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Chapter 10 1 Items 1 through 6 represent the items that an auditor ordinarily would find on a client-prepared bank reconciliation. The accompanying List of Auditing Procedures represents substantive auditing procedures. For each item, select one or more procedures, as indicated, that the auditor most likely would perform to gather evidence in of that item. The procedures on the list may be selected once, more than once, or not at all.

Assume • The client prepared the bank reconciliation on 10/2/X5. • The bank reconciliation is mathematically accurate. • The auditor received a cutoff bank statement dated 10/7/X5 directly from the bank on 10/11/X5. • The 9/30/X5 deposit in transit—outstanding checks #1281, #1285, #1289, and #1292—and the correction of the error regarding check #1282 appeared on the cutoff bank statement. • The auditor assessed control risk concerning the financial statement assertions related to cash at the maximum.

List of Auditing Procedures A. Trace to cash receipts journal. B. Trace to cash disbursements journal. C. Compare to 9/30/X5 general ledger. D. Confirm directly with bank. E. Inspect bank credit memo. F. G. H. I. J.

Inspect bank debit memo. Ascertain reason for unusual delay. Inspect ing documents for reconciling item not appearing on cutoff statement. Trace items on the bank reconciliation to cutoff statement. Trace items on the cutoff statement to bank reconciliation. GENERAL COMPANY Bank Reconciliation 1st National Bank of US Bank September 30, 20X5

a. Select 2 Procedures

Balance per bank

b. Select 5 Procedures

Deposits in transit

$39,325 D,I

9/29/X5

$500

9/30/X5

825

1,325 40,650 A,G,H,I,J

c. Select 5 Procedures

Outstanding checks # 988

8/31/X5

1,025

#1281

9/26/X5

700

#1285

9/27/X5

825

#1289

9/29/X5

475

#1292

9/30/X5

1,075

4,100

36,550 B,G,H,I,J

d. Select 1 Procedures e. Select 2 Procedures

f. Select 1 Procedure

Customer note collected by bank

(1,000) E

Error: Check #1282; written on 9/26/X5 for $560 was erroneously charged by bank as $650; bank was notified on 10/2/X5 Balance per books

90 E,I $35,640 C

Explanation: (a) D, I. The balance per bank may be traced to a standard form used to confirm balance information with financial institutions and to the cutoff statement (on which will appear the beginning balance).

(b) A, G, H, I, J. One of the deposits in transit does not appear on the cutoff bank statement (the 9/29/X5 deposit for $500). Accordingly, that deposit should be traced to the cash receipts journal (procedure A), the reason for the delay should be investigated (procedure G), and ing documents should be inspected (procedure H). Both deposits should be traced to and from the bank reconciliation and the cutoff statement (procedures I and J).

(c) B, G, H, I, J One of the checks does not appear on the cutoff statement (check #988 dated 8/31/X5 for $1,025). Accordingly, that check should be traced to the cash disbursements journal (procedure B), the reason for the delay should be investigated (procedure G), and ing documents should be inspected (procedure H). All checks should be traced to and from the bank reconciliation and cutoff statement (procedures I and J).

(d) E The credit memo from the bank for the note collected should be investigated.

(e) E, I The credit for the check that was charged by the bank for an incorrect amount should be investigated on both the bank credit memo and on the cutoff statement.

(f) C The only source of the balance per books is the cash general ledger as of 9/30/X5.

2. You are the senior auditor-in-charge of the July 31, 20X0, audit of Reliable Auto Parts, Inc. Your newly hired staff assistant reports to you that she is unable to complete the four-column proof of cash for the month of April 20X0, which you instructed her to do as part of the consideration of internal control over cash.

Your assistant shows you the working paper that she has prepared. Your review of your assistant’s work reveals that the dollar amounts of all the items in her working paper are correct. You learn that the ant for Reliable Auto Parts, Inc., makes no journal entries for bank service charges or note collections until the month following the bank’s recording of the item. In addition, Reliable’s ant makes no journal entries whatsoever for NSF checks that are redeposited and cleared. Your assistant’s working paper appears below.

Per bank statement Deposits in transit: At 3/31/X0 At 4/30/X0 Outstanding checks: At 3/31/X0 At 4/30/X0 Bank service charges: March 20X0 April 20X0 Note receivable collected by bank 4/30/X0 NSF check of customer L. G. Waite, charged back by bank 3/31/X0, redeposited and cleared 4/3/X0

RELIABLE AUTO PARTS, INC. Proof of Cash for April 20X0 July 31, 20X0 Balance 3/31/X0 Deposits $ 72,112.82 $ 61,855.41 2,130.89

(14,977.49)

14,977.49 (23,052.21)

23,052.21

22.30 (19.26)

19.26

(22.30)

18,300.00

$

(420.47)

420.47

58,823.45 59,708.99

85,523.43 45,951.60

Balance 4/30/X0 $ 65,433.02 (2,130.89) 4,947.55

4,947.55

Balances as computed Balances per book

Unlocated difference

Checks $ 68,535.21

18,300.00

60,463.53 76,612.97

(885.54) $ 39,571.83 $ (16,149.44) $

109,621.15 29,047.62

80,573.53

Prepare a corrected four-column proof of cash in good form for Reliable Auto Parts, Inc., for the month of April 20X0.

RELIABLE AUTO PARTS, INC Proof of Cash for April 20X0 July 31, 20X0 Balance 3/31/X0

Balance Deposits

Checks

4/30/X0

Per bank statement

$72,112.82 $61,855.41 $68,535.21 $65,433.02

Deposits in transit: At 3/31/X0

2,130.89

(2,130.89)

0

0

At 4/30/X0

0

4,947.55

0

4,947.55

Outstanding checks: At 3/31/X0

(14,977.49)

0 (14,977.49)

At 4/30/X0

0

0

22.30

0

23,052.21 (23,052.21)

Bank service charges: March 20X0 April 20X0 Note receivable collected by bank 4/30/X0

0 (18,300.00)

22.30

0

(19.26)

19.26

0 (18,300.00)

NSF check of customer L. G. Waite, charged back by bank 3/31/X0, redeposited and cleared 4/3/X0 Balances per book

420.47

(420.47)

0

0

$59,708.99 $45,951.60 $76,612.97 $29,047.62

3. During the audit of Sunset Building Supply, you are given the following year-end bank reconciliation prepared by the client:

SUNSET BUILDING SUPPLY Bank Reconciliation December 31 Balance per 12/31 bank statement Add: Deposits in transit

$49,204 4,514

Less: Checks outstanding

$53,718 20,958

Balance per ledger, 12/31

$32,760

According to the client’s ing records, checks totaling $31,791 were issued between January 1 and January 14 of the following year. You have obtained a cutoff bank statement dated January 14 containing paid checks amounting to $50,935. Of the checks outstanding at December 31, checks totaling $3,635 were not returned in the cutoff statement, and of those issued per the ing records in January, checks totaling $8,278 were not returned. Prepare a working paper comparing (1) the total of all checks returned by the bank or still outstanding with (2) the total per the client’s records of checks outstanding at December 31 plus checks issued from

January 1–14.

SUNSET BUILDING SUPPLY Comparison of Checks and Disbursements December 31 Checks returned or still outstanding: Returned in cutoff statement

$50,935

Outstanding checks on 1/14

11,913

$62,84 8

Disbursements per client records: Outstanding checks on 12/31

$20,958

Issued between 1/1 and 1/14

31,791

Excess of checks returned or outstanding over disbursements per client records

$52,74 9 $10,09 9

4. You are working on your firm’s fifth audit of SSC. The previous audits have all resulted in standard unqualified audit reports. Read the following write-up from your audit files concerning SSC and its industry, and then reply to the questions that follow. Company Information In 20X1, Gary Sherwood founded Sherwood Stone Company (SSC). In the middle of its second year of existence, the company completed development of a large extraction pit area and constructed an aggregate processing plant that is equipped to crush, screen, and wash aggregate products. By 20X4, the sand and gravel operation was profitable and growing market conditions justified modifications and expansion. Currently, SSC produces a wide range of sand and stone products from its pit near Bisbee, Arizona. The materials it develops are composed of sand and stone materials for commercial construction and highway projects. SSC sells to a wide variety of commercial and governmental customers, with only one of its numerous customers—Wingo Corporation—ing for more than 5 percent of total sales. In total, Wingo has represented approximately 30 percent of sales (and receivables) for the past few years. Wingo Corporation is by far Arizona’s largest street and road contractor and seems solid financially. Virtually all of SSC’s sales are on credit, although all but the smallest contracts require “progress” billings that result in payment being received by SSC on a pro rata basis with delivery of materials to the customer. Payments from customers are made directly to the company’s lockbox system with SSC’s local bank. All transactions occur in U.S. dollars, and SSC maintains both a general checking and a payroll . SSC has worked closely with Wingo Corporation in developing a superior road paying product (“QuietRide”). Not only is the car ride relatively quiet on QuietRide roads, but it is also relatively cool (thus lengthening the life of automobile tires) and less likely to lead to cars sliding in rainy conditions. Although Wingo Corporation holds the overall patent, SSC has patented a critical component that is used in the product (the component is “QSand”). The product now s for approximately 25 percent of the company’s sales (all to Wingo Corporation) and 33 percent of its profits.

The success of QSand has led SSC to start developing another product, QDeck. QDeck will be a final finishing coat over the pool deck—the concrete walking and lounging area that surrounds a swimming pool. QDeck is intended to address two problems: (1) individuals slipping and falling on pool decks while walking with wet feet, and (2) individuals burning their feet on the deck on particularly hot days. Gary indicates that the current compound seems to allow good traction and decks remain much cooler than with products of other companies. The problem being addressed at this point is that the current compound seems to crack easily and has a relatively short useful life. Indeed, in one test of the product on the deck at Gary’s home, Gary’s wife Madonna cut her foot on one of the cracks and required several stitches to close the wound. Gary laughed and said that at least she didn’t slip or burn her feet on that hot day when it happened. More seriously, he suggested that this deficiency is currently being worked on and must be solved before the product goes to market. The product is being independently developed and is intended for both residential and commercial markets. In 20X8, the company experienced a level of profitability just slightly above that of 20X7—but this was well below the net incomes of the preceding few years. Gary suggested to you that, surprisingly, intense price competition from several smaller competitors in the Bisbee area caused the somewhat low level of profitability. But, he added, he didn’t expect the problem to last for long because he doubted that those companies could continue to operate selling at those lower prices. Gary had hoped for a more profitable year in 20X8, as a significant amount of the company’s long-term debt is payable in 20X9. SSC is currently involved in discussions with the bank on refinancing. SSC added significant additional crushing and washing plant and equipment during 20X8 to increase production in the future by more than 100 percent while expanding capabilities to produce custom specification materials. No dividends have been paid during the past two years, although previously most of the earnings were distributed through dividends to SSC’s five shareholders—CEO and Chair of the Board of Directors Gary Sherwood, his wife Madonna Sherwood, CFO Jane Zhan, and two college friends of Gary’s who invested in the company, Cindy Stone and Kelly Higgins. These five individuals make up the company’s board of directors. The Bank of Arizona is the financial institution with which SSC maintains its two cash s (a general and payroll cash ) and from which it obtains a significant portion of its financing; the inventories are pledged on the Bank of Arizona loan. This year, in reaction to pressure from the bank, SSC est ablished an audit committee composed of Madonna Sherwood, Cindy Stone, and Kelly Higgins.

Industry Information The industry activities consist of the extraction and preparation of sand and rock products. These activities include the cleaning, separating, and sorting of quarried sand and the process of crushing rocks. The products are in the form of sand used in making concrete; sand used in laying bricks (which contains little soil); sand used for fill (which contains a large amount of soil); and quartz sand. It excludes the products of gravel quarrying (sandstone, gravel stone, and iron sand).

While sales within the industry are relatively unaffected by changes in technology or obsolescence, industry sales rely heavily upon both the residential and commercial construction markets as well as government spending. During the past five years, construction has performed well and that trend is expected to continue for at least the next several years. Sand and gravel production has increased at approximately 4 percent per year during this time period, as has construction within the central Arizona area. a. Which of the following represents a correct statement concerning the risk of misappropriation of cash for SSC?

This is not a major concern since sales are made on credit. Deposit of cash into a lockbox system decreases the risk of misappropriation. Misappropriation of cash is not a significant problem in a commercial company. The success of QSand increases the risk that cash will be misappropriated.

b. Which of the following correctly identifies a risk facing SSC that might adversely affect cash receipts during the coming years?

Establishment of the audit committee. Increase in the popularity of home swimming pools. Sales to many different customers. Sales to Wingo. c. Which of the following correctly identifies a risk facing SSC that might adversely affect sales during the coming years?

A general slowdown in the economy. Sales to many smaller customers other than Wingo Corporation. Increased attention to developing new products. A board of directors dominated by management. d. Which of the following correctly identifies a risk facing SSC that might affect its ability to continue as a going concern over the long run?

Competition from several competitors. Your A firm’s decision to issue standard unmodified audit reports not mentioning the goingconcern status during the past five years. Obsolescence of all products due to rapid changes in technology in the industry. The nature of inventory items—small in size, high in value. e. Of the following, the most significant risk factor relating to the risk of misstatement arising from fradulent financial reporting for SSC is that:

Company officers serve on the board of directors. The company must refinance a significant portion of its debt. The company operates in the Bisbee, Arizona, area. The company paid no dividend this year. f. In addition to the risk factor identified in the preceding question, another risk factor relating to misstatements arising from fraudulent financial reporting is:

Earnings this year are lower than management had hoped. s payable are limited to commercial suppliers. Sales are made to residential, commercial, and governmental purchasers. The industry faces great technological changes in almost all of its products.

