Professional Documents
Culture Documents
Auditing Cases
SOLUTIONS MANUAL 11e
Table of Contents
John M. Trussel and J. Douglas Frazer
A Not on Ethics, Fraud and Sox Questions
2
A Note on Research Assignments
4
Introductory Case
6
Case 1
13
Case 2
21
Case 3
29
Case 4
39
Case 5
51
Case 6
67
Case 7
74
Case 8
83
Case 9
92
Case 10
100
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Case 11
105
Case 12
115
Case 13
127
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To provide a means for improving the writing skills of students. From all
reports, accounting majors too often leave college lacking in the basic
ability to compose and construct sentences and paragraphs. Accounting
and auditing (especially as one moves up in an organization) obviously
require skills other than the purely quantitative.
Memos, reports,
footnotes, audit and accounting guides, etc., all require accountants and
auditors to be effective communicators of the written word. Indeed, the
instructor may want to team up with a member of the school's English or
communications department to enhance the effectiveness of these
assignments. The auditing instructor can then evaluate the technical and
research portions of the assignment, while the English instructor would
make suggestions as to grammar, syntax, construction of sentences and
paragraphs, logic of the thought process, etc. As a preliminary step, the
instructor may want to assign articles such as "Word Crunching: A Primer
for Accountants" from the March 1990 issue of the Journal of
Accountancy.
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INTRODUCTORY CASE
SUGGESTED ANSWERS TO DISCUSSION QUESTIONS
(1)
The staff auditor performs many of the detailed audit procedures, such as
preparing and controlling accounts receivable confirmations. In general the work
of the staff auditor is controlled by audit program and supervised by the senior
auditor
The senior auditor coordinates the audit at the client's location and performs
many of the more difficult audit procedures, such as analytical review
procedures. Usually the detailed work performed by the audit senior is more
sophisticated and requires the experience gained by someone holding that rank.
The audit senior is supervised by the manager.
The manager and the partner have supervisory roles. Managers and partners
often have more than one audit team under supervision at any given time.
The partner is the person who has responsibility for determining whether the
firms signature can be attached to audit report.
(2)
The partner-in-charge of an audit is the definitive decision-making position on the
audit team. Although the manager and senior auditor make several decisions,
they must get ultimate approval from the partner-in-charge of the audit. The
consulting partner's role is to add a further degree of objectivity to the audit. The
consulting partner reviews and critiques certain crucial decisions made by the
audit team, such as the final audit report. The partners should be rotated to
assure independence.
Sarbanes-Oxley (SOX-S203) requires the identification of a Leading Partner and
a Reviewing Partner. Both partners must be rotated every five years.
(3)
An accounting firm is a business like any other, and its management must
recognize that a marketing strategy is probably necessary to generate a
continual flow of sufficient operating revenues. However, in the accounting
profession, disagreement exists as to the extent that such marketing should take.
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In the past, overt marketing was not permitted since it was considered to be
unprofessional. This position was supported based on the reasoning that a firm
should be selected based solely on the quality of its service. No reliable system
existed, though, for conveying such information to potential clients. Hence, firms
with many clients tended to remain large, while smaller firms often found growth
to be nearly impossible. In the free market system espoused by the United
States, restrictions on such practices as advertising and solicitation were
inevitably overturned. Over the past three decades, attitudes toward marketing
have changed dramatically as competition has become much more intense.
Advertisements by CPA firms in newspapers and magazines are now common.
Newsletters such as that distributed by Abernethy and Chapman are also
frequently used to increase a firm's name recognition in the business community.
In the current world of business, some type of marketing strategy seems
imperative if an accounting firm is to compete. Whether that marketing should
extend to formal advertising is often a question of firm policy. Most importantly,
the firm must ensure that potential clients know of its presence and the services
that it offers. A client will probably not select a CPA firm based on advertising.
However, the client may initially become aware of the firm only through some
type of marketing.
Interestingly, some members of the accounting profession view marketing as
having had a negative impact on the profession as a whole. Price competition for
new clients is often associated with the marketing of a firm. These critics assert
that lowered fees result in sloppy and hurried audit work that can decrease the
overall reputation of the profession. [Additional resources discussing this issue
can be found in the "Suggested Readings" at the end of this case.]
(4)
A national or international CPA firm might consider acquiring Abernethy and
Chapman for several reasons:
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The larger firm may be interested in moving into this geographical region,
and buying the local firm will provide an instant base on which to build a
practice in the area.
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The larger firm may already have an office in this location and feels that
combining the practices will reduce expenses.
Abernethy and Chapman might have several reasons for viewing an acquisition
in a favorable light:
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The smaller firm may have trouble dealing with increased competition from
bigger firms. Often clients may decide that a change to a nationally known
CPA firm should be made to add extra stature to the audit report. If a local
organization has only a few large clients, it cannot economically afford to
lose a significant amount of revenue in this way. A merger may help the
firm to keep its clients.
The regional firm may also desire the additional backup services offered
by large organizations. National CPA firms usually have experts in many
industries as well as in specific audit areas who are available for
consultation. In a smaller firm, this degree of assistance is not always
available when a difficult accounting or auditing problem is encountered.
Many mergers have occurred in the auditing profession during recent years.
Critics assert that this trend has reduced competition and will inevitably lead to a
decrease in audit quality. Proponents counter by stating that mergers lead to
more efficient operations and, thus, improve audit quality. Obviously, mergers
will create a drastic change in the profession as more of the smaller firms
disappear. Audit work in this country may possibly become concentrated within
the largest CPA firms. Whether this result is good for the auditing profession may
be merely a question of perspective. To the smaller firms struggling to survive
and grow, the mergers are usually considered a threat as the bigger firms
become more competitive. To the larger firms, the chance for continued growth
and more efficient operations is always an important objective.
See the Sarbanes-Oxley section below for a follow up question related to the
impact of SOX on the auditing profession.
(5)
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Moving staff from one area of a CPA firm to another can cause the perception of
an independence problem. For example, the appearance of independence may
be in question if a member of the consulting staff helps to install a new
accounting system for a client and then she moves to the audit staff to audit this
same client.
See the Sarbanes-Oxley section below for a follow up question/answer related to
the impact of SOX, in particular the list of proscribed activities for registered CPA
firms.
SUGGESTED ANSWERS TO EXERCISE
(1)
The question requires students to address all the elements of a quality control
system, as included in Statement on Quality Control Standards No. 2. In some
cases, students should recognize the need for additional information.
-Independence, Integrity, and Objectivity: Abernethy and Chapman requires its
employees to sever all financial ties to audit clients. The AICPA's Code of
Professional Conduct does not require all employees to sever ties with all audit
clients. For example, staff auditors not working on a particular engagement need
not sever ties. In this case, the firm exceeds the minimum level of conduct for
independence. However, the case does not mention spouses or dependents of
the employees. Spouses and dependents must also be independent, as defined
by Section 100--Rule 101 of the Code. In this case, the firm should strengthen
its requirements.
-Personnel Management: The firm considers experience and technical
competence in assigning personnel to audit engagements. This appears to be a
reasonable quality control.
The firm hires only college graduates with a major in accounting and requires
that each professional sit for the CPA exam with one year of employment. This
seems to be a more than adequate quality control procedure. In fact, many firms
hire professionals, such as computer experts, who were not accounting majors.
The firm requires 40 hours of continuing education per year; however, the case
does not address the issue of the type of education (e.g., accounting and
auditing versus other courses). Many states require that a minimum number of
continuing professional education hours be in accounting- and auditing-related
courses.
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PCAOB
website
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The Act provides that an inspection shall include at least the following three
general components:
An inspection and review of selected audit and review
engagements of the firm, performed at various offices and by
various associated persons of the firm;
An evaluation of the sufficiency of the quality control system of the firm,
and the manner of the documentation an communication of that system by
the firm; and
Performance of such other testing of the audit, supervisory, and
quality control procedures of the firm as are necessary or
appropriate in light of the purpose of the inspection and the
responsibilities of the Board.
Regular inspection are on a three-year cycle, although smaller firms msay
be less frequent. Special inspections can be required by the PCAOB
Maintenance of independence under PCAOB rules and SOX proscribed
activities:
to "engage in any non-audit service, including tax services," that is not listed
above, only if the activity is pre-approved by the audit committee of the issuer.
The audit committee will disclose to investors in periodic reports its decision to
pre-approve non-audit services. Statutory insurance company regulatory audits
are treated as an audit service, and thus do not require pre-approval.
The pre-approval requirement is waived with respect to the provision of non-audit
services for an issuer if the aggregate amount of all such non-audit services
provided to the issuer constitutes less than 5 % of the total amount of revenues
paid by the issuer to its auditor (calculated on the basis of revenues paid by the
issuer during the fiscal year when the non-audit services are performed), such
services were not recognized by the issuer at the time of the engagement to be
non-audit services; and such services are promptly brought to the attention of the
audit committee and approved prior to completion of the audit.
The authority to pre-approve services can be delegated to 1 or more members of
the audit committee, but any decision by the delegate must be presented to the
full audit committee.
Partner rotation- The rotation of the lead partner and the reviewing partners
are required by the SOX act.
Quality Control Standars registered firms must maintain the SEC practice
requirements:
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CASE 1
SUGGESTED ANSWERS TO DISCUSSION QUESTIONS
(1)
Financial statements are frequently relied on by outside parties such as
stockholders and banks when making decisions about an enterprise. Should
equity securities be bought or sold? Should a long-term loan be given?
However, financial statements are the representations of the management of the
company. As such, these statements will not necessarily be fairly presented.
Material misstatements may exist in the form of errors, irregularities, or illegal
acts. The management might, for example, have an insufficient knowledge of
generally accepted accounting principles to produce appropriate statements.
Human error or bias is also possible in the gathering and reporting of financial
information. In addition, the management may have fraudulently manipulated the
data in hopes of achieving some objective.
Outside parties are aware that the financial information produced by a company
and its management may not always be reliable. Hence, to add credibility to this
reporting process, independent experts are retained to audit the financial
statements and test the underlying accounting records. These auditors then
issue an opinion for the benefit of outside parties as to the fair presentation of the
financial statements in conformity with generally accepted accounting principles.
This added degree of assuredness allows decision-makers to rely on reported
financial information.
(2)
A CPA firm could not be expected to maintain expertise in every potential industry
that it might audit. In reviewing a potential client, the firm should evaluate its
ability to gain the necessary industry expertise prior to the actual audit, but no
requirement exists that this knowledge must be possessed prior to accepting the
engagement.
Each industry may have its own specific accounting practices. In addition,
certain industries frequently offer unique auditing problems. Thus, without a
thorough investigation, the auditor cannot ascertain the knowledge that will be
needed in examining a potential client. In the consumer electronics business, for
example, the methods of distribution as well as credit policies would be
significantly different from those found in a car dealership. Damaged or obsolete
inventory are other problems that might be more important in this specific
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audit firms must make certain that their services are limited to making
recommendations, not carrying out management decisions. The firm cannot
make decisions for the client.
Sarbanes-Oxley specifically proscribes various activities that have traditionally
been part of the CPAs repertoire. Design of accounting systems is prohibited,
although helping a client with selection and implementation of off-the-shelf
packages would be acceptable. So, in this case, it depends on what the client
means by developing. In the event the Lakeside goes forward with its public
offering Abernathy and Chapman will need to decide whether to remain
independent so they can continue as Lakesides auditor, or sacrifice
independence to do systems consulting. Sarbanes-Oxley prevents trying to do
both.
(5)
In his article "The Initial Audit Engagement Conference" in the Journal of
Accountancy for September 1976, Bernard Valek lists a number of steps that can
be performed in a plant tour to avoid later "surprises" as well as to assist the firm
in estab lishing an appropriate audit fee. The first three are typical of a plant tour.
The others go beyond the typical tour. Students should not be expected to
anticipate each of these procedures but the question can be used to emphasize
the importance of the auditor's complete understanding of the audit client. These
steps include:
*
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Discuss with client the policy for valuing inventory and identifying obsolete
inventory items.
Discuss with client the procedures for obtaining a proper year-end cut-off.
(6)
A company may not want its CPAs to audit a client's records because the
auditors gain a substantial amount of competitive information during an
audit. However, CPAs are bound by confidentiality under the AICPA's
Code of Professional Conduct. Also, a CPA's knowledge of the industry
gained from having several clients in the same industry provides him or
her with insights he/she may not have otherwise had.
SUGGESTED ANSWERS TO EXERCISES
(1)
(a) and (b) The independent auditor must be able to review massive quantities of
information and identify the fraud risk factors that may affect the amount of
evidence to be gathered or the opinion to be rendered. This question calls upon
the judgment abilities of the students. The format used by students for this
memo is not important as long as it is clear and understandable. SAS 99 requires
use a brainstorming session in the planning stage to be sure that everyone
associated with the audit understands the nature of the business and the
potential risk of fraud. These sessions can also occur during the audit if
additional evidence presents itself. Potential problems that students would be
expected to identify are as follows:
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Internal Control - The president of the company admits that the company's
internal control is antiquated. Control problems may be heightened in that
operations extend throughout two states. Since understanding the internal
control is one of the prerequisites for ultimately determining the amount of
substantive testing that will be required, the weakness of the various
controls may require the extensive gathering of evidence, or even
preclude an opinion.
Uncertainty Involved with the Sixth Store - A qualified opinion was issued
by the predecessor auditor in connection with this store. Abernethy and
Chapman must face the question as to whether this issue can be resolved
during 2006.
Distributorship Sales - The case indicates that these sales have risen
dramatically during the past two years. Any sudden change or fluctuation
in an account balance will always warrant the auditor's attention. In this
instance, the auditor will be especially interested in verifying the validity of
these sales figures.
Related Party Transactions - The case indicates that Lakeside has begun
to have financial dealings with the president of the company. Obviously,
nothing is wrong with this arrangement, but such related party transactions
are often difficult for the auditor to verify. In addition, they require clear
disclosure.
Rental Agreements - Five of the stores have been leased and, apparently,
Store Seven will be rented from Rogers. Rental agreements pose the
question as to the need for capitalizing the lease. Abernethy and
Chapman will have to read the various agreements to see if any of them
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(2)
INDEPENDENT AUDITOR'S REPORT
To the Board of Directors:
We have audited the accompanying balance sheet of the Lakeside
Company as of December 31, 2008, and the related statements of income,
retained earnings, and cash flows for the year then ended. These financial
statements are the responsibility of the Company's management.
Our
responsibility is to express an opinion on these financial statements based on our
audit.
We conducted our audit in accordance with auditing standards generally
accepted in the United States of America. Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation.
We believe that our audit provides a
reasonable basis for our opinion.
