since the sale should be recognized in the current fiscal year, the following adjustment is necessary: Cost of merchandise sold Inventory

2,000 2,000

b. This sale is properly recorded as a current-fiscal-year sale. However, the auditor should inquire as to why there was such a delay in processing the sales invoice. c. The sale is properly recorded in the current year. d. Since the goods were not shipped until January 9, they would have been included in the physical inventory. However, the sale was recorded as a current-fiscal-year sale.

Therefore, the sale should be reversed since title has not passed to the customer. The following adjusting entry should be made: Sales Accounts receivable

4,000 4,000

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e. Since this transaction is a shipment of merchandise to a consignee, no sale should be recognized. Since the goods were not on hand on December 31, the following entry is necessary: Sales Inventory Accounts receivable Cost of merchandise sold

10,000 5,600 10,000 5,600

f. This sale should be recorded in the current fiscal year. Since the merchandise was shipped on December 30, it was not included in the physical inventory. Thus, the following adjusting entry is necessary: Accounts receivable Sales

6,000 6,000

g. This transaction is correctly recorded as a sale in the next period. h. Since the merchandise was shipped on December 31, it should be recorded as a sale in the current fiscal year. It was also included in the physical inventory because it was on hand on that date. Thus, the following adjusting entry is necessary: Accounts receivable Cost of merchandise sold Sales Inventory

8,000 5,500 8,000 5,500

Solutions to Discussion Cases 10-31 The listed conditions are the important criteria that should be used in evaluating any purported bill and hold sale. In some circumstances, a transaction may meet all the criteria listed but not meet the requirements for revenue recognition. In applying the above criteria to a purported bill and hold sale, the auditor should also consider the following factors and evidence related to each factor: 1.

The date by which the seller expects payment, and whether it has modified its normal billing and credit terms for this buyer;

2.

The seller's past experiences with, and pattern of, bill and hold transactions;

3.

Whether the buyer has the expected risk of loss in the event of a decline in the market value of the goods;

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4.

Whether the seller's custodial risks are insurable and insured; and

5.

Whether extended procedures are necessary in order to assure that there are no exceptions to the buyer's commitment to accept and pay for the goods sold, i.e., that the business reasons for the bill and hold have not introduced a contingency to the buyer's commitment.

10-32 a. Friendly Furniture carried insurance coverage for property loss at replacement value and business interruption insurance for lost production. Because the property loss is covered at replacement value, which exceeds carrying value, the recognition of both a reimbursement for costs incurred and a gain contingency should be considered.

Before deciding on when to recognize proceeds from insurance coverage, it is necessary to consider whether the amount of proceeds is a gain contingency, which generally cannot be recognized under GAAP. The gain must be realized before recognition is permitted. FASB ASC Topic 450, "Contingencies," reaffirms the principle on the recognition of gain contingencies.

The first issue that needs to be considered is the timing of recognition for some or all of the insurance proceeds that Friendly Furniture is entitled to and expects to receive. There is no specific guidance in the authoritative literature on when it is appropriate to recognize insurance proceeds. SFAC No. 5, "Recognition and Measurement in Financial Statements of Business Enterprises," provides some conceptual guidance. The company will likely want to recognize the estimated proceeds from insurance coverage at the earliest possible date to offset losses, if any, from the destruction of fixed assets and inventory as well as from lost production.

There are a number of points in time when the insurance proceeds may be recognized. The most conservative approach—the one likely to be least favored by the company and the least likely to be a gain contingency—would be when the proceeds are received. This would result in a cash basis of accounting and would not be supported by SFAC No. 6, "Elements of Financial Statements." The other extreme would be recognition of the insurance proceeds before verification of coverage or admission of liability by the insurance carrier. This is the most aggressive approach and the most likely to result in recognition of a gain contingency.

There are two other alternatives: (1) recognition when the company has been able to determine that coverage exists and has been able to develop a minimum estimate of the amount to be recovered or (2) when the insurance carrier has admitted liability. A decision as to which of those alternatives should be used needs to be based on the company's ability to estimate the proceeds as reliably as possible. If the insurance company has admitted to a liability, Friendly Furniture would have a good basis for recognizing the minimum amounts subject to an evaluation of the reliability of the estimates and the probability of collection.

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One possible answer is to recognize insurance proceeds (a receivable from the insurance company) in Friendly Furniture's financial statements at June 30 in the following manner: credit a portion of business interruption insurance to cost of sales and recognize in other income a gain that consists of the estimated minimum amount that the replacement cost insurance proceeds exceed the net book value of equipment and inventory destroyed and unallocated proceeds from business interruption insurance. b. The auditor can perform the following procedures to support the amount recorded for the receivable: • Examine the inventory records, including the perpetual and physical inventory, to determine the cost of the inventory destroyed by the flood.

• Examine the appraisal reports to test the fair market value of the inventory destroyed.

• Examine the property, plant, and equipment subsidiary records to determine the cost (book value) of the equipment destroyed.

• Examine the appraisal reports to test the fair market value of the equipment destroyed.

• Examine the entity's and insurance company's calculation of the amount of income to be recognized as a result of the business interruption.

Solution to Internet Assignments 10-33

Lands’ End is a public company and states in their January 31, 2020 10-K that ―While revenue recognition for the Company does not involve significant judgment, it represents an important accounting policy. For sales shipped from our distribution centers, we recognize revenue and the related cost of goods sold at the time the products are expected to be received by the customers. For sales transacted at stores, revenue is recognized when the customer receives and pays for the merchandise at the register. We record an allowance for estimated returns based on our historical return patterns and various other assumptions that management believes to be reasonable. We do not believe there is a reasonable likelihood that there will be a material change in the future estimates or assumptions we use to calculate our sales return allowance.

However, if the actual rate of sales returns increases significantly, our operating results could be adversely affected. We have not made any material changes in the accounting methodology used to estimate future sales returns in the past three fiscal years.‖ The North Face and Timberland are owned by VF Corporation, a publicly traded company, that has more than an entire page in its March 2020 annual report regarding details of its revenue recognition policies. L.L. Bean and Patagonia are privately held companies and there are no publicly available financial statements.

10-34

A search of the SEC’s website should identify a recent company that has been cited by the SEC for revenue recognition issues.

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CHAPTER 11 AUDITING THE PURCHASING PROCESS Answers to Review Questions 11-1

Expenses can be classified into three categories: 1. Product costs are expenses that can be matched directly with specific transactions or events and are recognized upon recognition of the revenues. An example of a product cost would be the expensing of inventory through cost of goods sold.

2. Period costs are expenses that are recognized during the period in which cash is spent or liabilities incurred for goods and services that are used up at that time or shortly thereafter. Such expenses cannot be directly related to specific transactions and are assumed to provide no future benefit. Examples of such expenses are administrative salaries, rent expense, and interest expense.

3. Allocable costs are allocated by systematic and rational procedures to the periods during which the related assets are expected to provide benefits. Depreciation of plant and equipment is an example of such an expense.

11-2

The three types of transactions that are processed through the purchasing process are: • Purchase of goods and services for cash or credit • Payment of the liabilities arising from such purchases • Return of goods to suppliers for cash or credit The more common accounts affected by each major type of transaction are: Purchase transaction: • Accounts payable • Inventory • Purchases or cost of goods sold • Various asset and expense accounts Cash disbursement transaction: • Cash • Accounts payable • Cash discounts • Various asset and expense accounts Purchase return transaction: • Purchase returns • Purchase allowances • Accounts payable • Various asset and expense accounts

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11-3

A purchase requisition is a request for goods and services by an authorized individual or department within the entity. A purchase order contains the description, quality, quantity, and other information on the goods and services being purchased. The purchase order is sent to the vendor. A receiving report is used to record the receipt of goods. A vendor invoice is the bill from the vendor that includes the description and quantity of the goods shipped or services provided, the price including freight, the terms of trade including cash discounts, and the date billed. A voucher is a document that is frequently used by entities to control the payment of acquired goods and services.

An entity might combine all these documents into a "voucher packet" because such a packet would contain all the information on a particular purchase transaction. If there are questions about the transaction at a later time, the entity can obtain access to all the documents and information more easily.

11-4

The key segregation of duties and the errors or fraud that can occur if such duties are not segregated are: Segregation of Duties

11-5

Possible Errors or Fraud Resulting from Conflicts of Duties

The purchasing function should be segregated from the requisitioning and receiving functions.

Theft of goods and possible payment for unauthorized purchases.

The invoice-processing function should be segregated from the accounts payable function.

Overpayment for goods and services or theft of cash.

The disbursement function should be segregated from the accounts payable function.

Theft of cash.

The accounts payable function should be segregated from the general ledger function.

A theft that would normally be detected by reconciling subsidiary records with the general ledger control account.

Two inherent risk factors that directly affect the purchasing process are (1) industryrelated factors, and (2) misstatements detected in prior audits.

If the entity deals with a large number of vendors and prices tend to be relatively stable, there is less risk that the entity's operations will be affected by raw-material shortages or that production costs will be difficult to control. However, if an entity is dependent on a single vendor to supply a critical component and the vendor is unable to provide the component, the entity may suffer production shortages and shipping delays that significantly affect financial performance. Additionally, industries that use commodities such as oil, coal, and precious metals may be subject to both shortages and price instability that significantly affect their financial results.

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The presence of misstatements in previous audits is a good indicator that misstatements are likely to be present during the current audit. If misstatements were present in previous audits, the auditor should assess inherent risk to be high.

11-6

The following controls and related tests are utilized to ensure that the occurrence, authorization, and completeness assertions are met for purchase transactions: Assertion

Control Activity

Tests of Controls

Occurrence

Segregation of duties

Observe and evaluate proper segregation of duties.

Purchase not recorded without approved purchase order and receiving report

Test of a sample of vouchers for the presence of an authorized purchase order and receiving report; if IT application, examine application controls; if data are available and reliable, use audit data analytics to match the population of vouchers to related purchase orders and receiving reports.

Accounting for numerical sequences of receiving reports and vouchers

Review and test entity procedures for accounting for numerical sequence of receiving reports and vouchers; if IT application, examine application controls.

Review entity's dollar limits authorization for acquisitions.

Authorization

Completeness

Approval of acquisitions consistent with the entity's authorization dollar limits Approved purchase requisition and purchase order

Examine purchase requisitions or purchase orders for proper approval; if IT is used for automatic ordering, examination of application controls.

Competitive bidding procedures followed

Review entity's competitive bidding procedures.

Accounting for numerical sequences of purchase orders, receiving reports, and vouchers

Review and test entity's procedures for accounting for numerical sequence of purchase orders, receiving report, and vouchers; if IT application, examine application controls.

Receiving report matched to vendor invoices and entered in

Trace a sample of receiving reports to their respective vendor invoices and

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purchases journal

vouchers. If data are available and reliable, use audit data analytic to trace the population of receiving reports to the related invoices.

Trace a sample of vouchers to the purchases journal.

Disclosure checklist

Review financial statement disclosure checklist.

11-7

CAATs can be used to test numerous controls in the purchasing process. For example, a generalized audit software package can be used to account for the numerical sequence of purchase orders, receiving reports, and vouchers. Another example involves the use of a CAAT to test programmed controls over approval of purchase orders when IT is used for automatic ordering (e.g., electronic data interchange).

11-8

The analytical procedures that can be used to test accounts payable and accrued expenses and the possible misstatements that can be detected by each analytical procedure are:

11-9

Substantive Analytical Procedure

Possible Misstatement Detected

Compare payable turnover and days outstanding in accounts payable with previous years’ and industry data.

Under- or overstatement of liabilities and expenses

Compare current-year balances in accounts payable and accruals with prior years' balances.

Under- or overstatement of liabilities and expenses

Compare amounts owed to individual vendors in the current year's accounts payable listing to amounts owed in prior years.

Under- or overstatement of liabilities and expenses

Compare purchase returns and allowances as a percentage of revenue or cost of sales to prior years' and industry data.

Under- or overstatement of purchase returns

Predict accrued interest expense based on loan terms and the outstanding balance

Understatement of accrued interest

The following audit procedures may be used as part of the search for unrecorded liabilities: • Ask management about control activities used to identify unrecorded liabilities and accruals at the end of an accounting period.

• Vouch large dollar items from the purchases journal and cash disbursements journal

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•

for a limited time after year-end; examine the dates on each receiving report or vendor's invoice to determine if the liability relates to the current audit period.

Examine the files of unmatched purchase orders, receiving reports, and vendor invoices for any unrecorded liabilities.

11-10 The following are examples of disclosures for the purchasing process and related accounts: • Payables by type (trade, officers, employee, affiliate, etc.).

• Short- and long-term payables.

• Long-term purchase contracts, including any unusual or adverse purchase commitments.

• Purchases from and payables to related parties.

• Dependence on a single vendor or small number of vendors.

• Costs by reportable segment of the business.

11-11 Accounts payable confirmations are generally used less frequently than accounts receivable confirmations because the auditor can test accounts payable by examining vendor invoices and monthly vendor statements. Since these documents originate from sources external to the entity, this evidence is viewed as reliable. Accounts payable confirmations primarily provide evidence on the completeness assertion, while accounts receivable confirmations primarily provide information on the validity (occurrence/existence) assertion. When confirming accounts payable, auditors generally use a form of positive confirmation referred to as a "blank or zero-balance" confirmation.

This type of positive confirmation does not state the balance owed. Instead, the confirmation requests that the recipient fill in the amount or furnish other information.

Both positive and negative confirmations are used for accounts receivable. Lastly, accounts payable confirmations are generally mailed at year-end rather than at an interim date because of the auditor's concerns about unrecorded liabilities. Accounts receivable confirmations are sent at both dates.

11-12 Some of the typical procedures that might be applied to the audit of the tax provision by the auditors and/or tax specialist include: • Compare the size and trend in the tax provision and related balance sheet accounts over time.

• Perform walkthroughs and test the design and operating effectiveness of internal controls over the income tax provision (required for an integrated audit). Identify issues that should be given particular attention in substantive testing and evaluate the entity’s documentation.

• Document the testing performed to evaluate the design and operating effectiveness of internal controls over the income tax process (primarily integrated audits).

• Test the mathematical accuracy of the computations supporting the tax provision and related balance sheet accounts and vouch underlying data to supporting documentation.

• Identify and test significant permanent and temporary differences in the tax provision calculation.

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appropriate disclosure and accounting under FASB ASC Topic 740.

• Consider the realizability of net deferred tax assets and adequacy of related valuation allowances.

• Test the reconciliation of income taxes payable, deferred income tax assets/liabilities (including any related valuation allowances), and tax liabilities to supporting documentation, including the general ledger, financial statements, and related footnote disclosure.

• Ensure proper documentation in the audit working papers to allow for reperformance of the audit procedures applied to the tax accounts.

Answers to Multiple-Choice Questions 11-13 11-14 11-15 11-16 11-17 11-18

c c b d b b

11-19 11-20 11-21 11-22 11-23

c d c c a

Solutions to Problems 11-24 This is a relatively straightforward analytical procedures problem. Here are some of the concerns the auditor might have about potential misstatements in both accounts: • Both inventory and accounts payable have increased significantly in absolute dollar terms from 2020 to 2021.

• The inventory increase is 69 percent, while the accounts payable increase is 28 percent.

• An auditor would have expected the increase in inventory to be approximately the same as the increase in accounts payable.

• Based on the auditor’s expectations and the entity’s data, the auditor might suspect that there are at least two possible misstatements: (1) inventory is overstated because obsolete and/or slow-moving products have not been written down to fair market value and (2) there are unrecorded accounts payable. Other misstatements are possible.

11-25 The internal control activities that most likely would provide reasonable assurance that specific control objectives for management assertions regarding purchases and accounts payable will be achieved are: • The purchasing, receiving, and accounts payable functions are segregated.

Requisitioning Department: • Proper authorization of requisitions by department head is required before purchase orders are prepared.

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the goods received.

Purchasing Department: • The purchasing department ensures that requisitions are within budget limits before purchase orders are prepared.

• The adequacy of each vendor's past record as a supplier is verified.

• Verifies that the best price is obtained.

Receiving Department: • Secure facilities limit access to the goods during the receiving activity.

• The receiving department makes a blind count of the goods received, independently of any other department.

Accounts Payable Department: • Requisitions, purchase orders, and receiving reports are matched with vendor invoices as to quantity and price.

• The accounts payable department recomputes the mathematical accuracy of each invoice.

• The voucher register is independently reconciled to the control accounts monthly.

• All supporting documentation is required for payments and is made available to the treasurer.

11-26 a. The flowchart for Kida Company is shown below:

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b. Kida Company's major internal control weaknesses are: Purchasing: • The buyer does not verify that the department head's request is within budget limitations.

• No procedures have been established to ensure that the best price is obtained.

Large-dollar requisitions should be ordered after receiving quotes and/or sealed bids.

• Prior to placing an order, the buyer does not determine the adequacy of the vendor's past record as a supplier to Kida.

Receiving: • Receiving clerk does not make blind counts for all special equipment or at least for large-dollar items.

• Written notice of equipment received is not sent to the purchasing department.

• Written notice of equipment received is not sent to accounts payable department.

Accounts Payable: • The mathematical accuracy of the invoice is not recomputed.

• Invoice quantity is not compared with a report of quantity received.

• Notification of the acceptability of the equipment from the requisitioning department is not obtained before the payable is recorded.

• No alphabetic file of vendors from which purchases are made is maintained.

Treasurer: • Documentation supporting the checks is not sent by the accounts payable department to the cashier in order for the cashier or treasurer to be assured that the check is for properly authorized and received equipment.

• Checks for large-dollar purchases are not signed by two officers of Kida Company to ensure that material expenditures are proper.

• All documentation to support a check is not canceled by the check signer and returned to the accounts payable department.

• The cashier alone has custody of the key, the signature plate, and record of usage.

• The controller is authorized to sign checks.

11-27 1. Test of details of transactions (substantive test of transactions).

2. Tests of details of transactions (cutoff test).

3. Tests of details of account balances.

4. Analytical procedure.

5. Tests of details of account balances.

6. Analytical procedure.

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11-28

The substantive audit procedures Coltrane should apply to Jang's trade accounts payable balances include the following: • Foot the schedule of the trade accounts payable.

• Agree the total of the schedule to the general ledger trial balance.

• Compare a sample of individual account balances from the schedule with the accounts payable subsidiary ledger.

• Compare a sample of individual account balances from the accounts payable subsidiary ledger with the schedule.

• Investigate and discuss with management any old or disputed payables.

• Investigate debit balances and, if significant, consider requesting positive confirmations and propose reclassification of the amounts.

• Review the minutes of the board of directors' meetings and any written agreements and inquire of key employees as to whether any assets are pledged to collateralize payables.

• Perform cutoff tests.

• Perform analytical procedures.

Confirm or verify recorded accounts payable balances by: • Reviewing the voucher register or subsidiary accounts payable ledger and consider confirming payables for a sample of vendors.

• Requesting a sample of vendors to provide statements of account balances as of the date selected.

• Investigating and reconciling differences discovered during the confirmation procedures.

• Testing a sample of unconfirmed balances by examining the related vouchers, invoices, purchase orders, and receiving reports.

Perform a search for unrecorded liabilities by: • Examining files of receiving reports unmatched with vendors' invoices and searching for items received before the balance sheet date but not yet billed or on the schedule.

• Inspecting files of unprocessed invoices, purchase orders, and vendors' statements.

• Reviewing support for the cash disbursements journal, the voucher register, or canceled checks for disbursements after the balance sheet date to identify transactions that should have been recorded at the balance sheet date but were not.

• Inquiring of key employees about additional sources of unprocessed invoices or other trade payables.

11-29

a. 3 b. 4 c. 5 d. 1

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11-30 a.

No adjustment is needed. The goods were received before December 31, 2021 and recorded in the Purchases Journal in December. b.

An adjustment is required. The $45,000 payment covers a 3-month period starting on December 1, 2021. The total amount was charged to consulting expenses, while only 1 month of services was used by year-end. The entry to correct is: Prepaid Consulting Expenses Consulting Expenses

30,000 30,000

c.

No adjustment is needed. The goods were received before December 31, 2021 and recorded in the Purchases Journal in December.

d.

No adjustment is needed. The forklift was received in 2022 as evidenced by RR# 49746 and recorded in the Purchases Journal in January.

e.

An adjustment is required. The paper products were received in December 2021 as evidenced by the RR# 49743 (RR #49745 is the last receiving report in December). Thus, these goods should have been recorded in December 2021. The entry to correct is: Supplies Accounts Payable

f.

42,000 42,000

An adjustment is required. The telephone bill applies to December 2021 and the $32,450 should be an accrued expense. The entry to correct is: Telephone expense Accrued Expenses

32,450 32,450

Solution to Discussion Case 11-31

a. The accounts payable audit procedures should be directed toward searching for proper inclusion of all accounts payable (i.e., the completeness assertion) and ascertaining that recorded amounts are reasonably stated (accuracy) because the primary audit purpose is to reveal any possible material understatements. b. Mincin is not required to use accounts payable confirmation procedures. Instead, the auditor can examine external evidence such as vendor invoices and vendor statements that substantiate the accounts payable balance. Although not required, the accounts payable confirmation is often used. The auditor might consider such use when: 1. Internal controls are weak.

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2. The company is in a "tight" cash position and bill paying is slow.

3. Physical inventories exceed general ledger inventory balances by significant amounts.

4. Certain vendors do not send statements.

5. Vendor accounts are pledged by assets.

6. Vendor accounts include unusual transactions.

7. Change in personnel or management behavior related to payables.

8. Regular vendors have small or zero balances c. A selection technique using the large dollar balances of accounts is generally used when the primary audit objective is to test for overstatements (e.g., accounts receivable audit work). Accounts with zero balances or relatively small balances would not be subjected to selection under such an approach. When auditing accounts payable, the auditor is primarily concerned with the possibility of unrecorded payables or understatement of recorded payables—the completeness assertion.

Selection of accounts with relatively small or no balances for confirmation is the more efficient direction of testing, since understatements are more likely to be detected when examining such accounts.

When selecting accounts payable for confirmation, the following procedures could be followed: 1. Analyze the accounts payable population and stratify it into accounts with large balances, accounts with small balances, accounts with zero balances, etc.

2. Use a sampling technique that selects items based on criteria other than the dollar amount of the items (e.g., select based on terminal digits, select every nth item based on predetermined interval, etc.).

3. Design a statistical sampling plan that will place more emphasis on selecting accounts with zero balances or relatively small balances, particularly when the entity has had substantial transactions with such vendors during the year.

4. Select prior-year vendors who are no longer used.

5. Select new vendors used in the subsequent period.

6. Select vendors that do not provide periodic statements.

7. Select accounts reflecting unusual transactions during the year.

8. Select accounts secured by pledged assets.

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Solution to Internet Assignments 11-32 Lands’ End is a publicly traded company. In a recent annual report, the company disclosed the following regarding the provision for income taxes: “We record a valuation allowance against our deferred tax assets when it is more likely than not that some portion or all of such deferred tax assets will not be realized. In determining the need for a valuation allowance, management is required to make assumptions and to apply judgment, including forecasting future income, taxable income and the mix of income or losses in the jurisdictions in which we operate. Our effective tax rate in a given financial statement period may also be materially impacted by changes in the mix and level of income or losses, changes in the expected outcome of audits, or changes in the deferred tax valuation allowance.

At any point in time, many tax years are subject to or in the process of being audited by various taxing authorities. To the extent our estimates of settlements change, or the final tax outcome of these matters is different from the amounts recorded, such differences will impact the income tax provision in the period in which such determinations are made.

Our income tax expense includes changes in our estimated liability for exposures associated with our various tax filing positions. Determining the income tax expense for these potential assessments requires management to make assumptions that are subject to factors such as proposed assessments by tax authorities, changes in facts and circumstances, issuance of new regulations, and resolution of tax audits. The Company performed an evaluation over its deferred tax assets and determined that a valuation allowance is considered necessary. See Note 9, Income Taxes, for further details on the valuation allowance.

We believe the judgments and estimates discussed above are reasonable. However, if actual results fall short of our estimates or assumptions, we may be exposed to losses or gains that could be material.‖ 11-33 A search of the SEC’s website or other web searches should identify a recent company that has been cited by the SEC for issues related to income tax reporting. For example, in 2016, the SEC fined Weatherford International $140 million for fraudulently lowering the tax provision to boost earnings. See: SEC.gov | Oil Services Company Paying $140 Million Penalty for Accounting Fraud.

CHAPTER 12 AUDITING THE HUMAN RESOURCE MANAGEMENT PROCESS Answers to Review Questions 12-1

In addition to policies and processes around payroll transactions, the human resource

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management process requires sound policies and processes for hiring, training, evaluating, counseling, promoting, compensating, terminating, and taking remedial actions for employees.

12-2

There are two major types of transactions that are processed through the human resource management process: (1) payments to employees for services rendered and (2) accrual and payment of payroll-related liabilities arising from employees' services.

The financial statements accounts that are generally affected by the two types of payrollrelated transactions are: Payroll transaction: • Cash • Inventory • Direct and indirect labor expense • Various payroll-related liability and expense accounts Accrued payroll liability transactions: • Cash • Various accruals (e.g., payroll taxes, and pension costs)

12-3

The payroll register, which is also referred to as the payroll journal, is a summary of all payroll checks issued to employees. The payroll master file is the computer file that maintains all of the entity's records related to payroll, including information on each employee such as name, Social Security number, pay rate, salary, and authorized deductions. The payroll master file changes report contains a record of the changes made to the payroll master file.

12-4

The following duties are performed in the human resources, timekeeping, and payrollprocessing functions: Human Resources: Timekeeping: Payroll processing:

Authorization of hiring, firing, wage rates and salary adjustments, and payroll deductions.

Processing of employees' attendance and time information and coding of account distribution.