Chapter 11 1 For each of the procedures described in the table below, identify the audit procedure performed and classification of the audit procedure using the following: Audit Procedures: (1) Analytical procedure (2) Confirmation (3) Inquiry (4) Inspection of records or documents (5) Inspection of tangible assets (6) Observation (7) Recalculation (8) Reperformance

Procedure

Classification of Audit Procedure (9) Substantive procedures (10) Test of controls

Audit Procedure

Classification of Audit Procedure

Requested responses directly from customers as to amounts due. Compared total bad debts this year with the totals for the previous two years. Questioned management about likely total uncollectible s. Watched the ing clerk record the daily deposit of cash receipts. Examined invoice to obtain evidence in of the ending recorded balance of a customer. Compared a sample of sales invoices to credit files to determine whether the customers were on the approved customer list. Examined a sample of sales invoices to see if they were initialized by the credit manager indicating credit approval.

(2)

(9)

(1)

(9)

(3)

(9)

(6)

(10)

(4)

(9)

(8)

(10)

(4)

(10)

2. An assistant on the Carter Company audit has been working in the revenue cycle and has compiled a list of possible errors and fraud that may result in the misstatement of Carter Company’s financial statements and a corresponding list of controls that, if properly designed and implemented, could assist in preventing or detecting the errors and fraud. For each possible error and fraud numbered a through o, select one internal control from the following answer list that, if properly designed and implemented, most likely could assist management in preventing or detecting the errors and fraud. Each response in the list of controls may be selected once, more than once, or not at all.

Controls A. Shipping clerks compare goods received from the warehouse with the details on the shipping documents. B. Approved sales orders are required for goods to be released from the warehouse. C. Monthly statements are mailed to all customers with outstanding balances. D. Shipping clerks compare goods received from the warehouse with approved sales orders. E. Customer orders are compared with the inventory master fi le to determine whether items ordered are in stock. F. Daily sales summaries are compared with control totals of invoices. G. Shipping documents are compared with sales invoices when goods are shipped. H. Sales invoices are compared with the master price file. I. Customer orders are compared with an approved customer list. J. Sales orders are prepared for each customer order. K. Control amounts posted to the s receivable ledger are compared with control totals of invoices. L. Sales invoices are compared with shipping documents and approved customer orders before invoices are mailed. M.Prenumbered credit memos are used for granting credit for goods returned. N. Goods returned for credit are approved by the supervisor of the sales department. O. Remittance advices are separated from the checks in the mailroom and forwarded to the ing department. P. Total amounts posted to the s receivable ledger from remittance advices are

compared with the validated bank deposit slip. Q. The cashier examines each check for proper endorsement. R. Validated deposit slips are compared with the cashier’s daily cash summaries. S. An employee, other than the bookkeeper, periodically prepares a bank reconciliation. T. Sales returns are approved by the same employee who issues receiving reports evidencing actual return of goods. Possible Errors and Fraud

Controls

a.

Invoices for goods sold are posted to incorrect customer s.

C

b.

Goods ordered by customers are shipped, but are not billed to anyone.

G

c.

Invoices are sent for shipped goods, but are not recorded in the sales journal.

F

d.

Invoices are sent for shipped goods and are recorded in the sales journal, but are not posted to any customer .

K

e.

Credit sales are made to individuals with unsatisfactory credit ratings.

I

f.

Goods are removed from inventory for unauthorized orders.

B

g.

Goods shipped to customers do not agree with goods ordered by customers.

D

h. i. j.

Invoices are sent to allies in a fraudulent scheme and sales are recorded for L fictitious transactions. Customers’ checks are received for less than the customers’ full balances, P but the customers’ full balances are credited. Customers’ checks are misappropriated before being forwarded to the cashier for C deposit.

k.

Customers’ checks are credited to incorrect customer s.

C

l.

Different customer s are each credited for the same cash receipt.

P

m. n. o.

Customers’ checks are properly credited to customer s and are properly deposited, but errors are made in recording receipts in the cash receipts journal. Customers’ checks are misappropriated after being forwarded to the cashier for deposit. Invalid transactions granting credit for sales returns are recorded. a. (C) Invoices posted to incorrect customer s will be detected by analyzing customer responses to monthly statements that include errors, particularly statements with errors not in favor of the customer. b. (G) The comparison of shipping documents with sales invoices will detect goods that have been shipped but not billed when no sales invoice is located for a particular shipping document. c. (F) To provide assurance that all invoiced goods that have been shipped are recorded as sales, daily sales summaries should be compared with invoices. For example, a sale that has not been recorded will result in a sales summary that does not include certain sales invoices. d. (K) A comparison of the amounts posted to the s receivable ledger with the control total for invoices will provide assurance that all invoices have been posted to a customer . e. (I) Comparing customer orders with an approved customer list will provide assurance that credit sales are made only to customers that have been granted credit. f. (B) Requiring an approved sales order before goods are released from the warehouse will provide assurance that goods are not removed for unauthorized orders. g. (D) A comparison by shipping clerks of goods received from the warehouse with the approved sales orders will provide assurance that goods shipped to customers agree with goods ordered by customers. h. (L) A comparison of sales invoices with shipping documents and approved sales orders will detect invoices that do not have the proper . Accordingly, it will help prevent the

S P N

recording of fictitious transactions. i. (P) Comparing amounts posted to the s receivable ledger with the validated bank deposit will detect improper postings to s receivable since any differences in amounts will be investigated. j. (C) Misappropriations of customers’ checks will be detected when customers indicate that they have made payments for items shown as payable on their monthly statement. Note that replies O and P will only detect this misappropriation in the unlikely event that the perpetrator does not dispose of the remittance advice. k. (C) Mispostings of payments made will be detected when customers indicate that they have made payments for items shown as payable on their monthly statement. l. (P) Crediting more than one for a cash receipt will be detected when the total of amounts posted to the s receivable ledger is compared with the validated bank deposit slip. m.(S) An independent reconciliation of the bank will reveal improper total recording of receipts in the cash receipts journal because unlocated differences between bank and book balances will occur and be investigated. n. (P) Comparing total amounts posted to the s receivable ledger with the validated bank deposit slip will detect a difference between total cash receipts and the amount credited to the s receivable ledger. o. (N) Requiring the approval of the supervisor of the sales department for goods received will provide assurance that invalid transactions granting credit for sales returns are not recorded. Note that using prenumbered credit memos (reply M) will only be effective if the sequence is ed for and if credit memos may be compared in some form to actual returns.

3. An auditor may use confirmations of s receivable. Reply as to whether the following statements are correct or incorrect with respect to the confirmation process when applied to s receivable.

Conditions a. b. c.

The confirmation requests should be mailed to respondents by the As. A combination of positive and negative request forms must be used if receivables are significant. Second requests are ordinarily sent for positive form confirmations requests when the first request is not returned.

Correct Incorrect Correct

d.

Confirmations address existence more than they address completeness.

Correct

e.

Confirmation of s receivable is a generally accepted auditing standard.

Incorrect

f.

The auditors ordinarily should confirm s receivable.

Correct

g. h. i. j.

4.

Auditors should always confirm the total balances of s rather than individual portions (e.g., if the balance is made up of three sales, all three should be confirmed). Auditors may ignore individually immaterial s when confirming s receivable. The best way to evaluate the results of the confirmation process is to compare the total misstatements identified to the ’s tolerable misstatements amounts. s receivable are ordinarily confirmed on a standard form developed by the American Institute of Certified Public ants and the Financial Executives Institute.

Incorrect Correct Incorrect Incorrect

A summary of the controls for the revenue and cash receipts cycle of Keystone Computers & Networks, Inc., is provided below: a. For the following three controls over sales, indicate one type of error or fraud that the control serves to prevent or detect. Select your solution as follows: (Each of the "Error or Fraud Controlled" may be used only once.)

1. 2. 3.

Error or Fraud Controlled Controls the recording of sales to ensure completeness. Controls errors in the delivery and billing of sales transactions. Controls the recording of fictitious sales and inaccurate sales to customer s.

Control

Error or Fraud Controlled

1.

Application controls are applied when customer orders are entered by the sales order clerk.

2

2.

The computer assigns numbers to sales invoices when they are prepared.

1

3.

Monthly statements are mailed to customers.

3

b.

For the following three controls over cash receipts, indicate one type of error or fraud that the control serves to prevent or detect. Select your solution as follows: (Each of the "Error or Fraud Controlled" may be used only once.)

Error or Fraud Controlled Controls the abstraction of cash and the incorrect recording of cash receipts and cash sales. Controls the embezzlement of cash receipts and errors in and incomplete postings to s receivables records. Controls errors in the recording of cash and controls the abstraction of cash.

1. 2. 3. Control 1.

Error or Fraud Controlled Cash receipts are prelisted by the receptionist. The ing manager reconciles control totals generated by the s receivable computer program. The computer summaries of cash collections and cash sales are reconciled to prelistings of cash receipts and cash deposits by the ing manager.

2. 3.

3 2 1

5. Listed below are types of errors and fraud that might occur in financial statements and audit procedures. Select the audit procedure with the error or fraud that the procedure is likely to detect.

Audit Procedure a. Confirming a sample of s receivable. b. Reviewing standard confirmations from financial institutions. c. Tracing a sample of shipping documents to recorded sales transactions. d. Comparing recorded sales several days before and after the balance sheet date with shipping documents. Error or Fraud

Audit Procedure

1.

Recording of sales made in the subsequent period.

d

2.

Failing to record all sales transactions.

c

3.

Recording fictitious s receivable.

a

4.

Failing to inform the auditors of pledged s receivable.

b

6. Smith Manufacturing Company's s receivable clerk has a friend who is also Smith's customer. The s receivable clerk, on occasion, has issued fictitious credit memorandums to his friend for goods supposedly returned. The most effective procedure for preventing this activity is to:

mail monthly statements. prenumber and for all credit memorandums. require receiving reports to all credit memorandums before they are approved. have the sales department independent of the s receivable department.

7. For effective internal control, the billing function should be performed by the:

shipping department. ing department. sales department. credit and collection department.

8. Which of the following is an effective control over s receivable?

Only persons who handle cash receipts should be responsible for the preparation of documents that reduce s receivable balances. Balances in the subsidiary s receivable ledger should be reconciled to the general ledger control once a year, preferably at year end. The billing function should be assigned to persons other than those responsible for maintaining s receivable subsidiary records. Responsibility for approval of the write-off of uncollectible s receivable should be assigned to the cashier.

9. You are involved with the audit of Jelco Company for year 1 and have been asked to consider the confirmation reply results indicated below. For each confirmation reply as to the proper action to be taken from the following possible actions: (Each of the "Action" items may be used once, more than once, or not at all.)

1. 2. 3. 4.

Exception; propose an adjustment. Send a second confirmation request to the customer. Examine shipping documents and/or subsequent cash receipts. whether the additional invoices noted on the confirmation reply pertain to the year under audit or the subsequent year.

5. Customer Reply (and any audit action already taken) a. b. c.

Not an exception, no further audit work is necessary.

Proper Action

“We mailed the check for this on December 31.”

3

“We returned those goods on December 2.” You have been able to determine that the 1 goods were received by the client on December 29, but not recorded until January 2. “We also owe for two more invoices for purchases we made around year-end; I’m not 4 sure of the exact date.”

d.

“We are very satisfied with Jelco and plan to purchase from them in the future. “

5

e.

“While that’s what we owe, we didn’t owe it on December 31 since we didn’t receive the goods until January 2 of year 2.”

3

f.

You received no reply to a negative confirmation request to Adams Co.

5

g.

You received no reply to a positive confirmation request to Blake Co. Subsequently you recalled that Blake Co. has a policy of not responding to confirmations—in writing 3 or orally.

10. An auditor’s working papers include the following narrative description of the cash receipts and billing portions of Southwest Medical Center’s internal control. Evaluate each condition following the narrative as being either (1) a strength, (2) a deficiency, (3) not a strength or a deficiency. Southwest is a health care provider that is owned by a partnership of five physicians. It employs 11 physicians, including the five owners, 20 nurses, five laboratory and X-ray technicians, and four clerical workers. The clerical workers perform such tasks as reception, correspondence, cash receipts, billing, s receivable, bank deposits, and appointment scheduling. These clerical workers are referred to as office manager, clerk #1, clerk #2, and clerk #3. Assume that the narrative is a complete description of the system. About two-thirds of Southwest’s patients receive medical services only after insurance coverage is verified by the office manager and communicated to the clerks. Most of the other patients pay for services by cash or check when services are rendered, although the office manager extends credit on a case-by-case basis to about 5 percent of the patients. When services are rendered, the attending physician prepares a prenumbered service slip for each patient and gives the slip to clerk #1 for pricing. Clerk #1 completes the slip and gives the completed slip to clerk #2 and a copy to the patient. Using the information on the completed slip, clerk #2 performs one of the following three procedures for each patient: • Clerk #2 files an insurance claim and records a receivable from the insurance company if the office manager has verified the patient’s coverage, or • Clerk #2 posts a receivable from the patient on clerk #2’s PC if the office manager has approved the patient’s credit, or • Clerk #2 receives cash or a check from the patient as the patient leaves the medical center, and clerk #2 records the cash receipt. At the end of each day, clerk #2 prepares a revenue summary.