During 2007, the company made a $186,000 investment in a retail store
located in the eastern sector of Richmond, Virginia. This store has failed to reach
a break-even sales point to date and total recovery of the Company's investment
is highly uncertain. In our opinion, the chances are reasonably possible that the
asset's value has been permanently impaired and should be reduced to the net
realizable value in conformity with generally accepted accounting principles.
In our opinion, except for the effects of not recording or disclosing the
impairment of value of the asset, as discussed in the preceding paragraph, the
aforementioned financial statements present fairly, in all material respects, the
financial position of the Lakeside Company at December 31, 2008, and the
results of its operations and its cash flows for the year then ended in conformity
with accounting principles generally accepted in the United States of America.
King and Company (signed), Certified Public Accountants
Date: (last day of audit fieldwork)
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CASE 2
SUGGESTED ANSWERS TO DISCUSSION QUESTIONS
(1)
The question of materiality is certainly one of the most complex issues in all of
auditing. No clear-cut guidelines have ever been established to aid the auditor in
deciding whether a specific balance or transaction is "material." This lack of an
official standard provides the auditor with the freedom to base all final decisions
on professional judgment. Unfortunately, without a formal rule, the auditor has
little guidance in applying judgment to a particular situation.
Materiality has traditionally been held to be any factor that would influence the
decisions of those parties relying on the financial statements. Identifying a
proper basis of comparison is an important aspect in determining whether an
uncertainty is material. Net income is the most obvious standard of comparison,
although another consideration is which of the statements is affected (e.g.,
Balance Sheet, Income Statement, or both?). The situation questioned by King
and Company involves an investment in fixed assets. Comparing the potential
loss to total assets, investment in stores, and owners' equity would seem a
reasonable basis for judging materiality. Another possible basis is the effect of
the asset write-off on net income.
In the Lakeside case, each auditor would have to decide independently as to
whether Store Six represents a material contingency for this client. The potential
closing of Store Six is certainly an unusual occurrence and for that reason should
be evaluated against the client's $500,000 net worth and the $1.8 million in total
assets reported in the case. In making these comparisons, the auditor needs to
anticipate the potential loss. Although the total loss could amount to $186,000,
Rogers has suggested $136,000 as a maximum figure. Unfortunately, estimates
provided by the president of the client company are circumstantial evidence,
having little power to persuade.
In the view of the authors, this potential loss (of over $100,000) for a company
with a net worth of only $500,000 would certainly appear to be material. Other
comparisons based on total assets or income would give similar results.
(2)
The CPA firm must talk with the predecessor auditor before accepting the
engagement. The new auditors can learn about the integrity of the potential
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the firm is required to reach an understanding of the audit function with the firm
and the engagement letter is used to document this understanding.
(7)
The providing of adequate service to a client would always require that the CPA
firm suggest a review rather than an audit whenever it might meet the company's
intended objectives. The client must understand, though, that a review is
substantially less than an audit. Procedures are limited primarily to inquiries of
the client's management along with analytical procedures applied to the financial
statements. The report then states that the firm was not aware of any material
modifications to the financial statements that require adjustment to be in
conformity with generally accepted accounting principles (a limited or "negative"
assurance).
In a review, control risk is not assessed, tests of controls are not made, and
adequate substantive testing procedures are not performed on which to base an
opinion as to the fair presentation of the financial statements. Because these
procedures are omitted, a review is less expensive than an audit. However, the
banks and stockholders must be willing to accept the lesser degree of assurance
being provided by the independent auditor. The client should be made aware of
this option but also the potential problems of not having a complete examination.
Of course, if Lakeside pursues the public offering a review will not be adequate.
(8)
Many students may want to reject this engagement based on the internal control
problems, the impairment of value issue, and Rogers' arguments with the
predecessor auditors, but such situations are not uncommon occurrences in
auditing. Public accounting is not a risk-free profession; no perfect audit client
ever exists. Thus, a firm must be able to assess the problems involved and
weigh them against potential rewards. Abernethy and Chapman has an
opportunity here to pick up a new client in a new industry. In addition, Lakeside
has demonstrated the possibility of significant growth in the future. However, the
auditing firm needs to seek some resolution for the uncertainty before becoming
involved. Since that problem is already obvious, an understanding should be
reached with Lakeside prior to beginning the engagement. If this issue can be
successfully resolved, the auditor should seek this new client.
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Privately held
2.
The basic liability to the client is for losses occurring as a result of any firm
negligence. If Abernethy and Chapman performs the engagement as an
average, prudent auditor would, no problem exists. If not, the client may
sue for return of its audit fee as well as any other resulting losses. A
special problem area exists in the Lakeside case: the client's weak
internal control. Such weaknesses increase the likelihood of fraud or
embezzlement. The control problems also make discovery of such
defalcations more difficult. In addition, proving that the firm is innocent of
negligence is often difficult to do if the client loses money through
defalcations not discovered by the auditor.
3.
4.
5.
As a privately held business, this audit does not fall under federal security
laws. Thus, the auditor is bound by common law and is judged under such
precedents as the Ultramares case, the CIT Financial Corp. case, and the Rusch
Factors case. In the Lakeside audit, the CPA firm should have no liability to third
parties unless the audit is performed in a grossly negligent manner or the firm is
negligently responsible for careless financial misrepresentations. In a few
jurisdictions, they may be held liable to foreseen or foreseeable beneficiaries for
ordinary negligence.
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2.
3.
Predecessor auditor stated that the firm was discharged over the wording
of the previous audit opinion.
4.
5.
6.
(2)
The auditor will perform a number of steps in reviewing the audit documents of
the predecessor auditor. The major objective is to examine the types of
information that would be available to an auditor in an ongoing engagement.
Through this review, the auditor can gain satisfaction as to the validity of
beginning account balances as well as accounting principles applied in the
previous audits. By relying on the work of the predecessor auditor, the extensive
review necessary in an initial audit can be held to a minimum.
The audit working paper review should include the following steps:
*
Review internal control evaluations for obvious weak areas and for
strengths.
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(3)
This answer assumes that King and Company, the predecessor auditor, has no
reason to believe that their previous report is not still appropriate. Furthermore,
that firm has reviewed the current financial statements and obtained a
representation letter from Abernethy and Chapman, the successor auditor,
stating that the current year's audit has not revealed anything that would have a
material effect on the prior year's audit.
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CASE 3
SUGGESTED ANSWERS TO DISCUSSION QUESTIONS
(1)
Although this question can be answered by a simple reading of Exhibit 3-1, it
does force the student to consider the contractual obligations being assumed by
both parties. One portion of this letter that might warrant discussion is the CPA
firm's declaration that absolute assurance is not being given in regard to major
misstatements. The students can be queried as to the reasons for including this
statement. In addition, the students can be asked to discuss the method by
which the client company can draw the distinction between reasonable
assurance and absolute assurance. As a different line of questioning, the
students can discuss other responsibilities that could have been accepted by
either party.
The engagement letter is required. Responsibilities of the CPA firm found in the
engagement letter:
*
(2)
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Past figures. If cost of goods sold has always been a certain percentage
of Lakeside's sales, that same relationship would be expected to continue
unless other factors have changed. Had Lakeside, for example, switched
from cheaper products to more expensive ones, the relationship between
cost of goods sold and sales would possibly be affected. Or, if Lakeside
has dropped the Cypress line in order to sell the products of some other
manufacturer, a similar change might have been anticipated. However,
without an adjustment of this type, cost of goods sold as a percentage of
sales would be expected to remain stable.
Industry averages.
By studying trade publications, Abernethy and
Chapman can determine an industry average for cost of goods sold as a
percentage of sales. Although Lakeside's results could not be expected to
be exactly the same as this average, the auditors should not anticipate a
significant variation to occur without some adequate explanation.
Competitors.
If available, the financial statements of competing
companies can be used to determine the normal relationship of cost of
goods sold to sales. Although no two companies are ever alike, important
comparisons such as this one should be made between similar
companies.
Budgeted figures. If Lakeside has an annual budget, the numbers
estimated by the company at the beginning of the period can be used by
the auditor in establishing an expected cost of goods sold.
(3)
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Hence, estimating
Lakeside has a large amount of debt. The auditor has to ensure that all
debt is being properly reported and disclosed. The interest expense
associated with these liabilities must also be correctly calculated and
recognized. In addition, the auditors need to verify that all loan covenants
are being met.
(4)
The auditor must be satisfied that sufficient, competent evidence has been
obtained to substantiate an opinion concerning the fair presentation of the client's
financial statements. The decision as to the sufficiency of this evidence is left
solely to the judgment of the auditor. Only through years of experience can the
auditor develop the ability to make this determination. Although specific
guidelines for this decision are not available, all significant problems must be
resolved and all suspicious occurrences should be investigated. Evidence needs
to be accumulated for each significant area of the financial statements to
substantiate the assertions made by the client about its reported balances.
Where inherent risk and control risk are judged to be high, the auditor must take
steps to reduce detection risk to an acceptable level. In such cases, several
steps are possible: performing additional substantive testing, using more
experienced staff personnel, performing testing procedures closer to the balance
sheet date, or relying on more effective testing procedures.
Another factor that influences the auditor's decision is the quality of evidence
being accumulated. Some information may come directly to the auditors from
outside parties, data that is usually considered to be of a higher quality than
evidence prepared by the client company. Less evidence is required if it is
judged by the auditor to be of a high quality.
Although each of these factors is considered, the ultimate decision still must rest
with the auditor's judgment. This individual is taking responsibility for the audit
opinion as well as accepting the risks involved in circulating this report. Thus, the
auditor must be satisfied that, based upon the wisdom gained through years of
audit experience, sufficient evidence has been obtained.
(5)
Any discussion as to the "quality" of evidence being gathered by analytical
procedures must be based on the objective of the testing. Analytical procedures
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performed in the planning stage are not primarily designed for the purpose of
indicating the fair presentation of financial information. Instead, they are used in
the assessment of risk, to alert the auditor to potential problem areas that may
require additional substantive testing. In that respect, analytical procedures
serve a vital audit purpose. Students should always be reminded, though, that
this testing is only one component of the overall substantive testing being
performed by the independent auditor. Furthermore, analytical procedures
provide circumstantial evidence which, taken alone, is not a high quality type of
evidence.
(6)
Knowledge of the consumer electronics business is just one aspect of Cline's
expertise that will allow him to evaluate the fair presentation of Lakeside's
financial statements. Overall knowledge of the client company and the industry in
which it operates should also allow the auditor to
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Airlines
Finance Companies
Investment Companies
Providers of Health Care Services
(7)
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A number of the current concerns faced by auditing firms as well as the auditing
profession as a whole relate either directly or indirectly to increased price
competition. Through class discussion of this particular question, students should
be able to ascertain at least three of these problems:
*
Because the initial year of an audit will often require signifi cantly more time
than examinations of subsequent years, price competi tion can lead a firm
to actually lose money in the first year of an engagement. Therefore, the
CPA firm must work to keep a client for several years to offset this initial
loss and produce a reasonable profit. The necessity of retaining an
engagement for a number of years may force the firm to be subservient to
management's demands to avoid being fired. This argument has lost much
of its impact over the last few years as client companies have established
audit committees comprised of outside members of the board of directors
to ensure the independence of the auditing firm.
Many auditors also feel that price competition is generally detrimental to the
public accounting profession. The main thrust of this argument is that price
competition encourages companies to select their independent auditors
based primarily on cost rather than on the quality of audit work. This type
of selection process would favor firms offering cheap rates over auditing
firms offering quality services.
After the students have been allowed to discuss the problems associated with
price competition, the instructor may want to ask whether these problems
outweigh the advantages of having the auditing profession participate in the free
market system. Since most business students in the United States appear to
advocate free markets within the country, some interesting discussion can be
stimulated as to whether the auditing profession should be exempt from price
competition.
(8)
According to the audit risk model, planned detection risk (PDR) equals
acceptable audit risk (AAR) divided by the product of inherent risk (IR) and
control risk (CR). Holding inherent risk and acceptable audit risk constant, there
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is an inverse relationship between control risk and planned detection risk. Thus,
an increase (decrease) in control risk leads to a decrease (increase) in planned
detection risk. Also, as planned detection risk decreases (increases), the amount
of substantive tests and other audit procedures increases (decreases). That is, if
the auditor determines the level of detection risk to be low, he or she wants the
chance of not detecting an error too small. In order to have a small chance of not
detecting an error, the auditor must do more testing. For example, given
AAR=10% and IR=80%, and assuming an 80% CR (high), then using the audit
risk model, planned detection risk is a relatively low 15.6% [.10/(.80x.80)], but
assuming a 20% CR (low), then planned detection risk is a relatively high 62.5%
[.10/(.80x.20)].
(9)
According to SAS 99 the assessment of the risk of fraud begins with a meeting of
the entire team for such purpose. This brainstorming session needs to
encourage the involvement of all team members and cannot be just a staff
training session. The objective is to solicit the ideas from all team members and
to sensitize the entire team to the particular problem areas that this client
presents. The process begins with such a session, but does not end there.
During the audit the entire team needs to consider how the information being
developed relates to the areas already identified, noting new areas that need
attention, or adjusting expectations on the areas already identified. The areas
identified by fraud risk are primarily in the areas of inherent risk and control risk.
Increased fraud risk represents an increase in inherent risk (the risk that errors
exist) or will also increase the control risk (the risk that the clients internal control
system will not detect the error or irregularity).
(10)
The registration process is not difficult. Maintaining the status of a registered CPA
firm is more difficult and requires that the firm be willing to adjust its operations
including independence and staffing quality control standards to meet the higher
expectations of the PCAOB. They may also be required to change the nature of
their practice, at least as far as publicly traded clients because of the list of
proscribed activities. Abernathy and Chapman have sufficient time to become
registered and therefore need only be concerned about accepting Lakeside as a
client if there is some obstacle to their registration. If Lakeside asks if they are
currently registered, then the answer has to be, no, but we are pursing
registration.
SUGGESTED ANSWERS TO EXERCISE
(1)
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Ratio
Current
# Days inventory on
hand
Receivable collection
period (days)
2007
1.35
93
2008
1.36
101
21
25
Debt-to-total-assets
74.4%
74.5%
Times
earned
3.6 times
2.8 times
Profit Margin
Return on Assets
2.79%
8.47%
2.27%
6.73%
Return on Equity
33.2%
26.4%
interest
Significance
No significant change
Increase may indicate obsolete or
slow moving inventory on hand
Slight increase may indicate
relaxing of credit policies and/or
possible
understatement
of
allowance
No significant change; however, the
high ratio indicates significant
leverage and potential solvency
problems if additional debt is
needed
Decline indicates reduced ability to
meet interest payments through
operations
No significant change
Declining return results from a
combination of declining net
income and increasing total asset
base.