Computation of gross pay, deductions, and net pay; recording and summarizing of payments; and verification of account distribution.

12-5 The following table contains the key segregation of duties in the human resource management process and possible errors and fraud that can occur if such segregation of duties is not present.

Segregation of Duties The supervision function should be segregated from the personnel records and

Possible Errors or Fraud as a Result of Conflicts in Duties Unauthorized payments to existing employees or payments to fictitious 17-132

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payroll-processing functions.

employees.

The disbursement function should be segregated from the personnel records, supervision, and payroll-processing functions.

Unauthorized payroll checks may be issued.

The payroll-processing function should be segregated from the general ledger function.

Concealment of a defalcation/theft that would normally be detected by independent review of accounting entries made to the general ledger.

12-6

Except for executive and share-based compensation, there are generally few inherent risk factors that affect the human resource management process and its related accounts. Some factors the auditor might consider include the effect of economic conditions on payroll costs, the supply of skilled workers, the frequency of employee turnover, the presence of labor contracts, and legislation such as the Occupational Safety and Health Act. Because officers may have motive and opportunity to take advantage of their highpositions in the form of excessive compensation, inherent risk associated with executive compensation is frequently not set at low. Key risk factors to consider are the level of performance-based compensation and the closeness of key performance measures to compensation/bonus thresholds. Share-based compensation also has a higher inherent risk because of the required assumptions and financial disclosures.

12-7

Two control environment factors that have a pervasive effect on the human resource management process must be considered. First, the entity's organizational structure, its personnel practices, and its methods used to assign authority and responsibility must be examined. Second, the entity should have sound policies for hiring, training, promoting, and compensating employees. These policies should include specific authority and responsibility for hiring and firing of employees, for setting wage rates and making salary changes, and for establishing benefits.

12-8

The key authorization points within the human resource management process include authorization procedures for hiring and terminating employees, approving time worked, setting pay rates, making withholdings, awarding benefits, and issuing payroll checks.

12-9

Control activities must exist over the classification of payroll transactions to ensure that the appropriate payroll accounts are charged. This is especially important at manufacturing entities because if payroll is not properly classified between direct and indirect labor, inventory and cost of goods sold may not be properly valued.

12-10 Examples of audit procedures that can be performed using CAATs or Audit Data Analytics are: (1) testing the computer logic used to calculate payroll amounts, (2) recomputing the calculation of gross pay, deductions, and net pay, (3) identifying unusual employee expense reimbursements, and (4) foot payroll reports and reconcile to general ledger.

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12-11 Substantive analytical procedures that can be used to test payroll accounts and payrollrelated accrual accounts are: Payroll expense accounts: 1. Use a reasonableness test to develop an expectation based on number of employees and prior year average compensation per employee category after considering pay rate changes. Compare the expectation to current-year balance and investigate the difference if it is greater than the threshold.

2. Compare payroll costs as a percentage of sales with prior years’ and industry data.

3. Compare labor utilization rates and statistics with industry data.

4. Compare budgeted payroll expenses with actual payroll expenses.

5. Estimate sales commissions by application of commission formulas to recorded sales totals.

Payroll-related accrual accounts: 1. Compare current-period balances in payroll-related accruals with the prior periods' balances after adjusting for changes in conditions.

2. Test reasonableness on accrual balances.

12-12 For the accrued payroll tax account, the auditor obtains a detailed account analysis schedule. The credits to the account represent the recognition of payroll tax expense at the end of each pay period. These amounts can be traced to the various payroll tax returns or other documentation filed by the entity and should agree to the amount of payroll tax expense included in the income statement. The debits to the account represent payments made to the relevant government agencies. These payments can be verified by tracing the amounts to the cash disbursements journal.

12-13 Disclosure items for the human resource management process and related accounts include: • Pension benefits • Postretirement benefits • Share-based compensation • Profit-sharing plans • Deferred-compensation arrangements

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Answers to Multiple-Choice Questions 12-14 12-15 12-16 12-17 12-18

b c a b c

12-19 12-20 12-21 12-22 12-23

c b c b c

Solutions to Problems 12-24 To best prevent errors and fraud, one person should be assigned to each of the following functions: human resources, supervision in the operating department, timekeeping, payroll processing, disbursement, and the general ledger management within the IT system. However, fewer could be hired, as long as certain segregations are in place. The supervision function should be separated from the human resources and payrollprocessing functions; the disbursement function should be separate from human resources, supervision, and payroll-processing; and the payroll-processing function should be separate from the general ledger function. These separations would help prevent fictitious employees from appearing on the payroll, unauthorized payments from being made, and alteration of the accounting records from happening.

12-25 a. Weaknesses in the internal control system are the following: • Lack of approval of the foreman's time sheet by an appropriate supervisor is an unsound practice. Employees should not be permitted to maintain their own time records and submit them without approval.

• The computation of regular and overtime hours prepared by payroll clerk no. 2 that is used in the preparation of the payroll register is not compared with the summary of regular and overtime hours prepared by the foreman.

• Arithmetic computations and rates of pay used in the preparation of the payroll register are not checked by a person who is independent of their preparation, and payroll register columns are not verified (re-added) by a person other than the preparer of the payroll register.

• Payroll checks are not reconciled to the payroll register in order to prevent improper disbursements.

• A signature-stamp machine should not be in the custody of any payroll clerk who has access to unsigned checks.

• An officer of the company does not approve payroll.

• Since the paymaster should be independent of the payroll process, signed payroll checks should not be distributed by the foreman.

• Unclaimed payroll checks should be in the custody of an employee who is independent of the payroll process.

• The comparison of regular and overtime hours indicated on payroll checks with regular and overtime hours indicated on time sheets should not be performed by the clerk who is responsible for the original computation of regular and overtime hours indicated on time sheets.

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• The clerk who is responsible for preparing the payroll register should not perform the comparison of gross and net payroll indicated on payroll check with gross and net payroll indicated in the payroll register. b. One should inquire whether: • Payroll clerk no. 2 checks time sheets for the foreman's written approval.

• Approved overtime is indicated on time sheets.

• Employment, wage, and related data in payroll files are periodically crosschecked with personnel files for agreement.

• The timekeeper system is proprietary or an ―off-the-shelf‖ third party software.

• How time entered through smart phone app is verified as being performed on company grounds.

• Other mitigating internal control measures (e.g., bonding, required vacations, and so forth) are in existence.

12-26 McCarthy should consider performing the following procedures in the audit of Kent Company's payroll transactions:

.

12-27

1. Select a sample of payments to employees from the payroll register and compare each selected transaction to the related documents and records, and examine • Evidence in support of authorization of pay rate.

• Evidence in support of time on which compensation was based, such as approved time cards or attendance records.

• Evidence in support of proper authorization of payroll withholdings.

• Evidence in support of account distribution.

• The clerical accuracy of the transaction.

• The entry to the employee's records used to summarize employee compensation for payroll reporting purposes.

2. Obtain the payroll register for a selected period and • Test the arithmetic accuracy of the payroll register.

• Determine whether payroll was approved in accordance with management's prescribed procedures.

• Trace totals per the register to postings in the general ledger.

3. Observe the distribution of payroll checks.

4. Review the accounting for unclaimed wages.

5. Observe a sample of employees in the performance of their duties.

6. Perform analytical procedures. a. In order to verify the information in the input form, James should: • Compare the names, Social Security numbers, and data on the input form with W-4 forms.

• Compare names with employment authorizations.

• Compare pay rates with wage authorizations and union contracts.

• Compare numbers of hours worked (regular and overtime) with approved time sheets or other supportive records; recompute regular and overtime hours.

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• Inspect employee authorization forms for "special deductions." b. James should perform the following procedures in the examination of the November payroll register: • Compare information on the input form with information in the payroll register and information on issued payroll checks (e.g., spelling of names, correctness of Social Security numbers, hours, rates, etc.).

• Test payroll deductions by using withholding tax tables to recompute Social Security and withholding taxes.

• Manually compute gross and net pay and compare with computer printed figures.

• Compare payroll summary totals with other pay periods and investigate any unusual variations among periods.

• Check footings and crossfootings in the payroll register.

• Perform other related basic auditing procedures that may be deemed necessary in accordance with the circumstances.

Solutions to Discussion Cases 12-28

a. The following edit checks might be used to detect errors during the typing of answers to the input cues: • Password: Ensures that the operator is authorized to access computer programs and files.

• Field check to ensure that • numbers are entered into and accepted by the system where only numbers are required to be entered (e.g., numbers 0-9 in Social Security number).

• letters are entered into and accepted by the system where only letters are required to be entered (e.g., letters A-Z in employee name).

• only specific special characters are entered into and accepted by the system where only those special characters are required to be entered (e.g., hyphens between numbers in Social Security number).

• Sign check: Ensures that positive or negative signs are entered into and accepted by the system where only such signs are required to be entered or that the absence of a positive or negative sign appears where such an absence is required (e.g., hours worked).

• Arithmetic check: Ensures the validity of the result of a mathematical computation (e.g., total employees for period equal number of employee numbers in system).

• Validity check: Ensures that only authorized data codes will be entered into and accepted by the system where only such authorized data codes are required (e.g., authorized employee account numbers).

• Limit (reasonableness) check: Ensures that only data within predetermined limits will be entered into and accepted by the system (e.g., rate per hour cannot be lower than the minimum set by law or higher than the maximum set by management, and regular hours worked are reasonable).

• Self-checking digit: Ensures that only specific code numbers prepared by using a specific arithmetic operation will be entered into and accepted by the system (e.g., 17-137 Copyright ©2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

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employee numbers generated by the modulus 11 method with prime-number weighting).

• Size check: Ensures that only data using fixed or defined field lengths will be entered into and accepted by the system (e.g., number of dependents requires exactly two digits).

• Missing-data check: Ensures that no blanks will be entered into and accepted into the system when data should be present (e.g., an "S" or "M" is entered in response to "single or married?").

• Overflow check: Ensures that no digits are dropped if a number becomes too large for a variable during processing (e.g., hourly rates "on size errors" are detected).

• Control-total check: Ensures that no unauthorized changes are made to specified data or data fields and all data have been entered.

• Logic check: Ensures that spurious data are rejected (e.g., no negative regular hours). b. The assurances provided by each validation check are provided within "a." above.

Solution to Internet Assignment 12-29 a. A rough estimate of the average employee’s salary can be computed by dividing the estimated employee compensation expense by the estimated total number of employees. The salaries of the executive officers can be found on a number of websites (e.g., www.aflcio.org/paywatch) and are usually found in the company’s proxy statement or annual report. The salary for one officer divided by the average salary equals the proportion of executive salary to average employee salary.

In 2019, for large companies, the average overall CEO Compensation was over $14.8 million, equal to a CEO-to-worker pay ratio of 264-to-1. The following examples are from some of the notable CEOs listed at http://www.aflcio.org In 2019, Sundar Pichai, CEO of Google received over $280 million in total compensation. Meaning Mr. Pichai made 1,085 times the average rank-and-file worker’s pay ($258,708).

Robert Swan, CEO of Intel received almost $67 million in salary and bonus in 2019 for a ratio of 695 to 1 compared to rank-and-file workers ($96,300).

James Dolan, CEO of Madison Square Garden received over $54 million in 2019 for a ratio of 2,902 to 1 compared to rank-and-file workers ($18,650).

In 2019, Robert Iger, the CEO of Disney received $47.5 million in total compensation for a ratio of 911 to 1 compared to rank-and-file workers ($52,184).

In 2019, Warren E. Buffett, the CEO of Berkshire Hathaway received $374,773 in total compensation for a ratio of approximately 6 to 1 compared to rank-and-file workers ($65,740).

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It is argued that this proportion is high because of the value of the executive’s strategic influence on the company. Whether or not this is true depends entirely on the circumstances of the company. In recent years, there has been increased public outrage at the large disparity between top executive salary and that of the average employee. b. It is argued that if executive compensation is tied to the value of the stock price then executives will perform better, because their interests will be aligned with those of the company’s stockholders. Also by using stock based compensation, companies are free to use the cash that would have been used as compensation to fund other areas of the company; this strategy is frequently employed by technology companies seeking rapid growth. The FASB did not always require companies to directly expense the value of stock option compensation to the income statement. However, under ASC 718 companies are now required to recognize the value of the options granted to employees over the vesting period as compensation expense.

The biggest disadvantage is the potential greed associated with high levels of stockoption compensation. When the executive stands to gain tens or hundreds of millions of dollars by achieving earnings targets, the executive’s self-interests provide incentives for earnings management or fraud in order to meet or beat earnings forecasts. c. Potential audit procedures may include: • Analytical procedures can be used to benchmark compensation levels to other companies in the industry and to examine trends over time.

• Evaluate whether there is proper objectivity in establishing compensation (i.e., is there a compensation committee independent of management).

Examine minutes of board of directors and compensation committee for approval of executive compensation and information on other cash transfers (e.g., loans, expense reimbursement).

• Use CAATs or audit data analytics to search for payments to executives or parties related to executives.

• If fraud or embezzlement is suspected, hire a private investigator to evaluate if the executive is seemingly living beyond his or her compensation level.

• Examine employee reimbursement for extravagant and unnecessary perquisites.

CHAPTER 13 AUDITING THE INVENTORY MANAGEMENT PROCESS Answers to Review Questions

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13-1

Inventory represents one of the most complex parts of the audit because the assignment of values to inventory quantities is difficult. There are also issues such as obsolescence and ―lower of cost or market‖ that affect the valuation of inventory. The complexity of auditing inventory may also be affected by the degree of processing required to manufacture products.

13-2

The inventory process is affected by control activities in the revenue, purchasing, and human resource management processes. The purchasing process controls the acquisition and payment of raw materials and overhead costs. The cost of direct and indirect labor assigned to inventory is controlled through the human resource management process.

Last, finished goods are sold and accounted for as part of the revenue process.

13-3

A production schedule is used to determine the quantity of goods needed and the time at which they are required to meet the production scheduling. The materials requisition is the document that authorizes the release of raw materials from the raw materials department. The inventory master file contains all the important information related to the entity's inventory, including the perpetual inventory records for raw material, work in process, and finished goods. Production data information is reported about the transfer of goods and related cost accumulation at each stage of production. This information is used to update the entity's perpetual inventory system and as input to generate the cost accumulation and variance reports produced by the inventory system.

The cost accumulation and variance report summarizes the various costs charged to departments and products and presents the results of inventory processing in terms of actual costs versus standard or budgeted costs.

13-4

The following duties are performed within the inventory management, raw materials stores, and cost accounting functions: Inventory management:

13-5

Maintenance of inventory at appropriate levels; issuance of purchase requisitions to the purchasing department; managing inventory through planning and scheduling manufacturing activities.

Raw materials stores: Custody of raw materials and issuance of raw materials to manufacturing departments.

Cost accounting: Responsible for ensuring that costs are properly attached to inventory as goods are processed through the manufacturing function. Cost accounting reviews the cost accumulation and variance reports after such data are processed into the accounting records.

The key segregation of duties in the inventory process and the errors or fraud that they can prevent are: Segregation of Duties

Possible Errors or Fraud as a

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Result of Conflicts in Duties The inventory management function should be segregated from the costaccounting function.

Production and inventory costs can be manipulated, leading to an over- or understatement of inventory and net income.

The inventory stores function should be segregated from the cost-accounting function.

Unauthorized shipments can be made or the theft of goods can be covered up.

The cost-accounting function should be segregated from the general ledger function.

Concealment of unauthorized shipments resulting in theft of goods, leading to an overstatement of inventory.

The responsibility for supervising the taking of physical inventory should be separated from the inventory management and inventory stores functions.

Inventory shortages can be covered up through the adjustment of the inventory records to the physical inventory resulting in an overstatement of inventory.

13-6

Industry-related factors and operating and engagement inherent risk factors affect the inventory process. Industry factors include industry competition and changes in technology. Operating and engagement characteristics are (1) the susceptibility of the products sold by the entity to theft, (2) the difficulty in auditing and valuing inventory (i.e., due to potential concerns about obsolete or slow-moving inventory), and (3) possible related-party transactions for the acquisition of raw materials and sale of the finished product.

13-7

The three major steps in assessing control risk in the inventory process are: 1. Understand and document the inventory internal control system based on the planned level of control risk.

2. Plan and perform tests of controls on inventory process transactions.

3. Assess and document control risk for the inventory process.

13-8

The following control activities can be used by the entity to prevent unauthorized inventory production: • Preparation and review of an authorized production schedule.

• Use of material requirements planning and/or just-in-time inventory systems.

• Review of inventory levels by the inventory management department.

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13-9

Substantive analytical procedures that can be used to test inventory and related account balances include: • Compare raw material, finished goods, and total inventory turnover to previous periods’ and industry averages.

• Compare days outstanding in inventory to previous periods and industry data.

• Compare gross profit percentage by product line with previous periods' and industry data.

• Compare actual cost of goods sold to budgeted amounts.

• Compare current-year standard costs with prior periods' after considering current conditions.

• Compare actual manufacturing overhead costs with budgeted or standard manufacturing overhead costs.

13-10

To audit standard costs, the auditor should first review the entity's policies and procedures for constructing standard costs. Once the policies and procedures are understood, the auditor normally tests the component cost buildup for materials, labor, and overhead for a representative sample of standard product costs. The material component requires testing of the quantity and type of materials included in the product and the price of the materials. The quantity and type of materials are tested by reviewing the engineering specifications for the product. Labor costs require evidence about the type and amount of labor needed for production and the labor rate. The amount of labor necessary to assemble a product can be tested by reviewing engineering estimates, which may be based on time-and-motion studies or historical information.

The labor rates for each type of labor necessary to assemble a product can be tested by examining a schedule of authorized wages. Overhead costs are tested by reviewing the entity's method of overhead allocation for reasonableness, compliance with GAAP, and consistency. The auditor examines the costs included in overhead to ensure that such costs are appropriate costs assignable to the product and that the inclusion or exclusion of such costs is consistent from one period to the next.

13-11

During the observation of the physical inventory count, the auditor should perform the following procedures: • Ensure that no production is scheduled. Or, if production is scheduled, ensure that proper controls are established for movement between departments in order to prevent double counting.

• Ensure that there is no movement of goods during the inventory count. If movement is necessary, the auditor and entity personnel must ensure that the goods are not double counted and that all goods are counted.

• Ensure that the entity's count teams are following the inventory count instructions.

• Ensure that inventory tags are issued sequentially to individual departments. If the entity uses another method of counting inventory, such as detailed inventory listings, the auditor should obtain copies of the listings prior to the start of the inventory count.

• Perform test counts and record a sample of counts in the working papers.

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• Obtain tag control information for testing the entity’s inventory compilation. Tag control information includes documentation of the numerical sequence of all inventory tags and accounting for all used and unused inventory tags.

• Obtain cutoff information, including the number of the last shipping and receiving documents issued on the date of the physical inventory count.

• Observe the condition of the inventory for items that may be obsolete, slow moving, or carried in excess quantities.

• Inquire about goods held on consignment for others or held on a "bill-and-hold" basis.

The auditor must also inquire about goods held on consignment (for sale by others) on behalf of the entity.

13-12

Possible causes of book-to-physical inventory differences include: • Inventory cutoff errors.

• Unreported scrap or spoilage.

• Theft.

13-13

Example disclosure items for inventory and related accounts include: • Cost method (e.g. FIFO, LIFO, retail method).

• Components of inventory.

• Long-term purchase contracts.

• Consigned inventory.

• Purchases from related parties.

• LIFO liquidations.

• Pledged or assigned inventory.

• Disclosure of unusual losses from write-downs of inventory or losses on long-term purchase commitments.

• Warranty obligations.

Answers to Multiple-Choice Questions 13-14 13-15 13-16 13-17 13-18 13-19 13-20

d a c b d c d

13-21 13-22 13-23 13-24 13-25 13-26

b d d b a d

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Solutions to Problems 13-27 There are many control weaknesses in the flowchart. It is unlikely that students will identify all weaknesses. The identification and explanation of the systems and control weaknesses are as follows: • The purchase requisition is not approved. A responsible person in the stores department should approve the purchase requisition. The approval should be indicated on the purchase requisition after the approver is satisfied that it was properly prepared based on a need to replace stores or the proper request from a user department.

• Purchase requisition number 2 is not required. Purchase requisitions are unnecessarily sent from the stores department to the receiving room. The receiving room does not make any use of the purchase requisitions, and no purpose seems to exist for the receiving room to obtain a copy. A copy of the requisition might be sent from the stores department directly to the accounts payable department, where it can be compared to the purchase order to verify that merchandise requisitioned by an authorized employee has been properly ordered.

• Purchase requisitions and purchase orders are not compared in the stores department.

Although purchase orders are attached to purchase requisitions in the stores department, there is no indication that any comparison is made of the two documents.

Prior to attaching the purchase order to the purchase requisition, the requisitioner’s functions should include a check that (1) prices are reasonable, (2) the quality of the materials ordered is acceptable, (3) delivery dates are in accordance with company needs, and (4) all pertinent data on the purchase order and purchase requisition (e.g., quantities, specifications, delivery dates, etc.) are in agreement. Since the requisitioner will be charged for the materials ordered, the requisitioner is the logical person to perform these steps.

• Purchase orders and purchase requisitions should not be combined and filed with the unmatched purchase requisitions in the stores department. A separate file should be maintained for the combined and matched documents. The unmatched purchase requisitions file can serve as a control over merchandise requisitioned but not yet ordered.

• Preliminary review should be made before preparing purchase orders. Prior to preparation of the purchase order, the purchase office should review the company's need for the specific materials requisitioned and approve the request.

• The purchase office should attempt to obtain the highest-quality merchandise at the lowest possible price, and the procedures that are followed to achieve this should be included on the flowchart. There is no indication that the purchase office submits purchase orders to competitive bidding when appropriate. That office should be directly involved with vendors in determining the cost of materials ordered and should be primarily responsible for deciding at what price materials should be ordered and which vendors should be used.

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•

•

• •

•

•

• •

•

•

The purchase office does not review the invoice prior to processing invoice approval.

The purchase office should review the vendor's invoice for overall accuracy and completeness, verifying quantity, prices, specifications, terms, dates, etc., and if the invoice is in agreement with the purchase order, receiving report, and purchase requisition, the purchase office should clearly indicate on the invoice that it is approved for payment processing. The approved invoice should be sent to the accounts payable department.

The copy of the purchase order sent to the receiving room generally should not show quantities ordered, thus forcing the department to count goods received. In addition to counting the merchandise received from the vendor, receiving department personnel should examine the condition and quality of the merchandise upon receipt.

There is no indication of the procedures in effect when the quantity of merchandise received differs from what was ordered. Procedures for handling overshipments should be clearly outlined and included on the flowchart.

The receiving report is not sent to the stores department. A copy of the receiving report should be sent from the receiving room directly to the stores department with the materials received. The stores department, after verifying the accuracy of the receiving report, should indicate approval on that copy and send it to the accounts payable department. The copy sent to the accounts payable department will serve as proof that the company received the materials ordered and are in the stores department.

There is no indication of control over vouchers in the accounts payable department.

In the accounts payable department, a record of all vouchers submitted to the cashier should be maintained, and a copy of the vouchers should be filed in an alphabetical vendor reference file.

There is no indication of control over dollar amounts on vouchers. Accounts payable personnel should prepare and maintain control sheets on the dollar amounts of vouchers. Such sheets should be sent to departments posting transactions to general and subsidiary ledgers.

There is no examination of documents prior to voucher preparation. In addition to the matching procedure, the mathematical accuracy of all documents should be verified prior to preparation of vouchers.

The controller should not be responsible for cash disbursements. The cash disbursement function should be the responsibility of the treasurer, not the controller, so as to provide proper segregation of duties between the custody of assets and the recording of transactions.

There is no indication of the company's procedures for handling purchase returns.

Although separate return procedures may be in effect and included on a separate flowchart, some indications of this should be included as part of the purchase’s flowchart.

Discrepancy procedures are not indicated. The flowchart should indicate what procedures are followed whenever matching reveals a difference between the information on the documents compared.

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13-28 1. Evidence found in the working papers to support the fact that the audit was adequately planned and assistants were properly supervised would be: • Documentation indicating discussions with entity personnel concerning developments affecting the entity that require recognition in the audit plan.

• Documentation of a pre-audit planning conference among audit firm personnel to develop an audit strategy by reviewing and considering matters noted in prior years' working papers, changes in accounting and auditing standards, etc.

• Documentation of assessed inherent risk.

• An internal control write-up documenting that the internal control system had been reviewed.

• Documentation of the results of internal controls testing and the final assessed level of control risk.

• Audit programs tailored to the strengths and weaknesses of the internal control system (i.e., tested the relevant assertions).

• Audit programs indicating steps that were assigned to and completed by individual assistants.

• A budget indicating the time to be spent in each audit area.

• Individual working papers signed by reviewers to document review, approval, and responsibility.

• Confirmations that all questions raised by assistants were answered.

2. Substantive tests that would document management’s completeness assertion as it relates to inventory quantities would be: • Observation of physical inventory counts.

• Analytical procedures for the relationship of inventory balances to purchase, production, and sales activities.

• Inspection of shipping and receiving documentation for proper amounts and dates to verify proper cutoff procedures.

• Obtaining confirmation of inventories at locations outside the entity.

• Tracing of test counts recorded during the physical inventory observation to the inventory listing.

• Accounting for all inventory tags and count sheets used in recording the physical inventory counts.

• Recomputation of the inventory calculations for clerical accuracy.

• Reconciliation of physical counts to perpetual records and general ledger balances and investigation of significant differences.

• Trace a sample of receiving reports to the inventory records 13-29 a. When an entity uses statistical sampling to estimate inventories, the auditor should perform procedures similar to the following: • The auditor should review the entity's procedures and methods for determining inventories to ascertain if they are sufficiently reliable to produce results substantially the same as those that would be obtained by a 100 percent inventory count.