Clerk #1 performs correspondence functions and opens the incoming mail. Clerk #1 gives checks from insurance companies and patients to clerk #2 for deposit. Clerk #2 posts the receipt of patients’ checks on clerk #2’s PC patient receivable records and insurance companies’ checks to the receivables from the applicable insurance companies. Clerk #1 gives mail requiring correspondence to clerk #3. Clerk #2 stamps all checks “for deposit only” and each day prepares a list of checks and cash to be deposited in the bank. (This list also includes the cash and checks personally given to clerk #2 by patients.) Clerk #2 keeps a copy of the deposit list and gives the original to clerk #3. Clerk #3 personally makes the daily bank deposit and maintains a file of the daily bank deposits. Clerk #3 also performs appointment scheduling for all of the doctors and various correspondence functions. Clerk #3 also maintains a list of patients whose insurance coverage the office manager has verified. When insurance claims or patient receivables are not settled within 60 days, clerk #2 notifies the office manager. The office manager personally inspects the details of each instance of nonpayment. The office manager converts insurance claims that have been rejected by insurance companies into patient receivables. Clerk #2 records these patient receivables on clerk #2’s PC and deletes these receivables from the applicable insurance companies. Clerk #2 deletes the patient receivables that appear to be uncollectible from clerk #2’s PC when authorized by the office manager. Clerk #2 prepares a list of patients with uncollectible balances and gives a copy of the list to clerk #3, who will not allow these patients to make appointments for future services. Once a month an outside ant posts clerk #2’s daily revenue summaries to the general ledger, prepares a monthly trial balance and monthly financial statements, s for prenumbered service slips, files payroll forms and tax returns, and reconciles the monthly bank statements to the general ledger. This ant reports directly to the physician who is the managing partner. All four clerical employees perform their tasks on PCs that are connected through a local area network. Each PC is accessible with a that is known only to the individual employee and the managing partner. Southwest uses a standard software package that was acquired from a software company and that cannot be modified by Southwest’s employees. None of the clerical employees are able to write checks on the company’s . For each of the following conditions, indicate whether they represent an internal control “strength” or “deficiency.” If the condition is not an internal strength or deficiency, respond that the condition is “neither.”

Conditions a. b. c. d.

Southwest is involved only in medical services and has not diversified its operations. Insurance coverage for patients is verified and communicated to the clerks by the office manager before medical services are rendered. The physician who renders the medical services documents the services on a prenumbered slip that is used for recording revenue and as a receipt for the patient. Cash collection is centralized in that clerk #2 receives the cash (checks) from patients and records the cash receipt.

Neither Strength Strength Deficiency

e.

Southwest extends credit rather than requiring cash or insurance in all cases.

Neither

f.

The office manager extends credit on a case-by-case basis rather than using a formal credit search and established credit limits.

Deficiency

g.

The office manager approves the extension of credit to patients and also approves the write-offs of uncollectible patient receivables.

Deficiency

h.

Clerk #2 receives cash and checks and prepares the daily bank deposit.

Deficiency

i. j. k. l.

Clerk #2 maintains the s receivable records and can add or delete information on the PC. Prenumbered service slips are ed for on a monthly basis by the outside ant who is independent of the revenue generating and revenue recording functions. The bank reconciliation is prepared monthly by the outside ant who is independentof the revenue generating and revenue recording functions. Computer s are only known to the individual employees and the managing partner, who has no duties in the revenue recording functions.

Deficiency Strength Strength Strength

m.

Computer software cannot be modified by Southwest’s employees.

Strength

n.

None of the employees who perform duties in the revenue generating and revenue recording are able to write checks.

Strength

Chapter 12 1. An auditor most likely would make inquiries of production and sales personnel concerning possible obsolete inventory to address:

Presentation. Rights. Existence. Valuation.

2. An auditor selects items from the client’s inventory listing and identifies the items in the warehouse. This procedure is most likely related to:

Completeness. Rights. Existence. Valuation.

3. An auditor concluded that no excessive costs for an idle plant were charged to inventory. This conclusion is most likely related to presentation and disclosure and:

Existence. Valuation. Completeness. Rights.

4.

During the inventory count an auditor selects items and determines that the proper description and quantity were recorded by the client. This procedure is most closely related to:

Existence. Rights. Completeness. Valuation.

5. An auditor most likely would analyze inventory turnover rates to obtain evidence about:

Rights. Presentation. Existence. Valuation.

6. During year 1 audit of Cellenting Co., the auditor performed various procedures relating to inventory. Match each of the descriptions provided below with the appropriate audit procedure. Audit procedures •Analytical procedure •External confirmation •Inquiry •Inspection of records or documents •Inspection of tangible assets •Observation •Recalculation •Reperformance Description of Audit Procedures Performed During the physical inventory count, the auditor asked the client to open various boxes of inventory items so she was able to assess the quality of the item. During a site visit to a construction site, the auditor determined that all employees b. were wearing proper safety equipment. The auditor asked the warehouse manager about whether certain inventory items c. were becoming obsolete. The auditor obtained a purchase order from the purchase order file and compared it d. to the authorized supplier list to determine that the related goods had been purchased from an approved supplier. a.

e. The auditor calculated the s receivable turnover for the year. f.

The auditor obtained a copy of the company’s ing manual and read the section on inventory to prepare for the physical inventory observation.

The auditing firm’s computer assisted audit specialist obtained an electronic g. inventory file from the company and checked the accuracy of the extensions and footings.

7.

Type of Audit Procedure Inspection of tangible assets Observation Inquiry Reperformance Analytical procedure Inspection of records or documents Recalculation

An auditor would be least likely to learn of slow-moving inventory through:

inquiry of sales personnel. inquiry of stores personnel. vouching of year-end purchases. review of perpetual inventory records.

8. An auditor has ed for a sequence of inventory tags and is now going to trace information on a representative number of tags to the physical inventory sheets. The purpose of this procedure is to obtain assurance that:

the final inventory is valued at cost. all inventory represented by an inventory tag is listed on the inventory sheets. all inventory represented by an inventory tag is bona fide. inventory sheets do not include untagged inventory items.

9. Described below are potential financial statement misstatements that are encountered by auditors. a. Inventory is understated because warehouse personnel overlooked several racks of parts in taking the physical inventory. b. Inventory is overstated because warehouse personnel included inventory items received subsequent to year-end while recording the purchase in the subsequent year to hide inventory shortages. c.Inventory is overstated because management instructed computer personnel to make changes in the file used to price inventories. Error or Misstatement Fraud a.

Error

b.

Fraud

c.

Fraud

Misstatement a.

Error or Fraud Error

b.

Fraud

c.

Fraud

Controls Development of adequate inventory taking procedures and adequate supervision of physical inventory. Use of prenumbered receiving reports and controls to insure adequate cutoff of purchases and payables. Effective audit committee and internal audit department to monitor management’s override of internal controls.

Substantive Procedure Observation of inventory.

Observation of inventory and collection of cut-off information that is traced to ing records.

Price tests of a sample of inventory items.

Chapter 13 1. To assure ability for fixed asset retirements, management should implement an internal control that includes: Continuous analysis of miscellaneous revenue to locate any cash proceeds from the sale of plant assets. Periodic inquiry of plant executives by internal auditors as to whether any plant assets have been retired. Utilization of serially numbered retirement work orders. Periodic observation of plant assets by the internal auditors. Serially numbered retirement work orders provide a systematic means of assuring that units of plant and equipment are not retired without authorization by management. Retirement work orders also provide the ing department with the information necessary to record the retirement of equipment in the ing records. The alternative procedures suggested are not satisfactory. Some retirements of plant asset do not involve cash receipts. The inquiries and observations by internal auditors would come after the fact of asset retirements

2. The auditors may conclude that depreciation charges are insufficient by noting:

Insured values greatly in excess of book values. Large amounts of fully depreciated assets. Continuous trade-ins of relatively new assets. Excessive recurring losses on assets retired. Excessive recurring losses on assets retired show that the depreciation expense recognized during the actual useful lives of the assets has been less than the real cost of using the assets.

3. Which of the following is an internal control weakness related to factory equipment? Checks issued in payment of purchases of equipment are not signed by the controller. All purchases of factory equipment are required to be made by the department in need of the equipment. Factory equipment replacements are generally made when estimated useful lives, as indicated in depreciation schedules, have expired. Proceeds from sales of fully depreciated equipment are credited to other income.

The purchase of factory equipment should be made by the purchasing department regardless of which unit of the company will use the equipment. The purchasing department has the expertise and the established procedures and documents to ensure that all purchases are made in accordance with company policy.

4. Which of the following s should be reviewed by the auditors to gain reasonable assurance that additions to property, plant, and equipment are not understated?

Depreciation. s Payable. Cash. Repairs and Maintenance. In recording expenditures on property, plant, and equipment, the logical choice usually is between a revenue expenditure and a capital expenditure. If the outlay is judged to be a revenue expenditure (rightly or wrongly), it will probably be recorded in the Repairs and Maintenance . If items that should be capitalized are erroneously charged to Repairs and Maintenance, the result will be an understatement of property, plant, and equipment. Consequently, the auditors can gain evidence that additions to property, plant, and equipment are not understated by reviewing the Repairs and Maintenance . The other alternatives suggested in the question are not plausible. An erroneous debit to cash would be disclosed quickly because of the disagreement between cash receipts and the cash being deposited daily in the bank. A debit to s Payable would lead to protests from creditors. A debit to Depreciation Expense would be a conspicuous error because of the timing of the entry and the lack of a related credit to Accumulated Depreciation.

5. The auditors are most likely to seek information from the plant manager with respect to the

Adequacy of the provision for uncollectible s. Appropriateness of physical inventory observation procedures. Existence of obsolete machinery. Deferral of procurement of certain necessary insurance coverage. The plant manager would be the most appropriate individual for inquiries about the existence of machinery that is no longer useable.

6. To strengthen internal control over the custody of heavy mobile equipment, the client would most likely institute a policy requiring a periodic:

Increase in insurance coverage. Inspection of equipment and reconciliation with ing records. Verification of liens, pledges, and collateralizations. ing for work orders. Inspection of equipment and the reconciliation of the equipment with ing records will strengthen internal control over custody of the equipment.

7. Error or

Audit Procedure

Fraud 1. 2. 3.

Land was exchanged for a long-term note receivable, but the exchange was not recorded. A machine was sold for cash, but the retirement was not recorded. The cost of repairing a machine was improperly capitalized.

Review current property tax bills. Analyze the Miscellaneous Revenue . Vouch additions to equipment s.

4.

A lien exists on certain equipment.

Review fire insurance policies.

5.

An expenditure for equipment was improperly expensed.

Review expenditures charged to a repairs and maintenance .

8. Which of the following is the best evidence of real estate ownership at the balance sheet date?

Original deed held in the client's safe. Title insurance policy. Paid real estate tax bills. Closing statement.

9. You are engaged in the audit of the financial statements of Holman Corporation for the year ended December 31, 20X6. The accompanying analyses of the Property, Plant, and Equipment and related accumulated depreciation s have been prepared by the chief ant of the client. You have traced the beginning balances to your prior year’s audit working papers.

Description Land Buildings Machinery and equipment

Description Buildings Machinery and equipment

HOLMAN CORPORATION Analysis of Property, Plant, and Equipment and Related Accumulated Depreciation s Year Ended December 31, 20X6 Final Assets 12/31/X5 Additions Retirements $ 422,500 $ 5,000 120,000 17,500 385,000 40,400 $ 26,000

62,900

$ 927,500

$

26,000

$964,400

Final 12/31/X5 $ 60,000 173,250

Accumulated Depreciation Additions* Retirements $ 5,150 39,220

Per Ledger 12/31/X6 $ 65,150 212,470

$ 233,250

$

44,370

$

Per Ledger 12/31/X6 $427,500 137,500 399,400

$ 277,620

*Depreciation expense for the year. All plant assets are depreciated on the straight-line basis (no residual value taken into consideration) based on the following estimated service lives: building, 25 years; and all other items, 10 years. The company’s policy is to take one half-year’s depreciation on all asset additions and disposals during the year. Your audit revealed the following information: 1. On April 1, the company entered into a 10-year lease contract for a die casting machine, with annual rentals of $5,000 payable in advance every April 1. The lease is cancelable by either party (60 days' written notice is required), and there is no option to renew the lease or buy the equipment at the end of the lease. The estimated service life of the machine is 10 years with no residual value. The company recorded the die casting machine in the Machinery and Equipment at $40,400, the present value at the date of the lease, and $2,020 applicable to the machine has been included in depreciation expense for the year. 2. The company completed the construction of a wing on the plant building on June 30. The service life of the building was not extended by this addition. The lowest construction bid received was $17,500, the amount recorded in the Buildings . Company personnel constructed the addition at a cost of $16,000 (materials, $7,500; labor, $5,500; and overhead, $3,000). 3. On August 18, $5,000 was paid for paving and fencing a portion of land owned by the company and used as a parking lot for employees. The expenditure was charged to the Land . 4. The amount shown in the machinery and equipment asset retirement column represents cash received on September 5 upon disposal of a machine purchased in July 20X2 for $48,000. The chief ant recorded depreciation expense of $3,500 on this machine in 20X6. 5. Harbor City donated land and a building appraised at $100,000 and $400,000, respectively, to Holman Corporation for a plant. On September 1, the company began operating the plant. Since no costs were involved, the chief ant made no entry for the above transaction. Required: Prepare the adjusting journal entries that you would propose at December 31, 20X6, to adjust the s for the above transactions. Disregard income tax implications. The s have not been closed

Transaction 1

General Journal

Debit

Prepaid rent

1,250

Accumulated depreciation-Machinery and equipment

2,020

Contract payable Rent expense

35,400 3,750

Machinery and equipment

40,400

Depreciation expense

2

Gain on construction of building Depreciation expense

2,020

1,500 317

Accumulated depreciation-Buildings

317

Buildings

3

Land improvements Depreciation expense Accumulated depreciation-Land improvements

Credit

1,500

5,000 250 250

Land

4

5,000

Accumulated depreciation-Machinery and equipment Loss on sale of machinery and equipment

20,300 2,800

Machinery and equipment

22,000

Depreciation expense

5

1,100

Land

100,000

Buildings

400,000

Depreciation expense

8,000

Paid-in capital from donated assets

500,000

Accumulated depreciation-Buildings

8,000

Explanation: 1. To correct April 1, 20X6, entry for lease of die casting machine under a 10-year, cancelable lease having no renewal or purchase option.