Decline in return results from a
combination of declining net
income and increasing equity base.
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Ratio
Current
Industry Ave.
1.73
Lakeside 2008
1.36
65
101
Receivables
collection period
11
25
Debt-to-total-assets
13%
74.5%
Times
earned
30 times
2.8 times
Profit Margin
2.93%
2.27%
Return on Assets
6.09%
6.73%
Return on Equity
13.27%
26.4%
Days
hand
inventory
on
interest
Significance
Lakeside is below the industry
average. This may indicate shortterm solvency (liquidity) problems.
Lakeside is well above the industry
average. This may indicate shortterm solvency problems.
Lakeside is well above the industry
average. This may indicate shortterm solvency problems.
Lakeside is significantly above the
industry average; this may indicate
long-term solvency problems.
Lakeside is significantly below the
industry average; this may indicate
solvency problems.
Lakeside is only slightly below the
industry average.
Lakeside is only slightly above the
industry average.
Lakeside is significantly above the
industry average.
Conclusion: Lakeside is well below the liquidity level of the industry, and the
company is in a significantly worse solvency level than the industry. Auditors
should be aware of methods to enhance the liquidity and solvency levels, such
as unrecorded liabilities. Lakeside profitability is about the same as the industry
average, except for return on equity, in which it is more than double that of the
industry (primarily due to the high level of leverage).
c.
Procedure
Scan the income statement
[Note: instructors may want to
suggest that students prepare
a common size income
statement]
Scan the balance sheet
[Note: instructors may want to
suggest that students prepare
a common size balance sheet]
Scan the cash flow statement
Results
The
company's
stores
continue to report an overall
loss which is increasing in
amount.
Something
Significance
These losses suggest the
possibility that the stores will
eventually be discontinued by
Lakeside or drastically altered
in some manner.
Nothing unusual
appears
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to
be
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CASE 4
SUGGESTED ANSWERS TO DISCUSSION QUESTIONS
(1)
Statement on Auditing Standards 78, "Consideration of Internal Control in a
Financial Statement Audit: An Amendment to SAS No. 55," identifies the five
elements of internal control as the Control Environment, Risk Assessment,
Control Activities, Information and Communication, and Monitoring. Cline's
questions appear to be designed to determine the degree of information that has
been established to date about each of these elements. Question (3) asks about
the information that the auditors could have looked at within the Lakeside
Company in order to respond adequately to these queries. Auditors must be able
to gather sufficient data in the early stages of an audit to assess the various risks
involved in the examination.
In studying the control environment of a company, SAS 78 recommends that a
number of factors should be assessed including those listed below. For several
of these factors, the types of information that the Abernethy and Chapman
auditors might use to make their evaluation is also discussed. A quick look at the
control environment will probably lead the auditors to the decision that Lakeside
has not established the environment needed for adequate internal control.
Integrity and ethical values. The auditors should inquire as to policy
statements and a code of ethics. They should also be aware of any actions
by Lakeside's management to remove or reduce incentives and temptations
that might prompt its employees to engage in dishonest, illegal, or unethical
acts.
2. Commitment to competence. Lakeside should have a training program to
ensure that its employees have the knowledge and skills necessary to
accomplish tasks. The auditors should inquire as to any such programs.
3. Board of directors or audit committee participation. Abernethy and Chapman
will need to determine the oversight role (if any) played by the board of
directors. By looking at the minutes of the meetings, the auditors should be
able to determine whether the board is actually serving in a control capacity.
The case mentions that the board of directors had to approve of the hiring of
new independent auditors. Thus, a separate audit committee probably does
not exist. In addition, Rogers' assurance that the board would approve this
request would seem to imply that the board does not provide significant
control over the management of the company.
1.
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Risk assessment is the second component of internal control. The auditors will
determine and evaluate how Lakeside identifies, analyzes, and manages risks
relevant to the preparation of the financial statements. The auditors will want to
pay particular attention to several changes occurring at Lakeside and how the
management deals with these changes. These changes include the expansion
of the company's stores, the concentration on the Cypress product line, and the
relatively new bonus system.
Next, the auditors will look at the actual control activities in place to see that
specific control objectives are being met. Within this testing, the auditors should
look at the following as goals of the company's internal control:
8.
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1
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1
After a preliminary assessment of control risk, the auditors have three possible
actions:
a) Because of potential strengths found within internal control, the auditor
may feel that control risk can be assessed at below the maximum level.
If so, the auditors must then be able to identify specific control
procedures that will likely prevent or detect material misstatements.
The auditors must perform tests of these controls to evaluate their
effectiveness to determine if a reduction in the assessment of control
risk is justified.
b) Because of weaknesses found within internal control, the control risk
may have to be assessed at the maximum level. This evaluation will
probably force the auditor to reduce detection risk by such means as
performing additional substantive testing, using more experienced staff
personnel, carrying out procedures closer to the balance sheet data, or
relying on more effective testing procedures.
c) Although potential strengths may be identified within internal control,
the auditors may still opt to assess control risk at the maximum level.
This decision would be made if additional substantive tests appear to
be easier and cheaper to make than performing the necessary tests of
specific control policies and procedures.
Sarbanes Oxley requires expanded internal control auditing because the
Management Assessment of Internal Control needs to be separately audited by a
registered CPA firm, regardless of its effect on the audit of the financial
statements.
(4)
The auditor will normally begin verifying control policies and procedures by
making inquiries of the employees as to the performance of their duties. The
answers provided indicate to the auditor whether each individual understands the
duties that have been assigned as well as their purpose. A proper knowledge of
a job usually means that employees are more likely to comply with the system
and fulfill their responsibilities. In addition, the auditor is often able to observe
the work of these individuals during the audit fieldwork.
From these
observations, an evaluation can also be made as to the quality of the work being
performed.
Although inquiry and observation are important steps in testing control
procedures, the auditor needs to obtain more substantial evidence. A welldevised system of controls should require each employee to leave physical proof
whenever a task has been completed: a tickmark must be used, the person must
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sign a form, a code number must be entered, etc. Thus, the auditor should be
able to trace this physical evidence through an entire system noting whether the
policies and procedures are operating efficiently. For important measures that
might reduce the assessment of control risk, the auditor may want to verify
effectiveness by examining a large number of documents.
Frequently, an
auditor evaluates control procedures within an entire system through a "test of
transactions." Transactions are traced through an accounting system to make
certain that the recording has been made properly and that each control
procedure is functioning as intended.
(5)
This new information provides an increased risk on the motivation/incentive for
fraud to occur, in terms of the fraud triangle. It does not mean that fraud has
occurred and does not affect the opportunity or rationalization necessary for
fraud to occur. The auditor faced with this information should document the
discussion, and make sure the audit team is aware of the conversation. It is not
the job of the staff auditor to initiate an investigation at this early point in the
audit.
SUGGESTED ANSWERS TO EXERCISES
(1)
a)
The following page presents a flowchart for the revenue recognition system.
Numerous acceptable variations of this flowchart may be created. This problem
is not intended to suggest a rigid format for the flowchart but rather to give the
student experience in constructing and reading one. When evaluating a
student's work, several questions should be asked:
6.
7.
8.
One technique that might be used with this assignment is to divide the class into
teams of three or four students each. Then select a flowchart at random from
each team and ask the team members to critique it. This process, which can be
done inside or outside of class, will compel the students to view the flowchart as
an instrument intended to communicate the design of a system.
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1
(1)
b)
Revenue and Cash Receipts Cycle
Distributorship Cash Receipts
Checks arrive from customers along with the copy of the invoice slip. The
checks are received by the Treasurer's Office where each check is immediately
stamped "For Deposit Only." The checks are listed on a bank deposit slip and on
a four-part cash remittance list. This listing includes the customer, the amount
paid, and the invoice number.
The checks and the bank deposit slips are taken by the Treasurer's Office to the
bank. The second copy of the bank deposit slip is validated and returned to the
Treasurer's Office where it is placed in a permanent file by date along with the
fourth copy of the cash remittance list. The bank returns the first copy of the
validated bank deposit slip directly to the Assistant to the President where it is
placed in a temporary file by date.
The invoice slips and the first three copies of the cash remittance list are sent by
the Treasurer's Office to the Sales Division. The second copy of the sales
invoice and the fourth copy of the bill of lading had originally been filed by that
department when the goods were shipped. Each invoice slip is matched with the
corres ponding sales invoice and bill of lading. The appropriate discount is
calculated and recorded on each copy of the cash remittance list. Each invoice
slip is then attached to the appropriate sales invoice and bill of lading and placed
in a permanent file by invoice number. The third copy of the cash remittance list
is placed in a permanent file by date.
The second copy of the cash remittance list is sent to the Controller's Office
where the cash receipts and the sales discounts are refooted. From this
information, a daily journal entry is made in the cash receipts journal.
Subsequently, the second copy of the cash remittance list is filed permanently by
date.
The sales division sends the first copy of the cash remittance list to the Assistant
to the President. He compares the bank deposit slip that he has received from
the bank against the total of the cash remittance list for that same date with a
spot check of individual items. The list of collections is then used to update the
Accounts Receivable Subsidiary Ledger before being placed in a temporary file
by date. Upon receipt of the monthly bank statement, the cash remittance lists
and the validated bank deposits are removed and used to prepare the monthly
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bank reconciliation. The reconcilia tion, the bank statement, the validated
deposit slips, and the cash remittance lists are then placed in a permanent file by
date.
(2)
The student is asked to complete Exhibit 4-5, a preliminary analysis of the control
procedures in the cash receipts system.
Documents Found in This System:
9. Invoice
10.
Validated Bank Deposit Slips (two copies per day) - prepared internally
but validated by outside bank and mailed directly to the Assistant to the
President.
11.
12.
13.
14.
15.
Prenumbering of forms - Exhibits 4-3 and 4-4 indicate that the sales invoices
(including the sales invoice slip) and the bills of lading are prenumbered.
None of the other documents shown in this system would normally be prenumbered.
1.
Authority for completing each document - Exhibit 4-4 indicates that all
documents within this system are clearly assigned to a specific department.
1.
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Procedures for completing each document and for reviewing each document all instructions on the worksheet appear to be reasonably complete, although
any set of written instructions could be put into more detail. One problem
does exist: none of the instructions give guidance when discrepancies are
found. For example, according to the flowchart, a major problem exists in the
sales division at point B. According to the explanation, no instructions exist
when the collection is less than the amount of the invoice. Rather than
rebilling the additional amount, the invoice information is placed in a
permanent file. Although this rebilling process may be handled through the
Assistant to the President or some other party, this procedure is not indicated
by the flowchart.
1.
1.
1.
1.
1.
spot checks made of cash remittance list totals to bank statement deposits
are made to counter potential "lapping" activities.
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1.
Other control weaknesses that might be noted by the students - invoice slips
and related documents are permanently filed by invoice number in the sales
division rather than by customer name without any apparent crossreferencing. In case of a later dispute, locating the invoice might be difficult.
(3)
As a small organization, the controls that might actually be implemented are
limited to those procedures that would be cost effective. Listed below are several
possible improvements that could be considered:
16.
17.
18.
Use a sales order form that is different from the sales invoice. The two
documents serve different purposes and are most useful if designed to
meet those specific needs.
19.
20.
21.
22.
(1)
The board of directors needs to be organized so that it can fulfill its purpose. The
primary improvement is to increase its independence and operation. The
President of the Corporation should need be the Chairman of the Board of
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CASE 5
SUGGESTED ANSWERS TO DISCUSSION QUESTIONS
(1)
SAS 31, "Evidential Matter," states that: "The measure of the validity of
[evidential matter] for audit purposes lies in the judgment of the auditor...." (par. .
02) Thus, the quality of oral evidence is an evaluation made by the auditor that
would be influenced by a number of factors: the perception of management's
integrity, the rank of the individual providing the information, the ability to
corroborate the evidence by other sources, and the purpose for which evidence
is being gathered. However, in all cases, statements made by the employees of
a client are only circumstantial evidence. In a comparison with other forms of
evidence (such as observing physical existence and receiving confirmations
directly from third parties), it provides less assurance.
In this case, Mitchell is attempting to gather additional evidence concerning
Lakeside's systems, especially the design and operating efficiency of control
procedures and policies. Oral evidence serves an important role in such testing
but still has to be complemented by other testing: a review of completed internal
documents, flowcharts, organizational charts, job descriptions, systems manuals,
etc.
Conversely, oral information provides less evidence in the substantive testing of
account balances. Whereas company employees should be able to furnish
relevant information as to the functioning of control pro cedures within the various
accounting systems, the auditor must rely almost exclusively on other types of
testing to determine the fair presentation of the client's financial statements.
(2)
Accounts receivable generate a constant flow of cash into a company, offering a
temptation to any employee who might be inclined to steal. Over the years,
ingenious individuals have devised a multitude of plans for diverting this
monetary inflow to themselves. Some of the more common schemes include the
following:
23.
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old account is collected, one that can be removed from the books without
arousing suspicion.
24.
Lapping can occur. One or more accounts receivable are collected by the
company but the money is stolen by an employee. However, since the
collection is not recorded, another invoice will eventually be sent to these
customers who would then alert the company to the earlier payment. To
prevent the processing of this second bill, subsequent cash collections from
other customers are applied to the balances of the original customers. This
series of events can be repeated indefinitely. Money is stolen on a daily or
weekly basis to cover each previous theft.
25.
(3)
A company's net income can always be inflated by creating fictitious credit sales.
For example, an invoice is prepared for a fake customer with the amount being
recorded as an increase in both accounts receivable and sales. In the Lakeside
audit, the client company wants to grow. Bank loans or new equity investments
may be needed for this purpose. Increased income would make this type of
financing easier (and, perhaps, cheaper) to negotiate. False sales might also be
created for a different reason: the regional sales representatives are paid a
commission based on sales. Thus, to inflate their own income, they might
attempt to falsify sales records.
Students may also suggest that fictitious sales will inflate the profits of the
individual stores and, thus, increase the bonuses paid to the manager and
assistant manager. However, this case indicates (as does the balance sheet in
Case 3) that all credit sales are made by the distributorship side of the business.
The stores do not sell on credit so that fictitious sales cannot be created through
the recording of extra accounts receivable.
(4)
In talking with client personnel, an auditor must be constantly alert for any
indication of potential problems. "Red flags" are often encountered in these
discussions that need to be investigated to ensure that material misstatements
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27.
28.
29.
30.
31.
32.
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33.
34.
35.
36.
37.
38.
also been encountered in the preceding year. The possibility exists that bad
accounts or false accounts are now included within the receivable balance.