• The auditor should be satisfied that the statistical sampling plan to be used by the

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• • •

•

entity has statistical validity, that it will be properly applied, and that the planned tolerable and expected misstatement and risk of incorrect acceptance will be reasonable in the circumstances.

The auditor should ascertain that proper steps have been taken to ensure that all parts and supplies in the warehouse are included in the perpetual inventory records. This would normally be checked in advance of the physical count.

The auditor should be present when the sample is drawn to make sure that the requirements for random selection are properly observed and that all items in the inventory have an equal or determinable probability of selection.

The auditor must be present to observe counts and must be satisfied with the entity's counting procedures. The inventory observation can be made either during or after the year-end of the period under audit if well-kept perpetual records are maintained and the entity makes periodic comparisons of physical counts with such records.

The auditor should review the statistical evaluation and be satisfied that the estimated value of the precision at a given level of reliability meets the materiality requirements set for the audit.

b. In addition to the above, the following standard audit procedures for verification of physical quantities should be performed whether the entity conducts a periodic physical count for all or part of its inventory. Please note that many of these procedures like verifying footings, reviewing items for proper cutoff, and tracing items to the inventory compilation, can be performed using IDEA and data analytics.

• Review and be satisfied with the entity's physical inventory-taking procedures.

• Observe the physical count.

• Make test counts where appropriate.

• Trace selected count data to the inventory compilation.

• Select items from compilation and trace them to original count data.

• Select items from the warehouse at random and trace these items to the perpetual inventory records.

• Verify footings.

• Compare inventory compilation amounts to the subsidiary ledger control and investigate significant differences.

• Ascertain that there was a proper purchases and sales cutoff.

• Review the treatment of merchandise in transit and consigned merchandise.

• Confirm merchandise in warehouses.

• Perform analytical procedures for inventories.

• Account for all entity inventory count sheets.

• Be sure inventory items are properly classified, in good condition, and of proper quality.

13-30 The substantive auditing procedures Kachelmeier may consider performing include: (a) Using the perpetual inventory file • Recalculate the beginning and ending balances (prices x quantities), foot, and create a report to be used to reconcile the totals with the general ledger or agree beginning

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•

•

• • • • • • •

balance with the prior year's working papers.

Calculate the quantity balances as of the physical inventory date for comparison to the physical inventory file. Alternatively, update the physical inventory file for purchases and sales from January 6 to January 31, 2021, for comparison to the perpetual inventory at January 31, 2021.

Select and print out a sample of items received and shipped for the periods (1) before and after January 5 and 31, 2021, for cutoff testing, (2) between January 5 and January 31, 2021, for vouching or analytical procedures, and (3) prior to January 5, 2021, for tests of details or analytical procedures.

Compare quantities sold during the year to quantities on hand at year-end. Print out a report of items for which turnover is less than expected. Alternatively, calculate the number of days' sales in inventory for selected items.

Select items noted as possibly unsalable or obsolete during the physical inventory observation and print out information about purchases and sales for further consideration.

Recalculate the prices used to value the year-end FIFO inventory by matching prices and quantities to the most recent purchases.

Select a sample of items for comparison to current sales prices.

Identify and print out unusual transactions. These are transactions other than purchases or sales for the year, or physical inventory adjustments as of January 5, 2021.

Recalculate the ending inventory by taking the beginning balances plus purchases, less sales, and print out the differences.

Recalculate the cost of sales for selected items sold during the year.

(b) Using the physical inventory and test count files • Account for all inventory tag numbers used and print out a report of missing or duplicate numbers for follow-up.

• Search for tag numbers noted during the physical inventory observation as being voided or not used.

• Compare the physical inventory file to the file of test counts and print out a report of differences for auditor follow-up.

• Combine the quantities for each item appearing on more than one inventory tag number for comparison to the perpetual file.

• Compare the quantities on the file to the calculated quantity balances on the perpetual inventory file as of January 5, 2021. Alternatively, compare the physical inventory file updated to year end to the perpetual inventory file.

• Calculate the quantities and dollar amounts of the book-to-physical adjustments for each item and the total adjustment. Print out a report to reconcile the total adjustment to the adjustment recorded in the general ledger before year-end.

• Using the calculated book-to-physical adjustments for each item, compare the quantities and dollar amounts of each adjustment to the perpetual inventory file as of January 5, 2021, and print out a report of differences for follow-up.

13-31

Basic Inventory-Auditing Procedures

How a Generalized Audit Software Package and the Inventory File Data Might Be Helpful

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

1. By determining which items are to be test counted by selecting a random sample of a representative number of items from the inventory file as of the date of the physical count.

2. Testing of the mathematical accuracy of the inventory compilation.

2. By mathematically computing the dollar value of each inventory item counted by multiplying the quantity on hand by the cost per unit and verifying the addition of the extended dollar values.

3. Comparison of the auditor's test counts to the inventory records.

3. By arranging test counts in an electronic file format identical to the inventory file and matching the data files.

4. Comparison of physical count data to inventory records.

4. By comparing the total extended values of all inventory items counted and the extended values of each inventory item counted to the inventory records.

5. Testing of the inventory pricing by obtaining a list of costs per item from buyers, vendors, or other sources.

5. By preparing an electronic data file in a format identical to the inventory file and matching the data files.

6. Examination of purchases and sales cutoff.

6. By listing a sample of items on the inventory file for which the date of last purchase and date of last sale are on or immediately prior to the date of the physical count.

7. Ascertainment of the propriety of items of inventory located in public warehouses.

7. By listing items located in public warehouses.

8. Analysis of inventory for evidence of possible obsolescence.

8. By listing items on the inventory file for which the quantity on hand is excessive in relation to the quantity sold during the year.

9. Analysis of inventory for evidence of possible overstocking or slowmoving items.

9. By listing items on the inventory file for which the quantity on hand is excessive in relation to the quantity sold during the year.

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10. Performance of an overall test for accuracy of inventory master file.

13-32 a. b. c. d. e.

10. By listing items, if any, with negative quantities or costs.

6 3 1 4 2

Solution to Discussion Case 13-33 a. The auditors did not follow several audit procedures in a satisfactory manner, including: • Control of count sheets during and after the inventory. There may not have been adequate supervision and instruction of the inventory observation teams by the auditors. There is no evidence that there was adequate preplanning of the inventory count. Even though it is difficult to spend continuous time in the upper racks, there must be a careful control over their contents and planned counting must still be observed.

• Although the late addition of such sheets is highly irregular, the auditors did very little to satisfy themselves of their accuracy. The altering of count sheets after the auditors left could have been prevented by "lining out" unused portions of the count sheet prior to leaving the inventory observation. Test counts of lines on sheets could also have detected the changes.

• Physically examining inventory represented on additional count sheets with specific assurances that the items did not represent duplications in the count.

Tracing the items to purchase invoices does not prove existence at the inventory date, only that the items were at one time bona fide.

• Questions about inventory turnover and similar comparisons should have been raised and addressed.

• If the additional items listed on the four additional sheets, the changing of unit designations, or the fictitious amounts added to completed sheets created unusual balances in specific inventory items, a review of the inventory balances and comparison with the previous year’s balance would have indicated unusual increases. Because of the weaknesses in inventory control, audit procedures should have been expanded. b. Failure to obtain adequate evidence to support management’s assertions can result in legal liability from injured third parties and in fines and sanctions by the PCAOB and the SEC. Possible PCAOB and SEC sanctions are discussed in Chapter 20. For example, SEC sanctions can involve prohibition of appearing before the commission, prohibition from accepting new SEC entities, and/or required peer reviews. c. The following auditing standards require that the auditor communicate specific 17-150 Copyright ©2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

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information to the audit committee.

AU-C 265 requires that the auditor report to the audit committee, or to a similar level of authority if the entity does not have an audit committee, internal control-related matters which are referred to as reportable conditions. For audits of public entities, AS 2201 requires that the auditor report to the audit committee all material control weaknesses and significant control deficiencies.

AU-C 240 and AS 2401 state that the auditor should inform the audit committee or board of directors of material fraud that is identified.

AU-C 260 and AS 1301 require that the auditor communicate certain matters related to the conduct of the audit to the audit committee and those individuals responsible for oversight of the financial reporting process. For AU-C 260 the communication should address the following matters: • The auditor's responsibility under GAAS. • Significant accounting policies.

• Management judgments and accounting estimates.

• Significant audit adjustments.

• Disagreements with management.

• Consultation with other accountants.

• Major issues discussed with management prior to retention.

• Difficulties encountered during the audit.

AS 1301 requires the following communications: • Terms of the engagement (objectives and responsibilities) • Information from the audit committee relevant to the audit • An overview of the audit strategy, significant risks, and timing of the audit • Timely observations arising from the audit that are significant to the financial reporting process (e.g., quality of accounting policies and practices, unusual transactions, quality of accounting estimates, difficult or contentious matters, uncorrected or corrected misstatements, disagreements with management, difficulties in performing the audit)

Solutions to Internet Assignment 13-34

A search of the SEC’s website should identify a recent company that has been cited by the SEC for financial reporting problems related to inventory. For example, on September 29, 2020, the SEC announced settled charges against Manitex International, Inc. for inventory-related fraud. Company management created false inventory lists and shipping documents to cover up a million-dollar inventory shortfall at a subsidiary (SEC.gov | SEC Charges Manitex International and Three Former Senior Executives With Accounting Fraud).

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PREPAID EXPENSES, INTANGIBLE ASSETS, AND PROPERTY, PLANT, AND EQUIPMENT Answers to Review Questions 14-1

Prepaid expenses provide a legal right to services or an economic benefit for less than a year and typically involve routine recurring expenditure paid in advance. Intangible assets provide economic benefit for longer than a year, therefore misstatements can occur which affect multiple periods. Intangible assets often represent intellectual property.

Examples of prepaid expenses include: • Prepaid insurance • Prepaid rent • Prepaid interest Examples of intangible assets include: • Copyrights • Trademarks • Trade names • Licenses • Patents • Franchises • Goodwill

14-2

Intangible assets often present serious inherent risks because there are possible judgment issues, including significant assumptions used in developing estimates, relating to the valuation (both initially and through subsequent impairment) and estimated lives of items such as patents, franchises, and goodwill. These issues can lead to disagreements between the auditor and the client.

14-3

The purchasing process affects prepaid insurance and property, plant, and equipment transactions because such transactions are subject to the control activities included in the purchasing process. For example, control activities in the purchasing process may provide assurance as to the proper authorization and recording of insurance policies.

Similarly, the occurrence (validity) and authorization of property, plant, and equipment transactions are normally part of the purchasing process.

14-4

Examples of substantive analytical procedures that can be used to test prepaid insurance are: • Compare the current-period balance in prepaid insurance and insurance expense with the prior periods’ balances after considering any changes in operations.

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• •

Compute the ratio of insurance expense to assets or sales and compare it with the prior periods’ ratios.

Create an estimate of the year-end balance in prepaid insurance based on the premium and the amount of time remaining on the policy at the end of the period.

14-5

A confirmation from insurance brokers would include information on the policy number, coverage, expiration date, deductibles, and premiums.

14-6

The categories of intangible assets are (only four are required to be listed): • Marketing—trademark, brand name, and Internet domain names.

• Customer—customer lists, order backlogs, and customer relationships.

• Artistic—items protected by copyright.

• Contract—licenses, franchises, and broadcast rights.

• Technology—patented and unpatented technology.

• Goodwill—the difference between the acquisition price for a company and the fair values of the identified tangible and intangible assets.

Four types of property, plant, and equipment transactions are: • Acquisition of capital assets for cash or other nonmonetary considerations.

• Disposition of capital assets through sale, exchange, retirement, or abandonment.

• Depreciation of capital assets over their useful economic life.

• Leasing of assets.

14-7

a) Inherent risk factors to be considered when assessing inherent risk for intangible assets are: 1. Nature of the judgments required to establish the assets value: Considerable judgment is involved in valuing intangible assets acquired in a transaction. Inherent risk may be reduced if a specialist was hired by the client to assist in the valuation of the intangible assets.

2. Complexity of the accounting rules: The complex rules with regards to acquisitions, tests for impairment, and amortization of intangible assets with definite lives also increase inherent risk because they require the entity to make assumptions regarding the assets estimated value, life, or future cash flows. b) Inherent risk factors that should be considered when assessing inherent risk for property, plant, and equipment are: 1. Complex accounting issues: Lease accounting, self-constructed assets, and capitalized interest are examples of transactions that involve complex accounting issues.

2. Difficult-to-audit transactions: The vast majority of property, plant, and equipment transactions are relatively easy to audit. However, transactions involving donated assets, nonmonetary exchanges, and self-constructed assets are more difficult to audit because it may be difficult to verify the value of such assets.

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If the auditor has detected misstatements in prior audits, the likelihood of misstatements in the current year is higher.

14-8

Most entities have some type of authorization table for approving capital asset transactions. Control activities should be present to ensure that the authorization to purchase capital assets is consistent with the authorization table. For example, the control activities should specify dollar limits at each managerial level to ensure that larger projects are brought to the attention of higher levels of management for approval before commitments are made. The entity also needs to have control activities for authorizing the sale or other disposition of capital assets. This should include a level of authorization above the department initiating the disposition. Control activities should also identify assets that are no longer used in operations, because they may require different accounting treatment. Finally, an appropriate level of management should properly authorize all major maintenance or improvement transactions.

14-9

Some of the key segregation of duties for property, plant, and equipment and possible errors or fraud that can occur if they are not present are: Segregation of Duties

Possible Errors or Fraud as a Result of Conflicts in Duties

The initiation function should be segregated from the final approval function.

Fictitious or unauthorized purchases of assets could occur, resulting in purchases of unnecessary assets, assets that do not meet the company's quality control standards, or illegal payments to suppliers or contractors.

The property, plant, and equipment records function should be segregated from the general ledger function.

A theft that would normally be detected by reconciling the subsidiary records with the general ledger control account could be concealed.

The property, plant, and equipment records function should be segregated from the custodial function.

Tools and equipment could be stolen and the theft could be concealed by adjusting the accounting records.

If a periodic physical inventory of property, plant, and equipment is taken, the individual responsible for the inventory should be independent of the custodial and recordkeeping functions.

Theft of the entity's capital assets could be concealed.

14-10 The following substantive analytical procedures can be used in the audit of property, plant, and equipment: • Compare prior-year balances in property, plant, and equipment and depreciation expense with current-year balances taking into account any changes in conditions or asset composition.

• Compute the ratio of depreciation expense to the related property, plant, and equipment accounts and comparison to prior years' ratios.

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• • •

Compute the ratio of repairs and maintenance expense to the related property, plant, and equipment accounts and compare to prior years' ratios.

Compute the ratio of insurance expense to the related property, plant, and equipment account and compare to prior years' ratios.

Review capital budgets and compare the amounts spent with the amounts budgeted.

14-11 The following audit procedures can be used to verify the completeness, rights and obligations, and accuracy and valuation assertions: Completeness:

-Physically examine a sample of capital assets and trace them into the property, plant, and equipment subsidiary ledger.

-Trace a sample of purchase requisitions to receiving reports and to the PP&E records -Obtain a lead schedule and agree total to the general ledger

Rights and Obligations:

-Examine or confirm deeds or title documents for proof of ownership.

Accuracy and Valuation:

-Test depreciation calculations for a sample of capital assets.

-Evaluate fixed assets for significant write-offs or impairments by: identifying events or circumstances that may indicate the carrying value is not recoverable, examining the expected future cash flows, or examining supporting documentation for write-offs.

-For assets written off, test amounts charged against income and accumulated depreciation.

Answers to Multiple-Choice Questions 14-12 14-13 14-14 14-15 14-16 14-17

c a b b a a

14-18 14-19 14-20 14-21 14-22

d a d b a

Solutions to Problems 14-23 a. Two substantive analytical procedures that can be used to test prepaid insurance are (only two required): • Examine the trend in prepaid insurance over 3-5 years to develop an expectation for the current year balance after considering any changes in operations. Compare the expectation to the current-year balance and investigate the difference if it is greater than the threshold.

• Compute the ratio of insurance expense to assets or sales and compare it with the

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•

prior years’ ratios.

Compute an estimate of the ending prepaid account balance using the current premium and the amount of time remaining on the policy at the end of the period.

b. The following substantive tests should be performed on the schedule of prepaid insurance: • Foot the schedule and trace the ending balance to the prepaid insurance account in the general ledger.

• Send confirmations to the entity's insurance brokers, requesting information on each policy's number, coverage, expiration date, and premiums; alternatively, examine supporting documents such as insurance bills and policies.

• Compare the detailed policies in the current year's insurance register with the policies included in prior years' insurance register.

• Recompute the unexpired portion of the prepaid insurance after considering the premium paid and the term of the policy.

• Examine the insurance policy coverage and ensure that costs are properly allocated to the various insurance expense accounts.

• Inquire of management or its insurance broker about the adequacy of the entity's insurance coverage.

14-24 a. Taylor should consider performing the following procedures in the audit of Palmer's goodwill and trademark accounts: • Obtain a copy of the entity’s detailed listing of intangible assets, which should agree with the total amount of intangible assets reported on the entity’s balance sheet.

• Examine the entity’s impairment documentation to ensure that each asset is subject to the appropriate impairment testing in accordance with GAAP including the goodwill and trademark accounts.

• If impairment tests have not been performed on the goodwill and trademark accounts, the auditor would establish the fair value of all assets and liabilities of the reporting unit using an appropriate valuation model consistent with GAAP. A qualified, objective specialist may be employed to assist in this process.

• The excess fair value of the reporting unit’s assets over liabilities is the implied fair value of goodwill. Verify if goodwill is impaired, and if so, verify if the amount of impairment loss is material.

• The result of the valuation of the trademark assets is compared with the current book values of the trademark assets to verify if the assets are impaired.

• If the trademark assets are impaired, verify if the amount of the impairment exceeds materiality. b. When specialists are used, the auditor is required to evaluate the specialist’s qualifications and objectivity. The auditor also must determine if the valuation model used by the specialist is appropriate and consistent with GAAP and the auditor must understand and agree with the reasonableness of the underlying assumptions.

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transactions that Nakamura may consider in assessing control risk include the following: • Advance approval in accordance with management's criteria is required for property and equipment transactions.

• Approval authority for transactions above an established dollar value is required at a higher level, such as the board of directors.

• Property and equipment transactions are adequately documented.

• There are written policies covering capitalizing expenditures, classifying leases, and determining estimated useful lives, salvage values, and methods of depreciation and amortization.

• There are written policies covering retirement procedures that include serially numbered retirement work orders, stating the reasons for retirement and bearing appropriate approvals.

• There are adequate policies and procedures to determine whether property and equipment are received and properly recorded, such as a system that matches purchase orders, receiving reports, and vendors' invoices.

• There are adequate procedures to determine whether dispositions of property and equipment are properly accounted for and any proceeds are received in accordance with management's authorization.

• A property and equipment subsidiary ledger is maintained showing additions, retirements, and depreciation, and the ledger is periodically reconciled.

• Property and equipment is physically inspected and reconciled at reasonable intervals with independently maintained property and equipment records.

• An annual budget is prepared and monitored to forecast and control acquisitions and retirements of property and equipment.

• Reporting procedures ensure prompt identification and analysis of variances between authorized expenditures and actual costs.

• Adequate safeguards protect property and equipment.

• Property and equipment are insured in accordance with management's authorization.

• Documents evidencing title and property rights are periodically compared with the detailed property records.

• The entity employs internal auditors to test whether the internal controls are operating effectively.

14-26 a. Property, plant, and equipment normally include only fixed tangible assets. Fixed tangible assets are capital assets with useful lives generally in excess of one year that are used in the operation of the business and that are not purchased for resale purposes.

b.

Item Number

Is Audit Adjustment or Reclassification Required?

1.

Yes

Reasons Why Audit Adjustment or Reclassification Is Required or Not Required Commissions paid to real estate agents are costs directly related to the acquisition of the property 17-157

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and should be included in the land cost. The costs of removing, relocating, or reconstructing property of others to acquire possessions are costs that are directly attributable to conditioning the property for use and should be included in land costs. An adjustment is required for these items so that total land costs can properly be included in property, plant, and equipment.

2.

No

No adjustment is required because clearing costs are costs that are directly attributable to conditioning the property for use and should be included in land costs, which are part of property, plant, and equipment.

3.

Yes

Since clearing costs are costs of the land, amounts realized from the sale of materials recovered, such as timber and gravel, should be a reduction of the cost of the land and should not be recorded as other income.

4.

Yes

All costs relating to the purchase of machinery and equipment should be capitalized. For purchased items such costs would include invoice price, freight costs, and unloading charges. Royalty payments, however, should not be included in the cost of the machinery. Such payments should be charged to expenses as they accrue. Machinery costs, other than royalty payments, should be included in property, plant, and equipment.

14-27 a. 4 b. 7 c. 2 14-28 Substantive audit procedures that Pierce should use in examining Wong's mobile construction equipment and related depreciation would include the following: • Determine that the equipment account schedule is properly footed.

• Determine that the subsidiary accounts agree with controlling accounts.

• Obtain, or prepare, an analysis of changes in the account during the year.

• Determine that beginning-of-year balances agree with the prior year's ending balances.

• Inspect documents in support of additions during the year.

• Inspect documents in support of retirements during the year.

• Analyze repairs and maintenance for possible reclassifications.

• Determine the propriety of accounting for equipment not in current use.

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• • • • • •

Test the accuracy of equipment and accounting records by (1) selecting items from the accounting records and verifying their physical existence and (2) selecting items of equipment and locating them in the accounting records.

Evaluate the reasonableness of estimated lives and methods of depreciation used.

Test the calculation of depreciation expense and accumulated depreciation balance.

Perform analytical procedures such as comparing depreciation expense to balance sheet accounts for proper relationship and compare the current year's depreciation expense with prior year's depreciation expense.

Evaluate the financial statement presentation and disclosures for conformity with generally accepted accounting principles.

Review insurance coverage.

Solution to Discussion Case 14-29 a. The relevant accounting standard for this is found in FASB ASC Topic 610-20, ―Gains and Losses from the Derecognition of Nonfinancial Assets.‖ The standard covers sales of nonfinancial assets that are not outputs of the entity’s ordinary activities (i.e., not sales of products to customers). The entity should recognize as a gain or loss the difference between the amount of consideration per the contract and the carrying amount of the distinct asset. In this case, because land is not depreciated, the gain is equal to the difference between the carrying value of $1M and the transaction price of $10M. b. In testing the transaction, the auditor should: • Examine the sales contract.

• Examine cash receipt of $10 million • Examine the subsidiary records containing the information on the land’s book value.

Solutions to Internet Assignments 14-30 It is difficult to get information directly on some of EarthWear’s competitors. Lands’ End’s most recent 10-K states that ―depreciation expense is recorded over the estimated useful lives of the respective assets using the straight-line method. Leasehold improvements are depreciated over the shorter of the associated lease term or the estimated useful life of the asset.‖ VF Corporation has apparel brands such as Vans, Timberland, The North Face, JanSport, and others. VF Corporation’s most recent annual report states, ―VF’s depreciation policies for property, plant and equipment reflect judgments on their estimated economic lives and residual value, if any. VF’s amortization policies for definite-lived intangible assets reflect judgments on the estimated amounts and duration of future cash flows expected to be generated by those assets. In evaluating the amortizable life for customer relationship intangible assets, management considers historical attrition patterns for various groups of customers…Depreciation of property,

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plant and equipment is computed using the straight-line method over the estimated useful lives of the assets, ranging from 3 to 10 years for machinery and equipment and up to 40 years for buildings. Amortization expense for leasehold improvements and assets under finance leases is recognized over the shorter of their estimated useful lives or the lease terms, and is included in depreciation expense. Intangible assets determined to have indefinite lives, consisting of major trademarks and trade names, are not amortized. Other intangible assets determined to have a finite life primarily consist of customer relationships, which are amortized over their estimated useful lives ranging from 10 to 24 years using an accelerated method consistent with the timing of benefits expected to be received. Depreciation and amortization expense related to producing or otherwise obtaining finished goods inventories is included in cost of goods sold, and other depreciation and amortization expense is included in selling, general and administrative expenses. ‖ Other clothing retailers are privately held companies and there are no publicly available financial statements.

14-31 A search of the SEC’s website should identify a company that has been recently cited by the SEC for problems related to property, plant, and equipment.

CHAPTER 15 AUDITING THE FINANCING/INVESTING PROCESS: LONGTERM LIABILITIES, STOCKHOLDERS' EQUITY, AND INCOME STATEMENT ACCOUNTS Answers to Review Questions 15-1

A substantive audit strategy is normally followed when auditing the long-term debt and capital accounts because, although the number of transactions is smaller, each transaction is usually material. Thus, it is normally more cost-effective to conduct substantive tests of the transactions that compose the account balance. The auditor may follow a reliance strategy for entities that engage in frequent financing activities.

15-2

The most important assertions to the auditor for long-term debt are occurrence, authorization, completeness, valuation, and classification. The documents that normally contain the authorization to issue long-term debt include a properly signed lending agreement and the minutes of board of directors' meetings.

15-3

The auditor can estimate interest expense by multiplying the twelve-monthly balances for long-term debt by the average interest rate. The reasonableness of interest expense can then be assessed by comparing this estimate to the interest expense amount recorded in the general ledger. If the two amounts are not materially different, the auditor can conclude that interest expense is fairly stated. If the estimated amount of interest expense is materially higher than the recorded amount, the auditor might conclude that the entity

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has failed to record a portion of interest expense. On the other hand, if the recorded amount of interest expense was materially higher than the estimated amount, the entity may have failed to record debt. It is important to remember that the inputs (i.e., interest rates, monthly balances) must be audited/verified in order to obtain assurance from the substantive analytical procedure.