2. To correct June 30, 20X6, entry for addition to building, and to correct depreciation on addition as follows:

Should be 1/12 × 1/2 × $16,000 (12-yr life from 6/30/X6) Per client (computed on 25-yr life)

DIFFERENCE

$

667

350

$

317

3. To correct August 13, 20X6, entry for paving and fencing parking lot, and to provide depreciation thereon as follows: 1/10 × 1/2 × $5,000 = $250

4. To correct September 5, 20X6 entry for disposal of machine and depreciation thereon, and to provide for loss on disposal as follows:

Cost Accumulated depreciation Through 20X5 For 20X6

$48,000 $16,800 2,400 19,200

Undepreciated cost Proceeds of sale

28,800 26,000

Loss on sale

$ 2,800

5. To record at appraised value land and building donated by Harbor city, and to provide depreciation on building as follows: 1/25 × 1/2 × $400,000 = $8,000

Chapter 14 1. Nancy Howe, your staff assistant on the April 30, 20X2, audit of Wilcox Company, was transferred to another audit engagement before she could complete the audit of unrecorded s payable. Her working paper, which you have reviewed and are satisfied is complete, appears below. Wilcox Company Unrecorded s Payable April 30, 20X2 Vendor and Description

Invoice Date

M-1-1

Hill & Harper—unpaid legal fees at Apr. 30, X2 (see lawyer’s letter at M-4)

$

Amount 1,150y

Apr.1,X2

Drew Insurance Agency—unpaid on fire insurance for period Apr. 1, X2- Mar. 31, X5 (see insurance broker letter at J-1-1)

2,340y

Apr.30,X2

Mays and Sage, Stockbrokers—advice for 100 shares of Madison Ltd. common stock (settlement date May 7, X2)

2,200y

Lane Company—shipment received Apr. 30, X2 per receiver no. 3361 and included in Apr. 30, X2, physical inventory; invoice not yet received (amount is per purchase order)

5,938y

$ 11,628

y-Examined document described In my opinion, the $11,628 adjustment includes all material unrecorded s payable.

Date April 30

General Journal

Debit

Marketable securities

2,200

Cost of goods sold

5,938

N.A.H. May 29, X2 Credit

Unexpired insurance

2,275

Insurance expense Professional fees expense

65 1,150

s payable

11,628

Explanation: Unexpired Insurance (35/36 × $2,340) = $2,275 To record liability for following unpaid invoices: Hill & Harper Drew Insurance Agency Mays and Sage Lane Company Total

$

1,150 2,340

2,200 5,938

$

11,628

2. The following flowchart depicts the activities relating to the purchasing, receiving, and s payable departments of Model Company, Inc. Assume that you are a supervising assistant assigned to the Model Company audit. Joe Werell, a beginning assistant, analyzed the flowchart and has supplemented the flowchart by making certain inquiries of the controller. He has concluded that the internal control over purchasing, receiving, and s payable is strong and has provided the following list of what he refers to as internal control strengths. Review his list and for each internal control strength indicate whether you agree or disagree that each represents a strength. Internal Control Strengths Prepared by Joe Werell a. b. c. d.

The department head of the requisitioning department selects the appropriate supplier. Proper authorization of requisitions by department head is required before purchase orders are prepared. Purchasing department makes certain that a low-cost supplier is always chosen. Purchasing department assures that requisitions are within budget limits before purchase orders are prepared.

Disagree Agree Disagree Agree

e.

The adequacy of each vendor’s past record as a supplier is verified.

Agree

f.

Secure facilities limit access to the goods during the receiving activity.

Agree

g.

Receiving department compares its count of the quantity of goods received with Disagree that listed on its copy of the purchase order.

h.

A receiving report is required for all purchases, including purchases of services. Disagree The requisitioning department head independently verifies the quantity and quality of the goods received. Requisitions, purchase orders, and receiving reports are matched with vendor invoices as to quantity and price. s payable department personnel recompute the mathematical accuracy of each invoice. The voucher is independently reconciled to the control s monthly by the originators of the related vouchers. All ing documentation is marked “paid” by s payable immediately prior to making it available to the treasurer. All ing documentation is required for payment and is made available to the treasurer.

i. j. k. l. m. n. o.

The purchasing, receiving, and s payable functions are segregated.

Agree Agree Agree Disagree Disagree Agree Agree

a. Disagree. Someone independent of requisitioning should select the supplier. c. Disagree. Often, factors in addition to cost are considered (e.g., quality, dependability). g. Disagree. A comparison of quantities is not possible because the quantity is blacked out on the purchase order provided to receiving. h. Disagree. No receiving report is ordinarily necessary for purchases of services. l Disagree. The reconciliation should be performed by an independent party. m.Disagree. Documentation should be marked “paid” by the individual making the payment.

3. The auditors of SSC Company, a nonpublic company, are working on both audit objectives for the various s and documentation requirements. Parts (a) through (d) of this question relate to objectives. The auditors have established the objectives listed below as a part of the audit. Substantive Procedures 1. Obtain a trial balance of payables and reconcile with the s payable subsidiary ledger. 2. Vouch sales from throughout the year. 3. Vouch purchases recorded after year-end. 4. Vouch sales recorded shortly before year-end. 5. Vouch major warranty expenses paid during 20X8. 6. Inquire of management concerning the existence of related party transactions. 7. Test the computations made by the client to set up the accrual. 8. Test the reasonableness of general and istrative labor rates. 9. Confirm outstanding year-end balances of payables. 10. Confirm warranty expenses payable as of year-end.

For each objective, select a substantive procedure (from the list of substantive procedures) that will help achieve that objective. Each of the procedures may be used once, more than once, or not at all. Audit Objectives a.

Substantive Procedures Determine the existence of year-end recorded s payable and that the client has 9

obligations to pay these liabilities. b.

Establish the completeness of recorded s payable.

3

c.

Determine that the presentation and disclosure of s payable are appropriate.

6

d.

Determine that the valuation of warranty loss reserves is measured in accordance with 7 GAAP. a.Answer (9) is correct because confirming the outstanding year-end balances will result in replies from suppliers as to those balances. b.Answer (3) is correct because vouching purchases recorded after year-end may result in identification of purchases that should have been recorded prior to year end. c. Answer (6) is correct because inquiry of management is a basic procedure for identifying related party transactions which, if material, should be disclosed. d.Answer (7) is correct because confirming the outstanding year-end balances will result in replies from suppliers as to proper valuation of recorded receivables.

4. In applying audit procedures and evaluating the results of those procedures, auditors may encounter specific information that may raise a question concerning the existence of noncompliance with laws and related party transactions. Indicate whether each of the following is more likely related to noncompliance with a law (NL) or a related party transaction (RP).

a. b. c. d. e.

Purchases have been made from a vendor at a price well above the market price for the goods involved. A purchasing agent’s spouse has the same name as a major vendor of the company. Unexplained payments have been made to government officials. The company exchanged certain real estate property for similar real estate property. A purchasing agent of the company has received large cash payments from a major vendor of the company.

RP RP NL RP NL

5. Which of the following procedures is least likely to be completed before the balance sheet date?

Confirmation of receivables. Search for unrecorded liabilities. Observation of inventory. Review of internal ing control over cash disbursements. Because a significant portion of the search for unrecorded liabilities deals with transactions recorded after year-end, it is least likely to be completed before the balance sheet date.

6.

An audit of the balance in the s payable is ordinarily not designed to:

Detect s payable that are substantially past due. that s payable were properly authorized. Ascertain the reasonableness of recorded liabilities. Determine that all existing liabilities at the balance sheet date have been recorded. The auditors do not have as an objective the determination of whether s payable are past due.

7. Which of the following is the best audit procedure for determining the existence of unrecorded liabilities?

Examine confirmation requests returned by creditors whose s appear on a subsidiary trial balance of s payable. Examine unusual relationships between monthly s payable balances and recorded purchases. Examine a sample of invoices a few days prior to and subsequent to year-end to ascertain whether they have been properly recorded. Examine selected cash disbursements in the period subsequent to year-end.

8. Auditor confirmation of s payable balances at the balance sheet date may be unnecessary because:

This is a duplication of cutoff tests. s payable balances at the balance sheet date may not be paid before the audit is completed. Correspondence with the audit client’s attorney will reveal all legal action by vendors for nonpayment. There is likely to be other reliable external evidence available to the balances. Auditors will usually find in the client's possession externally created evidence such as vendors' invoices and statements that substantiate the s payable. No such external evidence is on hand to s receivable.

9. An audit of the balance in the s payable is ordinarily not designed to:

detect s payable due to public versus non-public companies. that s payable were properly authorized. ascertain the reasonableness of recorded liabilities. determine that all existing liabilities at the balance sheet date have been recorded.

Chapter 15 1. Which of the following is least likely to be an audit objective for debt?

Determine the existence of recorded debt. Establish the completeness of recorded debt. Determine that the client has rights to receive proceeds relating to the redemption of debt. Determine that the valuation of debt is in accordance with generally accepted ing principles.

The client will not receive proceeds related to redemption of its interest-bearing debt—it will pay off the debt.

2. The auditors would be most likely to find unrecorded long-term liabilities by analyzing:

Interest payments. Discounts on long-term liabilities. s on long-term liabilities. Recorded long-term liability s. Auditors will test the relationship between interest payments and recorded long term liabilities. When interest payments seem too high, it may be due to the existence of unrecorded liabilities. Also, the process of performing procedures to determine who interest is paid to may reveal unrecorded debt.

3. A likely reason that consideration of client compliance with debt provisions is important to an audit is that violation of such debt provisions may affect the total recorded:

Number of debt restrictions. Current liabilities. Long-term assets. Capital stock. When debt provisions are violated, long term debt often becomes immediately payable, and therefore, a current liability.

4. Select the following definitions (or partial definitions) to the appropriate term. Each term may be used once or not at all. Definition (or Partial Definition) An institution charged with responsibility for avoiding overissuance of a corporation’s stock An institution responsible for maintaining detailed records of shareholders and b. handling changes of ownership of stock ownership a.

c. Cash or other assets set aside for the retirement of a debt

Term Stock registrar Stock transfer agent Sinking fund

Shares of its own stock acquired by a corporation for the purpose of being reissued Treasury stock at a later date The formal agreement between bondholders and the issuer as to the of the e. Trust indenture debt d.

5. Debt Covenant Violations Read the case and answer the questions that follow. Oftentimes, especially in challenging economic times, companies may not comply fully with lender restrictions on debt and, consequently, fail to meet the requirements of the debt covenant. The debt agreement may have a trigger, making the debt due on demand, and, therefore, it is a current liability. Often, the client will be able to obtain a waiver of compliance for such a violation in order to satisfy this provision.

CONCEPT REVIEW: If a debt covenant is violated and a waiver is obtained, the auditor needs to ensure the covenant is appropriately dated (as of the balance sheet date), and that it extends to one year from the balance sheet date in order to avoid classifying the related debt as a current liability.

1. A waiver needs to be received from the ______.

bank/lender

2. Covenants are typically calculated as of _____.

year-end

3. Waivers must be dated the same date as the _______.

balance sheet

4. Waivers must extend for a period of ________.

one year

5. Covenant violations should still be disclosed in the ________. financial statements

6. Confirmation Procedures for Debt Read the case and answer the questions that follow. Debt transactions and s are often few in number but material in dollar amount. Also, lenders are eager to confirm balances, thereby assisting auditors in ing amounts owed. As such, confirmations provide an easy tool for obtaining excellent evidence on material balances. CONCEPT REVIEW: Confirmations, while not required for debt, are an efficient and effective way for auditors to obtain a high level of third party evidence on material amounts and balances.

1. Confirmations should be drafted on client ______.

letterhead

2. Confirmations should include a request that the bank confirm ____ borrowings. all 3. Auditors need to determine whether debt _____ have been met.

covenants

4. _______ transactions are examined for all large debt agreements.

Individual

5. A copy of debt agreements is typically housed in the ______ file.

permanent

Chapter 16 1. Which of the following is least likely to be considered a substantive procedure relating to payroll?

Investigate fluctuations in salaries, wages, and commissions. Test computations of compensation under profit sharing for bonus plans. Test commission earnings. Test whether employee time reports are approved by supervisors. Testing whether employee time reports are approved by supervisors is an example of a test of a control, not a substantive procedure.

2. Which of the following is the best way for the auditors to determine that every name on a company’s payroll is that of a bona fide employee presently on the job?

Examine human resources records for accuracy and completeness.

Examine employees’ names listed on payroll tax returns for agreement with payroll ing records. Make a surprise observation of the company’s regular distribution of paychecks on a test basis. Visit the working areas and that employees exist by examining their badge or identification numbers. The best procedure for the detection of a fictitious employee is a surprise observation of the distribution of paychecks. The fictitious employee’s paycheck will ordinarily not be picked up, and further audit procedures performed by the auditors may reveal that this is a fictitious employee.