Miller indicates that the company might have previously been holding
accounts rather than writing them off as bad on a timely basis. The auditor
must be concerned that this practice is still being followed. Companies will
often attempt to manipulate net income by varying the point at which
accounts are determined to be bad.
No justification seems to exist for using .7% of net sales as the estimation
of bad accounts. The auditor cannot corroborate a number that appears to
have been selected at random. A new attempt must be made to derive an
estimation that is a reasonable representation of the company's
uncollectible accounts.
The company waits until an account is 15 days old before a second invoice
is mailed. This delay is, perhaps, one of the reasons that the age of the
accounts has increased. Many customers may be waiting for the pressure
of the second bill before making payment.
Miller writes off accounts as uncollectible with no apparent company
control. Since bad accounts may indicate errors or irregularities, they
should always be reviewed and approved by some independent party
within the organization.
Miller produces and mails the final invoice for overdue accounts. Since
Miller has a great many responsibilities in this system, this last billing
should be made by some other individual. Therefore, if the account has
been paid (and stolen or incorrectly recorded), the information comes back
to this independent person.
Prices and extensions of invoices are sometimes checked after the invoice
has been mailed to the customers. This system is obviously inefficient.
Payments may be made incorrectly, and customers can become
aggravated by later adjustments being made.
(5)
First, because of weaknesses found during the preliminary evaluation of the
internal control, control risk may be assessed at the maximum level. Since
maximum control risk is being assumed, the auditor has no reason to test the
operating efficiency of the control procedures.
Second, although potential strengths may be identified by the preliminary
evaluation of internal control, the auditors may still opt to assess control risk at
the maximum level. This decision would be justified if additional substantive tests
appear to be easier and cheaper to perform than the testing of the operating
efficiency of specific control policies and procedures. Thus, once again, the
testing of the control procedures becomes unnecessary.
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of these cases. Negative confirmations are not as costly and are most often used
when less evidence is required.
(8)
The selection of a specific account for confirmation is an indi cation that the
auditor desires additional evidence or assurance about that particular balance. A
number of situations exist that would suggest the need for confirmation of a
specific account:
a)
b)
c)
The account is far overdue, indicating a possible bad debt to be written off
or that payment has not been properly recorded;
d)
The activity within the account has been unusual. For example, later
invoices were paid while earlier charges were ignored.
(9)
The debit entries made to Lakeside's Accounts Receivable control account
produce an audit trail made up of the following documents or records:
39.
Sales Journal - indicates the original journal entry recorded for each sales
transaction. An auditor matches the debits in the general ledger account to
these journal entries to ascertain that no posting errors have been made.
40.
41.
Bill of Lading - records the quantity and description of the items being
shipped. The auditor compares it with the sales invoice to make certain that
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the items ordered and billed are in agreement with the items that were
shipped.
42.
43.
Inventory Price List - used to price sales invoices. An auditor can use this
listing to verify correct pricing of the sales invoices.
44.
Although the following documents are not part of the audit trail leading to the
recording of the Accounts Receivable debits, they are certainly relevant to any
testing made in connection with the fair presentation of those debits:
Invoice Slips, Cash Remittance Lists, Validated Bank Deposit Slips - some
or all of these documents can be used by the auditor to verify the actual
amount of cash received. The question of collectibility is best answered by
actual collection of the receivable. Thus, the auditor will compare the debit
entries in the receivable account to the subsequent cash collections.
This question also asks about the reliability of the evidence gathered from this
audit trail. Lakeside's audit trail is composed entirely of internally generated
documents. For example, even the original customer order is taken by telephone
and recorded by Lakeside employees. Thus, the reliability of the documents that
comprise this trail such as bills of lading or sales invoices would be closely tied to
the auditor's evaluation of internal control. If controls are perceived as strong,
the reliability of these documents is much higher than if controls are weak.
Because the audit trail is composed solely of Lakeside documents, the student
should be aware that testing this trail provides the auditor with only a portion of
the necessary evidence. Collection of the accounts receivable, for example, and
auditor confirmations would also provide evidence as to the fair presentation of
the accounts receivable.
(10)
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Miller is uncertain how the 0.7% figure was determined. He says that the
previous auditors determined this figure several years ago, and that the company
has always used this figure. Obviously, this is not a reasonable method for
estimating bad debts. The figure should be evaluated by Lakeside's management
at least annually for its reasonableness. This evaluation should include a review
of the history of uncollectible accounts, the current credit policy, and the current
aging of accounts receivable.
(11)
Mitchell probably should not recommend that Accounts Receivable be confirmed
as of an interim date (November). The internal control for the revenues and
cash receipts cycle appear to be poor and cannot be relied upon to provide
reliable financial information for the month of December; thus, Accounts
Receivable should be confirmed at yearend.
(12)
Consistent with our answer in #11 above, Miller has not designed an effective
system. It is not unusual for a company to grow and what worked before can no
longer be relied on to handle the increased volume. Miller seems to exhibit a lax
attitude in several of his answers and therefore, since he is responsible for the
system, we must conclude that he has not made good decisions.
Comments - Credit files contain only the sales representative's credit reports and
do not appear to be reviewed periodically.
Significance - As indicated above, the credit granting policy is informal and based
almost solely on Rogers' judgment. Thus, the efficiency of the system is
unknown, and review of the system by the auditor is quite difficult.
Suggestions - As a part of the design of a comprehensive credit system,
Lakeside should determine the desired contents of a credit file including items
such as outside credit reports, financial statements, correspondence, etc.
Periodically, these files need to be reviewed by an independent Lakeside
employee to verify that all information is complete and up-to-date. Each
customer's file is also reevaluated at regular time intervals to judge whether
credit should continue to be offered.
QUESTION (11)
Comments - Verification of goods and prices is made by Lakeside employees.
Miller implies that his checking of prices and extensions is not made on a timely
basis. In addition, this verification is another responsibility pertaining to accounts
receivable concentrated in Miller's hands.
Significance - Verifying extensions and prices after the invoice has been sent to
the customer is not a logical approach. Also, having Miller perform this task adds
nothing to the efficiency of the organization.
Suggestion - All verifications should be made prior to mailing the invoice, ideally
by a different employee.
QUESTION (12)
The answers to Question (11), above, appear to pertain equally as well to this
question.
QUESTION (13)
Comments - Cash discounts are verified by the sales division.
Significance - System appears adequate. Financial information should be fairly
presented.
Suggestions - None
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QUESTION (14)
Comments - Using prenumbered sales invoices and bills of lading along with the
periodic verification of all numbers is essential in assuring that all sales are
recorded. In an earlier case, the use of prenumbered forms is mentioned. Miller
suggests that the presence of all forms is tested periodically, but the auditor
should specifically ask about that procedure.
Significance - If the possibility exists that the company can make sales without
recording them, the auditor's ability to gain assurance as to completeness
assertion may be severely hampered.
Suggestions - Since the documents are already prenumbered, the auditor needs
to make certain that Lakeside has a policy for periodically verifying the presence
of all forms.
(2)
STEP (1-a)
Anticipated Results - The total listed on the sales invoice should agree with the
total on the sales invoice slip. In addition, evidence should be present to indicate
that a Lakeside employee has already made this same comparison.
Potential Problem - If the invoices do not agree, the possibility is raised that
fictitious or misstated sales are being recorded. Lack of tangible evidence (e.g.,
initials) that the matching procedure has been carried out would indicate that the
employees are not complying with the requirements of the system.
STEP (1-b)
Anticipated Results - The quantity and description of the items sold should be the
same as the items shipped. Again, Lakeside employees are supposed to have
previously made this comparison and left their initials or other proof of the
execution of this test.
Potential Problem - Differences warn the auditor that sales have been both billed
and recorded incorrectly, or incorrect amounts or types of inventory have been
shipped. Once again, a lack of compliance by Lakeside's employees may be
shown if this comparison has not been made.
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STEP (1-c)
Anticipated Results - Cash received as per the remittance list should be
consistent with the invoice and the invoice slip.
Customers should be
encouraged to include the amount of payment on the invoice slip as a further
control procedure. Because of the discount, the auditor may want to perform this
step in con nection with the discount computation in Step 1-d.
Potential Problem - The cash may have been stolen, or someone in the company
may be engaged in lapping.
STEP (1-d)
Anticipated Results - Calculated cash discounts should be identical with the
amounts recorded by the client company. In most cases, this calculated discount
figure will be equal to the difference between the sales invoice total and the cash
remittance.
Potential Problem - Discounts may be incorrectly recorded to hide cash
shortages or as a step in stealing cash funds from the company. Also, the
company may be allowing customers to take discounts that have not actually
been earned. Allowing these reductions would indicate lack of efficiency in
internal control.
STEP (1-e)
Anticipated Results - All prices on the invoices should agree with the prices being
shown on the approved price list.
Potential Problems - Wrong amounts may be paid by customers. Improper
pricing, either intentionally or unintentionally, also leads to incorrect sales and
receivables figures on the financial statements. If the invoice price is too high,
sales and income are overstated; if too low, the figures will be understated, and
company employees may be receiving kickbacks from customers.
STEP (1-f)
Anticipated Results - The extensions and footings on the invoice should be
correct.
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STEP (2-b):
Anticipated Results - Each credit should agree with the cash remittance list as to
amount and possibly date of payment depending upon the method of posting.
Potential Problems - This tracing could denote errors in postings within the
system. Errors could indicate lapping by company employees.
STEP (2-c)
Anticipated Results - Each credit to a specific account should agree with the
listing of individual items on the bank deposit slips.
Potential Problems - Again, lapping or attempts by employees to cover cash
shortages may be uncovered through this test.
STEP (3)
Anticipated Results - For each of the customers, complete and updated credit
reports should be on file.
Potential Problems - The use of credit reports is an essential step in establishing
an appropriate credit-granting system. The presence of these reports would
indicate that the control procedure is operating efficiently. If the reports are
missing or incom plete, the auditor may want to seek additional evidence as to
the validity and collectibility of the receivables.
STEP (4)
Anticipated Results - Each list should be arithmetically correct. Its total ought to
agree in amount and date with the balance entered in the cash receipts journal.
Potential Problems - Cash shortages and cash thefts are often covered by
incorrectly footing a listing of cash transactions.
SUGGESTED ANSWERS TO SARBANES-OXLEY QUESTION
(1)
This question is similar to the SOX question in Case 4. The emphasis is on the
difference between public and privately held companies. The difference involves
the testing of the controls. In the public company setting controls are always
tested because of the separate disclosure by management of their evaluation
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and testing of their system. In both public and privately held companies the
evaluation and possible testing of internal controls by the independent auditors is
related to the financial statement audit. The amount of substantive testing and
the determination of the detection risk is related to the internal control risk.
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CASE 6
SUGGESTED ANSWERS TO DISCUSSSION QUESTIONS
(1)
In the brief description presented of Lakeside's inventory procurement system,
several specific control activities can be seen:
45.
46.
the case implies that the company uses preprinted forms so that adequate
information is captured whenever a document is prepared;
47.
48.
49.
all invoices are matched with the appropriate purchase requisition and
receiving report before payment is approved;
50.
51.
(2)
Canceled checks are the last document in this system, while receiving reports
are one of the first. Whenever auditors select a final document such as a
canceled check and search for its documentation, they are seeking to
substantiate the validity of the balance being reported. All forms and documents
must be present to prove that the amount and the company's reporting were both
correct. Such testing also seeks to discover whether false transactions have
been entered into the system. For example, if a canceled check is found without
a corresponding receiving report or purchase requisition, the possibility exists
that money has been stolen from the company; a payment was made for
merchandise that was not ordered nor received.
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1
Taking a beginning document such as a receiving report and tracing the impact of
the transaction through an entire system is intended to provide evidence of
completeness and that the system and its controls are working as designed.
Obviously, such testing will also provide evidence as to the validity of the account
balance, but this particular procedure is more often associated with the
completeness assertion and internal control evaluation.
(3)
How might Lakeside pay for goods that were received? The company could, as
an example, receive an invoice and not properly match it with the corresponding
receiving report. The receiving report might state that 10 items were actually
acquired while the invoice was for 20 or 100. The individual doing the review
may not notice the discrepancy and erroneously approve the invoice. As another
possibility, this individual might authorize an incorrect invoice in order to receive a
kickback from the vendor.
How might Lakeside fail to pay for goods that were not received? If either the
receiving report or the invoice is lost, the documents will not match and payment
cannot be made. Thus, the company may wait indefinitely for the other (lost)
form before approving the cash disbursement.
(4)
Audit documentation, also called a working paper, is designed to demonstrate
that the auditor has obtained sufficient, competent evidence on which to base an
opinion as to the fair presentation of the client's financial statements. Given that
overall objective, the working paper indicates the testing that was performed and
the evidence that was accumulated. The working paper should also specify any
problems that were encountered and their resolution. The working paper must
demonstrate that this portion of the examination was properly planned and that
all assistants were adequately supervised. In addition, the audit documents as a
whole must indicate that internal control was studied and evaluated. All audit
documents are the property of the auditor and are maintained by the auditor in
order to support the opinion rendered by the auditor.
(5)
A CPA firm must establish policies and procedures for the supervision of work at
all organi zational levels to provide reasonable assurance that the examination
conforms to generally accepted auditing standards. Procedures for supervision
are necessary to ensure that appropriate judgments and conclusions have been
drawn from the work performed. Not every member of an audit team will have
the expertise necessary to evaluate the handling of each accounting and auditing
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problem that arises. Furthermore, some of the audit staff may lack an in-depth
knowledge of the client or the client's industry, thus increasing the possibility of
incorrect judgments. Supervision by auditors having the necessary experience
and expertise provides reasonable assurance that sufficient evidence and proper
conclusions were obtained.
Auditing literature places emphasis on the existence of appropriate supervisory
policies and anticipates that practices will be used by a firm in each audit
engagement to verify proper supervision. One such procedure is to have staff
members leave their initials to indicate the completion of a test or later review.
Thus, the working paper shown in Exhibit 6-1 was originally produced by Art
Heyman (AH) and subsequently reviewed by Carole Mitchell (CM), and Wallace
Andrews (WA). From the location of the initials, this auditing firm must require
acknowledgment at every point of audit judgment to indicate that the supervisors
concur with the actions taken. This policy enables the firm to monitor the degree
of supervision in each area of the audit as well as to ensure that no critical
problem will escape the attention of supervising auditors.
(6)
Because of the great volume of audit documentation accumulated during an
engagement, most firms use an indexing system to organize all materials.
Indexing allows the auditor easier access to the various documents and
expedites the review process. The "N-2" designation on this document is
apparently part of an indexing system, although no indication is given in the case
as to the actual derivation of the symbols. Abernethy and Chapman may be
using a code in which the letter N refers to the inventory account, and this
particular document presents the results of the second testing procedure
performed on that account.