15-4

Confirmation of long-term debt provides evidence for the existence, completeness, and accuracy and valuation assertions.

15-5

The registrar is responsible for ensuring that all stock issued is in compliance with the corporate charter and for maintaining control totals for total shares outstanding. The transfer agent is responsible for preparing stock certificates and maintaining adequate stockholders' records. The dividend-disbursing agent prepares and distributes dividend payments to the stockholders of record.

15-6

When the entity does not use a registrar or transfer agent and a sufficient number of personnel are available, the following segregation of duties should be maintained: • The individuals responsible for issuing, transferring, and canceling stock certificates should not have any accounting responsibilities.

• The individual responsible for maintaining the detailed stockholders' records should be independent of the maintenance of the general ledger control accounts.

• The individual responsible for maintaining the detailed stockholders' records should not also process cash receipts or disbursements.

• The preparation, recording, signing, and distribution of dividend payments should be appropriately segregated.

15-7

The two most common disclosures for stockholders' equity are (1) the number of shares authorized, issued, and outstanding for each class of stock and (2) restrictions on retained earnings and dividends. These disclosures are necessary so that stockholders can determine what share of the company they own and whether there are any restrictions on the declaration of dividends.

Other disclosures for stockholders' equity include: • Call privileges, prices, and dates for preferred stock.

• Preferred stock sinking funds.

• Stock option or purchase plans.

• Any completed or pending transactions (e.g., stock dividends or splits) that may affect stockholders' equity.

15-8

When the entity uses an independent dividend-disbursing agent, the auditor can confirm the amount disbursed to the agent by the entity. This amount is agreed with the amount authorized by the board of directors. The auditor can recompute the dividend amount by multiplying the number of shares outstanding on the record date by the amount of the per share dividend approved by the board of directors. This amount should agree to the amount disbursed to shareholders and accrued at year-end.

The auditor begins the audit of retained earnings by obtaining a schedule of the activity in the account for the period. The beginning balance is agreed to the prior year's 17-161 Copyright ©2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

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working papers and financial statements. Net income or loss can be traced to the income statement. The amounts for any cash or stock dividends can be verified as described in the previous paragraph. If there are any prior-period adjustments, the auditor must be certain that the transactions satisfy the requirements of the relevant accounting standards.

Any new appropriations or changes in existing appropriations should be traced to the contractual agreement that required the appropriation. Last, the auditor must make sure that all necessary disclosures related to retained earnings are made in the footnotes.

15-9

Three substantive analytical procedures that the auditor might use in auditing the income statement include: • Use the prior years’ trends in quarterly dollar amounts for each significant revenue and expense account (e.g., disaggregate revenue by product or location) to develop an expectation for the current year.

• Calculate the ratio of individual expense accounts to net sales and comparing these percentages across years.

• Perform substantive analytical procedures of specific revenue or expense accounts (e.g., sales commissions can be tested by using the entity's commission schedule and multiplying the commission rates times eligible sales).

15-10 The auditor conducts a detailed analysis and vouches the transactions in legal expense, travel and entertainment, and other income/expense accounts because these are accounts that are not directly affected by an accounting process, accounts which contain sensitive information or unusual transactions, or accounts for which detailed information is needed for the tax return or other schedules included with the financial statements.

Answers to Multiple-Choice Questions 15-11 15-12 15-13 15-14 15-15

d b b b b

15-16 15-17 15-18 15-19 15-20

d d d b c

Solutions to Problems 15-21 a. The procedures that Maslovskaya should employ in examining the loans are as follows: • Obtain an understanding of the business purpose of the loans made by the president.

• Confirm the loans, including terms, by direct communication.

• Recompute (or verifying) interest expense and interest payable.

• Recompute the long-term and short-term portions of the debt.

• Review minutes of meetings of the board of directors for proper authorization.

• Verify payments made during the year and transactions after year-end.

• Read the financial statements, including footnotes and loan agreements, and evaluating the adequacy of disclosure and compliance with restrictions.

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• Consider any tax implications for the interest on the loan from the company’s president.

• Obtain a management representation letter. b. Broadwall's financial statements should disclose the following information concerning the loans from its president: • The nature of the related-party relationship.

• The dollar amounts of the loans.

• Amounts due the president and, if not otherwise apparent, the terms and manner of settlement.

Subject to certain limited exceptions, loans to or from executives are prohibited for public companies.

15-22 To test the reasonableness of the amount of reported interest expense, the auditor could multiply (6%/12) by each of the monthly balances for long-term debt and add them together to estimate interest expense for the year. This estimate equals $4,575, which is significantly higher than the reported amount of $2,000. The auditor should investigate further as it appears the interest expense is likely misstated.

15-23 The working paper contains the following deficiencies: • The subject of the working paper is not properly indicated in the title.

• There is no indication of any follow-up on the identified error in the accrued interest payable computation.

• There is no indication as to whether the confirmation exception was resolved.

• The loan with the unwaived violation of a provision of the debt agreement is misclassified as long-term.

• The liability activities of Lender's Capital Corporation and the working paper totals do not crossfoot.

• There is no indication of cross-referencing of the stockholder loan to the relatedparty transactions working papers.

• There is no investigation of the payment on the stockholder loan that was reborrowed soon after year-end.

• There is no consideration of the need to impute interest expense on the 0 percent stockholder loan.

• There is no indication that the dates under ―Interest paid to‖ were audited.

• There is no indication that the unusually high average interest rate ($281,333/$1,406,667 = 20%) was noted and investigated.

• The working paper does not support the overall conclusions expressed.

• The tick mark ―R‖ is used but not explained in the tick mark legend.

• There is no indication that the working paper was prepared by entity personnel.

15-24 The substantive audit procedures that Lee should apply in examining the common stock and treasury stock accounts of Wu, Inc., are as follows: • Review the corporate charter to verify details of the common stock such as authorized shares, par value, etc.

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accounts.

• Compare opening balances with prior year’s working papers.

• Foot the total shares outstanding in the stockholders' ledger and stock certificate book.

• Determine authorization for common-stock issuances and treasury-stock transactions by inspecting the minutes of board of directors’ meetings.

• Verify capital-stock issuances by examining supporting documentation and tracing entries into the records.

• Verify treasury-stock transactions by examining supporting documentation and tracing entries into the records.

• Examine all certificates canceled during the year.

• Inspect all treasury-stock certificates owned by the entity.

• Reconcile the details of the individual certificates in the stock certificate book with the individual shareholders’ accounts in the stockholders' ledger.

• Compare the totals in the stockholders' ledger and the stock certificate book to the balance sheet presentation.

• Recompute the weighted average number of shares outstanding.

• Compare the financial statement presentation and disclosure with GAAP. • Determine the existence of and proper accounting for common-stock and treasurystock transactions occurring since year-end.

• Obtain written representations concerning common and treasury stock in the client representation letter.

Solution to Discussion Case 15-25 a. There are a number of audit procedures that Johnson can conduct in order to determine if the entity is in violation of the debt agreement. Note that the possible violation of the debt covenants may have occurred during the subsequent events period. The entity's year-end was June 30, and the suspected violation occurred on August 31, the date the restrictions became effective. Possible audit procedures are as follows: • Test the covenant restrictions at August 31. However, since the entity does not have good period-end cutoffs for sales and purchases, Johnson should perform cutoff procedures at August 31.

• Test the covenant procedures at June 30. This may provide some additional evidence on the reliability of the tests at August 31.

• Obtain a representation letter from management that the covenant restrictions were being met.

If Johnson determined that Mother Earth was in violation on August 31, she could (1) ask management if it intended to seek a waiver or modification of the loan restrictions and (2) inquire of the lenders as to whether Mother Earth Foods would be granted such a waiver or modification. b. FASB ASC Topic 470, ―Debt‖ provides guidance for situations in which a violation of a debt covenant has occurred at the balance sheet date. This standard basically states in 470-10-45-1 that ―if a covenant violation occurs that would otherwise give the lender the right to call the debt, a lender may waive its call right arising from the

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current violation for a period greater than one year while retaining future covenant requirements. Unless facts and circumstances indicate otherwise, the borrower shall classify the obligation as noncurrent, unless both of the following conditions are met: 1) A covenant violation that gives the lender the right to call the debt has occurred at the balance sheet date or would have occurred absent a loan modification.

2) It is probable that the borrower will not be able to cure the default (comply with the covenant) at measurement dates that are within the next 12 months.‖ In this case, the most appropriate solution is for Johnson to determine if Mother Earth violated the covenants on August 31. If so, and if the entity can obtain a waiver, the debt should continue to be classified as noncurrent because no violation existed at the balance sheet date and the waiver after the balance sheet date cures the problem. If Johnson determined that a violation had occurred at August 31, at a minimum, the status of the debt should be disclosed in the footnotes.

ASC 470-10-55-2 illustrates how to treat debt with covenants.

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Solution to Internet Assignment 15-26

Student’s answer will vary. a. Students should provide justification for their overall opinion. Most students will agree with the FASB’s decision to move operating lease obligations to the balance sheet because it results in a more accurate presentation of how companies use the leased assets. If students are opposed to the new standard, some reasons why could include potential complications with debt covenants or that such changes were not necessary given that external users such as analysts and investors already made adjustments to financial statements to account for uncapitalized operating leases. b. Some analysts have estimated that the new standard added at least $2 trillion to the balance sheets of companies in the U.S. c. This is a great question and one that is not yet fully determined. The FASB is suggesting that the new liabilities not be considered long-term debt, because that could trigger debt covenant violations (see footnote 2 in the chapter). Rather, the operating lease liability will be shown as a separate line item on the balance sheet.

However, it remains to be seen how lenders will classify operating lease liabilities.

Some would argue that it should not affect sophisticated users of financial statements who were already aware of these off-balance sheet leases and made their own adjustments when valuing companies. d. The shift in liabilities to the balance sheet will change ratios and trends relative to prior years. Before FASB Topic ASC 842, auditors were required to understand and verify the accuracy and completeness of the operating lease footnote and related schedule. Going forward, auditors will apply similar tests and procedures to an operating lease liability to what they perform for short and long-term debt.

CHAPTER 16 AUDITING THE FINANCING/INVESTING PROCESS: CASH AND INVESTMENTS Answers to Review Questions 16-1

The reliability of an entity's control activities over cash receipts and cash disbursements affects the nature and extent of the auditor's substantive tests of cash balances. If the control risk assessment is below the maximum level for both cash receipts and disbursements, the auditor can reduce the extent of substantive evidence gathered for the cash balances.

16-2

A general cash account is the principal cash account for most entities. The major source

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of cash receipts for this account is the revenue process, and the major sources of cash disbursements are the purchasing and human resource management processes.

Companies that have multiple locations are likely to have branch accounts. Such accounts provide the branch with the ability to pay local expenses and to maintain banking relations with the local community.

An imprest bank account contains a stipulated amount of money, and the account is used for limited purposes. Imprest accounts are frequently used for disbursing payroll and dividend checks.

An imprest account serves as a clearing account for similar types of checks. By separating similar types of checks, the entity facilitates the disbursement of cash while maintaining adequate control over cash. Use of imprest accounts also minimizes the time necessary to reconcile the general cash account.

16-3

Because of the residual nature of cash, it does not have a predictable relationship to other financial statement accounts. As a result, the auditor's use of analytical procedures for auditing cash is limited to comparisons with prior years' cash balances and to budgeted amounts. This limited use of analytical procedures is normally offset by (1) extensive tests of controls and/or substantive tests of transactions for cash receipts and cash disbursements or (2) extensive tests of the entity's bank reconciliations.

16-4

The standard bank confirmation form does not identify all information about an entity's bank deposits or loans because it does not require bank personnel to conduct a comprehensive, detailed search of the bank's records beyond the account information requested on the confirmation.

16-5

A cutoff bank statement is obtained to test the reconciling items included in the bank reconciliation. The outstanding checks or substitute checks returned with the cutoff bank statement are examined for proper payee, amount, and endorsement.

16-6

Three fraud-related audit procedures for cash are: • Extended bank reconciliation procedures. These procedures include examining the disposition of the reconciling items included in the prior months’ reconciliations and the reconciling items included in the current bank reconciliation.

• Proof of cash. The four-column proof of cash (1) ensures that all cash receipts recorded in the entity’s cash receipts journal were deposited in the entity’s bank account, (2) ensures that all cash disbursements recorded in the entity’s cash disbursements journal have cleared the entity’s bank account, and (3) ensures that no bank transactions have been omitted from the entity’s accounting records. See Exhibit 16-5 for an example.

• Tests for kiting. An interbank transfer schedule is used to test for kiting (see Exhibit 16-6).

16-7

An approach used by auditors to test for kiting is the preparation and evaluation of an interbank transfer schedule. With an interbank transfer schedule, the auditor tests the dates of cash disbursements and the cash receipt for each transfer to assure that the transfer is properly recorded. See Exhibit 16-6.

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16-8

The main transaction-related assertions for investments are occurrence, authorization, completeness, accuracy, and classification.

The key segregation of duties for investments and the errors or fraud that they can prevent are: Possible Errors or Fraud as a Result of Conflicts in Duties

Segregation of Duties The initiation function should be segregated from the final approval function.

Fictitious transactions can be made or securities can be stolen.

The value-monitoring function should be segregated from the acquisition function.

Securities values can be improperly recorded or not reported to management.

Responsibility for maintaining the securities ledger should be separate from that of making entries in the general ledger.

Concealment of a theft that would normally be detected by reconciliation of subsidiary records with general ledger control accounts.

Responsibility for custody of securities should be separate from that of accounting for the securities.

Theft of securities can be concealed.

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16-9

FASB ASC Topic 320, ―Investments – Debt Securities,‖ requires that debt investments be classified in three categories and accounted for as follows: • Debt securities that the entity has the positive intent and ability to hold to maturity are classified as held-to-maturity securities and reported at amortized cost.

• Debt and equity securities that are bought and held principally for the purpose of selling them in the near term are classified as trading securities and reported at fair value, with unrealized gains and losses included in earnings.

• Debt or equity securities not classified as either held-to-maturity or trading securities are classified as available-for-sale and are reported at fair value, with unrealized gains and losses excluded from earnings and reported in a separate component of shareholders' equity.

The auditor must also determine if there has been any permanent decline in the value of an investment security. Accounting standards provide guidance for determining whether a decline in value below amortized cost is other than temporary.

FASB ASC Topic 321, ―Investments – Equity Securities,‖ requires that equity investments (except those accounted for under the equity method of accounting or those that result in consolidation of the investee) to be measured at fair value with changes in fair value recognized in net income. For equity investments that do not have readily determinable fair value, an entity may choose to measure at cost minus impairment, plus or minus changes resulting from observable price changes in orderly transactions for the identical or a similar investment of the same issuer.

16-10 The two presentation classification issues that are important for the audit of debt investments are: • Marketable securities need to be properly classified between held-to-maturity, trading, and available-for-sale.

• The financial statement classification requires that all trading securities be reported as current assets and held-to-maturity securities and individual available-for-sale securities be classified as current or noncurrent assets based on whether management expects to convert them to cash within the next twelve months.

16-11 Fair value audit evidence for Level 1 is objective and market-based so the auditor will obtain fair values from publicly available sources (e.g., finance website). Level 3 fair value evidence will involve examining management’s assumptions and subjective inputs to valuation models. Complicated financial instruments, such as credit default swaps, asset-backed securities, and collateralized debt obligations, among others, may not be traded on active markets, making accurate valuation of such instruments difficult. The auditor will likely need to involve a valuation specialist.

Answers to Multiple-Choice Questions

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16-12 16-13 16-14 16-15 16-16 16-17

b a d a b b

16-18 16-19 16-20 16-21 16-22 16-23

d b b b c b

Solutions to Problems 16-24 The auditor's internal control questionnaire should include the following additional questions: • Does access to the bank safe-deposit vault require the signature or presence of two designated persons?

• Are all individuals who have access to marketable securities bonded?

• Are those who have access to the securities denied access to the accounting records?

• Does the accounting department keep detailed records of • Purchases and sales?

• Securities (including number of shares) owned?

• Stock certificate numbers?

• Dividend income?

• Gains and losses?

• Are all securities registered in the name of the company?

• Are all securities periodically inspected?

• Are the inspections performed on a surprise basis?

• Is the physical inventory of securities reconciled with the accounting records?

• Are all purchases and sales of securities executed by the treasurer within the directives of the investment committee?

• Is the amount of dividends received on individual investments periodically reconciled to published public records?

• Does the investment committee periodically review compliance with its established policy?

16-25 Typical audit program steps for auditing Sevcik's bank balance include the following steps: • Review answers to questions on confirmation requests to determine proper recognition in accounting records and the necessity for financial statement disclosure.

• Make inquiries as to compensating balances and restrictions.

• Obtain copies of the bank reconciliations as of the balance sheet date and • Trace the adjusted book balances to the general ledger balances; and • Compare the bank balances to the opening balances on the cutoff bank statements.

• Compare the bank balances to the balances on the confirmations.

• Trace amounts of deposits in transit to the cutoff bank statements and ascertain whether the time lags are reasonable.

• Verify the clerical accuracy of the reconciliations.

• Obtain explanation for unusual reconciling items, including checks drawn to "bearer," 17-170 Copyright ©2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

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• • • •

•

16-26

"cash," and related parties.

Trace checks dated prior to the end of the period that were returned with the cutoff statements to the list of outstanding checks.

Investigate outstanding checks that did not clear with the cutoff bank statements.

Examine a sample of checks for payee, amount, date, authorized signatures, and endorsements to determine any deviations from company policy or fraud in the accounting records.

Prepare a bank transfer schedule from a review of the cash receipts and disbursements journals, bank statements, and related paid checks for the last few days before and the first few days after year-end. Review the schedule to determine that the deposit and disbursement of each transfer is recorded in the proper period.

Trace incomplete transfers to the schedule of outstanding checks and deposits in transit. a. b. c. d. e.

4 1, 5, 6, 7, 8 2, 5, 6, 7, 8 7 3

16-27 a. The following information is missing: • The date of purchase of security ―S‖.

• The date of purchase and sale of security ―R‖.

• Data concerning the accrual and/or receipt of interest due on ―R‖ to the date of sale.

• Data concerning the accrual and/or payment of interest due on ―S‖ to the date of purchase.

• Justification for accrual of dividends.

• Accounting treatment of bond discount.

• Data concerning the December 31 revenue accruals.

• Data required to evaluate the classification of securities. b. The following procedures were not noted as having been performed: • The securities were not physically inspected or confirmed.

• The broker's advice (or other independent corroborating evidence) verifying the sale of ―R‖ was not examined.

• Dividend rates were not verified by reference to public records (e.g., Standard & Poor's) of dividend declarations.

• The stated interest rates, maturity dates, and market values were not verified.

• Computations of year-end accruals were not made.

• Not all amounts (e.g., loss on sale of ―R‖) were traced to the general ledger.

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16-28 a.

Primary Assertion 4. Existence or occurrence 5. Completeness 6. Accuracy, valuation and allocation 7. Authorization, Presentation and Classification 8. Accuracy, valuation and allocation b. Phung should consider applying the following additional substantive auditing procedures in auditing Vernon's investments: • Inspect securities on hand in the presence of the custodian.

• Examine supporting evidence (broker's advices, etc.) for transactions between the balance sheet date and the inspection date.

• Obtain confirmation from the issuers or trustees of investments in nonpublic entities.

• Examine contractual terms of debt securities and preferred stock.

• Determine if the board of directors or its designee properly approved sales and purchases.

• Examine broker's advices in support of transactions or confirm transactions with broker.

• Determine if gains and losses on dispositions have been properly computed.

• Trace payments for purchases to canceled checks and proceeds from sales to entries in the cash receipts journal.

• Determine if the amortization of premium or discount on bonds has been properly computed.

• Determine if trading securities and available-for-sale securities are properly valued and any unrealized gains and losses are properly accounted for.

• Ascertain whether any investments are pledged as collateral or encumbered by liens and, if so, are properly disclosed.

16-29

a. 5 b. 6 c. 4

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16-30 a. Stock portfolio inputs: Current Stock Prices Option Expense inputs: Current stock price; risk-free rate; dividend-yield; exercise price; time; standard deviation. b. Stock portfolio, FASB ASC Topic 820 Levels • Stock Price: Level 1 • Overall Portfolio: Level 1 Stock Compensation Expense, FASB ASC Topic 820 Levels • Current Stock Price: Level 2 • Risk-free Rate: Could be Levels 2 or 3 depending on whether management claims a rate difference from that commonly used by the industry.

• Dividend-Yield: Level 2 • Exercise Price: Level 2 • Time: Level 2 • Standard Deviation: Level 2 or Level 3 • Overall Account: Level 2 or Level 3 c. Audit Plan: Stock portfolio • Verify that stock prices listed by company are accurate according to NYSE ticker quotes as of period-end.

Audit Plan: Stock Compensation Expense • Verify that risk-free rate as used by the entity is consistent with quoted Treasury bill prices as of 12/31.

• Verify that standard deviation as used by the entity is consistent with market information about previous fluctuations in the stock price.

• Perform sensitivity analysis to see how much small changes in these inputs would impact the overall stock compensation expense listed on the financial statements.

• Tie out inputs to the model, verify model’s accuracy, trace model outcome to accounting records.

• Consider qualifications and competence of person(s) computing the valuation for the entity.

• Consider past history of input estimates; has the company’s process yielded reasonable results or have they tended to be aggressive or conservative?

• Consider involving an option valuation specialist.

• Develop independent estimate of fair value.

• Review subsequent events.

• Determine appropriateness of valuation techniques considering the current market environment.

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Solution to Internet Assignment Information regarding Intel and Microsoft are below. Students’ answers will vary. Of interest is the large difference between the investment balances between Intel and Microsoft. Most of this difference is due to overseas earnings by Microsoft that have yet to be repatriated and have been re-invested in US Treasury bonds.

16-31

INTEL As of 12/26/2020, Intel held $15.738 billion USD in trading assets and $5.152 billion in marketable equity securities. The filing is available here: 12.26.2020 (Q4) - 10K Document (intc.com) The footnotes state: Trading Assets Marketable debt investments are generally designated as trading assets when a market risk is economically hedged at inception with a related derivative instrument, or when the marketable debt investment itself is used to economically hedge currency exchange rate risk from remeasurement. Investments designated as trading assets are reported at fair value. Gains or losses on these investments arising from changes in fair value due to interest rate and currency market fluctuations and credit market volatility, largely offset by losses or gains on the related derivative instruments and balance sheet remeasurement, are recorded in interest and other, net.

Equity Securities We regularly invest in equity securities of public and private companies to promote business and strategic objectives. Equity investments are measured and recorded as follows: • Marketable equity securities are equity securities with RDFV that are measured and recorded at fair value on a recurring basis with changes in fair value, whether realized or unrealized, recorded through the income statement.

• Non-marketable equity securities are equity securities without RDFV that are measured and recorded using a measurement alternative that measures the securities at cost minus impairment, if any, plus or minus changes resulting from qualifying observable price changes.

• Equity method investments are equity securities in investees we do not control but over which we have the ability to exercise significant influence. Equity method investments are measured at cost minus impairment, if any, plus or minus our share of equity method investee income or loss. Our proportionate share of the income or loss from equity method investments is recognized on a one-quarter lag.

Realized and unrealized gains and losses resulting from changes in fair value or the sale of our equity investments are recorded in gains (losses) on equity investments, net. The carrying value of our non-marketable equity securities is adjusted for qualifying observable price changes resulting from the issuance of similar or identical securities in an orderly transaction by the same issuer. Determining whether an observed transaction is similar to a security within our portfolio requires judgment based on the rights and

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preferences of the securities. Recording upward and downward adjustments to the carrying value of our equity securities as a result of observable price changes requires quantitative assessments of the fair value of our securities using various valuation methodologies and involves the use of estimates.

Non-marketable equity securities and equity method investments (collectively referred to as non-marketable equity investments) are also subject to periodic impairment reviews.

Our quarterly impairment analysis considers both qualitative and quantitative factors that may have a significant impact on the investee's fair value. Qualitative factors considered include the investee's financial condition and business outlook, industry and sector performance, market for technology, operational and financing cash flow activities, and other relevant events and factors affecting the investee. When indicators of impairment exist, we prepare quantitative assessments of the fair value of our nonmarketable equity investments using both the market and income approaches, which require judgment and the use of estimates, including discount rates, investee revenue and costs, and comparable market data of private and public companies, among others.

MICROSOFT As of 6/30/2020, Microsoft held $122.9 billion USD in short-term investments and $2.9 billion in equity investments. The filing is available here: Download Center - Microsoft 2020 Annual Report. The footnotes state: Investments We consider all highly liquid interest-earning investments with a maturity of three months or less at the date of purchase to be cash equivalents. The fair values of these investments approximate their carrying values. In general, investments with original maturities of greater than three months and remaining maturities of less than one year are classified as short-term investments. Investments with maturities beyond one year may be classified as short-term based on their highly liquid nature and because such marketable securities represent the investment of cash that is available for current operations.

Debt investments are classified as available-for-sale and realized gains and losses are recorded using the specific identification method. Changes in fair value, excluding otherthan-temporary impairments, are recorded in other comprehensive income. Debt investments are impaired when a decline in fair value is judged to be other-thantemporary. Fair value is calculated based on publicly available market information or other estimates determined by management. We employ a systematic methodology on a quarterly basis that considers available quantitative and qualitative evidence in evaluating potential impairment of our investments. If the cost of an investment exceeds its fair value, we evaluate, among other factors, general market conditions, credit quality of debt instrument issuers, and the duration and extent to which the fair value is less than cost.