3. As a result of analytical procedures, the independent auditors determine that the gross profit percentage has declined from 30 percent in the preceding year to 20 percent in the current year. The auditors should:

Express an opinion that is qualified due to the inability of the client company to continue as a going concern. Evaluate management’s performance in causing this decline. Require note disclosure. Consider the possibility of a misstatement in the financial statements. The purpose of analytical procedures is to locate potential misstatements in the financial statements. The auditors should investigate this significant fluctuation to determine whether it results from a financial statement misstatement.

4. For each of the following subsequent events, indicate whether the financial statements should be:

(A)

adjusted; the event should be disclosed in the financial (D) statements; or (ND) the event need not be disclosed. Subsequent Event Action taken 1.

2.

3.

4.

5.

6.

An employee strike is called. A lawsuit that was begun a year ago is settled. A new subsidiary is purchased. A major customer of the company is lost. A significant decline in the value of inventories occurs. A plant of the company is destroyed by fire.

ND

A

D

ND

D

D

5. The following situations represent excerpts from the responses to audit inquiries of external legal counsel of XYZ Co. during the annual audit of year 1 (“legal response”). For each excerpt, select the most

appropriate financial statement effect and audit response. Each excerpt is independent. Responses may be used once, more than once, or not at all from the table below: a. The client’s year end is December 31, year 1. b. The anticipated audit report date is February 15, year 2. c. All amounts are material to the financial statements. Financial Statement Effect 1. No impact on financial statement amounts or notes. 2. Disclosure in notes relating to nature of litigation, but no amount disclosed. 3. Disclosure in notes relating to nature of litigation, including loss amount. 4. Potential litigation settlement accrued in financial statements. 5. Potential litigation settlement not accrued in financial statements, amount

Audit Response 7. Legal response is appropriately dated. 8. Update legal response. 9. Update audit report date.

disclosed in notes. 6. amount due attorney is recorded in financial statement amounts. Situations

Financial Statement Effect

Audit Response

Letter dated February 14, year 2: “I advise you that at and since December 31, year 1, I have not been engaged to give substantive attention to, or represent, XYZ Co. in connection with any pending or threatened 1 litigation, claims, or assessments, nor am I aware of any loss contingencies. No amounts were due to this office for services provided at December 31, year 1.”

7

Letter dated January 21, year 2: “I advise you that at and since December 31, year 1, I have not been engaged to give substantive attention to, or represent, XYZ Co. in connection with any pending or threatened 6 litigation, claims, or assessments, nor am I aware of any loss contingencies. There were fees outstanding of $3,675 due to this office for services provided at December 31, year 1.”

8

Letter dated February 26, year 2: K. Bowt v. XYZ Co.: This matter commenced in December, year 1. The plaintiff alleges discrimination relating to his termination on November 17, year 1. The company intends to defend this 2 case vigorously. At this time, we are unable to evaluate the likelihood of an unfavorable outcome or estimate the amount or range of potential loss. Letter dated March 16, year 2:

9

J. Myers v. XYZ Co.: This matter commenced in March, year 2. The plaintiff alleges discrimination relating to his termination on November 17, year 1. The company intends to defend this 2 case vigorously. At this time, we are unable to evaluate the likelihood of an unfavorable outcome. The plaintiff is demanding $50,000.

9

Letter dated February 14, year 2: R. Brown v. XYZ Co.: This matter commenced in November, year 1. The plaintiff alleges discrimination relating to 3 his termination on March 17, year 1. It is reasonably possible that the case will be settled for approximately $35,000.

7

Letter dated February 14, year 2: L. Peep v. XYZ Co.: This matter commenced in November, year 1. The plaintiff alleges discrimination relating to 4 his termination on March 17, year 1. The case is tentatively settled for $35,000.

7

6. In connection with your audit of the financial statements of Hollis Mfg. Corporation for the year ended December 31, 20X3, your review of subsequent events disclosed the following items: a. January 7, 20X4: The mineral content of a shipment of ore en route to Hollis Mfg. Corporation on December 31, 20X3, was determined to be 72 percent. The shipment was recorded at year-end at an estimated content of 50 percent by a debit to Raw Materials Inventory and a credit to s Payable in the amount of $82,400. The final liability to the vendor is based on the actual mineral content of the shipment. b. January 15, 20X4: Following a series of personal disagreements between Ray Hollis, the president, and his brother-in-law, the treasurer, the latter resigned, effective immediately, under an agreement whereby the corporation would purchase his 10 percent stock ownership at book value as of December 31, 20X3. Payment is to be made in two equal amounts in cash on April 1 and October 1, 20X4. In December, the treasurer had obtained a divorce from his wife, who is Ray Hollis’s sister. c. January 16, 20X4: As a result of reduced sales, production was curtailed in mid-January and some workers were laid off. d. On January 18, 20X4, a major customer filed for bankruptcy. The customer’s financial condition had been degenerating over recent years. e. On January 28, 20X4, a famous analyst who followed the industry provided a negative report on his expectations concerning the short and intermediate term for the industry. Required: 1. For each of the subsequent events, indicate whether they should result in: Adjustment—an adjusting entry as of 20X3. Consider Disclosure—consideration of note disclosure as of 20X3. Items a. b. c.

Adjustment Consider Disclosure Consider Disclosure

d.

Adjustment

e.

Consider Disclosure 2.

Select the two events least likely to be reflected (resulting in adjustment or disclosure) in the financial statements

A b c d e

Chapter 17 Emphasis-of-Matter Paragraph Read the overview below and complete the activities that follow. When issuing financial statements and their related opinion, the auditor needs to assess the situation to determine the proper type of report to issue. Auditors express an unmodified opinion when they are able to obtain sufficient and appropriate audit evidence that the financial statements as a whole are free of material misstatement. Under certain circumstances, however, auditors may add an emphasis-of-matter paragraph that refers to a matter appropriately presented. CONCEPT REVIEW: The emphasis-of-matter paragraph follows the opinion paragraph and states that the auditor's opinion is not modified, but that the matter is to be emphasized.

1. Auditors may add an emphasis-of-matter paragraph that refers to a matter that is _________ presented or disclosed. A going concern is to be evaluated for a period not to exceed _________ beyond 2. the date of the financial statements. If substantial doubt about a going concern exists, an ______ paragraph is the most 3. common resolution. 1.

appropriately one year emphasis-ofmatter

4. An emphasis-of-matter paragraph always _______ the opinion paragraph.

follows

5. Changes in ing estimates ______ result in an explanatory paragraph.

do not

1. Auditors may want to emphasize a matter even though it is appropriately presented. 2. A going concern needs to be evaluated for a period not to exceed one year beyond the date of the financial statements. 3. Auditors may add an extra paragraph to emphasize the situation regarding the going concern doubt. 4. The emphasis-of-matter paragraph comes after the opinion paragraph. 5. Changes in estimates do not require an explanatory paragraph.

2. Going Concern Opinions Read the case and answer the questions that follow. Oftentimes, especially in challenging economic times, companies may not have positive financial results. The professional standards require that auditors evaluate whether there is substantial doubt about the company's ability to continue as a going concern for a reasonable period of time--a year from the balance sheet date. CONCEPT REVIEW: Tremendous judgment is involved in this phase of the audit. It should be noted that while auditors are not required to perform procedures to test the going concern assumption, they must evaluate the assumption in relation to the results of the audit procedures performed relative to the other components of the audit.

1. An emphasis-of-matter paragraph always follows the ______ paragraph. Auditors are _____ required to perform procedures specifically designed to test the going concern assumption. When items are identified that affect the going concern assumption, auditors must gather 3. ________. In addition to an emphasis-of-matter paragraph, auditors could issue a(n) _________ in a 4. going concern situation. A going concern evaluation should include evaluation of ________ from the balance sheet 5. date. 2.

opinion not evidence disclaimer one year

1. The emphasis-of-matter paragraph comes after the opinion paragraph. 2. Auditors must consider the going concern assumption but not design specific procedures to test it. 3. Auditors must gather evidence when going concern issues are identified. 4. Auditors can also consider issuing a disclaimer. 5. Going concern assumptions should be evaluated for a year. 3. The primary responsibility for the adequacy of disclosure in the financial statements of a publicly-held company rests with the: partner assigned to the audit engagement. Securities and Exchange Commission. auditor in charge of the field work. management of the company. 4. Which of the following is not correct relating to an audit report for a public company? It includes an additional paragraph indicating that the auditors have also issued a report on the client’s internal control over financial reporting. It includes the term “PCAOB Compliant” in the title. It refers to standards of the Public Company ing Oversight Board. It must include the city and state in which it was issued. 5. Auditors report on the consistency of application of ing principles. Assume that the following list describes changes that have a material effect on a client’s financial statements for the current year.

For each of the following situations, state whether the audit report should include an emphasisof-matter paragraph on consistency. Item Situation No. (1) (2) (3) (4)

(5)

(6)

(7)

A change from the completed-contract method to the percentage-ofcompletion method of ing for long-term construction contracts. A change in the estimated service lives of previously recorded plant assets based on newly acquired information. Correction of a mathematical error in inventory pricing made in a prior period. A change from direct costing to full absorption costing for inventory valuation. A change from deferring and amortizing preproduction costs to recording such costs as an expense when incurred because future benefits of the costs have become doubtful. The new ing method was adopted in recognition of the change in estimated future benefits. A change to including the employer’s share of FICA taxes as “Retirement benefits” on the income statement. This information was previously included with “Other taxes.” A change from the FIFO method of inventory pricing to the LIFO method of inventory pricing.

Emphasis-of-Matter Paragraph on Consistency Added? Yes No Yes Yes

Yes

No

Yes

6. The five types of reports that may be issued by auditors include:

(A) An unmodified opinion (B) An "except for" qualified opinion (C) An unmodified opinion with an emphasis of a matter paragraph (D) An adverse opinion (E) A disclaimer opinion For each of the following situations indicate the letter(s) that corresponds to the appropriate type of auditors' report, both when the situation is "material" and when it is "material and pervasive." Type of audit report may be used once, more than once, or not at all.

Situation a.

b.

c. d.

Material The financial statements contain a departure from generally accepted ing principles. The financial statements reflect a change from one generally ing principles to another generally accepted ing principle. The auditor considers the new principle preferable to the previous one. The auditors wish to emphasize in the report a subsequent event described in the notes to the financial statements. The scope of the auditors' examination is restricted.

Material and Pervasive

B

D

C

C

C

C

B

E

7. For each of the following types of audit reports, indicate whether the opinion may be "unmodified" and whether the report typically contains an emphasis-of-matter or basis for modification paragraph. Assume in all situations that the effects are material. Additional Paragraph?

Unmodified?

Situation a.

A change to an ing principle that the auditor considers desirable.

Yes

Yes

b.

A scope limitation

No

Yes

c.

The emphasis-of-matter

Yes

Yes

d.

A departure from GAAP

No

Yes

e.

Reliance upon component auditors

Yes

No

8. Items 1 through 5 present various independent factual situations an auditor might encounter in conducting an audit. For each situation, assume: • • • • • •

The auditor is independent. The auditor previously expressed an unmodified opinion on the prior year’s financial statements. Only single-year (not comparative) statements are presented for the current year. The conditions for an unmodified opinion exist unless contradicted in the factual situations. The conditions stated in the factual situations are material. No report modifications are to be made except in response to the factual situation.

List A represents the types of opinions the auditor ordinarily would issue and List B represents the report modifications (if any) that would be necessary. Select as the best answer for each situation (items 1 through 5) the type of opinion and alterations, if any, the auditor would normally select. Replies may be selected once, more than once, or not at all. List A: Types of Opinions A. Unmodified B. Qualified C. Adverse D. Disclaimer E. Qualified or adverse F. Qualified or disclaimer G. Disclaimer or adverse

List B: Report Alteration H. Add an emphasis-of-matter paragraph—prior to opinion paragraph. I. Add an emphasis-of-matter paragraph—after opinion paragraph. J. Add a basis for modification paragraph—prior to opinion paragraph. K. Add a basis for modification paragraph—after opinion paragraph. L. Modifications other than addition of a paragraph. M. Issue standard report without alteration.

tems Situation

1.

In auditing the long-term investments , an auditor is unable to obtain audited financial statements for an investee located in a foreign country. The auditor concludes that sufficient appropriate audit evidence regarding this investment cannot be obtained.

List A: List B: Types of Report Opinions Alteration F

J

Due to recurring operating losses and working capital deficiencies, an auditor has substantial doubt about an entity’s ability to continue as a 2. going concern for a reasonable period of time. However, the financial A I statement disclosures concerning these matters are adequate. The auditor has decided not to issue a disclaimer of opinion. A group auditor decides to take responsibility for the work of a component A who audited a wholly owned subsidiary of the entity and issued an 3. unmodified opinion. The total assets and revenues of the subsidiary A M represent 17 percent and 18 percent, respectively, of the total assets and revenues of the entity being audited. An entity changes its depreciation method for production equipment from straight-line to a units-of-production method based on hours of utilization. 4. A I The auditor concurs with the change, although it has a material effect on the comparability of the entity’s financial statements. An entity discloses certain lease obligations in the notes to the financial statements. The auditor believes that the failure to capitalize these leases 5. is a departure from generally accepted ing principles and, although B J the possible effects on the financial statements of the misstatements is material, they could not be pervasive. 1.(F,J) A situation in which an auditor is unable to obtain audited financial statements for an investee represents a scope restriction. Scope restrictions lead to either a qualified opinion or a disclaimer of opinion. A decision as to whether the auditors should qualify or disclaim the opinion is dependent upon whether pervasive misstatements are possible.