(7)
One of the purposes of audit documentation is to serve as an historical record of
all audit testing performed by the CPA firm. This documentation provides a
guideline for future audits but, more importantly, serves as evidence should the
auditor's work ever come under question. To assure that the audit documents
clearly reflect the procedures that were carried out and the evidence gathered,
many auditing firms require that the objective, the scope, and the conclusions
reached be included in the documentation of each test. Furthermore, by having
to furnish this information, the staff auditor is more likely to understand the
purpose of the procedures being applied.
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(8)
Audit procedures are the steps that are required to test a particular control,
transaction, or account. Some firms write procedures specifically designed for a
particular audit client. Also, some firms have standardized audit procedures for
use on all audits. For quality control standards, standardized procedures are
preferable to ensure that all audits are performed in a like fashion. However,
these standardized procedures should be supplemented with procedures
designed to meet the particular circumstances of each client.
SUGGESTED ANSWERS TO EXERCISES
(1)
Exhibit 6-1 may well be a student's first view of audit documentation. Therefore,
discussion of its clarity and completeness should force the student into a close
examination of the structure and function of the document. Students should be
encouraged to discuss the strengths of this particular working paper as well as its
weaknesses.
The audit procedures seem generally clear, although they do contain some
problems. For example, the fifth procedure states that the auditor "examined
canceled checks for amounts, dates, signatures, endorsements, and payee."
Obviously, the auditor is not just physically examining this information but is
confirming the data against some other document (the invoice).
This
reconciliation is not clearly stated. Also, in the seventh procedure, no indication
is given as to the purpose of verifying the account code.
Exception (A) is poorly written. The staff auditor does not indicate whether the
$200 and the $360 amounts are over or under the current list price. Additionally,
the explanation for the discrepancies is vague. Stating that "the difference
represents monthly purchases from Cypress at different prices than shown in
current price list" indicates nothing about the reason for the change. The major
problem, though, with this explanation (and the actual testing procedure) is that
Thomas' word is accepted as an adequate explanation for the discrepancy. The
auditor provides no information that any further testing has been carried out to
verify these amounts. The assump tion has apparently been made through the
comment "Pass Further Work" that the differences are immaterial and, thus, do
not require additional testing. Since all of the supervisors have added their
initials, concurrence appears to exist with this evaluation. Students may want to
discuss whether these two discrepancies warrant further examination and, if so,
what testing could be performed.
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Exception (B) is also vague and poorly written. Once again, Thomas' explanation
is apparently accepted without further question or testing. The comment does
not indicate the amount of the differences that are involved in this replacement.
Therefore, judging the materiality of the items will be quite difficult for the audit
supervisors.
Exception (C) seems relatively clear. An auditor would prefer to see this policy in
an official Lakeside manual rather than accepting oral evidence, but in a small
company such as Lakeside, that may not be possible. The auditor should adjust
the flowchart and memorandum for this system to include this discovery.
On the whole, other than comments A and B, this working paper appears to be
clear and comprehensive. By reviewing the steps of the audit program listed in
this case, students can see that Heyman has performed the audit procedures
designed by Mitchell.
(2)
Attached is one example of an audit document that could be produced by
carrying out the prescribed auditing procedures. A great amount of variety exists
in format, and students ought to be evaluated on the clarity and understandability
of their approach rather than on the development of a particular structure.
In reviewing this audit document with students, the instructor should be aware
that this question was developed with several educational objectives in mind:
52.
53.
54.
(3)
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Lakeside Company
Tests of Receiving Reports and Cash Disbursements
12/31/09
Audit Procedures
Date
t
t
t
t
t
t
t
t
t
t
t
t
8/20/09
Receiving
Report Number
3918
Invoice
Number
711
Number
3091
Check
8/21/09
3919
802
3121
GC
8/24/09
3920
991
3164
E F
8/27/09
3921
1261
3203
GBD
8/28/09
3922
1313
3251
9/2/09
3923
1406
3310
9/3/09
3924
1510
3345
9/7/09
3925
1616
3397
GB
9/7/09
3926
1691
3425
GC
9/14/09
3927
1812
3451
G E
9/16/09
3928
2072
3471
GC
9/21/09
3929
2149
3510
Audit Objective:
To verify that items received were properly ordered, received, and paid.
Scope:
12. Population: All receiving reports prepared during the period under audit.
13. Sample: Judgmentally selected 12 receiving reports from inventory department file. Pulled
reports sequentially, randomly starting with #3918.
Audit Procedures:
Compared receiving report with purchase invoice for quantity and description. All agreed except
B.
Compared receiving report to purchase requisition for quantity and description. All agreed except
B and C. All requisitions approved by Rogers or Miller.
Invoices reviewed for compliance to see if they were checked, extended, and footed by Lakeside
employees. All were except D.
Compared invoice prices with Cypress Master Price List. All agreed except E.
Inspected canceled checks and compared them to invoice amounts, recomputing 3% discount. All
agreed except E.
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Lakeside Company
Tests of Receiving Reports and Cash Disbursement (cont.)
12/31/09
Comments
A Receiving report not in file. Client should be asked to find it or provide a reason for its absence.
Unless it is accounted for, the scope of testing may need to be expanded. AH
B On two invoices Cypress billed Lakeside for items different from those received. In both cases the bill
was for the items ordered, not those received. R.R. #3923 shows an item that is more expensive
than the one billed, while R.R. #3927 has an item that is less expensive than the one billed. The
purchase requisition for R.R. #2923 indicates Lakeside's acceptance of a replacement but no
indication in connection with R.R. #3927. Lakeside has paid for goods ordered, not goods received.
This reflects a serious problem with both the Lakeside and Cypress systems. AH
C Some receiving reports indicate receiving a different amount of goods than ordered. Requisitions
indicate that goods have been backordered in both cases. Lakeside, however, paid only for goods received.
System is functioning properly. AH
D No indication on this invoice that pricing, footing, or extensions were verified. Other invoices show
initials and tick marks. Failure to comply with the system in this one case. AH
E In a number of cases, invoice prices were less than the Master Price List. There seems to be a
discount on special items, but more evidence is needed. AH
F One invoice was reduced by a 4% discount, instead of 3%. Further inquiry required to determine
reason. AH
G In virtually all cases, checks were issued 2 or 3 days after the 20-day deadline for taking discounts, but
Lakeside took the discount in every case. Further inquiry is required to determine if Lakeside still
has a liability for these amounts. AH
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CASE 7
SUGGESTED ANSWERS TO DISCUSSION QUESTIONS
(1)
A company profit-sharing arrangement is a matter of auditor concern because it
provides an incentive for employees to generate artificially high income figures.
These individuals can receive direct financial benefits from the manipulation of
reported earnings. This potential problem is even more of a concern in the
Lakeside engagement because controls are weak and each store is
geographically isolated from the oversight provided by the administrative offices.
(2)
This case describes the payroll system used by the Lakeside Company. Tests of
controls are designed by the auditor to verify that specific control features
identified as possible strengths are operating effectively. A sample of such tests
would include the following:
a.
b.
c.
d.
e.
f.
g.
h.
1
i.
Verify that each payroll record has been properly authorized by Mark
Hayes;
j.
Compare the payroll transfer made from the general fund each period to
the total payment computed on the payroll record;
k.
Review canceled checks for proper signature, amount, payee, date, and
endorsement;
l.
Review payments made for withholdings and payroll taxes. Compare these
amounts to payroll records kept for each of these items.
(3)
Existence or Occurrence - For payroll expense, the auditor would want to
determine that all employees do, indeed, work for the company. If 48 employees
are paid each period, the auditor needs to ensure that 48 individuals are working
for Lakeside. The auditor should be concerned that one or more employees are
stealing money by receiving more than one check. A review of the payroll
records completed by the employees before they begin work provides some
evidence that the individuals do exist. In addition, the auditor can accompany the
paymaster (or whoever serves in this capacity) when paychecks are distributed.
This procedure allows the auditor to identify the person receiving each check to
ensure that the employee is the same as is listed on the check itself.
Completeness - Completeness is not usually a major problem in the area of
payroll expense where misstatements most often result from having extra
expense recorded (because of theft) rather than from having transactions
omitted. However, the auditor still wants to ascertain that the $1.1 million figure
to be reported contains all applicable payroll expenses. Thus, for example,
verifying that a year-end expense accrual has been made helps to prove that all
expenses were recorded. Furthermore, if payroll taxes and other costs are to be
reported within the payroll expense figure, the auditors should determine that all
such costs (Social Security, unemployment taxes, medical insurance premiums,
etc.) have been properly included in the final balance to be presented.
Rights and Obligations - For payroll expense, the auditor would want to ascertain
that work did occur during the period for which the company does have a legal
obligation to pay. The auditor would review the time tickets to make sure that
they seem proper and then recompute the amounts to be paid based on the
hours worked. These calculations provide evidence that the payments were,
indeed, the actual obligations of the client company.
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f)
j)
Correlation with related information (including ratio and trend analysis) another analytical procedure to identify possible problem areas.
k)
l)
Obtaining a representation letter from the client's senior management management acknowledges responsibility for statements and provides
evidence in areas where other evidence may not be available.
This question also asks about the competence (significance and reliability) of
these procedures. Each test is potentially quite important and produces reliable
evidence but only if used in the appropriate circumstances. For example,
confirmation is one of the most important steps in auditing cash bank balances
but is rarely used in connection with an account such as land. Physical
examination is essential in auditing marketable securities where ownership and
value can often be ascertained visually. This same procedure is much less of a
factor in examining equipment. An audit procedure must match an account and
the type of evidence needed.
(5)
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1
Allows for easier application of control procedures such as limit tests, item
counts, and validity checks;
2.
3.
Allows for additional control over unclaimed checks, uncashed checks, etc.;
4.
Facilitates the audit function in that the payroll balances are easier to verify;
5.
6.
(6)
Some of the more critical potential problems involving payroll include:
A.
2.
3.
4.
5.
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1
B.
C.
6.
7.
8.
9.
Review payroll tax forms for agreement with computed balances and
with payroll register.
last payroll for the year to verify that recording was made in
proper period.
11. Recalculate
period.
The working paper is not properly dated so that a reviewing auditor cannot
be certain that this testing applies to 2009.
8.
The columns are not labeled. No method exists for identifying the
information that has been gathered.
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1
9.
In the first three columns, abbreviations such as "SM," "M-2," and "Salar."
are used without explanation, which makes possible the erroneous usage of
the information.
10.
In the column that starts with $388, the seventh item and two items in the
next column do not have tickmarks, which may indicate that they have not
been tested. No indication is given as to the significance of these three
omissions.
11.
According to the working paper, none of the items in the column that begins
with $39 has undergone any testing. That possibility seems unlikely, since
an exception has been found at point A.
12.
Comment A is vague and does not indicate any reason for the exception nor
does it discuss the significance of the problem. In addition, the note makes
no mention of potential testing that may be required because of the
exception.
13.
Two canceled checks could not be found at point B, but no reason is given
nor is any suggestion included for further testing.
14.
One tickmark (a caret) was used for two different tests. The reviewer has
no method of distinguishing the actual procedure performed.
15.
Several of the auditing procedures listed at the bottom (on the left) use
vague terms such as "company records," "government records," and
"calculations" without any specific identification. Thus, determining the
procedures actually performed and the specific documents analyzed would
be virtually impossible.
16.
The working paper does not contain objectives, scope, or conclusion (see
Exhibit 6-1). Therefore, it does not clearly spell out what was done or what
was found. No indication is presented as to the method of selecting the
employee names that have been used.
(2)
a.
It appears that the 2008 bonus expense account is overstated (actual balance =
$6,000 v. estimated balance = $3,940); however, the amount of overstatement
($1,060) does not seem material. The 2009 expense appears to be overstated
by $8,184 (= $19,500 recorded - $11,316 estimated). This overstatement
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Exhibit 7
Lakeside Company
Account 585, Estimated Bonus Expense, for Nine Months ended
September 30, 2008 and 2009
2008 Bonus Plan
Sales
-Sales Returns
-Cost of Sales
-Dir. Sal. Exp.
-Rent
=Bonus Basis
x Bonus %
=Bonus
STORE
STORE
STORE
STORE
STORE
STORE
TOTAL
No.1
No.2
No.3
No.4
No.5
No.6
STORES
$273,000
7,900
162,600
45,200
9,600
48,200
2%
964
$397,800
25,190
239,300
59,200
28,400
45,710
2%
914
$236,100
11,950
138,200
39,300
12,000
34,650
2%
693
$242,300
14,050
137,200
38,600
13,200
39,250
2%
785
$373,000
30,010
229,000
54,800
30,000
29,190
2%
584
$110,800
11,300
68,100
32,300
12,000
(12,900)
2%
0
$1,633,500
100,400
974,400
269,400
105,200
184,100
2%
3,940
STORE
STORE
No.1
Sales
-Sales Returns
-Cost of Sales
-Dir. Sal. Exp.
-Rent
=Bonus Basis
x Bonus %
=Bonus
$319,900
12,200
185,300
51,200
10,500
60,700
4%
2,428
STORE
STORE
STORE
STORE
TOTAL
No.2
No.3
No.4
No.5
No.6
STORES
$398,900
29,900
228,400
59,300
33,000
48,300
4%
1,932
$458,800
49,500
231,100
40,400
13,200
124,700
4%
4,988
$265,400
19,850
152,400
41,200
14,000
37,950
4%
1,518
$364,600
48,250
218,000
55,100
32,000
11,250
4%
450
$121,200
13,700
73,800
32,300
12,200
(10,500)
4%
0
$1,928,800
173,400
1,088,900
279,400
114,700
272,400
4%
11,316
Notes: Lakeside makes an "imputed rent" charge to Store No. 6 for the purpose of determining this bonus. Sales (A/C
500); Sales Returns (Prepared by Client); Cost of Sales (A/C 550); Direct Salary Expense (A/C 580); Rent (Prepared by
Client).
significant deficiencies have been identified both in the management report and
the CPA internal control audit.
Managements report. Management will state its responsibility for maintaining
adequate internal control over financial reporting and give its assessment of
whether or not internal control over financial reporting is effective. According to
the rules, management cannot state that internal control over financial reporting
is effective if even one material weakness exists at year-end.
Auditors report. The independent auditor will evaluate and report on the
fairness of managements assessment. The auditor also will perform an
independent audit of internal control over financial reporting and will issue an
opinion on whether internal control is operating effectively as of the assessment
date (i.e., the companys fiscal year-end). If one or more material weaknesses
exist at the companys fiscal year-end, the auditor cannot conclude that internal
control over financial reporting is effective.