We also evaluate whether we have plans to sell the security or it is more likely than not that we will be required to sell the security before recovery. In addition, we consider specific adverse conditions related to the financial health of, and business outlook, for the investee, including industry and sector performance, changes in technology, and operational and financing cash flow factors. Once a decline in fair value is determined to

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be other-than-temporary, an impairment charge is recorded in other income (expense), net and a new cost basis in the investment is established.

Equity investments with readily determinable fair values are measured at fair value.

Equity investments without readily determinable fair values are measured using the equity method or measured at cost with adjustments for observable changes in price or impairments (referred to as the measurement alternative). We perform a qualitative assessment on a quarterly basis and recognize an impairment if there are sufficient indicators that the fair value of the investment is less than carrying value. Changes in value are recorded in other income (expense), net.

Cash, Cash Equivalents, and Investments Cash, cash equivalents, and short-term investments totaled $136.5 billion and $133.8 billion as of June 30, 2020 and 2019. Equity investments were $3.0 billion and $2.6 billion as of June 30, 2020 and 2019, respectively. Our short-term investments are primarily intended to facilitate liquidity and capital preservation. They consist predominantly of highly liquid investment-grade fixed-income securities, diversified among industries and individual issuers. The investments are predominantly U.S. dollardenominated securities, but also include foreign currency-denominated securities to diversify risk. Our fixed-income investments are exposed to interest rate risk and credit risk. The credit risk and average maturity of our fixed-income portfolio are managed to achieve economic returns that correlate to certain fixed-income indices. The settlement risk related to these investments is insignificant given that the short-term investments held are primarily highly liquid investment-grade fixed-income securities.

CHAPTER 17 COMPLETING THE AUDIT ENGAGEMENT Answers to Review Questions 17-1

A contingent liability is defined as an existing condition, situation, or set of circumstances involving uncertainty as to possible loss to an entity that ultimately will be resolved when some future event occurs or fails to occur. FASB ASC Topic 450, ―Contingencies,‖ classifies uncertainties into three categories: 1. Probable: The future event is likely to occur.

2. Reasonably possible: The chance of the future event occurring is more than remote but less than likely.

3. Remote: The chance of the future event occurring is slight.

Examples of contingent liabilities include • Pending or threatened litigation • Actual or possible claims and assessments • Income tax disputes • Product warranties or defects 17-176 Copyright ©2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

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• Guarantees of obligations to others • Agreements to repurchase receivables that have been sold 17-2

The auditor requests that the attorney provide the following information on pending or threatened litigation: • A list and evaluation of any pending or threatened litigation to which the attorney has devoted substantial attention. The client may provide the list.

• A listing of unasserted claims and assessments considered by management to be probable of assertion and reasonably possible of unfavorable outcome.

• A description and evaluation of the outcome of each pending or threatened litigation.

This should include the progress of the case, the action the entity plans to take, the likelihood of unfavorable outcome, and the amount or range of potential loss.

• Identification of any pending or threatened litigation or claims not included in management’s list or a statement that the list is complete.

• Comments on unasserted claims where his or her views differ from management's evaluation.

• Indication if his or her response is limited and the reasons for such limitations.

17-3

Two examples of long-term commitments are the purchase of raw materials or the sale of products at a fixed price. When the fair market value of the good is less than the purchase price included in the purchase contract, the entity will have to recognize a loss on a longterm commitment even though there has been no exchange of goods.

17-4

The two types of subsequent events that require consideration by management and evaluation by the auditor relevant to financial statement audits are Type I Events that provide additional evidence about conditions that existed at the date of the balance sheet and affect the estimates that are part of the financial statement preparation process. These types of events require adjustment of the financial statements.

Type II Events that provide evidence about conditions that did not exist at the date of the balance sheet but arose subsequent to that date. These types of events usually require disclosure in the notes to the financial statements. In some instances, where the effect of the event or transaction is very significant, pro forma financial statements may be necessary in order to prevent the financial statements from being misleading.

Examples of Type I events or conditions are • An uncollectible account receivable resulting from continued deterioration of a customer's financial condition leading to bankruptcy after the balance sheet date, where the bankruptcy is the event that reveals the customer’s poor financial condition at the balance sheet date.

• The settlement of a lawsuit after the balance sheet date for an amount different from the amount recorded in the year-end financial statements.

Examples of Type II events or conditions are 17-177 Copyright ©2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

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• • • •

Purchase or disposal of a business by the entity after the balance sheet date.

Sale of a capital stock or bond issue by the entity after the balance sheet date.

Loss of the entity's manufacturing facility or assets resulting from a casualty such as a fire or flood occurring after the balance sheet date.

Losses on receivables arising from conditions such as a casualty arising subsequent to the balance sheet date.

While not required by this question, it is important to note that the two types of subsequent events that require consideration by management and evaluation by the auditor relevant to the audit of internal control over financial reporting (ICFR) are 1. Control events that reveal information about a material weakness that existed as of the end of the reporting period. If the event reveals information about a material weakness, the auditor should issue an adverse opinion regarding the effectiveness of internal control over financial reporting. If the auditor is unable to determine the effect of the subsequent control event on the effectiveness of the company’s internal control, the auditor should disclaim an opinion.

2. Control events that create or reveal information about a new condition that did not exist as of the end of the reporting period. If the information has a material effect on the company, the auditor should include an explanatory paragraph describing the event and its effects or directing the reader’s attention to the event and its effects as disclosed in management’s report.

Examples of the control events or conditions (relating to both before and after the reporting period) are • Relevant internal audit reports (or similar functions, such as loan review in a financial institution) issued during the subsequent period.

• Independent auditor reports (if other than the primary auditor’s) of significant deficiencies or material weakness.

• Regulatory agency reports on the company’s internal control over financial reporting.

• Information about the effectiveness of the company’s internal control over financial reporting obtained through other engagements (AS5).

17-5

The auditor would consider dual dating the audit report when a subsequent event is recorded or disclosed in the financial statements after the date on which the auditor has obtained sufficient appropriate audit evidence but before the issuance of the financial statements (refer to Figure 17-1 in the text). In this case, the auditor will choose to dual date if they want to limit their responsibility for events subsequent to the date on which they auditor has obtained sufficient appropriate audit evidence to the disclosed subsequent event.

17-6

Auditing standards (AU-C 520, PCAOB AS No. 2810), require that the auditor perform analytical procedures at the final review stage of the audit. The objective of conducting final analytical procedures near the end of the engagement is to help the auditor assess the conclusions reached on the financial statement components and to help the auditor evaluate the overall financial statement presentation.

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17-7

The auditor obtains a representation letter in order to corroborate significant oral representations made to the auditor and to document the continued appropriateness of those representations. The representation letter also reduces the possibility of misunderstanding between management and the auditor.

17-8

A quality review partner is generally not associated with the details of the engagement and is expected to provide an independent review of the audit. The quality review partner can protect the firm from an inappropriate or non-independent relationship between the audit partner and the client. The engagement quality control reviewer performs an objective evaluation of the significant judgments made by the engagement team and the conclusions reached in formulating the auditor’s report. He or she discusses significant findings or issues with the engagement partner and reads the financial statements and the proposed auditor’s report. The engagement quality reviewer reviews selected audit documentation relating to the significant judgments the engagement team made and the related conclusions it reached, and evaluates the conclusions reached in formulating the auditor’s report. Finally, he or she considers whether the proposed auditor’s report is appropriate.

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17-9

The four overall steps in the going concern evaluation process are as follows: 1. Independently evaluate whether the results of audit procedures performed during the planning, performance, and completion of the audit indicate whether there is substantial doubt about the entity's ability to continue as a going concern for a reasonable period of time not to exceed one year from the issuance of the financial statements.

2. If there is substantial doubt, the auditor should obtain information about management's plans to mitigate the going concern problem and assess the likelihood that such plans can be implemented.

3. Conclude, in light of management’s plans, whether it is probable that the entity will be able to continue as a going concern; if not, consider the adequacy of the disclosures about the entity’s ability to continue and include a separate section in the auditor’s report disclosing the going-concern issue under the heading ―Substantial Doubt About Entity’s Ability to Continue as a Going Concern.‖ 4. Assess management’s going-concern evaluation and related disclosures.

17-10 The four major categories of events or conditions that may indicate going concern problems and examples of each are Financial conditions: • Recurring operating losses • Current-year deficit • Accumulated deficits • Negative net worth • Negative working capital • Negative cash flow • Negative income from operations • Inability to meet interest payments Other financial difficulties: • Default on loans • Dividends in arrears • Restructuring of debt • Denial of trade credit by suppliers • No additional sources of financing Internal matters: • Work stoppages • Uneconomic long-term commitments • Dependence on the success of one particular project External matters: • Legal proceedings • Loss of a major customer or supplier • Loss of a key franchise, license, or patent

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17-11 The items to be communicated are organized into three categories: (1) appointment and retention of the auditor, (2) obtaining information relevant to the audit and communicating the audit strategy, and (3) communicating the results of the audit. See Table 17-5 for examples of items to be communicated.

Note: The auditor’s communication with those charged with governance would normally take place at or near the end of the engagement. However, if a significant event occurs, such as fraudulent activities by senior management, the auditor would normally contact those charged with governance immediately.

17-12 Generally, when previously issued financial statements contain material misstatements due to unintentional or intentional actions by management, the financial statements will require revision. If the client refuses to cooperate and make the necessary disclosures, the auditor should notify the board of directors and take the following steps, if possible: 1. Notify the client that the auditor's report must no longer be associated with the financial statements.

2. Notify any regulatory agencies having jurisdiction over the client that the auditor's report can no longer be relied upon.

3. Notify each person known to the auditor to be relying on the financial statements.

Usually, notification to a regulatory agency, such as the SEC, is the only practical way to provide appropriate disclosure.

Answers to Multiple-Choice Questions 17-13 17-14 17-15 17-16 17-17

c d a b a

17-18 17-19 17-20 17-21

a a a c

Solutions to Problems 17-22 Since the events or conditions that should be considered in the financial accounting for and reporting of litigation, claims, and assessments are matters within the direct knowledge, and often, control of management of an entity, management is the primary source of information about such matters. Accordingly, Harper's audit procedures with respect to the existence of loss contingencies arising from litigation, claims, and assessments should include the following: • Inquire and discuss with management the policies and procedures adopted for identifying, evaluating, and accounting for litigation, claims, and assessments.

• Obtain from management a description and evaluation of litigation, claims, and assessments that existed at the date of the balance sheet being reported on, and during

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• •

•

the period from the balance sheet date to the date the information is furnished, including an identification of those matters referred to legal counsel.

Examine documents in the client's possession concerning litigation, claims, and assessments, including correspondence and invoices from lawyers.

Obtain assurance from the client, ordinarily in the form of a representation letter, that it has disclosed all unasserted claims which the lawyer has advised the client are probable of assertion and must be disclosed in accordance with generally accepted accounting principles (FASB ASC 450).

The auditor should request the client's management to send a letter of inquiry to those lawyers with whom management consulted concerning litigation, claims, and assessments.

Examples of other procedures undertaken for different purposes that might also disclose litigation, claims, and assessments are the following: • Read minutes of stockholders, directors, and appropriate committee meetings held during and subsequent to the period being examined.

• Read contracts, loan agreements, leases, and correspondence from taxing or other governmental agencies, and similar documents.

• Obtain information concerning guarantees from bank confirmation forms.

• Inspect other documents for possible guarantees by the client.

17-23 The omissions, ambiguities, and inappropriate statements and terminology in Cao's letter are as follows: • A description of the progress of each case to date is omitted.

• The evaluation of the likelihood of an unfavorable outcome for each case is unclear.

• An estimate, if one can be made, of the amount or range of potential loss of each case is omitted.

• The other pending or threatened litigation on which Young was consulted is not identified and included.

• The unasserted claims and assessments probable of assertion that have a reasonable possibility of an unfavorable outcome are not identified.

• Consolidated's understanding of Young's responsibility to advise Consolidated concerning the disclosure of unasserted possible claims or assessments is omitted.

• Materiality (or the limits of materiality) is not addressed.

• The reference to a limitation on Young's response due to confidentiality is inappropriate.

• Young is not requested to identify the nature of and reasons for any limited response.

• Young is not requested to include matters that existed after the balance sheet date, up to the date of Young's response.

• The date by which Young's response is needed is not indicated.

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• The reference to Young's response possibly being quoted or referred to in the financial statements is inappropriate.

• Vague terminology such as "slight" and "some chance" is included where "remote" and "possible" are more appropriate.

• There is no inquiry about any unpaid or unbilled charges, services, or disbursements.

17-24 a. For the financial statement audit, the two types of subsequent events that require Namiki’s consideration and evaluation are • Events that provide additional evidence concerning conditions that existed at the balance sheet date and affect the estimates inherent in the process of preparing financial statements. This type of subsequent event requires that the financial statements be adjusted for any changes in estimates resulting from the use of such additional evidence.

• Events that provide evidence concerning conditions that did not exist at the balance sheet date but arose subsequent to that date. Such events result in financial statement disclosure.

If Taylor is a public company, the audit of internal control over financial reporting includes two types of subsequent events that the auditor must consider: • Control events that reveal information about a material weakness which existed as of the end of the reporting period. If the event reveals information about a material weakness, the auditor should issue an adverse opinion on the effectiveness of internal control over financial reporting. If the auditor is unable to determine the effect of the subsequent control event on the effectiveness of the company’s internal control, the auditor should disclaim any opinion.

• Control events that create or reveal information about a new condition which did not exist as of the end of the reporting period. If the information has a material effect on the company, the auditor should include an explanatory paragraph describing the event and its effects or directing the reader’s attention to the event and its effects as disclosed in management’s report. b. The auditing procedures Namiki should consider performing to gather evidence concerning subsequent events include the following: • Compare the latest available interim statements with the financial statements being audited.

• Ascertain whether the interim statements were prepared on the same basis as the audited financial statements.

• Inquire whether any contingent liabilities or commitments existed at the balance sheet date or the date of inquiry.

• Inquire whether there was any significant change in the capital stock, long-term debt, or working capital to the date of inquiry.

• Inquire about the current status of items in the audited financial statements that were accounted for on the basis of tentative, preliminary, or inconclusive data.

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• • • • •

Read or inquire about the minutes of meetings of stockholders or the board of directors.

Inquire of the client's legal counsel concerning litigation, claims, and assessments.

Obtain a management representation letter, dated as of the date of Namiki's audit report, as to whether any subsequent events would require adjustment or disclosure.

Make such additional inquiries or perform such additional procedures Namiki considers necessary and appropriate.

Examine and/or inquire about findings included in internal audit reports completed after year end.

17-25 1. The explosion in Agronowitz's plant that led to the uncollectibility of Scornick Company’s accounts receivable was an event whose conditions did not exist at the balance sheet date. Thus, the event is a Type II event, and should be disclosed in the financial statements of the year just ended.

2. The tax court ruling in favor of Scornick Company is an event whose conditions existed at the balance sheet date but were clarified later, and which involves the revision of an estimate. Thus, under normal circumstances the event would be considered a Type I event, and the financial statements of the year just ended would be adjusted to reflect the favorable ruling. However, ASC 740-10-25-8, Income Taxes, prescribes special rules for resolutions of income tax matters after the balance sheet date. According to ASC 740-10-25-8, ―a change in facts subsequent to the reporting date but prior to the issuance of the financial statements shall be recognized in the period in which the change in fact occurs.‖ Accordingly, the adjustment to reflect the favorable ruling would be recognized in 2019, and not in the financial statements for the year ended December 31, 2018.

3. The sale of Scornick's Manufacturing Division is an event whose conditions did not exist at the balance sheet date and is thus a Type II event. This event, at a minimum, requires disclosure in the financial statements of the year just ended. However, due to the size of the division being sold, pro-forma financial statements may be necessary.

4. This is not an event that is considered a subsequent event for financial statement purposes.

5. This is not an event that is considered a subsequent event for financial statement purposes.

17-26 a. An auditor is required to obtain a written management representation letter as part of every audit performed in accordance with generally accepted auditing standards.

The purposes of obtaining a written management representation letter are to • Confirm the oral representations given to the auditor, including that management accepts responsibility for the fair presentation of the financial statements.

• Indicate and document the continuing appropriateness of management's representations.

• Reduce the possibility of misunderstanding concerning the matters that are the subject of the representations.

• Complement the other auditing procedures by corroborating the information discovered in performing those procedures.

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• Obtain evidence concerning management's future plans and intentions (e.g., when refinancing debt or discontinuing a line of business). b. The representation letter should be addressed to the auditor and dated as of the date of the auditor's report. The letter should be signed by members of management whom the auditor believes are responsible for and knowledgeable, directly or through others in the organization, about the matters covered by the representation. Their refusal to sign the letter would constitute a limitation on the scope of the audit sufficient to preclude an unqualified/unmodified opinion and affect the auditor's ability to rely on other management representations. c. Obtaining a management representation letter does not relieve an auditor of any other responsibility for planning or performing an audit. Accordingly, an auditor should still perform all the usual tests to corroborate representations made by management.

17-27 Other matters that Gonzalez's representation letter should specifically confirm include whether or not • Management acknowledges responsibility for the fair presentation in the financial statements of financial position, results of operations, and cash flows in conformity with generally accepted accounting principles (or other 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 accounts 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 balance sheet 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, the board of directors, or other similar bodies that may affect the financial statements.

• All financial records and data were made available.

• Management is aware of fraud that could have a material effect on the financial statements or that involve management or employees who have significant roles in the internal control system.

• Provision, when material, has been made to reduce receivables to their estimated net realizable value.

• Provision, when material, has been made to reduce excess or obsolete inventories to their lower of cost of market.

• Provision has been made for any material loss to be sustained in the fulfillment of, or from inability to fulfill, any sales commitments.

• 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.

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17-28 1.

2.

3.

4.

5.

6.

7.

8.

9.

10.

11.

12.

13.

14.

15.

16.

B N N D L F N P J B B F B C N M

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Solutions to Discussion Cases 17-29 a. FASB ASC Topic 450, "Contingencies," deals with the accounting for loss contingencies. The auditor must decide whether an estimated loss from the contingency is probable and estimable, probable but not estimable, reasonably possible, or remote. Since the EPA has not initiated a lawsuit or other regulatory action against Ceramic Crucibles of America (CCA), the potential loss is an unasserted claim. It is necessary to consider whether the facts would lead to a conclusion about the probability that a claim will be asserted against CCA and, if so, whether the amount of the cleanup cost is reasonably estimable.

An argument can be made that a claim will not occur or not have a significant effect on CCA's financial statements. First, the fact that CCA has been named as a PRP with two other companies may not lead to a claim against the company. This line of reasoning argues that the Durango site was placed on the National Priorities List (NPL) only because each state must have a site on the list, not because of the extent of the pollution. Second, the rating of the Durango site is considerably lower than the ratings of other sites on the list. Third, there are two viable PRPs who are responsible for the vast majority of the contaminants. Finally, based on the fact that the EPA has paid most of the costs of pollution cleanups and only a fraction of the costs of pollution cleanups have been borne by industry, it is quite likely that the company may never have to pay. An unfavorable outcome under these facts might be considered remote, and no disclosure would be required.

An argument can also be made that, based on the current evidence of pollution on the site, and the fact that once the EPA has put a site on the NPL and has authorized an investigation of the site, it is unlikely that they will not assert a claim. In this case, it is considered probable that a claim will be asserted and there is a reasonable possibility that the outcome will be unfavorable. However, CCA's financial position does not appear to be threatened by potential action because its pollution levels are significantly below the levels of others, the other PRPs are capable of paying their share of potential fines, the company no longer uses lead in its production process, its past use of lead met FDA requirements, and no waste water has been discharged since the company acquired the property. CCA could also sue the prior owners of the property for their share of the damages should there be an adverse outcome to the investigation. b. In assessing the materiality of an uncertainty it must be recognized that some uncertainties are unusual in nature or infrequent in occurrence and thus more closely

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related to financial position than to normal, recurring operations (e.g., litigation related to alleged violations of antitrust or securities laws). In such instances, the auditor should consider the possible loss in relation to shareholders' equity and other relevant balance sheet components such as total assets, total liabilities, current assets, and current liabilities.

The potential loss of between $10 million to $13 million represents a reduction in stockholders' equity of 4.5 percent to 7.0 percent. These amounts might be considered material to the financial statements and thus require disclosure by the client in the footnotes. However, considering that the likelihood of the claim is remote and that CCA (or EPA) can take action against the other PRPs, it is unlikely that an unfavorable outcome would be material. It also does not appear that an unfavorable outcome would have an adverse effect on the company's financial position. c. The auditor could obtain and examine a number of additional pieces of evidence, including the following: • Copies of any public documents (e.g., the report rating the site as 8.3) that led to the site being added to the National Priorities List.

• Financial information on the other PRPs. • Information on CCA's change to lead-free mud in its crucibles.

• The affidavits from CCA's employees on the discharges into the levee.

• Any environmental engineering studies conducted by CCA. The auditor would obtain representations from management concerning its estimate of the likelihood of a materially adverse outcome. This should be included in the management representation letter. d. It is highly unlikely that the investigation would affect the auditor's report. Thus, a standard unqualified audit report would be issued.

17-30 This case presents a realistic situation that can arise on an audit engagement. The main issue of the case is whether the auditor needs to require the client to make adjustments to the financial statements for possible misstatements that have been identified during the audit. These proposed adjustments can result in conflicts between the auditor and client. a. The issue is the possible obsolescence of the specialized computer components for the special-order optical scanner. The auditors identified these components as possible obsolete items in the prior year. The client explained that the items could be sold without a loss. The components were not sold during the prior year or in the year just ended, and there appear to be no prospects of a future sale. Based on these facts, the auditor should insist that the components be written down to their fair market value, which appears to be zero. b. In the prior year, the auditors waived the adjustment of $20,000 for accrued vacation pay based on materiality considerations. By the end of the next year, the amount of accrued vacation pay amounted to $300,000. Since GAAP requires accrual of such expense and the amount is material, the auditor should insist on accruing the executives' vacation pay.

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c. It is difficult to provide detailed guidance on how Schmidt should handle the client's demands. Schmidt should try to explain to Adams that GAAP requires that such adjustments are required in order for the financial statements to present fairly. She should also point out that shareholders might react very negatively if they were to discover that management was manipulating earnings from period to period in order to maintain the stock's price. The potential for stockholders' lawsuits could increase significantly. Regardless, if Schmidt believes that both adjustments are necessary, she must require the client to make the adjustments or resign from the engagement.

17-31 a. For publicly traded companies, materiality must be evaluated under both the rollover and iron curtain methods; if errors are deemed to be material under either approach, a correction must be made. Your partner would not require WGM to record the adjustment since the individual errors are immaterial relative to the year in which they were incurred (i.e. immaterial under the ―rollover‖ method), and the cumulative total of the errors ($7,500 + $5,000 + $75,000 = $87,500) is less than materiality of $100,000 for the current year (i.e. immaterial under the ―iron curtain‖ method). b. With prior years’ items of $22,500 and $15,000, although each individual item is immaterial under the rollover method, the cumulative total of the errors ($22,500 + $15,000 + $75,000 = $112,500) would be greater than materiality for the current year under the iron curtain method, so an adjustment would be required. (Note: We have ignored the effect of depreciation in this example.) c. The adjustment would have to be large enough to reduce the unadjusted amount to less than $100,000. Therefore, the auditor would require WGM to adjust its financial statements by at least $12,501.

Solutions to Internet Assignments 17-32 a. Students can find any of a number of reported contingencies—this is a common type of disclosure. The identified contingency will be disclosed in the financial statements if it is a Type II contingency, or if it is a Type I contingency but the amount is not reasonably estimable. b. Examples of procedures that may help the auditor identify contingent liabilities include • Reading the minutes of meetings of the board of directors, committees of the board, and stockholders.

• Reviewing contracts, loan agreements, leases, and correspondence from government agencies.

• Reviewing tax returns, IRS reports, and schedules supporting the client’s income tax liability.

• Confirming or otherwise documenting guarantees and letters of credit obtained from financial institutions or other lending agencies.

• Inspecting other documents for possible guarantees or other similar arrangements.

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In addition, near the completion of the engagement the auditor conducts specific audit procedures to identify contingent liabilities. Such procedures include: • Inquiry of management regarding the client’s policies and procedures for identifying, evaluating, and accounting for contingent liabilities.

• Examining documents in the entity’s records such as correspondence and invoices from attorneys for pending or threatened lawsuits.

• Obtaining a legal letter that describes and evaluates any litigation, claims, or assessments.

• Obtaining written representation from management that all litigation, asserted and unasserted claims, and assessments have been disclosed in accordance with FASB ASC Topic 450, ―Contingencies.‖ 17-33 The SEC’s EDGAR database search engine is a good source for finding situations where the auditor has withdrawn an audit report on a company (www.sec.gov). Students will also find information on news sites (e.g., The Dow Jones Interactive website).

CHAPTER 18 REPORTS ON AUDITED FINANCIAL STATEMENTS Answers to Review Questions 18-1

An auditor is associated with financial statements when he or she has consented to the use of his or her firm’s name in a document such as an annual report.

18-2

Accounting changes can be categorized into changes that affect consistency and those that do not affect consistency. The word ―consistency‖ refers to the application of accounting principles. If a change in accounting principle or in the method of its application has a material effect on the comparability and consistency of the financial statements and the auditor concurs with the change, the auditor should refer to the change in an explanatory or emphasis-of-matter paragraph. Accounting changes that affect comparability but do not affect consistency, such as a change in an estimate or the correction of an error that does not involve a change in accounting principle, are normally disclosed in the notes to the financial statements but do not require an explanatory or emphasis-of-matter paragraph in the auditor's report.

An accounting change can affect comparability but not consistency because an accounting principle can be consistently applied even when the underlying data used to apply it may change. For example, when the estimate of the useful life of a building changes, the company may still consistently apply straight-line depreciation, but the depreciation expense will not be comparable to that of the previous year due to the change in estimate.