2. (A,I) Substantial doubt about an entity's ability to continue as a going concern leads to either an unqualified opinion with an emphasis-of-matter paragraph, or a disclaimer. Because the problem indicates a disclaimer will not be issued, only an unqualified opinion with an emphasis-of-matter paragraph is appropriate.

3. (A,M) A standard unmodified opinion is appropriate in circumstances in which a group auditor takes responsibility for the work of a component auditor.

4. (A,I) When an auditor agrees with a change in ing principles, a lack of consistency results in an unmodified opinion with an emphasis-of-matter paragraph following the opinion paragraph.

5. (B,J) Departures from generally accepted ing principles result in either a qualified opinion or an adverse opinion, based on the pervasiveness of misstatements. Given that the situation suggests that the misstatement cannot be pervasive, a qualified opinion is appropriate.

9. For each of the following brief scenarios, assume that you are reporting on a client’s financial statements. Select the type(s) of opinion (per below) possible for the scenario. In addition:

• Unless stated otherwise, assume the matter involved is material. If the problem doesn’t tell you whether a misstatement pervasively misstates the financial statements or doesn’t list a characteristic that indicates pervasiveness, two reports may be possible (i.e., replies 6 to 9). • Do not read more into the circumstances than what is presented. • Do not consider an auditor discretionary circumstance for modification of the audit report unless the situation explicitly suggests that the auditor wishes to emphasize a particular matter.

Types of Opinion 1. Unmodified—standard. 2. Unmodified with an emphasis-of-matter paragraph. 3. Qualified. 4. Adverse. 5. Disclaimer. 6. Unmodified with an emphasis-of-matter paragraph or disclaimer. 7. Qualified or adverse. 8. Qualified or disclaimer. 9. Adverse or disclaimer. 10. Other.

Situation 1. 2. 3.

4.

5. 6. 7.

8. 9. 10.

11.

12.

13.

Report A company has not followed generally accepted ing principles in the recording of its leases. A company has not followed generally accepted ing principles in the recording of its leases. The amounts involved are immaterial. A company valued its inventory at current replacement cost. Although the auditor believes that the inventory costs do approximate replacement costs, these costs do not approximate any GAAP inventory valuation method. A client changed its depreciation method for production equipment from the straight-line method to the units- of-production method based on hours of utilization. The auditor concurs with the change. A client changed its depreciation method for production equipment from the straight-line to a units-of-production method based on hours of utilization. The auditor does not concur with the change. A client changed the depreciable life of certain assets from 10 years to 12 years. The auditor concurs with the change. A client changed the depreciable life of certain assets from 10 years to 12 years. The auditor does not concur with the change. Confined to fixed assets and accumulated depreciation, the misstatements involved are not considered pervasive. A client changed from the method it uses to calculate post employment benefits from one acceptable method to another. The effect of the change is immaterial this year, but is expected to be material in the future. A client changed the salvage value of certain assets from 5 percent to 10 percent of original cost. The auditor concurs with the change. A client uses the specific identification method of ing for valuable items in inventory, and LIFO for less valuable items. The auditor concurs that this is a reasonable practice. Due to recurring operating losses and working capital deficiencies, an auditor has substantial doubt about an entity’s ability to continue as a going concern for a reasonable period of time. The notes to the financial statements adequately disclose the situation. Due to recurring operating losses and working capital deficiencies, an auditor has substantial doubt about an entity’s ability to continue as a going concern for a reasonable period of time. The notes to the financial statements do not adequately disclose the substantial doubt situation, and the auditor believes the omission fundamentally affects the s’ understanding of the financial statements. An auditor reporting on group financial statements decides to take responsibility for the work of a component auditor who audited a 70 percent owned subsidiary and issued an unmodified opinion. The total assets and revenues of the subsidiary are 5 percent and 8 percent, respectively, of the total assets and revenues of the entity being audited.

7 1 7

2

7 1 3

1 1 1

6

4

1

14.

15.

16.

17.

18.

19.

20.

21.

22.

23. 24.

An auditor reporting on group financial statements decides not to take responsibility for the work of a component auditor who audited a 70 percent owned subsidiary and issued an unqualified opinion. The total assets and revenues of the subsidiary are 5 percent and 8 percent, respectively, of the total assets and revenues of the entity being audited. An auditor was hired after year-end and was unable to observe the counting of the yearend inventory. She is unable to apply other procedures to determine whether ending inventory and related information are properly stated. An auditor was hired after year-end and was unable to observe the counting of the yearend inventory. However, she was able to apply other procedures and determined that ending inventory and related information are properly stated. An auditor discovered that a client made illegal political payoffs to a candidate for president of the United States. The auditor was unable to determine the amounts associated with the payoffs because of the client’s inadequate record-retention policies. The client has added a note to the financial statements to describe the illegal payments and has stated that the amounts of the payments are not determinable. An auditor discovered that a client made illegal political payoffs to a candidate for president of the United States. The auditor was unable to determine the amounts associated with the payoffs because of the client’s inadequate record-retention policies. Although there is no likelihood that the financial statements are pervasively misstated, they may be materially misstated. The client refuses to disclose the payoffs in a note to the financial statements. In auditing the long-term investments of a new client, an auditor finds that a large contingent liability exists that is material to the consolidated company. It is probable that this contingent liability will be resolved with a material loss in the future, but the amount is not estimable. Although no adjusting entry has been made, the client has provided a note to the financial statements that describes the matter in detail. In auditing the long-term investments of a new client, an auditor finds that a large contingent liability exists that is material to the consolidated company. It is probable that this contingent liability will be resolved with a material loss in the future, and this amount is reasonably estimable as $2,000,000. Although no adjusting entry has been made, the client has provided a note to the financial statements that describes the matter in detail and includes the $2,000,000 estimate in that note. A client is issuing two years of comparative financial statements. The first year was audited by another auditor who is not being asked to reissue her audit report. (Reply as to the successor auditors' report.) A client is issuing two years of comparative financial statements. The first year was audited by another auditor who is being asked to reissue her audit report. (Reply as to the successor auditors' report.) A client’s financial statements follow GAAP, but the auditor wishes to emphasize in his audit report a significant related party transaction that is adequately described in the notes to the financial statements. A client’s financial statements follow GAAP except that they do not include a note on a significant related party transaction.

10

8

1

8

3

1

7

10

1

2 7

Report Comment Situati on 1. A company has not followed generally accepted 7 This is a departure from GAAP. ing principles in the recording of its leases. 2. A company has not followed generally accepted 1 Because the amounts involved are ing principles in the recording of its immaterial, no audit report modification is leases. The amounts involved are immaterial. necessary. 3. A company valued its inventory at current 7 Although the auditor believes that the replacement cost. While the auditor believes that costs approximate replacement costs, the inventory costs do approximate replacement they depart from GAAP. costs, these costs do not approximate any GAAP inventory valuation method.

4. A client changed its depreciation method for production equipment from the straight-line method to the units-of-production method based on hours of utilization. The auditor concurs with the change. 5. A client changed its depreciation method for production equipment from the straight-line to a units-of-production method based on hours of utilization. The auditor does not concur with the change. 6. A client changed the depreciable life of certain assets from 10 years to 12 years. The auditor concurs with the change. 7. A client changed the depreciable life of certain assets from 10 years to 12 years. The auditor does not concur with the change. Confined to fixed assets and accumulated depreciation, the misstatements involved are not considered pervasive. 8. A client changed from the method it uses to calculate post employment benefits from one acceptable method to another one. The effect of the change is immaterial this year, but expected to be material in the future. 9. A client changed the salvage value of certain assets from 5% to 10% of original cost. The auditor concurs with the change. 10. A client uses the specific identification method of ing for valuable items in inventory, and LIFO for less valuable items. The auditor concurs that this is a reasonable practice.

2

This situation involves a lack of consistency.

7

Because the auditor does not concur with the change, it is treated as a departure from GAAP.

1

A proper change in estimate does not require an emphasis of matter paragraph.

3

11. Due to recurring operating losses and working capital deficiencies, an auditor has substantial doubt about an entity's ability to continue as a going concern for a reasonable period of time. The notes to the financial statements adequately disclose the situation. 12. Due to recurring operating losses and working capital deficiencies, an auditor has substantial doubt about an entity's ability to continue as a going concern for a reasonable period of time. The notes to the financial statements do not adequately disclose the substantial doubt situation and the auditor believes the omission fundamentally affects the s’ understanding of the financial statements. 13. An auditor reporting on group financial statements decides to take responsibility for the work of a component auditor who audited a 70% owned subsidiary and issued an unmodified opinion. The total assets and revenues of the subsidiary are 5% and 8%, respectively, of the total assets and revenues of the entity being audited. 14. An auditor reporting on group financial statements decides not to take responsibility for the work of a component auditor who audited a

6

Because the auditor does not concur with the change in estimate, it is treated as a departure from GAAP. A qualified report is appropriate because the misstatements are not considered pervasive. A change in ing principles with an immaterial effect (even if expected to become material in the future) does not result in addition of an emphasis of matter paragraph on consistency. This is a change in estimate that does not result in addition of an emphasis of matter paragraph on consistency. Consistency is a between periods concept; using different inventory valuation methods such as here is acceptable and does not result in an emphasis of matter paragraph on consistency. This is a situation in which there is substantial doubt about a client’s going concern.

1

1

1

4

The lack of disclosure creates a departure from GAAP. Because effects are pervasive (fundamental to s’ understanding of the financial statements is a characteristic of pervasiveness), an adverse opinion is appropriate.

1

Because the auditor takes responsibility for the work of the component auditor, there is no mention of the component auditor.

10

In this situation the auditor’s responsibility section and the opinion sections have additional wording added, but there is no

15.

16.

17.

18.

19.

20.

21.

70% owned subsidiary and issued an unqualified opinion. The total assets and revenues of the subsidiary are 5% and 8%, respectively, of the total assets and revenues of the entity being audited. An auditor was hired after year-end and was unable to observe the counting of the year-end inventory. She is unable to apply other procedures to determine whether ending inventory and related information are properly stated. An auditor was hired after year-end and was unable to observe the counting of the year-end inventory. However, she was able to apply other procedures and determined that ending inventory and related information is properly stated. An auditor discovered that a client made illegal political payoffs to a candidate for president of the United States. The auditor was unable to determine that amounts associated with the payoffs because of the client's inadequate record retention policies. The client has added a note to the financial statements to describe the illegal payments and has stated that the amounts of the payments are not determinable. An auditor discovered that a client made illegal political payoffs to a candidate for president of the United States. The auditor was unable to determine that amounts associated with the payoffs because of the client's inadequate record retention policies, although there is no likelihood that the financial statements are pervasively misstated, they may be materially misstated. The client refuses to disclose the payoffs in a note to the financial statements. In auditing the long-term investments of a new client, an auditor finds that a large contingent liability exists that is material to the consolidated company. It is probable that this contingent liability will be resolved with a material loss in the future, but the amount is not estimable. Although no adjusting entry has been made, the client has provided a note to the financial statements that describes the matter in detail. In auditing the long-term investments of a new client, an auditor finds that a large contingent liability exists that is material to the consolidated company. It is probable that this contingent liability will be resolved with a material loss in the future, and this amount is reasonably estimable as $2,000,000. Although no adjusting entry has been made, the client has provided a note to the financial statements that describes the matter in detail and includes the $2,000,000 estimate in that note. A client is issuing 2 years of comparative financial statements. The first year was audited by another auditor who is not being asked to reissue her

emphasis of matter paragraph in what remains a report with an unmodified opinion.

8

This is a scope limitation.

1

Because the auditor has satisfied herself through performing other procedures, a standard report is appropriate.

8

This is a scope limitation because of the inadequate record retention policies and the auditor’s inability to perform other procedures.

3

The lack of disclosure results in a departure from GAAP. Because the effect is less than pervasive, a qualified opinion is appropriate.

1

Because the amount is not estimable, no adjusting entry can be recorded. The auditor might choose to emphasize this matter, but the problem’s background rules out this treatment.

7

Because the amount is estimable, an adjusting entry should be recorded; since it was not, a departure from GAAP exists.

10

The successor auditor reports on year 2. But an other matter paragraph is added indicating (1) the prior-period statements

audit report. (Reply as to the successor auditor’s report.)

22. A client is issuing 2 years of comparative financial statements. The first year was audited by another auditor who is being asked to reissue her audit report. (Reply as to the successor auditor’s report.) 23. A client's financial statements follow GAAP, but the auditor wishes to emphasize in his audit report a significant related-party transaction that is adequately described in the notes to the financial statements. 24. A client's financial statements follow GAAP except that they do not include a note on a significant related party transaction.

1

were audited by other auditors, (2) the date and type of report issued and, (3) if the report was other than standard, the reasons therefore. A standard report is issued on the second year. The other auditor’s report on the first year is reissued and included.

2

This is an emphasis of a matter situation.

7

This is a departure from GAAP. No information is provided on whether the omission is considered pervasive.

Chapter 18 1. In an integrated audit, which of the following must the auditors communicate to the audit committee?

Known Material Known Significant Weaknesses Deficiencies Yes Yes Yes No No Yes No No PCAOB Standard No. 5 requires that the auditors communicate both material weaknesses and significant deficiencies to the audit committee.

2. In an integrated audit, which of the following lead(s) to an adverse opinion on internal control?

Known Material Weaknesses

Yes Yes No No

Known Significant Deficiencies

Yes No Yes No

An audit report on internal control is modified for material weaknesses, not significant deficiencies.