Source: Internal Control over Financial Reporting: An Investor Resource,
December 2004 by: Deloitte & Touche LLP; Ernst & Young LLP; KPMG LLP;
PricewaterhouseCoopers LLP.
Documenting a significant deficiency could appear as in this example:
A material weakness is a control deficiency, or combination of control
deficiencies, that results in more than a remote likelihood that a material
misstatement of the annual or interim financial statements will not be prevented
or detected. The following material weakness has been identified and included in
managements assessment. The company has no effective human resource
function and personnel files are inadequate to assure approval of salaries and
wages. In addition, salaries are not approved by the board of directors. This
material weakness was considered in determining the nature, timing, and extent
of audit tests applied in our audit of the 200X financial statements, and this report
does not affect our report dated [same date as below] on those financial
statements.
Source: Perspectives on Internal Control Reporting A Resource for Financial
Market Participants, December 2004 by: Deloitte & Touche LLP; Ernst & Young
LLP; KPMG LLP; PricewaterhouseCoopers LLP. [Note: Payroll example was not
in the original quoted material].
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CASE 8
SUGGESTED ANSWERS TO DISCUSSION QUESTIONS
(1)
A number of reasons could explain a difference between the physical inventory
count and a company's perpetual inventory records. When faced with any
discrepancy such as this, the auditor should consider all possible causes.
17.
18.
The cost flow assumption (FIFO, in this case) may have been improperly
applied in the perpetual records.
19.
20.
21.
22.
23.
Goods in transit could have been incorrectly handled in either the perpetual
records or the physical inventory.
24.
25.
The specific cost assigned to each inventory item might have been incorrect
in certain cases.
26.
The final inventory listing (Exhibit 8-4) may have been extended or footed
erroneously.
agree with the physical inventory, the auditor is primarily interested in potential
errors contained in the counted figure. If Mitchell has appropriately observed the
taking of the physical count, the possibility of errors in the quantity of inventory
should be at a minimum. Additional testing, such as verifying the costing, the
extensions, and the footings will further reduce the risk of a material error in the
figure to be reported.
The presence of perpetual records adds another dimension to the inventory
verification. By comparing the ending figures from the physical count with the
perpetual records, the auditors can determine whether differences are connected
with the quantity or the unit cost for the individual inventory items. If the $6,000
is primarily created by quantity differences, the auditors should consider the need
for selected recounts. Conversely, if the difference is based on costing
variances, the auditors will con centrate on establishing the validity of those
particular figures.
A question may be raised by the students as to the reasonableness of a $6,000
difference between the physical count and the perpetual inventory records. For a
company having $3.5 million in cost of goods sold and a warehouse with over
$650,000 in inventory, this difference is not significant in size even with the use of
a perpetual system. A more important issue would be the composition of the
difference. If a great number of items are not in agreement with the records and
simply net to a $6,000 variance, the auditors have reason to be concerned.
Conversely, if only a few items display differences, verification is much easier.
(2)
An over-count of inventory leads to a decrease in cost of goods sold and, thus,
an increase in reported net income. In any situation in which the company
desires a high reported income (for example, to maintain high stock prices, in
anticipation of a loan or a bond issuance, to reach the level anticipated by a
financial forecast, etc.), over-counting of inventory must be of concern to the
auditors. This possibility is especially relevant to the Lakeside stores because of
the profit-sharing plan. The inventory is being counted by the manager and
assistant manager of each store, the same people who receive a bonus based
on that store's net income. Therefore, these employees can increase their bonus
for the current year simply by over-counting the inventory.
(3)
An undercount of ending inventory leads to an increase in cost of goods sold and
a decrease in reported net income for the current year. The most obvious reason
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1
Trace the tags recorded by the auditor (Exhibit 8-3) to the physical inventory
listing (Exhibit 8-4), noting agreement as to description and quantity.
b.
Verify that no tags were added to the inventory listing beyond the last tag
recorded by the auditor.
c.
For each of the inventory items recorded by the auditor, compare the unit
cost indicated on the inventory listing with the cost per the master price list
(Exhibit 6-6). Note agreement as to description as well as unit cost. (Note:
Students may choose to select a new sample for this and the remaining
tests. The advantages to using the same sample throughout are that
recording on the working paper may be simplified and efficiency gained.)
d.
e.
f.
Using the master price list, compute a cost for the January 1-2, 2010,
receiving reports. Compare this total to the inventory listing for agreement.
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g.
Using the master price list, compute a cost for the January 1-2, 2010, bills
of lading. Compare this total to the inventory listing for agreement.
h.
Review the inventory listing to ascertain that all tag numbers are included
with no duplications.
i.
j.
a.
Agree the "total adjusted cost of inventory - 12/31/09" to the general ledger
at December 31, 2009.
(2)
One technique for approaching this case is to assign Question (1) for one class
period with the working paper to be prepared only after review of the students'
audit programs. This procedure helps to stress the connection between preparing
an audit program, evidence gathering, and developing a working paper. It
demonstrates a continuum from:
27.
28.
14.
In reviewing the audit documents prepared by the students, the instructor should
insist that each specific audit procedure be spelled out along with the results of
that testing. As always, the working paper should be clear and complete, but it
must also indicate the fulfillment of each audit program step.
The attached working paper has been created as an example. It was produced
to correspond with the audit procedures outlined in Exercise (1). In completing
this assignment, procedure (i) has not been performed because the information
was not made available in the case. In addition, the working paper has been
prepared under the assumption that all goods are sold f.o.b. shipping point and
all purchases are acquired f.o.b. destination. These assumptions have been
made to simplify the audit testing, but the students may want to discuss the
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additional procedures that would be required if other f.o.b. points had been
appropriate.
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Lakeside Company
Tests of Inventory Listing--Warehouse
12/31/09
WP # F-3 p. 1
Prepared by: PR
1/12/10
Reviewed by:
Inventory Item
Tag No.
Serial Number
Quantity
Amplifiers
116
BC76-W
22
Component Systems
124
JB45-M
69
Beepers
102
CB21-S
80
Stereo Systems
138
FU87-R
60
Amplifiers
130
KZ54-T
88
Speakers
150
YG28-Y
71
Stereo Systems
127
RA69-M
99
CD Players
142
RW21-X
49
Receivers
113
NB73-X
112
Stereo Systems
126
JH88-A
77
VCRs
104
CZ55-H
46
Speakers
137
BF23-G
84
Head Phones
147
PO88-Q
49
CD Players
132
CD00-N
121
Audit
Procedures
Audit Objectives:
15. To verify that the physical count she observed agrees with the inventory
listing.
16. To verify that the inventory listing provides a fairly presented inventory cost
balance.
Scope: Items that were selected during the inventory observation. See WP F-1 and F-2.
Audit Procedures:
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Other Procedures:
17. Agreed last tag (#152) on inventory listing to WP F-1.
18. Footed inventory listing. No exceptions noted.
19. Accounted for sequence of tag numbers on inventory listing. No exceptions or
duplicates noted.
Audit Conclusion: The inventory listing is fairly stated.
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Lakeside Company
Tests of Inventory Counts--Warehouse
12/31/09
WP # F-3 p. 1
Prepared by: PR
1/12/09
Reviewed by:
Rec.
Rep.
Qty.
Unit Cost
Total Cost
Audit Proc.
Jan. 1, 10 Televisions
JB45-H
3988
20
481.87
9,637.40
Jan. 2, 10 Headphones
KJ32-K
3989
40
32.00
1,280.00
RX04-L
3989
10
285.99
2,859.90
Total
13,777.30
Qty
Unit Cost
Total Cost
Audit
Proc.
Jan. 1, 10
Amplifier
XY76-R
6015
20
219.95
4,399.00
Jan. 1, 10
Televisions
BM09-H
6015
10
812.35
8,123.50
Jan. 2, 10
Stereo Systems
AB15-M
6016
20
256.98
5,139.60
Jan. 2, 10
Stereo Systems
JH88-A
6016
12
324.00
3,888.00
Jan. 2, 10
Receivers
CS33-P
6016
10
698.98
6,989.80
Jan. 2, 10
Televisions
AR65-C
6016
1,319.00
7,914.00
Jan. 2, 10
Speakers
BF23-G
6017
469.00
3,752.00
Total
42,205.90
Audit Objective:
To verify that the reconciling items to the inventory listing are valid and reasonable.
Scope:
All reconciling items to the inventory listing.
Audit Procedures:
20. Agreed quantity and description to WP F-1. No exceptions noted.
21. Agreed to master price list noting agreement as to description and unit cost. No exceptions
noted.
@ Agreed to inventory reconciliation.
Other Procedures:
22. Recomputed discounts on inventory reconciliation without exception.
23. Footed inventory reconciliation without exception.
24. Inventory adjustment of $6,156.78 is immaterial. Pass further work.
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WP # F-1
Prepared by: PR
Date: 1/12/09
Lakeside Company
RECONCILIATION OF
PHYSICAL INVENTORY - WAREHOUSE
January 3, 2010
TOTAL COST OF INVENTORY - JANUARY 3,
2010 - WAREHOUSE
$664,950.33 @
Less: Inventory Received on January 1 and
January 2 (from Receiving Reports)
(13,777.30) F-3 p. 1
Add: Inventory Shipped Out on January 1 and
January 2 (from Bills of Lading)
40,205.90 F-3 p. 1
TOTAL COST OF INVENTORY - DECEMBER 31,
2009 - WAREHOUSE
$691,378.93 F
Less: Adjustments for Monthly Discounts
Given by Cypress
Tag 113 - Discount $30.00 x 85 Items Purchased
( 2,550.00) R
Tag 121 - Discount $ 8.25 x 40 Items Purchased
( 330.00) R
Tag 132 - Discount $12.60 x 60 Items Purchased
( 756.00) R
Tag 146 - Discount $11.50 x 80 Items Purchased
( 920.00) R
Tag 149 - Discount $ 6.50 x 35 Items Purchased
( 227.50) R
SUB-TOTAL
$686,595.43 F
Less: Adjustment for 3% Cash Discount Taken
on All Inventory Purchases
( 20,597.86)
TOTAL ADJUSTED COST OF INVENTORY - DECEMBER 31,
2009 - WAREHOUSE
$665,997.57 F L
INVENTORY IN WAREHOUSE PER PERPETUAL
INVENTORY RECORDS
(672,154.35)
INVENTORY ADJUSTMENT (REDUCTION)
$( 6,156.78) F A -6.1
Audit Objective:
To verify that the inventory balance is valid and reasonable.
Scope:
The listing to the inventory balance reconciliation.
Procedures:
@ Agreed to Inventory Listing
F Footed
R Recalculated
A Agrees to T/B
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CASE 9
SUGGESTED ANSWERS TO DISCUSSION QUESTIONS
(1)
Any company which does not maintain an extensive accounting staff will often
rely on the independent auditors for information concerning the application of
authoritative pronouncements. Most CPA firms assume some responsibility for
keeping client companies aware of important accounting standards and the
potential effects on financial reporting. Thus, Rogers' lack of knowledge about
Statement 34 is not unusual; a bigger surprise might be that the company's
auditors had not previously discussed the requirement with this client.
(2)
Where possible, expense accounting follows the matching principle which states
that expenses should be recognized in the period in which they assist in
generating revenues. An asset produces no revenues prior to being placed into
service. Therefore, any expense recognition (such as depreciation or interest)
would be inappropriate during construction. Only after the asset is in use
generating revenues, should any related expense be recorded.
(3)
Theoretically, the management of the client company prepares all financial
figures which are then corroborated by the independent auditors. However,
Lakeside apparently has no one on its staff with the expertise to make this
particular calculation. In such cases, the auditor is frequently forced to generate
the data, and provide figures which are presented to the client as proposed
adjustments. Lakeside should be warned though that this task is outside the
realm of a normal audit and, if extensive, may require an additional fee.
(4)
This question offers another opportunity for interesting class discussion.
Students often view accounting as a discipline in which all questions can be
ultimately resolved by an adequate knowledge of accounting standards. In this
instance, they face a case of financial statement manipulation that is being
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carried out by the client within the framework of accounting's own official
guidelines. A review of FASB Statement 13 can be assigned to assist the
students in analyzing this case. Paragraph 29 of this pronouncement states:
"Insofar as the separate financial statements of the related parties are
concerned, the classification and accounting shall be the same as for
similar leases between unrelated parties except in cases where it is
clear that the terms of the transaction have been significantly affected
by the fact that the lessee and lessor are related. In such cases the
classification and/or accounting shall be modified as necessary to
recognize economic substance rather than legal form. The nature and
extent of leasing transactions with related parties shall be disclosed."
After reading FASB Statement 13, students may argue that the lease is actually
for a number of years (probably the life of the building) and that the proposed
series of one-year contracts is only a sham to create the appearance of an
operating lease. In reality, the lease (or so this argument would go) is for over
75% of the economic life of the property. However, if new lease payments are to
be negotiated each period (or if Lakeside intends to stay for only a short time in
that location), a legitimate economic reason may exist for this arrangement.
Unless Lakeside can show such a rationale for the one-year leases, the auditor
will probably use the "actual" life of the lease as justification for requiring
capitalization.
The auditors also need to verify that the $21,000 payment for the building has not
been "significantly affected" by the relationship between Lakeside and Rogers.
Abernethy and Chapman will want to learn how this figure was determined and,
perhaps, seek information about rental rates for similar property in the vicinity of
that store. Rogers states that "the price is quite reasonable for that store at that
location," but his opinion does not provide the auditors with much assurance.
Regardless of the accounting, as a related party transaction, the auditors must
ensure that the nature and extent of the lease has been fully disclosed within the
financial statements. Rogers has indicated that such reporting will be made.
Even if the lease were deemed to be an operating lease, the information included
within these notes could be used by readers to come to an understanding of the
nature of this transaction. This case indicates the importance of a complete
knowledge of accounting. A decision-maker need not be limited to working with
just the numbers presented in financial statements but should become capable of
using and understanding all of the information that is provided.
[Note: Another interesting issue is whether or not the Rogers Development
Company is a variable interest entity (VIE) that should be consolidated, as
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defined in FASB Interpretation No. 46. See the "Apply Your Research" section
for this case].
(5)
The recording of accounting information is normally based on objective evidence
gathered by analyzing the impact of transactions that occur between the
reporting entity and outside parties. However, related party transactions do not
provide evidence with the same degree of objectivity. Sales prices or contracts,
for example, might not be negotiated as they would otherwise be with outsiders.
Figures may simply be fixed by management. Consequently, to inform the
financial statement readers of the impact of these dealings, the relationship must
be described along with the details of the transactions.
(6)
The potential impairment of value of Store Six has been an underlying problem
throughout the Lakeside audit. In discussing this issue, students frequently
concentrate on the wrong issues: client retention versus safety from litigation.