18-3

An example of a client-imposed scope limitation is where a client requests that the auditor not confirm accounts receivable because of concerns about creating conflicts with 1-4 Copyright ©2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

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customers. An example of a circumstances-imposed scope limitation is when the auditor is not engaged to conduct the audit until after year-end. Under such circumstances, the auditor may not be able to observe inventory. Auditors should be particularly cautious when a client places a limit on the scope of the engagement because the client may be trying to prevent the auditor from discovering material misstatements. Auditing standards suggest that when restrictions imposed by the client significantly limit the scope of the engagement, the auditor should disclaim an opinion on the financial statements.

18-4

The concept of materiality plays a major role in the auditor's choice of audit reports. If the departure from GAAP is immaterial, the auditor issues an unqualified/unmodified opinion. If the departure from GAAP is material but not pervasive, the auditor issues a qualified (―except for‖) opinion. If the departure is so pervasive that its effects are highly material, the auditor issues an adverse opinion. For example, suppose that a client accounts for leased assets as operating leases when proper accounting requires that the leases be capitalized. If a client has only one small piece of equipment that is accounted for inappropriately, the auditor will probably issue an unqualified/unmodified opinion because the item is not material. However, if the client has many significant leased assets that are accounted for as operating leases instead of capitalized leases, the auditor will normally issue a qualified or adverse opinion, depending on the magnitude of the problem.

18-5

The auditor should issue an unmodified report (―unmodified‖ because Tosi is a private company) on the 2020 financial statements and a qualified report on the 2021 financial statements because the current year is not in conformity with GAAP. The non-GAAP accounting for the lease transaction should be disclosed in the audit report. The opinion on the 2021 financial statements would not be adverse because, while the misstatement is material, it is not pervasive.

18-6

The auditor has no responsibility beyond the financial information contained in the report, and he or she has no obligation to perform any audit procedures to corroborate the other information. However, auditing standards (AU-C 720) requires that the auditor read the other information and consider whether such information is consistent with the information contained in the audited financial statements.

18-7

If the auditor determines that other information contained with audited financial statements is incorrect, the auditor should request that the client correct the other information. If the other information is not revised, the auditor should include an explanatory (or other-matter) paragraph in the audit report, withhold the report, or withdraw from the engagement. The auditor also should communicate the material inconsistency to the client and the audit committee in writing and consider getting legal advice as to any further appropriate action.

18-8

Examples of special reports include reports on • Financial statements prepared on a basis of accounting other than GAAP (e.g. The cash basis of accounting) • Specified elements, accounts, or items of a financial statement.

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•

Compliance with aspects of contractual agreements or regulatory requirements related to audited financial statements.

(In addition to these, there are others that are beyond the scope of this book, such as financial presentations to comply with contractual agreements or regulatory provisions, and financial information presented in prescribed forms or schedules that require a prescribed form of auditor's report.)

18-9 Four bases for financial statements prepared on an other comprehensive basis of accounting are • Regulatory basis.

• Tax basis.

• Cash (or modified cash) basis.

• Contractual basis (for non-public entities).

It is important that the financial statements and the audit report clearly identify which basis of accounting is being used so that the financial statements are not confused with financial statements prepared on a GAAP basis.

Answers to Multiple-Choice Questions 18-10 18-11 18-12 18-13 18-14 18-15

b c a a a c

18-16 18-17 18-18 18-19 18-20 18-21

c b b b c c

Solutions to Problems 18-22 a. The auditor would issue an unqualified audit report with explanatory language for the reliance on the other auditors. In this case, the principal auditor does not intend to take responsibility for the other auditor's work. b. The auditor should issue a qualified audit report because management has not complied with GAAP. The auditor is not required to prepare the statement of cash flows for disclosure in the audit report. c. This approach is not in accordance with GAAP because such contingencies must be recognized by an accrual in the financial statements if the amount of the contingency can be reasonably estimated and the loss is probable. A departure from GAAP such as this one requires either a qualified or an adverse opinion, depending on the materiality 1-6 Copyright ©2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

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of the item in question. In this case the potential settlement is likely to be very large given the proportions of the tragedy in terms of human loss and suffering. In addition, the tragedy may well threaten the company’s ability to be involved in similar projects in the future and perhaps its own survival. Thus, an adverse opinion is very likely the most appropriate response. d. Because the client wouldn’t allow the confirmations to be sent, the appropriate response would generally be either a qualified opinion or a disclaimer of opinion for a scope limitation imposed by the client’s management, depending on the materiality of accounts receivable. However, even if accounts receivable isn’t highly material, if the auditor suspects fraud by upper management, the scope limitation would merit a disclaimer. e. Since the auditor is satisfied about the inventory balance using alternative audit procedures, a standard unqualified audit report can be issued. The alternative audit procedures would normally include a physical count subsequent to year end and reconciliation to the balance at the end of the reporting period. f. The client’s failure to disclose the related party transaction represents a GAAP departure. Since there is a departure from GAAP, the auditor should issue a qualified or adverse audit report depending on the materiality of the matter. g. Recall that the instructions to the problem indicate the assumption that all matters listed are at least material. Since the change in accounting principle is properly accounted for, the auditor should issue an unqualified audit report with an explanatory paragraph for a lack of consistency in the application of GAAP. 18-23 a. The auditor should issue a standard unqualified/unmodified audit report. It is acceptable for an entity to use different inventory methods in different international regions. Many countries do not allow LIFO, and it can be costly for the entity to maintain inventory records using both valuation methods. b. The auditor should issue a standard unqualified/unmodified audit report so long as this uncertainty is properly disclosed or accounted for in accordance with GAAP. In this case, a negative outcome for this uncertainty appears to be remote. Therefore, the client is not required to disclose the uncertainty in the financial statements. c. This is a correction of an error in principle because the use of replacement cost to value inventory is not in accordance with GAAP. The auditor should add an explanatory or emphasis-of-matter paragraph describing the change from replacement cost to FIFO for valuing inventory to the standard unqualified/unmodified report. d. This is a change in accounting estimate. Such a change does not affect consistency in the application of accounting principles, and the auditor should thus issue a standard unqualified/unmodified audit report.

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e. The auditor should issue a standard unqualified/unmodified audit report because the client corrected the mistake before issuing the financial statements. f. The CPA is not independent of the company but how the lack of independence should be handled depends on whether Rothenburg is a public company. Under PCAOB standards the auditor should issue a disclaimer for a lack of independence, and the auditor is not allowed to disclose the reasons for the auditor’s lack of independence.

Under ASB standards (for non-public entities), the auditor will not issue a report unless required to do so by law or regulation, but similar to PCAOB standards, if issued, the report should disclaim an opinion due to lack of independence. However, under ASB standards, the auditor may choose to disclose the reasons for the lack of independence, but if the auditor so chooses, all relevant reasons for the lack of independence must be included. g. If the client refuses to make the adjustment to the loan-loss reserve, the auditor should issue a qualified or adverse opinion because the financial statements will not be in accordance with GAAP. The auditor may also have substantial doubt about the entity’s ability to continue as a going concern, which could result in the addition of an explanatory or emphasis-of-matter paragraph to the audit opinion to disclose the going concern issues. If the auditor concludes that there is a going concern problem and the client refuses to disclose the issue in the notes to the financial statements, the auditor’s opinion will be adverse.

18-24 1. May & Marty needs to satisfy itself about the independence and professional reputation of Dey & Dee and assure itself that there has been coordination of activities between the two auditors in order to achieve a proper review of matters affecting consolidation. Whether or not it makes reference to Dey & Dee's examination, May & Marty should consider performing the following procedures: •

• •

Make inquiries about the professional reputation and standing of Dey & Dee to one or more of the following: • AICPA, applicable state society of CPAs, and/or local chapter.

• Other sources such as other practitioners, bankers, or other credit grantors.

Obtain a representation from Dey & Dee that it is independent under the requirements of the AICPA and, if appropriate, the requirements of the SEC. Ascertain through communication with Dey & Dee that • Dey & Dee is aware that the BGI-Western financial statements are to be included in the BGI consolidated financial statements on which May & Marty will report, and that Dey & Dee's report will be relied upon by May & Marty.

• Dey & Dee is familiar with GAAP and GAAS and conducted its examination in accordance therewith.

• Dey & Dee has knowledge of the relevant financial reporting requirements for statements and schedules to be filed with regulatory agencies, such as the SEC. • A review will be made of matters affecting elimination of intercompany transactions and accounts, as well as the uniformity of accounting practices 1-8

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among components included in the financial statements.

2. May & Marty could adopt the position of not making reference to Dey & Dee's examination of BGI-Western if May & Marty is able to satisfy itself about the independence and professional reputation of Dey & Dee and takes steps it considers appropriate to satisfy itself as to Dey & Dee's examination of BGI-Western.

Ordinarily, May & Marty would be able to adopt the position of not making reference to Dey & Dee's examination when any one of the following conditions exists: • Dey & Dee is an associate or correspondent firm and its work is acceptable to May & Marty based on May & Marty's knowledge of the professional standards and competence of Dey & Dee; or • Dey & Dee is retained by May & Marty and the work is performed under May & Marty's guidance and control; or • May & Marty takes steps it considers necessary to satisfy itself as to Dey & Dee's examination.

Such steps may include a visit to Dey & Dee to discuss Dey & Dee's audit procedures or a review of Dey & Dee's audit program and/or working papers. In addition, May & Marty is satisfied about the reasonableness of the statements of BGI-Western for purposes of inclusion in BGI's consolidated financial statements; or BGI-Western's financial statements are not a material part of BGI's consolidated financial statements.

18-25 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Shareholders and Board of Directors of Devon Incorporated

Opinion on the Financial Statements

We have audited the consolidated balance sheet of Devon Incorporated as of December 31, 2021 and the related consolidated statement of operations, stockholders' equity, and cash flows for the period ended December 31, 2021. In our opinion, except for the effects of not capitalizing finance-lease obligations, and except for not disclosing the change in inventory methods as discussed in the preceding paragraphs, the financial statements referred to above present fairly, in all material respects, the financial position of Devon Incorporated as of December 31, 2021, and the results of its operations and its cash flows for the year then ended, in conformity with accounting principles generally accepted in the United States of America.

We also have audited, in accordance with the standards of the Public Company 1-9 Copyright ©2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

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Accounting Oversight Board (United States), the effectiveness of Devon Incorporated’s internal control over financial reporting as of December 31, 2021, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated February 28, 2022 expressed an unqualified opinion that Devon Incorporated maintained, in all material respects, effective internal control over financial reporting.

Basis for Opinion

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 are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (―PCAOB‖) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. The financial statements of Devon Incorporated for the year ended December 31, 2020, were audited by other auditors, whose report dated March 30, 2021, expressed an unqualified opinion on those statements.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. An audit includes performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion.

Critical Audit Matters

The critical audit matters communicated below are matters arising from the current period audit of the financial statements that were communicated or required to be communicated to the audit committee and that: (1) relate to accounts or disclosures that are material to the financial statements and (2) involved especially challenging, subjective, or complex audit judgments. The communication of critical audit matters does not alter in any way our opinion on the financial statements, taken as a whole, and we are not, by communicating the critical audit matters below, providing separate opinions on the critical audit matters or on the accounts or disclosures to which it relates.

Critical Audit Matters

Auditor Response

Inventory Valuation

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The Company is heavily involved in inventory sales, leading any changes to the inventory account to warrant detailed review from us and the audit committee. During the year, Devon changed its method of valuing inventory from the first-in, first-out method to the last-in, first-out method. This change was made because management believes LIFO more clearly reflects net income by providing a closer matching of current costs and current revenues. Our focus was to validate that the change helped current revenues match current costs, as stated from management’s assertion.

As seen in Devon’s financial statements, the Company’s inventory account is material and it is the primary asset that it uses to generate revenue.

Finance – Lease Obligations The Company is involved in a wide-range of leasing agreements with outside parties. Current leasing standards, according to generally accepted accounting principles, require finance-lease obligations to be capitalized. Our focus was to understand why certain finance-lease obligations were not capitalized and how they should properly be treated.

The balance sheet accounts relating to property and debt were impacted as they did not include these finance-lease obligations that should have been capitalized. No disclosure had been made concerning these amounts.

We conducted detailed end-to-end walkthroughs of the inventory processes, utilizing Company conducted inventory counts and our own inventory counts to verify that recorded amounts are appropriate.

We then conducted testing of inventory values by use of market rates to determine the reasonableness of differences between last-in inventory values and first-in values.

In response to the changes in the method of valuing inventory made during the year, we also performed the following: • reviewed the design of the new method to ensure that inventory amounts and prices are properly recorded and will be correctly utilized in valuations going forward • verified with other industry competitors that a similar method of valuing inventory using LIFO is appropriate.

We confirmed with outside party regarding the amounts and terms of the various finance-lease agreements that the Company was engaged in. The use of positive confirmations allowed for high assurance of the amounts in question and the true structure of the agreements.

Based on observations and interviews conducted with key accounting personal over these leasing agreements, we gathered evidence regarding the current treatment financingleases are given.

Rao Rao, CPA We have served as the Company’s auditor since 2021.

February 28, 2022

18-26 Report of Independent Registered Public Accounting Firm To the Shareholders and Board of Directors of Kim Company: 1-11 Copyright ©2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

2023

Opinion on the Financial Statements We have audited the accompanying balance sheets of Kim Company as of December 31, 2021 and 2020, and the related statements of income, retained earnings, and cash flows for the years then ended. In our opinion, the balance sheets of Kim Company as of December 31, 2021 and 2020, and the related statements of income, retained earnings, and cash flows for the year ended December 31, 2021, present fairly, in all material respects, the financial position of Kim Company as of December 31, 2021 and 2020, and the results of its operations and its cash flows for the year ended December 31, 2021, in conformity with accounting principles generally accepted in the United States of America.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Kim Company’s internal control over financial reporting as of December 31, 2021, based on criteria established in Internal Control—Integrated Framework issued in 2013 by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 12, 2022 expressed an unqualified opinion that Kim Company maintained, in all material respects, effective internal control over financial reporting.

Basis for Opinion 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 are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (―PCAOB‖) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. Except as explained in the following paragraph, we conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States).

Those standards require that we plan and perform our audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. An audit includes performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion.

We did not observe the taking of the physical inventory as of December 31, 2019, since that date was prior to our appointment as auditors for the Company, and we were unable 1-12 Copyright ©2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

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to satisfy ourselves regarding inventory quantities by means of other auditing procedures.

Inventory amounts as of December 31, 2019, enter into the determination of net income and cash flows for the year ended December 31, 20120 Because of the matter discussed in the preceding paragraph, the scope of our work was not sufficient to enable us to express, and we do not express, an opinion on the results of operations and cash flows for the year ended December 31, 2020.

Critical Audit Matters

(No critical audit matters were noted in the problem; however, at a minimum the noted issue with the auditor not taking physical inventory would likely be noted as a critical audit matter. Since this issue is referred to above, this critical audit matter could be cited by reference to the above description).

Friday & Co. Friday & Co., CPAs We have served as the Company’s auditor since 2020.

March 12, 2022

18-27 The auditors' report contains the following deficiencies: The report should be divided by the main categories: • • •

Opinion on the Financial Statements Basis of Opinion Critical Audit Matters

Report title & Address: • The title should be ―Report of Independent Registered Public Accounting Firm‖.

• Report should be addressed to the shareholders and board of directors.

Opinion on Financial Statements paragraph: • The opinion section should be first and should also include the first paragraph • The opinion paragraph references owners’ equity while the opening paragraph references the statement of ―capital.‖

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Basis of Opinion paragraph: • The auditor’s responsibility to express an opinion on the financial statements is omitted.

• Management’s responsibility for the financial statements is omitted.

• There is no mention that the auditor considers internal control in making risk assessments and in designing appropriate audit procedures.

• Reference to assessing ―significant estimates made by management‖ is omitted.

• A statement that they are a public accounting firm registered with the PCAOB is omitted.

Critical Audit Matters paragraph: • No deficiencies. However, even if no CAMs are identified, the definition should be provided and a statement indicating the auditor determined there were no CAMs should be included. (AS3101.16) Signature: • CPA firm’s name must be signed • Must disclose the year that the firm began serving consecutively as the client’s auditor.

• The city and state from where the report has been issued should be included

Solution to Discussion Case 18-28 a. PCAOB AS 2415 provides guidance to the auditor for evaluating an entity's ability to continue as a going concern. This auditing standard states specifically that the auditor has a responsibility to evaluate whether the entity will be able "to continue as a going concern for a reasonable period of time," which is defined in that paragraph as "not to exceed one year beyond the date of the financial statements being audited." The standard provides that in the process of the audit, the auditor has to consider whether certain conditions and events that have been identified might indicate that there is substantial doubt about the entity's ability to continue as a going concern (see Ch. 17).

It states further that the conditions and events "depend on the circumstances," which may not be significant in and of themselves but may be significant in combination with other conditions and events, such as the following: • Negative trends.

• Other indications of possible financial difficulties.

• Internal matters.

• External matters that have occurred.

Once conditions or events that may indicate a going-concern problem have been identified, the auditor should consider how management plans to overcome the adverse effects of the conditions and events. The auditor should consider the following: • Plans to dispose of assets.

• Plans to borrow money or restructure debt.

• Plans to reduce or delay expenditures.

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• Plans to increase ownership equity. b. In this case, the situation is somewhat different, because the auditor knows that for the year ended March 31, 2021, the previous auditor had determined that there was substantial doubt about Paper Packaging's ability to continue as a going concern and consequently the auditor's report included an explanatory paragraph discussing a going-concern uncertainty. That report identified the conditions and events, which resulted in those conclusions. PCAOB AS 2415.16 states that ―if substantial doubt about the entity's ability to continue as a going concern for a reasonable period of time existed at the date of prior period financial statements that are presented on a comparative basis, and that doubt has been removed in the current period, the explanatory paragraph included in the auditor's report (following the opinion paragraph) on the financial statements of the prior period should not be repeated.‖ (Emphasis added.)

It appears, then, that the burden of proof has shifted. The auditor needs to evaluate whether the conditions and events that caused the auditor to modify the report for a going-concern uncertainty continue to exist or whether the auditor can be satisfied that there has been sufficient improvement in Paper Packaging's financial condition that there is no longer a substantial doubt about the company's ability to continue as a going concern. c. In making the determination of whether to modify the report, the auditor must consider how successful management has been in overcoming the conditions that existed at March 31, 2021. In this case, the following positive events have occurred since the March 31, 2021, year-end: • The company has renegotiated its 2017 credit agreement. That agreement has a ten-year term, requires no repayment of principal during the first two years, and provides for 8 percent annual interest for the term of the agreement.

• The arbitration proceedings were resolved in 2022.

• The company settled all outstanding legal actions in 2021.

• Most of the company's tax issues have been resolved, and, according to the company’s outside legal counsel, those still pending are expected to result in a net cash inflow to the company.

• The company is negotiating with the remainder of the holders of the debentures that had been due in 2021 in an attempt to settle the matter in an orderly manner.

Although most of the adverse conditions that existed at the 2021 year-end have been resolved favorably, at March 31, 2022, the company is still in default on $4.6 million of the 2021 debentures. Further, the company’s loss exceeds the amount allowed on its renegotiated credit agreement, putting the company in technical default even with respect to the revised covenants. These facts alone may well be sufficient grounds for including a going concern modification in the report on the March 31, 2022, financial statements.

Paper Packaging’s management may argue that the company had a cash balance of $5.5 million at year-end and expects to generate net cash flow of $3.2 million in the upcoming year. Further, Paper Packaging expects its 2020 earnings before income taxes and extraordinary items to be $1.5 million. However, the data presented raises 1-15 Copyright ©2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

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questions about whether the company’s budgeting process is reliable (see past budget-to-actual data).

In the end, whether or not to include a going-concern paragraph in the auditor’s report (and to require the company to include relevant disclosures to the financial statements) is a difficult and often contentious judgment. While there is often no clear ―right answer,‖ the facts in this case would indicate a strong presumption toward concluding that there is substantial doubt about the company’s ability to continue as a going concern.

CHAPTER 19 PROFESSIONAL CONDUCT, INDEPENDENCE, AND QUALITY Management Answers to Review Questions 19-1

The three theories of ethical behavior are (1) utilitarian approach, (2) rights-based approach, and (3) justice-based approach. Utilitarian theory recognizes that decision making involves trade-offs between the benefits and burdens of alternative actions, and it focuses on the consequences of an action on the individuals affected. The theory proposes that the interests of all parties affected, not just one's self-interest, should be considered.

The rights-based theory assumes that individuals have certain rights and that other individuals have a duty to respect those rights. Thus, a decision maker who follows a theory of rights should undertake an action only if it does not violate the rights of any individual. The justice-based theory is concerned with issues such as equity, fairness, and impartiality. Decisions made within this theory should lead to a fair and equitable distribution of resources among those individuals or groups affected. There may be difficulty in trying to apply this theory in practice because the rights of one or more individuals or groups may be affected when a better distribution of benefits is provided to others.

19-2

Kmart had physical assets and trades in physical goods, but Arthur Andersen’s primary asset was a reputation for competence, professionalism, and integrity. While Kmart could file for bankruptcy and reorganize its business, Andersen’s loss of reputation, its most important operating asset, could not be repaired, resulting in the loss of its clients.

Andersen’s fate was essentially sealed long before the firm was convicted on obstruction of justice charges. Interestingly, Andersen’s conviction was later overturned on appeal, but it was too late for the accounting firm. It is also interesting to note that no major professional services firm has ever survived a federal indictment, much less a conviction, in the U.S.

19-3

The AICPA establishes auditing standards for nonpublic-company audits (through the ASB) and maintains a Code of Professional Conduct, mapping out the primary areas in which ethical conduct is expected of public accountants.

The SEC has the legal authority to oversee the public accounting profession but has generally allowed private-sector entities such as the FASB and AICPA to set accounting 1-16 Copyright ©2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

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and auditing standards. However, in 2003 the PCAOB was established to set auditing standards for the audits of public companies. The SEC and PCAOB have set rules regarding conduct and independence of public-company auditors, which differ from the AICPA rules and standards, but at present the Code of Professional Conduct maintained by the PCAOB is still very similar in most respects to that established by the AICPA in 2003 with the exception of the PCAOB’s and SEC’s additional independence requirements for auditors of public companies.

19-4

The AICPA Code of Professional Conduct consists of four major sections: a preface that is applicable to all CPAs, and three ―Parts‖: • Preface: Applies to all CPAs; defines ideal Principles of Professional Conduct that are expected of all CPAs. • Part 1: Applies to CPAs in public practice, including auditors practicing in public accounting firms and government auditors who issue audit and other assurance reports on government entities. Part 1 requires the CPA to be independent of the entities on which he or she is providing assurance.

• Part 2: Applies to CPAs who are working in business but who are not working as auditors that issue assurance reports on which the public will rely. Part 2 of the Code does not require independence but does require integrity and objectivity on the part of CPAs working in any business capacity.

• Part 3: Applies to CPAs who are neither functioning as an auditor nor in business. In such cases, the profession expects that CPAs will behave in certain ways and not engage in any act that would be discreditable to the profession.

Guidance for applying the Rules of Conduct is provided by the Interpretations of Rules of Conduct by the Professional Ethics Executive Committee (PEEC).

19-5

The six Principles of Professional Conduct are: Responsibilities: In carrying out their responsibilities as professionals, members should exercise sensitive professional and moral judgments in all their activities. This is the responsibility of all CPAs. The public interest: Members should accept the obligation to act in a way that will serve the public interest, honor the public trust, and demonstrate commitment to professionalism. This is the responsibility of all CPAs. Integrity: To maintain and broaden public confidence, members should perform all professional responsibilities with the highest sense of integrity. This is the responsibility of all CPAs. Objectivity and independence: A member should maintain objectivity and be free of conflicts of interest in discharging professional responsibilities. A member in public practice should be independent in fact and appearance when providing auditing and other attestation services. Independence is the responsibility of ―Part 1‖ CPAs, but objectivity is the responsibility of all CPAs.

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Due care: A member should observe the profession's technical and ethical standards, strive continually to improve competence and the quality of services, and discharge professional responsibility to the best of the member's ability. This is the responsibility of all CPAs. Scope and nature of services: A member in public practice should observe the Principles of the Code of Professional Conduct in determining the scope and nature of services to be provided. This is the responsibility of all CPAs.

19-6

The eleven major sections of the Rules of Conduct in Part 1 of the Professional Code of Conduct are: • Integrity and Objectivity.

• Independence • General Standards • Compliance with Standards • Accounting principles • Acts discreditable • Contingent fees • Commissions and referral fees • Advertising and other forms of solicitation • Confidential client information • Form of organization and name

19-7

Interpretation 1.260 permits the following types of personal loans from a financial institution: • Automobile loans and leases collateralized by the automobile.

• Loans fully collateralized by the cash surrender value of an insurance policy.

• Loans fully collateralized by cash deposits at the same financial institution.

• Credit cards and cash advances on checking accounts where the aggregate outstanding balance is reduced to $10,000 or less by the payment due date.

Normal lending procedures, terms, and requirements are defined as lending procedures, terms, and requirements that are reasonably comparable to those relating to loans of a similar character given to other borrowers during the period in which the loan to the member is given.