3. Bill Jensen, a staff member of Zhan & Co., As, has given you the following list of what he

refers to as “internal control deficiencies” for the Zabling Co. audit and has asked you to review each point and make certain that you agree that each is an internal control deficiency. For each of the following items, reply A (Agree) or D (Disagree) indicating whether the item represents an internal control deficiency.

Internal Control Deficiency(Agree/ Disagree)

Item

a. Voided checks are torn up and destroyed.

Agree

b. Separate sequences of prenumbered checks are used for each bank .

Disagree

c.

The purchasing department manager and assistant manager are the authorized check signers.

Agree

d. Checks are made payable to cash.

Agree

e. The authorized check signers reconcile bank s.

Agree

f.

All cash receipts (checks) received through the mail are prelisted by the two individuals who open the mail.

g. All cash receipts received through the mail are restrictively endorsed when received. h.

When a disbursement is made based on paper ing documents, those ing documents are canceled by the individual who signs the check.

Disagree Disagree Disagree

a. Agree Voided checks should be saved so there is no question as to whether it is voided or outstanding. b. Disagree Each bank ordinarily has its own series. c. Agree Purchasing, which authorizes purchase, should not also sign checks, which in essence disburse funds related to those purchases. d. Agree Checks made payable to cash may be cashed by an inappropriate person. e. Agree Authorized check signers disburse funds and effective oversight of the disbursement function requires reconciliation by another individual. f. Disagree Cash receipts should be so prelisted to establish control over total receipts. g. Disagree A policy of restrictively endorsing receipt (e.g., endorsing them “pay only to Zabling Co.”) is a control that makes it more difficult for another individual to cash the checks for personal use. h. Disagree This policy eliminates the possibility of the inappropriately being used to an improper second disbursement using those documents. 4. Definition (or Partial Definition)

Term

A control deficiency, or a combination of control deficiencies, in internal control over financial reporting, such that there is a reasonable a. possibility that a material misstatement of the company’s annual or interim financial statements will not be prevented or detected on a timely basis A weakness in the design or operation of a control that does not allow b. management or employees, in the normal course of performing their functions, to prevent or detect misstatements on a timely basis An for which there is a reasonable possibility that it could c. contain misstatements that individually, or when aggregated with others, could have a material effect on the financial statements

Material weakness

Control deficiency Significant

The primary section of the Sarbanes-Oxley Act dealing with d. management and auditor reporting on internal control over financial reporting Those transaction flows that have a meaningful bearing on the totals e. accumulated in the company’s significant s and, therefore, have a meaningful bearing on relevant assertions Tracing a transaction from origination through the company’s f. information systems until it is reflected in the company’s financial reports

Section 404 Major classes of transactions Walk-through

5. An is significant if there is at least a

remote likelihood that it could contain material misstatements. reasonable possibility that it could contain material misstatements. remote likelihood that it could contain more than inconsequential misstatements. reasonable possibility that it could contain more than inconsequential misstatements. 6. Walk-throughs provide evidence that helps auditors to:

evaluate design effectiveness of controls. confirm whether controls operate with absolute completeness. substantiate balances. document systems flows throughout compliance testing of operational aspects of transactions.

7. An auditor identified a material weakness in December. The client was informed and corrected it shortly after year-end (December 31); the auditor agrees that the correction eliminates the material weakness as of January 31. The appropriate audit report on internal control under a PCAOB Standard No. 5 audit of internal control is:

qualified. adverse. unqualified with explanatory language relating to the material weakness. unqualified.

8. During audits of internal control over financial reporting of various issuers, the auditors encountered the independent situations below. For each situation a through e select from the following list the appropriate audit responses. Each reply may be used once, more than once, or not at all.

1. 2. 3. 4. 5. 6. 7.

Assess control risk as low for the purpose of the financial statement audit. Consult legal counsel to explore reducing auditor liability. Determine if the control deficiency is a material weakness by obtaining further evidence. Disclose in the notes to the financial statements that there are material weaknesses. Express an adverse opinion on internal control. Express an unqualified opinion on internal control. Express an unqualified opinion on internal control and add a paragraph on whether a previously reported material weakness in internal control continues to exist. 8. Insist that management’s assessment of internal control includes a description of the significant deficiency. 9. Issue a disclaimer of opinion. 10. Issue a report on internal control stating that no deficiencies were noted. 11. Issue a separate report on the client’s internal control. 12. Modify the opinion in the report on internal control for significant deficiencies.

13. Report matter only to the board of directors.

Response

Situation a.

b.

c. d. e.

The client did not furnish adequate evidence for the auditors to evaluate internal control over inventory. All other evidence was provided. The auditors examined the client’s internal control over cash receipts and concluded that they are operating exactly as designed. However, the design of the controls does not include control procedures to prevent misstatements and the potential omission of cash receipts. The auditors concluded that the ineffectiveness of the design of controls over s payable and cash disbursements represents a material weakness in internal control, even though the financial statements are not materially misstated. The auditors concluded that a significant deficiency in internal control exists in the payroll function, but no material weakness. The auditor’s prior-year report on internal control included an adverse opinion. The client has since modified internal control and no material weaknesses were found in the current year.

Situation a. The client did not furnish adequate evidence for the auditors to evaluate internal control over inventory. All other evidence was provided. b. The auditors examined the client’s internal control over cash receipts and concluded that they are operating exactly as designed. However, the design of the controls does not include control procedures to prevent misstatements and he potential omission of cash receipts. c. The auditors concluded that the ineffectiveness of the design of controls over s payable and cash disbursements represents a material weakness in internal control, even though the financial statements are not materially misstated. d. The auditors concluded that a significant deficiency in internal control exists in the payroll function, but no material weakness. e.

The auditor’s prior-year report on internal control included an adverse opinion. The client has since modified internal control and no material weaknesses were found in the current year.

9

3

5 6 6

Response Issue a disclaimer of opinion. Determine if the control deficiency is a material weakness by obtaining further evidence. Express opinion control.

an on

adverse internal

Express an unqualified opinion on internal control. Express an unqualified opinion on internal control.

9. An Audit of Internal Control Over Financial Reporting Read the overview below and complete the activities that follow. The auditors' objective in an audit of internal control is to express an opinion on the company's internal control over its financial reporting. To meet this objective, an auditor must plan and perform the audit and obtain reasonable assurance. A properly planned audit does this in five distinct stages. CONCEPT REVIEW: A properly planned audit to report on internal control consists of the following five stages: 1) Plan the engagement; 2) Use a top-down approach to identify controls to test; 3) Test and evaluate design effectiveness of internal control; 4) Test and evaluate operating effectiveness of internal control; and 5) Form an opinion on the effectiveness of internal control.

Efficient planning of the evaluation of internal control requires ____________ the financial statement audit. Evidence as to the design of internal control and its operating effectiveness should be 2. considered ____________ the date specified in the assessment. Management's evaluation process of internal control ____________ with the 3. management report on internal control--the first step of the audit process.

coordination with

4. Auditors should use a ______ approach to assess controls.

top-down

1.

5.

The ______ committee is especially important as it exercises oversight responsibility over the financial statements.

as of concludes

audit

1. To efficiently plan an internal control audit, the auditor must plan the audit in coordination with the financial statement audit. This coordination is referred to as an integrated audit. 2. The evidence must be considered as of the date of the assessment by management. 3. Management's evaluation period ends with its report on internal control. This evaluation begins the audit process. 4. Using a top-down approach, auditors start at the top (the financial statement level) and link to the controls in the significant s. 5. An audit committee exercises responsibility for oversight over the financial statements--an important part of the internal control structure.

Chapter 19 1. Which of the following would not be included in a A's review report on the financial statements of a nonissuer company?

A statement that a review is less in scope than an audit. A statement that the review was performed in accordance with generally accepted auditing standards. A statement that all information is based upon representations of management. A statement describing the principal procedures performed during a review.

2. Comfort letters help underwriters in fulfilling their obligation to perform a reasonable investigation of a(n):

annual report sent to shareholders. annual report filed with the Securities and Exchange Commission. registration statement for the sale of securities. condensed financial statements.

3. An engagement in which specified s agree with the As on the procedures to be performed is:

a form of special audit engagement. considered unethical under the professional standards. only allowable under engagements related to not-for-profit organizations. referred to as an agreed-upon procedures engagement.

4.

An auditors' report on cash-basis financial statements should include a statement that:

the financial statements are not prepared in conformity with GAAP. disclosure is inadequate. the financial statements are misleading. the auditors are disclaiming an opinion.

5. State whether you agree or disagree with each of the following relating to the topic of special-purpose financial reporting frameworks.

Agree/Disagree a. b.

c. d. e.

International Financial Reporting Standards are considered a special-purpose financial Disagree reporting framework. Cash basis financial statements are considered as having been prepared following a special-purpose financial reporting framework, and their use should be restricted to specified Disagree s. Financial statements prepared following a contractual basis are considered as having been prepared following a special-purpose financial reporting framework, and their use should be Agree restricted to specified s. An emphasis-of-matter paragraph should be added to a cash basis set of financial Agree statements indicating that the framework is other than GAAP. When financial statements are prepared following a contractual basis, the auditors must Agree obtain an understanding of significant management interpretations of the contract. (a) Disagree (International Financial Reporting Standards are considered a general purpose financial reporting framework). (b) Disagree (Cash basis financial statements use need not be restricted).

6. Indicate whether a A may provide each of the following services, and whether independence is required, by selecting the relevant answer from the dropdown.

Service a.

Provide an opinion on whether financial statements are prepared following the cash basis of ing.

b.

Compile the financial statements for the past year and issue a publicly available report.

c. d. e. f.

Apply certain agreed-upon procedures to s receivable for purposes of obtaining a loan, and express a summary of findings relating to those procedures. Review quarterly information and issue a report that includes limited assurance. Perform an audit of the financial statements on whether they are prepared following generally accepted ing principles. Prepare the financial statements for the past year.

7. Listed below are four types of reports issued by As:

May provide; independence is required May provide; independence is not required May provide; independence is required May provide; independence is required May provide; independence is required May provide; independence is not required

1. Unmodified (unqualified) audit report 2. Cash-basis statements audit report. 3. Review report 4. Compilation report

Indicate the type of report (or reports) in which the following phrases appear by selecting the identifying numbers from the dropdown provided below. A phrase may appropriately appear in more than one type of report. If the phrase should not appear in any of the reports, select "X" from the dropdown. Report

Phrase

1,2

"in accordance with generally accepted auditing standards."

3,4

In all cases, an indication that the A does not express an opinion.

4

"presenting in the form of financial statements, information that is the representation of management."

X

"is in compliance with the requirements of the Foreign Corrupt Practices Act."

4 3,4 3

"Management has elected to omit substantially all of the disclosures required by generally accepted ing principles." "in accordance with standards established by the American Institute of Certified Public ants." "is substantially less in scope than an audit in accordance with generally accepted auditing standards....."

X

"met those criteria."

3

"we are not aware of any material modifications that should be made"

X

"designed to obtain absolute assurance."

X

"adequate informative disclosure....."

2

"which is a basis of ing other than generally accepted ing principles."

8. Differences in a A's Responsibilities Read the overview below and complete the activities that follow. Public companies are required to have annual audits and interim reviews of their first three quarters. Nonpublic companies that have their annual financial statements audited also may choose to have interim reviews. Nonpublic companies not required to have an audit may instead choose to have a review of their financial statements. CONCEPT REVIEW: Interim reviews under standards of the PCAOB and the Auditing Standards Board are both very similar to reviews performed under the SSARS.

1. Public companies are required to have _____audits and interim reviews.

annual

2. Nonpublic companies _____choose to have interim reviews.

may

3. SSARS reviews are performed on clients that ______an annual audit.

do not need

4. Public company guidance comes from the ________.

PCAOB

5.

Nonpublic companies that are audited may also want interim reviews. Auditors must then follow the _______.

ASB standards

1. SEC filers must have annual audits. 2. Nonpublic companies may choose to have reviews quarterly. 3. SSARS reviews are performed for clients that prefer a review rather than an annual audit. 4. The PCAOB regulates public companies. 5. The ASB standards are set for nonpublic companies that are audited. They include statements for interim reviews for audited companies.

9. Compilations of Historical Financial Statements Read the case and answer the questions that follow. Many clients request that As perform a compilation rather than a review or an audit. Compilations provide no explicit assurance that the information is fairly presented and independence is not required. CONCEPT REVIEW: Traditionally, a compilation is performed to assist management in presenting financial information in financial statement format. ants must understand ing principles and practices used and have a good understanding of the client's business transactions and records.

1.

Each ______ of the compiled financial statements should be marked "see ant's page compilation report."

2. An engagement letter needs to be signed by _________.

management

3. Compilations can omit substantially all _________.

disclosures

An engagement letter documents the _______ of the of the engagement with the 4. understanding client. 5. At a minimum, the ants must _____ the financial statements.

read

1. Each page of the compiled financial statements needs to be marked with "see ant's compilation report." 2. Management needs to sign the engagement letter. 3. Disclosures may not be particularly useful in some situations -- for example, the financial statements of a nonpublic company for internal purposes. 4. Engagement letters document the understanding of the of the engagement. 5. At a minimum, the ants need to read through the financial statements.

Chapter 20 1. Following are descriptions of potential needs of clients for various services. For each need identify the type of service that would best meet the client’s need using the following:

1. Attestation of prospective financial information

2. PrimePlus/Elder Care Services 3. Attestation of MD&A 4. Agreed-upon Procedures Engagement 5. SOC 1(Service Organization Controls Type 1) 6. SOC 2 7. SOC 3 8. SysTrust in an area other than a SOC report 9. XBRL engagement 10.Other attestation service

Client Need a. b. c. d. e. f. g. h.