Audit opinions, however, should be based on the actual evidence accumulated
and the related reporting employed by the client, not on the avoidance of
problems. Such a limited approach fails to recognize the auditor's function: to
gather corroborative evidence on which to base an opinion as to the fair
presentation of the financial statements. Virtually no corroborative evidence is
presented in these cases in connection with Store Six and its potential
impairment of value; therefore, students have no basis for any specific course of
action. In practice, auditors first gather as much evidence as possible and only
then do they make a final determination when faced with this type problem.
Students can be asked to list the kinds of evidence Abernethy and Chapman
might seek in evaluating the possibility of a material impairment of value in
connection with Store Six. This exercise is a good technique for demonstrating
the necessity of creativity in the auditor's work. The auditor needs to consider all
possible ways to gain assurance about the future of this store. A few of the
evidence-gathering procedures that might be carried out would include:
29.
Discussion with the owners and managers of the shopping center as to their
strategies for renting more space and improving customer traffic.
30.
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specific plans, the auditors will have much more assurance than if Rogers is
simply acting on intuition.
31.
Talk to owners and managers of the stores located in the shopping center to
see whether their projections are similar to those of Rogers.
32.
Search for any studies that have been prepared on the consumer
electronics business which might a) project a break-even point for a store or
b) assess the risks involved in the failure of a single outlet.
33.
Hire a real estate appraiser to estimate the sales value of the building if it
should have to be sold. This valuation will enable the auditor to anticipate
the potential loss being faced by Lakeside.
One final point should be made in connection with this potential impairment of
value. The implication is made throughout these cases that the primary
responsibility for resolving this issue lies with the auditors. That is not correct.
The financial statements are representations of the management of the client
company. As such, management is responsible for justifying the financial
reporting. Unless Rogers makes a significant attempt to prove his present
position in this controversy, the auditors will have trouble rendering an unqualified
opinion.
(7)
Little doubt exists that Rogers has issued a subtle threat to the new audit firm.
One of the primary reasons for investigating the integrity of management prior to
accepting an engagement is to avoid the possibility of this type of blackmail. This
warning was issued in such a way by Rogers that Abernethy and Chapman will
probably not need to consider the possibility of resigning but, if a similar threat is
ever made in an overt manner, immediate resignation by the CPA firm should be
considered.
SUGGESTED ANSWERS TO EXERCISE
(1)
This assignment requires the students to analyze the client's Warehouse
account. In this case, for the first time, no audit program is available. The
students must determine which procedures to perform and then record the
actions taken as well as the evidence accumulated. The instructor may want to
discuss this requirement by simply asking the class what evidence-gathering
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LAKESIDE COMPANY
Building-Warehouse/Office A/C 111-1
W.P. I-3
2
Accountant: AH
Date: 1/14/10
12/31/09
163,500-
21,800
16,90025,300
14,600-
Proposed AdjustmentAJE#1
Proposed AdjustmentAJE#2
Proposed AdjustmentAJE#3
Subtotal (warehouse construction excluding interest)
Proposed Adjustment-interest
AJE#4
Subtotal (warehouse construction including interest)
Proposed reclassificationAJE#5
Adjusted Total
163,500-
25. Audit Objective: To verify the fair presentation of the "Building--Warehouse/Office" account.
26. Scope: All charges and potential charges to the account.
Audit Procedures:
Traced to 12/31/08 audited balance per predecessor auditor's audit documents noting agreement.
(Note: Although necessary, this procedure cannot be performed with the information given in this
text.)
Traced to general ledger noting agreement. Also, traced to purchase invoice noting agreement as
to amount, and approval.
Other Audit Procedures:
27. Examined 9/1/09 minutes of Board of Directors' meeting noting approval for expansion.
28. Examined bank confirmation from Virginia Capital Security Bank indicating lien on warehouse in connection
with $100,000 loan.
Proposed Adjustments: See next page.
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LAKESIDE COMPANY
Building - Warehouse/Office A/C 111-1
W.P. I-3
1
Accountant: AH
Date: 1/14/10
12/31/09
PROPOSED ADJUSTMENTS
A
640-1
111-1
B
111-1
210-2
3500-
C
Invoice for work done 12/28/09-1/8/10 by Gainer Electrical Company received after year-end.
Accrue four days (4/12 x $4,800= $1,600).
AJE 3
111-1 Building-Warehouse/Office
1600210-2
Accounts Payable
1600D
Capitalize interest on building loans. This figure is roughly estimated based on the expenditures
on construction (from "subtotal" on previous page) of $93,800, the interest rate charged on the direct loan,
10%, and the time of construction during 2009 (3 months from October to December, per the invoices in
Exhibit 9-6). Thus, $93,800 x .10 x 3/12 = $2,345.
111-1
220-1
AJE 4
Building-Warehouse/Office
Accrued Interest Payable
New
acct.
111-1
AJE 5
Construction in Progress-Warehouse
23452345-
96145-
Building-Warehouse/Office
96145-
Audit Conclusion: Account is fairly stated, after adjustments, in accordance with GAAP.
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(1)
Quoting from the Act:
Section 301: Public Company Audit Committees.
Each member of the audit committee shall be a member of the board of directors of the
issuer, and shall otherwise be independent. "Independent" is defined as not receiving,
other than for service on the board, any consulting, advisory, or other compensatory fee
from the issuer, and as not being an affiliated person of the issuer, or any subsidiary
thereof.
The SEC may make exemptions for certain individuals on a case-by-case basis. The audit
committee of an issuer shall be directly responsible for the appointment, compensation,
and oversight of the work of any registered public accounting firm employed by that
issuer. The audit committee shall establish procedures for the "receipt, retention, and
treatment of complaints" received by the issuer regarding accounting, internal controls,
and auditing. Each audit committee shall have the authority to engage independent
counsel or other advisors, as it determines necessary to carry out its duties.
Each issuer shall provide appropriate funding to the audit committee.
(2)
Quoting from the act:
Section 302: Corporate Responsibility For Financial Reports.
The CEO and CFO of each issuer shall prepare a statement to accompany the audit report
to certify the "appropriateness of the financial statements and disclosures contained in the
periodic report, and that those financial statements and disclosures fairly present, in all
material respects, the operations and financial condition of the issuer." A violation of this
section must be knowing and intentional to give rise to liability.
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CASE 10
SUGGESTED ANSWERS TO DISCUSSION QUESTIONS
(1)
The sheer quantity of transactions that are processed by most modern
corporations prohibits the auditor from attempting to evaluate more than a portion
of the total. Many large companies record millions of transactions per year, a
number that could not possibly be verified by an audit team at an acceptable
cost. Even if complete testing were possible, nonsampling risk would still exist
because of potentially unrecorded transactions, fraudulent transactions, and
auditor errors and oversights. Just as importantly, independent auditors are
employed to provide reasonable rather than absolute assurance as to the fair
presentation of a company's financial statements. The desired degree of
assurance can be achieved without examining every item.
Thus, some amount of risk is tolerated in the testing procedures being applied.
Statistical sampling allows certain aspects of that risk to be measured
mathematically. Auditors use statistics to determine the number of items that
should be examined to reduce sampling risk to a level that is considered justified.
(2)
Statistical sampling does not create additional work; rather, it guides the auditor
in performing the proper amount of work. In addition, although statistical
sampling may initially appear to be complex, the various procedures become
significantly easier with practice.
In any sampling plan (statistical or judgmental), a degree of uncertainty about the
final results must be accepted. Statistical sampling allows the auditor to set in
advance the amount of risk that is acceptable for a particular test. Mathematical
formulas and charts then enable the auditor to compute the size of the sample
that is necessary to reduce the risk involved to this tolerable level. Computer
programs make these calculations quick and easy. An auditor who appropriately
calculates a sample size of 89, for example, knows that the examination of this
number of items will provide results within predetermined parameters.
Statistical sampling also forces the auditor to consciously consider several
important aspects of the specific testing procedure. In this case, Mitchell has to
analyze the type of work being performed by the client and then set an
acceptable risk of assessing control risk too low (ARACR). She must also
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evaluate the ability of the client personnel and estimate an expected population
exception rate. Finally, she has to arrive at a tolerable exception rate, the highest
rate at which reliance can be justified. All of these considerations are important
in applying this audit procedure. The statistical sampling plan being used by
Abernethy and Chapman requires the auditor to consider each of these limits
before testing can begin.
(3)
Sampling for attributes is utilized whenever an auditor wants to estimate the
occurrence rate of a specified characteristic. This procedure is frequently applied
in tests of controls where the auditor is seeking to measure the prevalence of
errors made by employees in following the control procedures built into a
particular accounting system. Thus, the auditor is attempting to determine a rate the percentage of errors committed. Although sampling for attributes has other
uses within an examination, it does enable the auditor to derive this specific
information being sought in a test of controls.
(4)
Mitchell is seeking to verify that a proper cut-off has been performed by the client
in recording its year-end accounts payable and accrued expenses. In this
process, a number of invoices are to be reviewed to ensure that Luck has
appropriately determined the amount owed by Lakeside on December 31, 2006.
At the same time, the auditor can also ascertain that a purchase requisition has
been prepared for each of these invoices. Mitchell may also elect to examine the
invoices to determine if physical evidence exists to indicate that each document
has been mathematically proven and properly authorized by company personnel.
Thus, several testing procedures can be carried out simultaneously by the audit
team.
(5)
Once again, as in question (1), the auditor is seeking only reasonable, not
absolute, assurance about the fair presentation of the client's financial
statements. Thus, the presence of some errors, especially if they are not
material, does not necessarily nullify the value of the information. In addition, the
auditor rarely relies exclusively on the work of one particular individual in making
an assessment. Luck's analysis will provide evidence about this expense
accrual, but other testing should be carried out before the audit team is satisfied
that the account balances are fairly presented.
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Luck might commit mistakes for a number of reasons, most of which involve
human errors caused by carelessness, fatigue, misunderstanding, etc. She may,
for example, misread an invoice or miscalculate the amounts involved. She
could also omit an invoice entirely or include one a second time by accident. The
possibility also exists that Luck might have purposely misrepresented the yearend accrual as a way of manipulating the income figures to be reported by the
company.
(6)
In most examinations, previous experience with the client and its personnel will
assist the auditor in arriving at an estimation of an actual exception rate.
However, the firm of Abernethy and Chapman has not audited Lakeside in the
past; thus, Mitchell must rely more heavily on other techniques. To begin, she
should ascertain the difficulty of the task being performed. She will also have
had the opportunity to observe Luck's work throughout the engagement and
should hold some opinion as to the reliability of this employee. She may do a
pilot test, choosing a relatively small random sample to see what the sample
exception rate is. Finally, from experience with other clients, the auditor can
usually anticipate an exception rate for a particular task.
(7)
The 6% figure established by Mitchell in this case is a good example of the
importance of an auditor's being able to use judgment developed through
experience. The selection of this rate was undoubtedly influenced by a number
of factors such as the size of Lakeside's accrual, the adequacy of other testing
procedures, Mitchell's evaluation of Luck's ability, the risk involved in accepting
an incorrect accrual, experience with other audit clients, etc. However, after
assessing these and other possible variables, the ultimate decision as to the line
between reliance and non-reliance must always lie with the auditor.
(8)
According to Exhibit 10-2, a sample size of 40 (left column) with 2 errors (top
row) indicates a maximum error rate of 12.8% with a 10% ARACR. Since
Mitchell has specified a tolerable exception rate of only 6%, she cannot accept
the client's work as a fair representation of the amount of the year-end accrual.
The client's total accrual figure may, indeed, still be accurate, but the sample
indicates the possibility of too many errors for the accrual to be judged as
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reliable. The error rate indicates that the risk level is too high for auditor
acceptance without additional testing.
(9)
In most cases, the auditor would now seek to apply other procedures to verify the
reported balance. The client might, for example, be requested to reconstruct the
accrual with the newly derived balance then being tested, again using sampling
for attributes. However, because of the small population size in this case,
Mitchell may simply resort to reviewing all 283 invoices to achieve adequate
assurance about the accrual. After analyzing the entire population, the auditor
can either accept the client's accrual or propose an adjustment.
SUGGESTED ANSWERS TO EXERCISES
(1-a)
ABERNETHY AND CHAPMAN
Sampling for Attributes
Client: The Lakeside Company
Year Ending: December 31, 2009
Audit Area: Accrued Expenses
Date of Testing: February 4, 2010
(1) State the objectives of the audit testing:
To verify the year-end accrual of expenses developed by the client.
(2) Define the attribute or attributes to be estimated:
The exception rate made by the client in determining the year-end
liability owed in connection with invoices received during December
2009, and January 2010.
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CASE 11
SUGGESTED ANSWERS TO DISCUSSION QUESTIONS
(1)
Statistical sampling requires the auditor to establish risk parameters prior to the
start of a testing procedure. Thus, a desired level of assurance (and, conversely,
an acceptable level of risk) is always defined whenever statistical concepts and
mathematical formulas are to be utilized. The auditor is aware in advance of the
possibility of a mistaken conclusion. Such information is especially important if
the audit firm ever has to justify its examination and the opinion rendered.
However, application of statistical sampling does demand a specialized degree of
knowledge. The auditor must have an adequate understanding of statistical
methodology. In addition, developing a statistical sampling plan may require a
significant amount of audit time.
Judgmental sampling is many times easier and quicker to apply and is, thus,
especially appealing in audit areas where exact precision is not required. For the
auditor with sufficient experience, this type of sampling can frequently provide
satisfactory conclusions about much of the client's data. Unfortunately, since no
guidelines exist for key decisions such as acceptable risk levels, required sample
size, or the evaluation of final results, the auditor has no way of measuring the
potential for an incorrect assessment. In any test, not enough items may have
been examined to support a conclusion, or too much testing could occur creating
an inefficient audit. Furthermore, if the auditor must ever demonstrate in a peer
review or court case the basis for a particular decision, objective evidence to
substantiate the judgment is usually not available.
There is no correlation between sample size and choice of statistical versus
judgmental sampling methods.
(2)
As the partner-in-charge of the Lakeside examination, Cline must ensure that
sufficient, competent evidence has been obtained to satisfy himself that the
client's figures are fairly presented. Based on his years of audit experience, if
Cline is uncomfortable with the evidence accumulated to date, he is obligated to
seek additional assurance. No other individual has the responsibility; no one
else can specify the appropriate amount of evidence required in a particular
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situation. Because the decision is a judgment, some auditors might agree with
Mitchell that the testing presented in Exhibit 11-2 is sufficient. However, Cline is
in charge of this audit, and he should never accept a client figure until personally
satisfied of its fair presentation.