19-8

While most of the SEC’s independence rules are very similar to the AICPA’s, the SEC has added some important restrictions in the following areas: Provision of other professional services • The SEC prohibits several types of professional services by accounting firms for public company audit and review entities ―unless it is reasonable to conclude that the results of these services will not be subject to audit procedures during an audit of the entity’s financial statements.‖ The rules do not limit the scope of nonaudit 1-18 Copyright ©2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

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services provided by accounting firms to nonpublic companies or to public companies that are not audit entities. Additionally, accounting firms are allowed to provide certain types of tax services to their audit entities. Specific categories of nonaudit services that are considered to impair independence if provided to a public company audit entity are: o Bookkeeping or other services related to the accounting records or financial statements of the audit entity o Financial information systems design and implementation o Appraisal or valuation services, fairness opinions, or contribution-inkind reports o Actuarial services o Internal audit outsourcing services o Management functions or human resources o Broker or dealer, investment adviser, or investment banking services o Legal services o Expert services

Handling of human resource and compensation-related issues • Lead and engagement quality review partners of public company audit firms are required to ―roll off‖ their clients every five years so that there is a fresh perspective given to the audit on a regular basis. They cannot return to those clients until after a five-year ―time-out‖ period.

• If any client employee with a ―financial reporting oversight role‖ was previously an audit team member within a one-year ―cooling-off period,‖ the firm is prohibited from auditing the client.

• Audit partners must not receive compensation based on selling engagements to the client for services other than audit, review, and attest services, if they are to be considered independent.

Required communications • The auditor of a public company must report to the company’s audit committee all ―critical accounting policies" used by the company, all alternative treatments within GAAP related to material items discussed with management, and other material written communications between the auditor and management.

• The audit committee must be responsible for the appointment, compensation, and oversight of the external auditor’s work.

• Proxy statements and annual reports issued by public companies must disclose 1) audit fees, 2) audit-related fees, 3) tax fees, and 4) all other fees billed during the prior two fiscal years by the principal auditor.

Many of the independence restrictions for public company auditors were in response to specific circumstances that came to light in the frauds of the early 2000s. The changes, many of which were required by the Sarbanes-Oxley Act, are designed to correct these circumstances.

19-9

Section 1.700 specifies five situations when a CPA can disclose confidential information 1-19 Copyright ©2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

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without the client's consent: (1) to meet disclosure and performance requirements under GAAP and GAAS, (2) to comply with a valid subpoena, (3) to allow a review of a member’s professional practice under the authority of the AICPA, a state CPA society, or a state board of accountancy, (4) to comply with an investigative or disciplinary proceeding, and (5) to allow a review of a CPA’s professional practice in conjunction with the purchase, sale, or merger of the practice.

19-10 The following acts are considered discreditable under Section 1.400: • Discrimination and harassment in employment practices (.010).

• Solicitation or disclosure of CPA examination questions and answers (.020) • Failure to file tax return or pay tax liability (.030) • Negligence in the preparation of financial statements or records (.040) • Failure to follow requirements of governmental bodies, commissions, or other regulatory agencies (.050) • Confidential information obtained from employment or volunteer activities (.070) • False, misleading, or deceptive acts in promoting or marketing professional services (.080) • Improper use of the CPA credential (.100) • Failure to comply with records requests (.200) 19-11 The following are examples of advertising activities that are prohibited by the Rules of Conduct, as outlined in Interpretation 1.600: • Creating false or unjustifiable expectations of favorable results.

• Implying an ability to influence any court, tribunal, regulatory agency, or similar body or official.

• Claiming that specific professional services in current or future periods will be performed for a stated fee, estimated fee, or fee range when it is likely at the time of representation that such fees will be substantially increased and the prospective client was not advised of that likelihood.

• Making any other representations that would be likely to cause a reasonable person to misunderstand or be deceived.

These acts are of concern to the profession because of the central role that reputation plays to a CPAs service. Deceitful advertising will seriously damage the reputation of the CPAs involved as well as negatively affect the reputation of the profession as a whole.

Just as with Arthur Andersen, if CPAs are not seen as credible, competent professionals, the demand for a CPA’s services will disappear.

19-12 A firm’s system of quality management should be designed, implemented, and operated in such a way as to provide a public accounting firm with reasonable assurance that (a) the firm and its personnel fulfill their responsibilities and conduct engagements in accordance with professional standards and with other legal and regulatory requirements, and (b) the firm issues engagement reports that are appropriate in the circumstances.

The standard describes eight components that make up an effective system of quality management: 1-20 Copyright ©2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

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The firm’s risk assessment process Governance and leadership Relevant ethical requirements Acceptance and continuance of client relationships and specific engagements Engagement performance Resources Information and communication The monitoring and remediation process

1.

2.

3.

4.

5.

6.

7.

8.

The eight components of a system of quality management and examples of policies or procedures that can be used to fulfill each element are found in Table 19-5 in the chapter.

19-13 The PCAOB conducts regular inspections of public accounting firms that are required to register with the Board. These inspections focus on selected audit engagements to determine whether registered firms are complying with relevant legal and professional standards (e.g., the auditing standards of the PCAOB) and to identify needed corrections in firms’ systems of quality management. Registered firms that issue more than 100 audit reports for public companies each year are subject to annual inspection. Registered firms that issue at least 1 but fewer than 101 audit reports for public companies in a year are inspected once every three years. If a PCAOB inspection team identifies a deficiency in a specific audit engagement in which it believes that sufficient appropriate audit evidence was not obtained to support the audit firms’ opinions on the audited entity’s financial statements or internal control over financial reporting, the PCAOB reports such engagement deficiency in Part I of the inspection report. This part of the report is made public. If the PCAOB team identifies criticisms or potential defects in a firm’s system of quality management, such defects are described in Part II of the inspection report. These potential defects are not made public unless the firm fails to respond in a satisfactory way within 12 months after the issuance of the inspection report.

The AICPA’s Peer Review Program (PRP) is designed to review and evaluate those portions of firms’ accounting and auditing practices that are not subject to inspection by the PCAOB. Reviews are performed by firms and individuals approved by the Peer Review Board. PCAOB inspections are conducted by the PCAOB’s own inspection teams. The PCAOB is only required to inspect firms that audit public U.S. companies, while any firm that is a member of the AICPA participates in the AICPA’s PRP.

Answers to Multiple-Choice Questions 19-14 19-15 19-16 19-17 19-18 19-19 19-20

c d c b b c c

19-21 19-22 19-23 19-24 19-25 19-26

a c b b a a

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Solutions to Problems 19-27 1. The client would clearly benefit from the following nonaudit services: • Developing an automated accounting system.

• Providing tax-planning advice.

• Outsourcing the internal audit function.

• Developing projections and/or forecasts for the company’s new products.

However, because the client is a public company audit client, the firm would be prohibited from helping the client design or implement a software system and from providing internal audit outsourcing. Provision of tax-planning advice is allowed by SEC independence rules. Assisting the client to develop projections and/or forecasts for the company’s new products and other nonaudit work would be subject to approval by the audit committee and would be strictly limited by the principles of not performing a management function, auditing one’s own work, or performing an advocacy role.

2. Most of the above non-audit services would not be prohibited if the client were not publicly held, though there are restrictions to be observed. For example, see the discussion relating to the AICPA’s restrictions regarding financial information systems design and implementation for a non-public client. Also, auditors would have to make sure that they didn’t make managerial decisions or audit their own work when deciding the nature of the services that they could provide.

19-28 a. A CPA may provide such advisory services to an audit client and not impair independence because the member's role is advisory in nature and because the client is a privately held entity (see Section 1.295). b. The CPA’s independence is not impaired under these circumstances provided the client makes all significant management decisions related to the hiring of new personnel and the implementation of the system. The auditor must also limit his or her supervisory activities to initial instruction and training of personnel and should avoid direct supervision of the actual operation of the system or related activities that would constitute undue involvement in or identification with management functions.

The auditor would be prohibited from providing these services for a public company audit client (see Section 1.295). c. The independence of the auditor, according to section 1.245 of the Code, would be considered impaired whether or not the financial interest is placed in a blind trust. d. Section 1.270 of the Code indicates that an auditor's independence would be considered impaired if a close relative (e.g., a parent) has a material financial interest in an enterprise of which the auditor is participating in the engagement and has knowledge of the financial interest. e. Saad’s independence is impaired by his acceptance of payment for the audit fee in stock of the audited entity. Independence is impaired if a member has a direct 1-22 Copyright ©2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

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financial interest in a client during the period of the professional engagement or at the time of expressing an opinion. The period of professional engagement starts when the member begins to perform professional services requiring independence and ends with the client's or member's notification of that relationship's termination (see section 1.240). f. Independence is impaired under section 1.230 of the Code because the note is a prohibited loan from the member to the client.

19-29 a. b. c. d.

Yes No Yes No

19-30 a. Yes. Signing such a letter would be a known misrepresentation of fact by Jackson, in violation of section 2.130 of the Code. b. Yes. This would be a violation of section 2.110 of the Code because Abebe’s employer is the source of the revenues for the entities being audited. c. Yes, Jett’s actions violated the Code. If a member in industry uses confidential information obtained from an employer for his or her personal benefit, disclosure of the information is considered an act discreditable to the profession in violation of section 2.400 of the Code. d. No, Achebe’s actions did not violate the Code. Section 2.400 states that if a member in industry concludes that the financial statements or records could be materially misstated and do not comply with professional standards, the member should consider whether any responsibility exists to communicate the problem to third parties, such as regulators. However, the CPA should consult his attorney prior to any disclosure. e. Yes, Nguyen’s actions violated the Code. Under 2.400, a member who, through his or her negligence, makes or permits another to make false and misleading entries in the financial statements has committed an act discreditable to the profession.

19-31 Services that Perez may perform: • Counsel on potential expansion plans.

• Search for and interview new personnel.

• Train personnel.

Services that Perez may not perform: • Hire new personnel.

• Supervise the operation of the system.

• Monitor client-prepared source documents and make changes in basic IT-generated data without the concurrence of the client.

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Solutions to Discussion Cases 19-32 a. If Pina, Johnson & Associates audited one of the entities that received one of the large loans, it would not be appropriate for Johnson to seek financial information about that entity from the other auditors in his firm. Release of such information would violate section 1.700.001 of the Code, even if the information were provided to Johnson without his asking for it. The right of confidentiality for that entity would be violated.

The possible costs of using the information would be lawsuits and disciplinary actions taken by the AICPA, as well as possible lawsuits filed by Sun City or its stakeholders.

The benefit would be that Johnson could gather more reliable evidence, Sun City’s financial statements would be more accurate, and Pina, Johnson & Associates might avoid potential shareholder lawsuits. b. If Johnson had obtained the information about the possible violations of environmental laws from appropriate sources, such as public records, etc., it would not be unethical to use such information in determining the fair value of the loan to Sun City Savings & Loan. The auditor has an obligation to use such information in assessing the entity's ability to repay the loan. The auditor should consider the rights of the parties involved and the source of the information.

19-33

The Code of Professional Conduct applies to all parties who are members of the AICPA or have CPA licenses, whether or not they are practicing public accounting. There are, however, a number of interpretations of the Code of Professional Conduct that are directed specifically toward individual CPAs working outside of public accounting (see Part 2 of the Code). Newey will need to consult the Code to see what interpretations will apply differently to him in his new job.

19-34

a. No, the independence rule is not violated because Adrian does not occupy a ―financial reporting oversight role‖ for Swiss Precision Tooling; therefore, the one-year ―cooling-off‖ period is not necessary. b. Yes, the independence rule is violated because Susana did audit work during the 2020 audit engagement period, which ended on April 14, 2021. To fulfill the SEC requirement for a one-year ―cooling off‖ period, she needed to ―sit out‖ the 2021 audit engagement period, which ran from April 15, 2021 to March 12, 2022.

However, Susana took the controllership of Unigate on February 10, 2022, prior to the end of the 2021 audit engagement period. In order to preserve BDB’s independence, Susana would have had to start her financial reporting oversight role with Unigate no sooner than March 13, 2022, assuming Unigate files its 2021 financial report with the SEC on March 12. c. As long as Basma is not providing the appraisal service for the client, but only as part of the audit to verify the valuation assertion, no violation has been committed. If the appraisal service were performed on behalf of the client, and not strictly for the purposes of verifying the client’s estimates for audit purposes, then this would violate independence standards.

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d. No violation exists as long as all of the services are performed in accordance with the SEC’s independence rules, were accepted by the client’s audit committee, and the audit partner does not receive compensation based on selling engagements for nonaudit services.

19-35 1. a. If the auditor records the ―social‖ time, she may suffer some consequences from her supervisor. She may also cause the team to go over budget. On the other hand, the auditor may be helping the other auditors that work with this client in the future. Further, healthy personal interaction is an important aspect of a healthy business environment. If the auditor doesn’t record the ―social‖ time, she will not suffer any immediate personal consequences and the team will stay on budget, but past a reasonable amount of time, the auditor may be compromising her integrity. The auditor may also hurt the other auditors that work with this client in the future by establishing unreasonable expectations. b. The auditor has the right to not have to work on her own time when she is at home. Future auditors that also work with this client have the same right to not have to work on their own time. c. It is not fair for the supervisor to ask the auditor to give up her personal time to do work that is not going to be recorded. On the other hand, it is not fair for one auditor to affect the performance evaluation of the entire team by making it go over budget.

2. Student answers will vary, depending on their individual viewpoint.

19-36 1. a. If the auditor signs off on the exception without examining the underlying documents, he will save his and the client’s time. The downside is that if the exception really is a problem, it will go undetected and could cause serious problems for the firm. b. The client has the right to use his time as he sees fit but also has the right to a properly performed audit. Financial statement users have the right to know about any control problems or to have the problems identified and corrected. c. It’s not fair for the auditor to deceive those who read the auditor’s report by failing to properly investigate the exception. It’s also not fair for the in-charge senior to ask the auditor to give up his integrity by not looking into the exception.

2. Student answers will vary, depending on their individual viewpoint.

Solution to Internet Assignment 19-37 a. If a covered member belongs to a trade association that is an attest client, management participation or self review threats to the covered member’s compliance with the Independence rule may exist. Such threats might be effectively mitigated, 1-25 Copyright ©2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

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however, as long as the member did not serve as an officer, director, or in any management capacity See Interpretation 1.280.020 of the Code. b. Independence would not be impaired if, as indicated in the problem, the member’s role is strictly advisory in nature. If any of the activities listed were to cross the line to constitute performance of management activities, independence would be impaired whether or not the company was a private or a public entity. (section 1.275.015) c. Independence is impaired because the member is performing a management function.

This is covered by section 1.295.120. d. The designation by itself would not impair independence, but if a member served in such a capacity then independence would be considered impaired. The member would have to refuse to serve in order to maintain his or her independence. (section 1.245.010). e. Independence would be considered to be impaired if any partner or professional employee of the firm served as a director or officer of the organization and the organization exercised managerial control over the local charities. If the member believes that professional service can be performed objectively and the service is disclosed to and consent is obtained from the involved parties, then the service would be allowed. Otherwise independence is impaired (Interpretation section 1.275.010). f. If fees pertaining to services provided more than one year prior to the date of the audit report remain unpaid, the auditor’s independence is impaired with respect to that client. However, unpaid fees from a client that is in bankruptcy do not impair the auditor’s independence. This is addressed in section 1.230.010. Because this constitutes a financial interest in the client (it is basically a loan) it also relates to Interpretation 1.260.010.

CHAPTER 20 LEGAL LIABILITY Answers to Review Questions 20-1

The four general stages in the initiation and disposition of audit-related disputes are: (1) the occurrence of events that result in losses for users of the financial statements, (2) the investigation by plaintiff attorneys before filing suit to link the user losses with allegations of material omissions or misstatements of financial statements, (3) the legal process which commences with the filing of the suit, and (4) the final resolution of the dispute. The first stage includes the events that resulted in the losses; for example, bankruptcy, financial distress, fraudulent financial reporting, and misappropriation of assets. The second stage, pre-suit investigation, may involve investigation activities by plaintiffs and their attorneys before initiating legal proceedings. The third stage involves activities such as filing of complaints, discovery, trial preparation, and the trial. The last stage involves the resolution of the dispute, which may include a summary judgment, a 1-26 Copyright ©2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

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settlement to avoid or discontinue litigation, or a court decision on appeal after a trial.

20-2

Proportionate liability is where each defendant is liable solely for the portion of the damages that correspond to the percentage of responsibility of that defendant. Under the doctrine of joint and several liability, each defendant is held fully liable for all assessed damages, regardless of the extent to which they contributed to the injury.

20-3

Under common law, an auditor can be held liable to clients for breach of contract, negligence, gross negligence/constructive fraud, and fraud (see Table 20-2). A client would prefer to sue an auditor for a tort action because larger amounts for damages can be assessed than for a breach of contract.

20-4

The elements required for establishing an auditor's liability for negligence to clients are (1) the duty to conform to a required standard of care, (2) failure to act in accordance with that duty, (3) a causal connection between the auditor's negligence and the client's damage, and (4) actual loss or damage to the client.

20-5

The four standards that have evolved for defining the extent of the auditor's liability to third parties are (1) privity, (2) near privity, (3) foreseen persons or classes, and (4) reasonably foreseeable third parties. The traditional view held that auditors had no liability under common law to third parties who did not have a privity relationship with the auditor. Privity here means that the obligations that exist under a contract are between the original parties to the contract, and failure to perform with due care results in a breach of that duty only to those parties. Near privity does not require strict privity of contract, but that the third party be known to the auditor and that the auditor has directly conveyed the audit report or acted to induce reliance on the audit report. Many courts have reexamined the privity notion and substituted the concept of public responsibility.

Under the foreseen persons or classes approach, Section 522 of the Restatement (Second) of the Law of Torts is applied to an accountant's third-party liability suit. The Restatement is a compendium of common law prepared by legal scholars and presents an alternative view to the traditional Ultramares doctrine or rule. Finally, a small number of states have adopted a more expansive view of auditors' liability to third parties: the reasonably foreseeable third parties approach. The reasons cited for extending auditors' liability beyond privity include auditors' ability to spread the risk through the use of liability insurance.

Auditors' liability to third parties under common law is complex because court rulings are not consistent across federal and state jurisdictions.

20-6

The Securities Act of 1933 generally regulates the disclosure of material facts in a registration statement for a new public offering of securities. The Securities Exchange Act of 1934 is concerned primarily with ongoing reporting by companies whose securities are listed and traded on a stock exchange or who meet certain other statutory requirements.

It is easier for a plaintiff to sue an auditor under the Securities Act of 1933, because the plaintiff does not have to prove negligence or fraud, reliance on the auditor's opinion, a causal relationship, or a contractual relationship; the plaintiff need only prove that a 1-27 Copyright ©2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

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loss was suffered by investing in the registered security and that the audited financial statements contained a material omission or misstatement. The misstatement can be the result of mere ordinary negligence. Thus, this act, and in particular Section 11, is more favorable for plaintiffs than common law since the auditor must prove that he or she was not negligent.

20-7

Under Rule 10b-5 of the Securities Exchange Act of 1934, the following elements must be proved by a plaintiff: (1) the existence of a material, factual misrepresentation or omission, (2) reliance by the plaintiff on the financial statements, (3) damages suffered as a result of reliance on the financial statements, and (4) scienter.

The Ernst & Ernst v. Hochfelder case was significant because the Supreme Court ruled that an action under Rule 10b-5 may not be maintained by showing that the defendant was negligent but that scienter, or intent to deceive, had to be present. The Supreme Court did not decide whether gross negligence or reckless behavior was sufficient for liability under Section 10(b) or Rule 10b-5, but several courts have since determined that gross negligence or reckless behavior satisfies the scienter requirement of Rule 10b-5.

20-8

Prior to the passage of the Private Securities Litigation Reform Act of 1995, auditors sued under federal statutory law were held to the legal doctrine of joint and several liability.

The Act of 1995 limits the legal responsibility to proportionate liability, where each defendant is liable solely for the portion of the damages that corresponds to each defendant. The act also raises the pleading requirement at the beginning of a case. No longer can plaintiffs plead a general claim of fraud, rather the plaintiff must state the time, place, and contents of the allegedly false representations, the identity of the person making them, and what he or she obtained as a results of the fraud.

In 1998, Congress passed the Securities Litigation Uniform Standards Act in response to concerns that plaintiff lawyers would circumvent the federal legislation and protections brought by the 1995 Act by bringing class action suits involving nationally traded securities to state court. As a result of the 1998 Act, most large class actions against auditors alleging securities fraud must be brought to federal court.

The Tellabs, Inc. v. Makor Issues & Rights, Ltd case made it harder for prosecutors to hold auditors liable for fraud. In this case, the Supreme Court ruled that in determining whether the plaintiff’s complaint provides evidence of scienter, a court must consider both fraudulent and nonfraudulent plausible causes and the plaintiff ―must demonstrate that it is more likely than not that the defendant acted with scienter.‖ In other words, the courts determine whether a reasonable person would deem the inference of fraudulent intent to be at least as compelling as any inference of nonfraudulent intent. This helps avoid determining the strength of inference in a vacuum. GAAS violations alone are not adequate evidence of scienter. Rather, plaintiffs must meet the ―more likely than not‖ burden of proof. The increased pleading requirements may discourage trivial or baseless lawsuits where plaintiff hopes to pressure ―deep pockets‖ defendants to settle out of court as the plaintiffs have a higher pleading requirement.

20-9

Numerous sections of the Sarbanes-Oxley Act include criminal provisions. The Act enhances prosecutorial tools available in major fraud cases by expanding statutory 1-28 Copyright ©2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

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prohibitions against fraud and obstruction of justice, increasing criminal penalties for traditional fraud and cover-up crimes, and strengthening sentencing guidelines applicable to large-scale financial frauds. The Act adds a new securities fraud offense and increases authorized penalties for securities and financial reporting fraud (e.g., up to 25 years in prison). It is expected that the Act’s increased penalties will result in longer prison terms because of the corresponding changes in the federal sentencing guidelines.

The Sarbanes-Oxley Act increases penalties for impeding official investigations, and because most frauds are discovered by employees rather than external auditors, the Act strengthens the legal protections accorded whistleblowers. It is common for employers to retaliate against informants by demoting or firing them. The Act makes it a felony punishable by 10-year imprisonment to retaliate against anyone who voluntarily comes forward to report suspected violations of any federal laws.

20-10 Rule 2(e) of the Rules of Practice empowers the SEC to suspend for any person the privilege of appearing and practicing before it. These sanctions can be applied not only to an individual auditor but also to an entire accounting firm. Typically, if a firm is faced with suspension, it will agree to some type of consent agreement in which the firm does not admit guilt but agrees to lesser sanctions. These sanctions may include not taking on new SEC clients for a specified period of time and submitting to special reviews to ensure that the alleged problems have been corrected. The sanctions can also include substantial fines.

The Sarbanes-Oxley Act grants the PCAOB broad investigative and disciplinary authority over registered public accounting firms and persons associated with such firms.

When violations are detected, the PCAOB can impose sanctions such as revoking a firm’s registration, barring a person from participating in audits of public companies, monetary penalties and requirements for remedial measures, such as training, new quality control procedures, and the appointment of an independent monitor.

20-11 The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 impacts the auditing profession in several ways. Specifically mentioned in the chapter are • The Act gives the PCAOB authorization to share its inspection and investigation reports with non-US regulators, which will greatly improve the PCAOB’s ability to inspect registered foreign accounting firms.

• Revises whistleblower compensation, whereby a whistleblower that brings violations of securities law or FCPA to the attention of the SEC or U.S. Department of Justice is entitled to 10 to 30 percent of any government recovery in excess of $1 million.

While not specifically mentioned in the chapter, the Act also authorizes the PCAOB to create a program through which it can monitor the auditors of non-public broker-dealers.

20-12 The external auditor may detect activities that violate the FCPA including violations of codes of conduct that prohibit bribery, insufficient detail to accurately reflect transactions, inadequate systems of internal control, and other violations of the recordkeeping and internal control requirements for public companies under the FCPA. Any such violations should be communicated to management immediately.

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20-13 Yes. As outlined in LO 20-13, multiple academic papers show that auditors increase fees when exposed to higher litigation risk and that those fee increases include elements of more auditor effort. Research also shows evidence of higher audit quality when auditors are exposed to more risk of litigation, and that when litigation risk decreases, so does auditor effort.

Answers to Multiple-Choice Questions 20-14 20-15 20-16 20-17 20-18 20-19

d c b d b d

20-20 20-21 20-22 20-23 20-24 20-25

c c a b d d

Solutions to Problems 20-26 City Bank is not likely to prevail against Salam based on ordinary negligence. In order to establish a cause of action for negligence against Salam, City must prove that: • Salam owed a legal duty to protect City.

• Salam breached that legal duty by failing to perform the audit with the due care or competence expected of members of the profession.

• City suffered actual losses or damages.

• Salam's failure to exercise due care proximately caused City to suffer damages.

The facts of this case establish that Salam was negligent by not detecting the overstatement of accounts receivable because of his failure to follow the audit program.

However, Salam will not be liable to City for negligence because Salam owed no duty to City. This is the case because Salam was not in privity of contract with City, and the financial statements were neither audited by Salam for the primary benefit of City, nor was City within a foreseen (known and intended) class of third-party beneficiaries who were to receive the audited financial statements.

City Bank is likely to prevail against Salam based on constructive fraud. To establish a cause of action for constructive fraud, City must prove that: • Salam made a materially false statement of fact.

• Salam lacked a reasonable ground for belief that the statement was true. Constructive fraud may be inferred from evidence of gross negligence or recklessness.

• Salam intended another to rely on the false statement.

• City justifiably relied on the false statement.

• Such reliance resulted in damages or injury.

Under the facts of this case, Salam is likely to be liable to City based on constructive fraud. Salam made a materially false statement of fact by rendering an unqualified opinion on Bell's financial statements. Salam lacked a reasonable ground for belief that the financial statements were fairly presented by recklessly departing from the standards of due care in that it failed to investigate other embezzlements, despite having knowledge of at least one embezzlement, and did not notify Bell's management of the matter. Salam intended that others rely on the audited financial statements. City justifiably relied on the 1-30 Copyright ©2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

2023

audited financial statements in deciding to loan Becker $600,000 and damages resulted evidenced by Becker's default on the City loan.