Type of Service A computer manufacturing company wants to provide assurance about estimated future results to be included in the company’s annual report. A company that processes payroll for other companies wants to provide assurance on its internal control over financial reporting that will be useful to the auditors of the companies that use its services. A public company wants to provide its shareholders assurance about the narrative analysis of financial results provided in the company’s Form 10-K. A service organization wishes to provide a general-use report from its auditor on its processing integrity and confidentiality controls. The relative of an institutionalized uncle wants a A firm to oversee the uncle’s financial affairs. A bank wants a A firm to confirm receivables of a company that has pledged the receivables as collateral for a loan. A service organization wishes to provide a restricted-use report from its auditor to regulators on its processing integrity and confidentiality controls. A grocery store wants to provide the highest level of assurance that its prices are less than the prices of its competitors.

1 5 3 7 2 4 6 10

2. Indicate whether a A may provide each of the following services, and whether independence is required, by selecting the relevant option from the dropdown. Service a. b. c. d.

e.

Compile a forecast for the coming year. Perform a review of a forecast the company has prepared for the coming year. Perform an examination of Management’s Discussion and Analysis when they have not audited the year’s financial statements. Issue a SysTrust examination report on the security against unauthorized access of a service organization’s electronic processing system. Assist an elderly client with his estate planning.

May provide; independence is not required May not provide May not provide May provide; independence is required May provide; independence is not required

3. For each of the situations (a) through (f), select the A engagement that is most likely to be appropriate from the lists of services below:

1. Compliance.

2. 3. 4. 5. 6. 7. 8. 9.

Continuous auditing. Forecast. Internal control over financial reporting. MD&A. PrimePlus/ElderCare. Service organization audit. SysTrust. WebTrust.

Each reply may be used a maximum of one time, with two replies not being used at all. A Engagement

Situation a. b. c. d. e. f.

Williams is worried about the welfare of his father who lives in a distant state.

6

ABC Company is involved in a very vibrant industry. It would like all of its press releases to include audited results, regardless of when they are issued. DEF Mortgage Banking Co. services mortgages for others, and the auditors of those other organizations are constantly inquiring of DEF concerning its internal control as a part of their audits of the other organizations. GHI Company would like to assure its Web site s of the reliability of its Web site and its operations. JKL would like all of its customers and potential customers to have assurance about the effectiveness of its internal controls related to processing information. MNO Company believes that it has effective internal control to assure itself that it complies with various legal requirements, but would like assurance from its A on compliance with the legal requirements.

2 7 9 8 1

4. An examination of management's discussion and analysis (MD&A) is least likely to provide assurance on whether the

29_2015_QC_CS-20427 Presentation includes, in all material respects, the required elements of the rules and regulations adopted by the SEC. The underlying information of the entity provides a reasonable basis for the discourses contained in the MD&A. Disclosures required by SEC requirements are properly presented. Historical financial amounts included in the presentation have been accurately derived from the entity's financial statements.

5. Which of the following examinations (audits) is most likely to result in a A issuing a “restricted use” report?

Financial projection. Trust Services. Management’s discussion and analysis. Internal control over financial reporting.

6. Assurance Services that are Attestation Services

Other Assurance Services

Are forms of engagements limited to examinations and reviews? No

No

Must report form be written?

No

Yes

Is independence required?

Yes

Yes

Is conclusion only on reliability of information?

Yes

No

7.

INDEPENDENT ANTS’ REPORT We have examined the accompanying schedule of investment performance statistics of Terrill

Investment Fund for the year ended December 31, 20X2.

express an opinion

on this schedule based on our examination.

Our examination was conducted in accordance with evidence ing the schedule and performing such other procedures provides a

In our opinion in conformity with the measurement and disclosure

attestation standards as we considered necessary in the circumstances. We believe that our reasonable basis for our opinion the schedule of investment performance statistics referred to above presents, criteria set forth by the Association of Investment

This schedule is the responsibility of Terrill Investment Fund’s management.

established by the American Institute of Certified Public

Our responsibility is to

ants and, accordingly, included examining, on a test basis,

examination

in all material respects

the performance of Terrill Investment Fund for the year ended December 31, 20X2,

Management Research, Inc., as described in Note 1.

8. Attestation Standards Read the overview below and complete the activities that follow. Attestation standards apply to engagements in which practitioners are engaged to issue or do issue an examination, a review, or an agreed-upon procedures report on subject matter or an assertion about subject matter that is the responsibility of another party. CONCEPT REVIEW: It is important to distinguish between the subject matter itself and the assertion about the subject matter. The subject matter may be financial information, physical characteristics, historical events, or systems or processes.

A(n) ____ is a declaration about whether the subject matter is presented in accordance with certain criteria. Practitioners report either on the ______ about the subject matter or the subject matter 2. itself. 1.

assertion assertion

3. SSARS reviews are performed on clients that ______ an annual audit.

do not need

4. Public company guidance comes from the ________.

PCAOB

5.

Nonpublic companies that are audited may also want interim reviews. Auditors must then follow _______.

the ASB standards

1. Assertions tell whether the subject matter is presented in accordance with certain criteria. 2. Assertions are claims made about the subject matter. Auditors may either report on the subject matter itself or an assertion about the subject matter. 3. SSARS reviews are performed for clients that prefer a review rather than an annual audit. 4. The PCAOB regulates public companies. 5. The ASB standards are for nonpublic companies that are audited. 9.

1. Limited assurance is also called ______ assurance.

negative

2. If a material departure is not ______, the report needs to be modified.

corrected

3. In a review, practitioners gather sufficient evidence to drive risk to a(n) _______ level. moderate 4. Examples of limited procedures in a review are ______ procedures and inquiries.

analytical

5. The review report provides ______ assurance that the information is fairly presented. limited

1. Negative assurance and limited assurance disclaims an opinion but notes that the ant is not aware of material modifications needed. 2. When a material departure is noted and not corrected, the report needs to be modified. 3. Reviews require gathering only enough evidence to reduce risk to a moderate level. 4. Analytical procedures are required in review procedures. 5. Reviews provide limited assurance on the information provided.

Chapter 21 1. Under the Single Audit Act, auditors must test for compliance with the specific requirements of all major programs. State whether each of the following is required under that act: Statement a. b. c. d.

Is it required? Determine that the organization complies with generally accepted ing principles applicable to the program. Determine that the organization complies with specific requirements regarding the activities allowed or not allowed by the program. Determine that wages paid are not more than those established for the locality of the project by the Department of Labor. Determine that the organization contributes the appropriate amount of its own resources to the program.

No Yes No Yes

e.

Determine that federal funds were spent or obligated within the period of availability.

Yes

f.

Determine whether program income is correctly recorded and used in accordance with the program requirements.

Yes

g.

Determine whether subrecipients monitor the compliance of recipients.

No

h.

Determine that only ed U.S. citizens work on the program.

No

Determine that the organization does not contract with vendors that are suspended or debarred. Determine that the organization followed procedures to minimize the time elapsing between the transfer of funds from the U.S. Treasury and their disbursement.

i. j.

Statement a.

b.

c.

d. e. f.

g. h. i. j.

Yes Yes

Is it required? Determine that the organization complies with generally accepted ing principles applicable to the program.

No

Determine that the organization complies with specific Yes requirements regarding the activities allowed or not allowed by the program. Determine that wages paid are not more than those No established for the locality of the project by the Department of Labor. Determine that the organization contributes the Yes appropriate amount of its own resources to the program. Determine that federal funds were spent or obligated Yes within the period of availability. Determine whether program income is correctly Yes recorded and used in accordance with the program requirements. Determine whether subrecipients monitor the No compliance of recipients. Determine that only ed U.S. citizens work on the No program. Determine that the organization does not contract with Yes vendors that are suspended or debarred. Determine that the organization followed procedures to Yes minimize the time elapsing between the transfer of funds from the U.S. Treasury and their disbursement.

Compliance must be with federal cost ing policies applicable to the program.

Wages should not be less than those so established.

Recipients must monitor the compliance of subrecipients. There is no such general requirement.

2. Match the following with the appropriate definition (or partial definitions). Each definition may be used once or not at all.

Definition (or Partial Definition) 1. A document that contains standards for audits of government organizations, programs, activities, and functions and of government assistance received by contractors and other nonprofit organizations. 2. A document that presents the major and minor program requirements for all federal contracts. 3. A publication of the U.S. Office of Management and Budget that specifies audit procedures for federal financial assistance programs. 4. A supplement to the U.S. Business Code, published by the General ability Office, dealing with overall compliance issues. 5. An act requiring that every single municipality undergo an annual audit of its financial statements. 6. Legislation ed by the U.S. Congress that establishes uniform requirements for audits of federal financial assistance provided to state and local governments. 7. Performing procedures to test compliance with laws and regulations. 8. A significant federal assistance program as determined by the auditors based on a risk-based approach. In a single audit, the auditors must provide an opinion on compliance related to major programs. 9. The process of reviewing a department or other unit of a business, governmental, or nonprofit organization to measure the effectiveness, efficiency, and economy of operations.

Term

Definition (or Partial Definition)

a.

Compliance auditing

7

b.

Compliance Supplement

3

c.

Government Auditing Standards

1

d.

Major federal financial assistance program

8

e.

Single Audit Act

6

3. When performing financial statement audits the auditors perform tests of compliance with laws and regulations to determine that:

any violations do not have a direct and material effect on line-item financial statement amounts. civil or criminal statutes have not been violated. civil statutes have not been violated. subrecipients of funds have appropriately spent funds prior to remitting them to recipients.

4. An internal auditor’s independence is most likely to be assured if she reports to the:

treasurer controller. president. audit committee of the board of directors.

5. A typical objective of an operational audit is for the auditors to:

evaluate the feasibility of achieving the entity's operational objectives. make recommendations for improving performance. report on the entity's success in maximizing profits. determine that the financial statements fairly present the entity's operating results.

6.

1. Governmental ability Office Government Auditing Standards 2. Single audit

Opinions on major federal assistance programs

3. Subrecipient

-through funds

4. Compliance test

Substantive tests

5. Specific requirements

Noncompliance

6. Operational audit

Efficiency and effectiveness

7. The Key Principles of GAGAS Read the overview below and complete the activities that follow. GAGAS, or Generally Accepted Government Auditing Standards, are commonly referred to as the "Yellow Book." They are produced in the United States by the Government ability Office (GAO). The GAO issued GAGAS for use in auditing federal entities

and organizations that receive federal financial assistance. CONCEPT REVIEW: GAGAS place additional emphasis on ethical principles as the basis for the implementation of the standards, including five key principles to guide government audits.

1.

The GAO issues the publication entitled Government Auditing Standards, which include GAGAS. This publication is commonly referred to as the ____________ Book.

Yellow

2. These GAGAS apply only when regulated by ______, regulation, or agreement.

law

3. GAGAS provide audits for financial and _____ audits.

performance

4.

Audit communication with GAGAS requires communication with the client, those charged with governance, and ________.

5. Objectivity includes being free from influence and _________.

regulators conflicts of interest

1. The GAO issues the publication entitled Government Auditing Standards, which include GAGAS. This publication is commonly referred to as the Yellow Book. 2. Laws dictate which agencies must follow GAGAS. 3. Governmental Auditing Standards include requirements for financial and performance audits. 4. GAGAS requires communication with clients, client's governing bodies, and government regulators. 5. An important part of objectivity is a freedom from conflict of interest. 8. The Operational Audit Read the overview below and complete the activities that follow. An operational audit is a comprehensive examination of an operating unit or a complete organization to evaluate its systems, controls, and performance--as measured by management's own objectives. CONCEPT REVIEW: An operational audit focuses on the efficiency, effectiveness, and economy of operations.

The broad statement of purpose of an operational audit includes the intent to appraise the ______ of a particular organization. Auditors must familiarize themselves with the _____ being performed in the unit being 2. audited. 1.

performance function

3. Each operational audit is _____ to the particular engagement.

unique

4. A formal operational audit report is prepared for _______.

management

5. In follow up, it is ensured that _____ are satisfactorily handled.

deficiencies

1. Operational audits are focused on performance. 2. In an operational audit, auditors must familiarize themselves with the function of what is being performed. 3. Each audit is unique to the particular engagement. 4. An operational audit is prepared for the company's management. 5. An important part of the follow up is ensuring that all deficiencies are properly handled.

9. The Single Audit Act Read the case and answer the questions that follow. Congress ed the Single Audit Act to help improve the way federal financial assistance programs that are granted are managed. CONCEPT REVIEW: The Single Audit Act provides a statuatory requirement to test compliance with laws and regulations and internal controls over all federal program compliance requirements.

1. Audits under the Single Audit Act are _____ than traditional financial statement audits.

more extensive

2. Congress ed the Single Audit Act to ensure federal dollars were spent _________.

effectively

GAGAS audits have _____ documentation standards besides those under traditional audit standards. Federal financial assistance must be spent in accordance with the program's 4. _________. 3.

5. Auditors are also required under GAGAS to report fraud or _______.

additional requirements illegal acts

1. Because of the extra compliance steps, Single Audit Act audits are more extensive than traditional financial statement audits. 2. Congress wanted to add regulations to ensure federal dollars were spent in accordance with the regulations and laws governing them. 3. Audits following GAGAS have additional documentation standards to comply with. 4. Federal programs require those receiving money to follow certain requirements. 5. Auditors are required under GAGAS to report any fraudulent or other illegal acts that they find during the course of their audit.