20-27 a. The elements necessary to establish negligence are: • A legal duty to protect the plaintiff (Musk) from unreasonable risk.

• A failure by the defendant (Applegate) to perform or report on an engagement with the due care or competence expected of members of its profession.

• A causal relationship, (i.e., that the failure to exercise due care resulted in the plaintiff's loss).

• Actual damage or loss resulting from the failure to exercise due care. b. The elements necessary to establish a violation of Rule 10b-5 include: • A material misstatement or omission.

• Justifiable reliance on the misstatement or omission.

• Damages suffered as a result of reliance.

• The material misstatement or omission made by the defendant (Apple) with knowledge (scienter). Reckless disregard for the truth may constitute scienter. c. Applegate is not in privity of contract with Musk because there is no direct contractual relationship between them. Therefore, in the absence of other factors, Applegate would not be liable to Musk for Apple's alleged negligence based on the Ultramares decision. However, the privity defense would not protect Applegate if Musk could prove that Applegate had committed actual or constructive fraud (that is, Applegate owes a duty to all parties, including third parties, to practice its profession in a nonfraudulent manner).

20-28 a. 1. Union Bank will be successful in its negligence suit against Meng. To be successful in a lawsuit for accountant's negligence, there must be: • Duty.

• Breach.

• Reliance.

• Loss.

Meng had a duty because it knew that Union would receive the financial statements and was thereby an intended user. Meng was negligent in performing the audit by failing to confirm accounts receivable, which resulted in failing to discover the overstatement of accounts receivable. Meng's failure to confirm accounts receivable was a violation of Meng's duty to comply with generally accepted auditing standards. Union relied on Meng's opinion in granting the loan and, as a result, suffered a loss.

2. Union Bank will be successful in its common-law fraud suit against Meng. To be successful in a lawsuit for common-law fraud, there must be: • A false representation by the accountant.

• Knowledge by the accountant that the representation was false.

• Intent to deceive.

• Reliance on the false representation.

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•

Loss.

Meng was grossly negligent for failing to qualify its opinion after being advised of Butler's potential material losses from the product liability lawsuit by legal counsel. Meng will be liable to anyone who relied on Meng's opinion and suffered a loss as a result of this fraudulent omission. b. Butler's stockholders who purchased stock will also be successful in their suit against Meng under Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934.

Under the act, stock purchasers must show: • Material misstatement.

• Reliance.

• Loss.

• Scienter Meng's failure to qualify its opinion for Butler's potential legal liability was material and done intentionally (scienter). Meng will be liable for losses sustained by the purchasers who relied on Meng's opinion.

20-29 a. Knox would recover from Garson for fraud. The elements of fraud are: the misrepresentation of a material fact (because Garson issued an unqualified opinion on misleading financial statements; Garson's opinion did not include adjustments for or disclosures about the embezzlements and insider stock transactions); knowledge or scienter (because Garson was aware of the embezzlements and insider stock transactions); and a loss sustained by Knox (because of Sleek's default on the loan). b. 1. The general-public purchasers of Sleek's stock offerings would recover from Garson under the liability provisions of Section 11 of the Securities Act of 1933.

Section 11 of the Act provides that anyone, such as an accountant, who submits or contributes to a registration statement or allows material misrepresentations or omissions to appear in a registration statement is liable to anyone purchasing the security who sustains a loss. Under the facts presented, Garson could not establish a "due diligence" defense to a Section 11 action because it knew that the registration statement failed to disclose material facts.

2.

The general-public purchasers of Sleek's stock offerings would also recover from Garson under the antifraud provisions of Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934. Under Rule 10b-5, Garson's knowledge that the registration statement failed to disclose a material fact, such as the insider trading and the embezzlements, is considered a fraudulent action. The omission was material. Garson's action was intentional or, at a minimum, a result of gross negligence or recklessness (scienter). These purchasers relied on Garson's opinion on the financial statements and incurred a loss.

Solutions to Discussion Cases 20-30 a. The bases for shareholders' and creditors' suits against CD&A under state common law include: • Breach of contract: The relationship between CD&A and Lestrad is contractual 1-32 Copyright ©2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

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and requires that the CPAs' performance be rendered in a competent manner. The shareholders and creditors may claim breach of contract as third-party beneficiaries of the contract between the CPAs and Lestrad, since it could be held that the contract was entered into for their benefit and therefore they are in privity with the CPAs. • Negligence: The shareholders and creditors could assert an independent claim of negligence in addition to the action for breach of contract. Negligence will be established when the CPAs fail to exercise reasonable care, taking into account such superior skill and knowledge the CPAs have or hold themselves out as having. Despite their lack of contractual privity, the shareholders and creditors will probably be able to successfully assert this action if they can show that they are members of a class of persons intended to benefit from the services performed by the CPAs and that this was reasonably foreseen by the CPAs. • Actual fraud or constructive fraud: Recent court decisions have substantially eroded the privity barrier faced by third parties. CD&A may be held liable for actual fraud if it can be shown that they intentionally deceived the shareholders and creditors. CD&A may be held liable for constructive fraud if there are deficiencies or lapses in their professional work of such a magnitude that they constitute gross negligence or a reckless disregard for the truth. b. The bases for shareholders’ and creditors’ suits against Conan Doyle & Associates (CD&A) under the federal Securities Acts include: • That a violation of the 1933 act has occurred as a result of misstatements or omissions in the prospectus or elsewhere in the registration statement required in order to "sell" the securities. The Securities and Exchange Commission has ruled that the issuance and exchange of stock pursuant to a merger constitutes a "sale" within the meaning of the Securities Act of 1933.

• That a violation of the antifraud provisions of the 1934 act and of Rule 10b-5 issued pursuant thereto has occurred since misstatements and omissions of material facts may be fraudulent. Additionally, the antifraud provision (Sec. 17) of the 1933 act could be asserted.

• That a violation of the reporting requirements of the Securities Exchange Act of 1934 has occurred to the extent that false or misleading statements were included or material facts were omitted in the reports or other documents relating to the merger that were filed with the SEC. • That a violation of the proxy rules of the Securities Exchange Act of 1934 resulted from misstatements in or omissions from the merger proxy statement used in soliciting shareholder approval.

20-31 Students will form their own opinions. Possible arguments for and against include: Yes SOX Will Deter Fraud • By requiring top executives to certify the fairness of financial statements and the effectiveness of internal controls, SOX will deter fraud because top executives will take their responsibility for financial reporting more seriously.

• SOX improves corporate governance and tone at the top as well as other controls, which will reduce the opportunities for fraud.

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• • •

SOX clarifies and increases criminal liability for corporate officers.

SOX increases punishment for corporate fraud to better fit the damages caused.

SOX has raised the level of performance of internal and external auditors, which will reduce the incentive and opportunity to commit fraud.

No SOX Will Not Deter Fraud • Honesty and ethical behavior cannot be legislated.

• Fraudsters seem to stay one step ahead of the rules, laws, and audit tests.

• There is limited evidence that white collar crime will not continue to pay well (huge financial rewards, small financial costs, and some limited time in a comfortable correctional facility).

• Most corporate fraud involves management override of controls and collusion, at the same time auditors will be relying more on controls due to PCAOB AS 2201 (based on Section 404).

• Internal and external auditors are so busy just trying to comply with the requirements related to PCAOB AS 2201 (based on Section 404) that they may be less effective at detecting fraud.

• The legislation does not increase the ability for law enforcement to find and detect fraud.

Chapter 21: Assurance, Attestation, And Internal Auditing Services

Answers to Review Questions 21-1

Assurance services are independent professional services that improve the quality of information, or its context, for decision makers. The definition focuses on decisionmaking because good decision-making requires quality information that can be financial or nonfinancial. An assurance service engagement can aid the decision maker in searching through the available information in order to identify which pieces of information are relevant for the required decision and in improving the quality of the information or its context. An assurance service engagement can also improve quality through increasing confidence in the information’s reliability and relevance.

21-2

SSAE No. 21 indicates an attestation engagement is an engagement that is conducted under AICPA attestation standards, of which there are four types: assertion-based examination, direct examination, review, and agreed-upon procedures. Attestation engagements are a subset of assurance services (see Figure 21-1) but they focus specifically on performing and reporting on engagements that enable practitioners to report on subject matter other than historical financial statements. Assurance services that are not attestation services do not necessarily involve issuance of a report by the auditor with respect to underlying subject matter or subject matter information (or an assertion that is the responsibility of a responsible party). Non-attestation assurance services provide clarity around information or the context of the information to help clients make decisions, but the practitioner does not ―attest to‖ that information.

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21-3

Attestation standards provide for four types of attestation engagements: (1) assertionbased examination, (2) direct examination, (3) review, and (4) agreed-upon procedures.

However, an individual SSAE may prohibit one or more of these types of engagements relating to specific subject matter. For example, in reporting on a nonpublic entity’s internal control, the auditor may perform either an examination or an agreed-upon procedures engagement but may not perform a review engagement. Examples of attestation engagements are (1) reporting on an entity's adherence to environmental, social, and governance (ESG) policies, (2) providing assurance on financial forecasts and projections, and (3) providing assurance on compliance with the requirements of specified laws, regulations, rules, contracts, or grants.

21-4

Relevant background: An examination under attestation standards is an engagement in which a practitioner obtains sufficient appropriate evidence in order to obtain reasonable assurance about the underlying subject matter of the engagement or about subject matter information. The practitioner provides an opinion either directly on the underlying subject matter or on subject matter information. The subject matter of an examination attestation engagement is something other than historical financial statements; if the subject matter is historical financial statements, the engagement is covered by auditing standards. Subject matter information is the outcome of a measurement or evaluation of the underlying subject matter against identified criteria.

Answer to specific question: An assertion is one form of subject matter information, in that an assertion is the outcome of a measurement or evaluation that is performed by the party responsible for the underlying subject matter in accordance with an identified set of criteria. An assertion-based examination is an attestation engagement that evaluates and expresses an opinion on the responsible party’s assertion, which is based on the underlying subject matter of the engagement. A direct examination is an attestation engagement that evaluates and expresses an opinion on the underlying subject matter of the engagement directly, rather than on any form of subject matter information (including an assertion).

21-5

An examination under attestation standards is an engagement in which a practitioner obtains sufficient appropriate evidence in order to obtain reasonable assurance about the underlying subject matter of the engagement or about subject matter information. The practitioner provides an opinion either directly about the underlying subject matter or about subject matter information. Subject matter information is the outcome of a measurement or evaluation of the underlying subject matter against identified criteria. An examination attestation engagement conducted under attestation standards is similar in rigor to an audit of historical financial statements (conducted under auditing standards) except that the focus is on subject matter other than historical financial statements. An agreed-upon procedures attestation engagement is an engagement in which a practitioner conducts a set of procedures which are ―agreed-upon‖ by the parties involved. The set of procedures is not intended to provide reasonable assurance as a basis for a conclusion or opinion by the practitioner; instead, the practitioner’s report in an agreed-upon procedures engagement simply describes the procedures performed along with the results 1-35 Copyright ©2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

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of those procedures without conveying any conclusion or opinion on underlying subject matter or on subject matter information.

21-6

Prospective financial statements are either financial forecasts or financial projections.

Financial forecasts are prospective financial statements that present an entity's expected financial position, results of operations, and cash flows. They are based on assumptions reflecting conditions the responsible party expects to exist and the course of action it expects to take. Financial projections are prospective financial statements that present, given one or more hypothetical assumptions, an entity's expected financial position, results of operations, and cash flows. The primary difference between the two is that the financial projection is based on hypothetical assumptions and is intended to respond to a question such as "What would happen if...?" A financial projection is sometimes prepared to present one or more hypothetical courses of action for evaluation.

Additionally, financial projections can be used only for limited distribution to specified parties, while forecasts can be generally distributed.

21-7

Three types of services can be performed under SSARS: (1) preparation of financial statements, (2) compilation of financial statements, and (3) review of financial statements.

21-8

In conducting a compilation, the accountant must have the following knowledge about the entity: • The accounting principles and practices of the industry in which the entity operates.

• A general understanding of the entity’s organization; its operating characteristics; and the nature of its assets, liabilities, revenues, and expenses.

• An understanding of the accounting principles and practices used by the client.

In conducting a review, the accountant must possess the following knowledge: • The accounting principles and practices of the industry in which the entity operates.

• A general understanding of the entity's organization; its operating characteristics; and the nature of its assets, liabilities, revenues, and expenses.

• An understanding of the accounting principles and practices used by the entity in measuring, recognizing, recording, and disclosing all significant accounts and disclosures in the financial statements.

21-9

Corporate governance entails all management-administered policies and procedures to control risk and oversee operations within a company. The IAF can help management and the board identify and manage risk and can help ensure the compliance of the organization with applicable laws, rules, and regulations. In addition, if reporting responsibilities are properly defined, the internal audit function can assist the audit committee in ensuring that executive management is exercising responsible and appropriate stewardship over the entity’s resources for the benefit of the entity’s stakeholders.

21-10 Internal auditors play a direct role in helping management comply with at least two sections of the Sarbanes-Oxley Act. By testing internal control over financial reporting, 1-36 Copyright ©2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

2023

the internal audit function directly assists management to certify the effectiveness of internal controls as per Section 404. In so doing, internal auditors provide a degree of assurance that internal controls over the reliability of financial reporting are working as planned. This assurance facilitates senior management’s responsibility to certify to the accuracy of the financial statements as required by Section 302.

21-11 The AICPA Special Committee on Assurance Services developed the following six assurance services: Risk assessment-assurance that the entity’s profile of business risks is comprehensive and evaluation of whether the entity has appropriate systems in place to effectively manage those risks.

Business performance measurement-assurance that an entity’s performance measurement system contains relevant and reliable measures for assessing the degree to which the entity’s goals and objectives are achieved or how its performance compares to competitors.

Information system reliability-assurance that an entity’s internal information systems provide reliable information for operating and financial decisions.

Electronic commerce-assurance that systems and tools used in electronic commerce provide appropriate data integrity, security, privacy, and reliability.

Health care performance measurement-assurance about the effectiveness of health care services provided by HMOs, hospitals, doctors, and other providers.

PrimePlus-assurance that specified goals regarding the elderly are being met by various caregivers.

21-12 There are three broad categories of risks associated with electronic commerce: business practices, transaction integrity, and information protection. As seen in Table 21–7, Trust Services are built on five criteria: Security: Information and systems are protected against unauthorized access, unauthorized disclosure of information, and damage to systems that could compromise the availability, integrity, confidentiality, and privacy of information or systems and affect the entity’s ability to meet its objectives.

Availability: Information and systems are available for operation and use to meet the entity’s objectives.

Processing Integrity: System processing is complete, accurate, timely, and authorized to meet the entity’s objectives.

Confidentiality: Information designated as confidential is protected to meet the entity’s objectives.

Privacy: Personal information is collected, used, retained, disclosed, and disposed to meet the entity’s objectives.

21-13 A Trust Services engagement is performed as an examination under the attestation standards.

In performing a Trust Services engagement, the practitioner uses guidance provided in AICPA attestation standards and COSO’s Internal Control—Integrated Framework. In such an examination, the practitioner expresses a positive opinion as to whether the presentation of assertions conforms to the AICPA’s Trust Services principles and criteria. An e-commerce 1-37 Copyright ©2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

2023

company might consider purchasing this service because threats exist to the safety of electronic business. Users of the company’s services might worry whether the entity is legitimate or whether it follows good business practices and won’t defraud them. Similarly, they might want assurance that electronic transactions will not be changed, lost, duplicated, or processed incorrectly, and that private information will be protected.

21-14 A SOC 2 report provides detailed information for management’s use to ensure that the organization’s system controls are effective with respect to Trust Services criteria, such as security and availability. A company doing a large amount of online business may want to provide assurance to specified users that all online resources are secure and working effectively. A SOC 3 report contains a high-level overview of information generally contained in SOC 2 and is for a broad group of external users. A company doing business online might want a SOC 3 report in order to assure website users that information stored with them will be kept confidential and private. A SOC for Cybersecurity would also be extremely beneficial to address issues regarding data breaches and additional online security threats.

Answers to Multiple-Choice Questions 21-15 21-16 21-17 21-18 21-19 21-20 21-21 21-22

d b d c b a c b

21-23 21-24 21-25 21-26 21-27 21-28 21-29

d c a c b c d

Solutions to Problems 21-30 A compilation is defined as presenting, in the form of financial statements, prospective financial information, pro-forma financial information, or other historical financial information, information that is the representation of management or owners without the accountant expressing any assurance on the statements. A review is defined as the performance of inquiry and analytical procedures to provide the accountant with a reasonable basis for expressing limited assurance that no material modifications should be made to the financial statements in order for them to conform to GAAP or another comprehensive basis of accounting. An audit is defined as a process of objectively obtaining and evaluating evidence regarding assertions about economic actions and events to ascertain the degree of correspondence between those assertions and established criteria. An audit provides the most assurance, followed by a review, and finally a compilation.

21-31 a. A compilation of prospective financial statements involves • Assembling, to the extent necessary, the prospective financial statements based on 1-38 Copyright ©2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

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•

•

the responsible party's assumptions.

Performing the required compilation procedures, which include reading the prospective financial statements with their summaries of significant assumptions and accounting policies and considering whether they appear to be (1) presented in conformity with the attestation standards and (2) not obviously inappropriate.

Issuing a compilation report.

b. Independent Accountant's Report Board of Directors Cheaney Rental Properties We have compiled the accompanying forecasted balance sheet, statements of income, retained earnings, and cash flows of Cheaney Rental Properties as of December 31, 2021, and for the year then ending, in accordance with attestation standards established by the American Institute of Certified Public Accountants.

A compilation is limited to presenting, in the form of a forecast, information that is the representation of management and does not include evaluation of the support for the assumptions underlying the forecast. We have not examined the forecast and, accordingly, do not express an opinion or any other form of assurance on the accompanying statements or assumptions. Furthermore, there will usually be differences between the forecasted and actual results, because events and circumstances frequently do not occur as expected, and those differences may be material. We have no responsibility to update this report for events and circumstances occurring after the date of this report.

21-32 The following deficiencies were noted in Currie's draft: • The report does not contain the heading "Independent Accountant's Report."

• The report is not dated.

First paragraph: • The first line should read ―we have examined,‖ rather than ―we have taken a careful look at…‖ • The report should state that management is responsible for the projection.

• The report should state who the examination was prepared for and for what purpose.

• The report should state the auditor’s responsibility to express an opinion on the examination, rather than to ―describe our work.‖ Second paragraph: • The report should state that the examination was conducted in accordance with "attestation standards established by the American Institute of Certified Public Accountants."

• The report in this paragraph refers to a ―guidelines for the presentation of a forecast,‖ rather than of a ―projection,‖ an altogether different kind of prospective financial information. This clearly is a projection given the particular assumption of obtaining a loan to expand Honey’s plant.

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Third paragraph: • The report should indicate that there will likely be differences between the projected and actual results, because events and circumstances frequently do not occur as expected, and those differences may be material.

• The report should state that the practitioner has no responsibility to update the report for events and circumstances occurring after the date of the report.

Fourth paragraph: • The fourth paragraph, which is missing, should limit the use of the projection to those for whom it was intended (because an attestation report on a financial projection can be made available only for limited use, as projections are based on specific, hypothetical assumptions—in this case receipt of the loan to expand the plant).

Signature Block: • There should be a signature block that includes the signature, city and state, and the date of the report.

21-33 a. Consumers are reluctant to engage in electronic commerce for several reasons. First, consumers want to know that the entity behind the website is ―real.‖ In other words, how can the consumers be sure that the entity follows good business practices and that they will not be defrauded? Second, consumers are worried that electronic transactions will be changed, lost, duplicated, or processed incorrectly. Lastly, consumers are concerned that private information will be stolen. b. Your firm can provide a SOC 2 report to provide assurances about Park Corporation’s security, availability, processing integrity, online privacy, and confidentiality by completing a Trust Services engagement. This report would be most useful as it focuses on conveying information to members of management, such as HeeSoo Park, who desire to gain assurance regarding Trust Services Criteria. c. In addition to a SOC 2 report for management, the firm can also provide a SOC 3 report for Park Corporation’s customers. A SOC 3 report is typically a higher-level overview of the detailed information that would ordinarily be found in a SOC 2 report, and it is intended for general use. Topics included in the report would include items such as efforts taken by the Company to ensure customer information is kept private and secure along with availability of information on the website regarding the Company’s sporting goods business.

Solution to Discussion Case 21-34 A practitioner may perform an agreed-upon procedures engagement to evaluate an entity's written assertion that it was in compliance with its state's environmental laws and regulation provided that • The practitioner is independent.

• The practitioner and specified users agree upon the procedures performed or to be 1-40 Copyright ©2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

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• • • • • • •

performed.

The engaging party acknowledges the appropriateness of the procedures before the practitioner issues a report.

The specific subject matter to which the procedures are to be applied is subject to reasonably consistent estimation or measurement.

The criteria to be used in the determination of findings are agreed upon between the practitioner and the specified users.

The procedures to be applied to the specific subject matter are expected to result in reasonably consistent findings using the criteria.

Evidential matter related to the specific subject matter to which the procedures are applied is expected to provide a reasonable basis for expressing the findings in the practitioner's report.

Where applicable, the practitioner and the specified users agree on any materiality limits for reporting purposes.

Use of the report is restricted to the specified users, unless a general-use report is deemed appropriate.

In addition, the practitioner should obtain an understanding of the specified compliance requirements by considering the following: • Laws, regulations, rules, contracts, and grants that pertain to the specified compliance requirements, including published requirements.

• Knowledge about the specified compliance requirements obtained through prior engagements and regulatory reports.

• Knowledge about the specified compliance requirements obtained through discussions with appropriate individuals within the entity (e.g., the chief financial officer, internal auditors, legal counsel, compliance officer, or grant or contract administrators).

• Knowledge about the specified compliance requirements obtained through discussions with appropriate individuals outside the entity (e.g., a regulator or third-party specialist).

Solutions to Internet Problems 21-35 a. The Internal Auditor’s mission is to arm practitioners with the cutting-edge information and practices they need to do their jobs today and tomorrow. The articles identified by students will vary but should reflect current topics of interest in internal auditing. b. From the homepage, under the ―Certification‖ tab, click on the ―Why Become Certified?‖ link. There, the IIA’s website indicates that there are many reasons to obtain an official IIA certification designation. Whether it's the Certified Internal Auditor® (CIA) designation or one of the IIA’s three specialty industry certifications, obtaining a certification signals professionalism.

This site provides information on the exam and suggests that the (CIA) designation is 1-41 Copyright ©2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

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the only globally accepted certification for internal auditors and remains the standard by which individuals demonstrate their competency and professionalism in the internal auditing field. The site also indicates that those who complete the program are enriched with educational experience, information, and business tools that can be applied immediately in any organization or business environment.

21-36

a. The five broad areas in which Trust Services Criteria are organized are as follows: Security: Information and systems are protected against unauthorized access, unauthorized disclosure of information, and damage to systems that could compromise the availability, integrity, confidentiality, and privacy of information or systems and affect the entity’s ability to meet its objectives.

Availability: Information and systems are available for operation and use to meet the entity’s objectives.

Processing integrity: System processing is complete, valid, accurate, timely, and authorized to meet the entity’s objectives.

Confidentiality: Information designated as confidential is protected to meet the entity’s objectives.

Privacy: Personal information is collected, used, retained, disclosed, and disposed to meet the entity’s objectives.

b. A SOC 1 report is obtained by a service organization that provides outsourced accounting or other data/information services (e.g., payroll) and desires to provide assurance that the controls relevant to financial reporting of the service organization are in place. A type 1 SOC 1 report covers the design effectiveness of the controls of the service organization and a type 2 SOC 1 report covers both the design and operating effectiveness of controls at the service organization.

A SOC 2 report is limited for use by either the management of the organization or to specified users with detailed knowledge and understanding of the organization and its system. A SOC 2 engagement will vary depending on the circumstances and the information system being examined, but the report will typically consist of at least four sections: (1) management’s description of the information system relevant to the Trust Services criteria (or criterion) being reported upon; (2) management’s assertion(s) relating to (a) the accuracy of the description of its system and relevant controls, (b) the effectiveness of the design of relevant controls, and (c) the operating effectiveness of relevant controls (if the report is a Type 2 SOC 2 report); (3) the practitioner’s restricted-use report, which provides an opinion relative to each of management’s assertions; and (4) a description of the applicable Trust Services criteria as well as a description of the controls that were tested, how they were tested, and the results of the tests. Exhibit 21-9 shows an example of a practitioner’s report.

A SOC 3 engagement is similar to a SOC 2 engagement in that the practitioner assesses whether (a) management has provided an accurate description of its information system, and (b) the controls within a system were effective in accordance with the applicable Trust Services criteria. A SOC 3 report is ordinarily intended for general use to provide assurance to a broad group of external users. SOC 3 reports 1-42 Copyright ©2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.

2023

typically provide a higher-level overview of the detailed information that would ordinarily be found in a SOC 2 report.

21-37 Answers to this question may vary based on the year of the SOC 3 report. a. For the period ending 30 April 2020, EY was the accounting firm that performed the attestation engagement. References to Trust Services Principles and Criteria of security, availability, processing integrity, confidentiality, and privacy are all noted under the ―Approach‖ section of the report. b. Due to the high traffic of users that Google experiences daily, the company hires a CPA firm provide a SOC 3 report in order to ensure its users that the Cloud Platform System is reliable and satisfies Trust Services Criteria. Users may be wary of using a cloud service to store personal information that is unverified by an outside party.

1-43 Copyright ©2022 McGraw Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill Education.