(3)
Although based on mathematical concepts, statistical sampling relies heavily on
the auditor's professional judgment. Such judgments can be seen throughout the
sampling plans discussed by the Abernethy and Chapman audit team in Case 11:
34.
35.
36.
37.
38.
39.
40.
41.
The auditors had to decide whether to test the 283 invoices by sampling or
by examining the entire population.
The auditors had to choose between applying sampling for attributes to
evaluate the client's expense accrual or some type of sampling for variables
plan.
The auditors had to establish an acceptable risk of incorrect acceptance.
The auditors had to establish an acceptable risk of incorrect rejection.
The auditors had to set a tolerable misstatement, the amount of error the
firm was willing to accept in the reported balance.
The auditors had to decide which type of sampling for variables plan would
be used; both mean-per-unit and difference estimation were discussed in
this case. Monetary unit sampling and stratified mean-per-unit sampling
are just two of the other techniques used by auditors.
The auditors had to select a point estimation of the population error.
The auditors had to choose a method for randomly selecting the items to be
sampled.
Because of the time pressures present in modern auditing, each auditor needs to
possess a ready knowledge of statistical sampling techniques so that the
efficiency of their use can be increased substantially. Certainly, any procedure is
time-consuming if the auditor's understanding is limited. Through education and
the utilization of devices such as preprinted forms and computers, statistical
sampling plans can be carried out in a minimum of time. However, the auditor
should continue to be alert to situations where judgmental sampling can be
applied. Not every test warrants the use of statistical sampling, and the auditor
needs to be capable of drawing this distinction.
(5)
If the auditor is seeking to measure a rate of occurrence, sampling for attributes
is utilized. Consequently, this type of statistical sampling is often associated with
tests of controls where an error rate is being estimated. If, however, the auditor
is attempting to determine an amount, sampling for variables is appropriate. This
sampling technique is frequently used in substantive testing to evaluate the
reasonableness of a reported balance.
As is shown by Cases 10 and 11, the distinction between sampling for attributes
and sampling for variables is not always as clear-cut as the previous paragraph
implies. In Case 10, sampling for attributes was used to verify Luck's expense
accrual, whereas sampling for variables was utilized in Case 11 for this same
purpose. The auditor must always determine the objective of a specific test and
evaluate which type of testing will achieve that goal in the most efficient manner.
(6)
Given the risk parameters that have been established by the auditor, the actual
total of the differences in the client's population is estimated to lie between an
understatement of $8,960 ($3,760 + $5,200) and an overstatement of $1,440
($3,760 -$5,200). Since the auditor wants assurance that the client figure is
within $8,000 of the real total, the firm cannot accept the $46,311 as fairly
presented. The $8,960 estimation derived from the sample lies outside of the
acceptable boundary. The client total may still be appropriate, but this sample
indicates that too much risk exists to accept the balance without further testing.
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(e)2
42,025
2,401
12,100
24,336
80,862
e
205
49
(110)
156
300
1
1
= 300/30 or 10
(2) - Specify the acceptable level of risk for incorrect acceptance. Identify the
confidence coefficient (Z value) for this percentage.
Include any
considerations that were used in arriving at this parameter:
The risk of incorrect acceptance was set at 10% but no information was
provided in this case to indicate the rationale for this decision. The Z
Value for a 10% risk of incorrect acceptance is 1.28 according to Exhibit
11-1.
(3) - Specify the acceptable level of risk for incorrect rejection. Identify the
confidence coefficient (Z value) for this percentage.
Include any
considerations that were used in arriving at this parameter:
The risk of incorrect rejection was set at 30% but no information was
provided in this case giving the rationale for this decision. The Z value
for a 30% risk of incorrect rejection is 1.04 according to Exhibit 11-1.
(4) - Specify a tolerable misstatement for this population.
considerations that were used in arriving at this parameter:
Include any
Where:
N is the population size
Za is the confidence coefficient for the acceptable risk of incorrect
acceptance
Zr is the confidence coefficient for the acceptable risk incorrect rejection
SD is the estimate of the standard deviation of the difference
TM is the tolerable misstatement of the population
E is the point estimate of the population misstatement
Sample size =
(1)-(B)
ABERNETHY AND CHAPMAN
SAMPLING FOR VARIABLES DIFFERENCE ESTIMATION
Client: The Lakeside Company
Form Completed By: Carole Mitchell
Audit Area: Accrued Expenses
Date of Testing: 2/4/10
Year Ending: 12/31/09
(1) - State the objectives of the audit testing:
To determine the reasonableness of the client's year-end cut-off to
arrive at accrued expenses.
(2) - Define the population:
All differences between the year-end accrual (as determined by the
client) and the audited balance. Accruals were computed using all
invoices received by the client in December 2009 and January 2010.
(3) - Define the sampling unit:
The difference between each year-end accrual determined by the client
and the proper balance as calculated by the independent auditors.
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(4) - Specify the acceptable level of risk for incorrect acceptance and identify the
confidence coefficient (Z value) for this percentage:
Risk of incorrect acceptance is 10% with a confidence
coefficient of 1.28.
(5) - Specify the acceptable level of risk for incorrect rejection and identify the
confidence coefficient (Z value) for this percentage:
Risk of incorrect acceptance is 30% with a confidence
coefficient of 1.04.
(6) - Specify a tolerable misstatement for this population:
$8,000
(7) - Specify a point estimate of the population error:
$2,830
(8) - Calculate appropriate sample size (all computations should be attached):
50 (given in the problem)
(9) - Indicate the method used to draw a random sample:
Random number generator using computer
(10) - Recompute the standard deviation using the entire sample selected:
Estimated Standard Deviation =
Where:
e is the value of each unit sampled
is the average of each unit sampled
n is the number of units sampled
All 50 items sampled in Exhibit 11-2 and 11-3 show 43 differences with
a zero balance and seven with either positive or negative balances.
(e)2
e
1
1
205
49
(110)
156
(97)
(150)
47
100
42,025
2,401
12,100
24,336
9,409
22,500
2,209
114,980
= 100/50 or 2
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(13) - Identify the upper and lower confidence limits of the population based on
the precision interval and the average difference of the sample:
Actual population of difference is estimated to be between an
understatement of $2,804 ($566 + $2,238) and an overstatement of
$1,672 ($566 - $2,238).
(14) - Conclusions/Recommendations:
No portion of the computed range of total errors falls outside of the $8,000
tolerable error limit. The client's accrual should be accepted as a fair
representation of the year-end liability.
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CASE 12
SUGGESTED ANSWERS TO DISCUSSION QUESTIONS
(1)
The examination of a bank cut-off statement is a common audit procedure that
serves to generate several types of corroborative evidence. In reviewing this
document, the auditor is seeking to verify the client's reported balance for cash
and related accounts. In addition, the auditor must always be aware of the
possibility of theft in connection with cash held by the client. Thus, the auditor is
especially attentive to any information from the cut-off statement (such as a
check that did not clear the bank in a reasonable time) suggesting the existence
of a defalcation problem.
Audit procedures that could be performed using the information obtained in a
bank cut-off statement would include:
*
Review of the checks clearing the bank during the first few days of the new
year. Clearance of these checks serves as evidence of the validity of the
"outstanding checks" total included in the client's year-end bank
reconciliation. Any check which is not returned by this time may have been
falsified to cover a cash shortage.
Review of the specific date on which each returned check cleared the bank.
This procedure serves as a means of ascertaining the appropriateness of
the year-end cut-off made of cash disbursements.
Identification of all inter-bank transfers made near the end of the year so
that they can be scheduled in assessing the possibility of check kiting.
Review of all deposits clearing the bank during this cut-off period as proof of
the "deposits-in-transit" figure on the year-end reconciliation.
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(2)
Many thefts and other illegal acts are perpetrated through the use of bank
accounts that supposedly have been closed. For example, a dishonest
employee can utilize such an account to cash checks made out in the name of
the company. The check is first deposited in this account followed by a
subsequent withdrawal by the employee. In a different vein, the company itself
could use a "closed" account to hide illegal payments or other transactions from
the auditors. To gain evidence of the possibility of such actions, a confirmation
should be used to obtain final information about any bank account that has been
closed by the client during the current year.
(3)
a.
b.
Fire Damage - Although the fire occurred subsequent to the fiscal year,
Statement on Auditing Standards 1 specifies that some events happening
after the end of the period "may be of such a nature that disclosure of them
is required to keep the financial statements from being misleading." SAS 1
goes on to list a number of examples, including inventory destroyed by fire.
Thus, Lakeside's 2007 fire loss will probably require disclosure in the 2006
financial statements.
Students may raise a question as to the materiality of the estimated loss
especially since it did not occur during 2009 and only disclosure is at issue.
Certainly, if the loss is not judged to be material, disclosure will not be
required. Frequently, though, unless the amount is extremely small, the
auditors will propose reporting a loss simply to avoid any later recrimination,
an example of data being included for protection rather than for information.
However, if Lakeside objects to the inclusion, the auditor once again faces
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the materiality issue that has been discussed at several points within these
cases. Now that the students are familiar with the information involved in
this audit, the question may be asked of them as to whether the nondisclosure of this 2010 loss would require a qualification by the auditors in
2009.
c.
(4)
For many companies, a number of transactions occur within two or three days of
the end of the fiscal year. In seeking evidence of the fair presentation of the
financial information, the auditor needs to ensure that the impact of these
transactions is recorded in the proper time period. Cut-off testing is designed to
accomplish this goal. Reporting problems are especially likely if the client's
accounting system is not able to adequately classify the sheer volume of
transactions that can occur at year's end. In addition, the auditor must be aware
that company management can manipulate reported net income by having the
cut-off made either a few days before or a few days after the end of the period.
Cut-off testing is especially important in connection with inventory and sales.
First, the daily quantity of transactions involving these accounts is usually quite
large. Second, if shipment of merchandise is required (either for goods being
bought or sold), the auditor must ascertain the point at which title legally transfers
as well as the physical location of inventory at the end of the year.
(5)
Determining the fair presentation of the liability accounts is a concern to the
auditor because of the possibility that obligations may have gone unrecorded by
the client company. At least two reasons exist for this potential problem:
*
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asked to indicate any disagreements with this client data. The inquiry letter also
seeks a confirmation that the client (not the auditor) will be advised of any other
unasserted claims that should be disclosed.
Finally, the letter requests the law firm to identify the nature and reason for any
limitations in the response to these inquiries.
(8)
The discovery and assessment of pending and threatened litigation has long
been an area of contention between the auditing and legal professions.
Traditionally, the independent auditor has looked to the client's attorney for
information to help evaluate these contingent losses. The legal profession has
often protested such inquiries for a number of reasons. One objection is that any
communication between the attorney and the auditor may be construed as a
breach of the confidentiality that exists between the attorney and the client.
Having broken the confidential nature of the relationship, attorneys risk not being
able to avail themselves of this privilege in the future. In addition, the question
has been raised as to whether the attorney could incur any liability if the
assessments provided to the auditor proved to be incorrect. Finally, attorneys
are cognizant of the effect upon client retention if they should reveal information
to the auditor which the client did not want disclosed.
Auditors search for all possible contingent losses which would then be evaluated
by the client. The client would describe these contingencies in a letter to the
company's legal counsel. The losses were to be split between "pending or
threatened litigation" and "unasserted claims and assessments." In response to
the first category, the attorney was to inform the auditor of any omissions or any
disagreements with the client's evaluations.
For unasserted claims and
assessments, the attorney was asked to inform the auditor only of disagreements
with the evaluations. If unasserted claims were omitted, the attorney would
advise the client of the necessity of making appropriate disclosure. If the client
then refused to report this information, the attorney was instructed to consider
withdrawal by resignation.
(9)
Related party transactions will always concern independent auditors because of
the difficulty in distinguishing the economic substance of the transaction from its
legal form. To obtain evidence that all related party transactions have been
disclosed, auditors send out inquiry letters to all related parties. The letter
questions the existence and extent of the dealings with the reporting entity, the
nature of the transactions, and the relationship between the parties. Once the
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identity and terms of these transactions have been established, the auditor has to
use other means to verify their validity. Statement on Auditing Standards 45
suggests that the auditor may want to follow such steps as examining contracts,
verifying approval by the board of directors, evaluating any collateral, and
confirming information with intermediaries such as banks, attorneys, or agents to
determine the true economic substance of each transaction. (A complete listing
of "related parties" can be found in the glossary to FASB Statement No. 57,
Related Party Disclosures.)
(10) and (11)
In order to arrive at an estimation of the product warranty expense for 2006, the
auditors must certainly look at the past history of the company as mentioned in
this case. A schedule can be determined from the information given of the
expense incurred during the previous months. However, the auditors cannot be
satisfied with that evidence alone. Abernethy and Chapman should look for
factors that would cause the future repairs of the company to differ from the past.
For example, in scheduling the past repairs, the auditors need to watch for any
trends that are evident. Repair costs (such as labor or parts) might have begun
to climb recently or the incidence of product failure could be falling. Such trends
affect the calculation of the client's present liability.
The auditors should also look for other changes that are occurring that might
have an impact on this estimation. Some products, as an example, might be
more likely to break. If so, the auditors should determine if sales of those items
were growing or decreasing. A call to Cypress Products could provide valuable
data as to the repair rate for various items. This company, most likely, will
monitor closely the need for repairs. In addition, publications such as Consumer
Reports often provide statistics on the likelihood that products will fail. For
example, radios may break more often than stereo systems and, thus, require a
different percentage for estimation purposes.
Changes at Cypress Products can also impact on the product warranty. If
Cypress has recently begun to stress quality in its production, repairs may be
reduced; whereas, if quality control is not emphasized, Lakeside's repairs can
potentially skyrocket. Abernethy and Chapman may want to talk with the
management of the local shops that do Lakeside's repairs to see if they have
noted changes in the quality of the items produced by Cypress. These
individuals can also provide the auditors with information on any changes in
repair costs that have occurred recently.
Finally, the auditors will want to review the repair costs incurred during the
approximately seven weeks following the end of the fiscal year. If repair costs
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jump during the subsequent period, Abernethy and Chapman may need to raise
their estimation. However, if costs are being held at a minimum, the accrual
should be decreased.
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LAKESIDE COMPANY
Estimated Accrued Product Warranty Expense
December 31, 2009
AH
Date: 2/2/10
Audit Objective:
To estimate the accrued product warranty expense as of Dec. 31, 2009.
Audit Procedures:
29. Agreed Sales per Month to the general ledger. No exceptions noted.
30. Agreed Repairs per Month to the general ledger. No exceptions noted.
Comments:
A
Historical data for the months from January 2008 to June 2009 (18 months) are being used to develop
an estimate of monthly repairs expense. This estimate will be applied to the last six months sales of 2009
to determine the year end accrual. During the 18-month test period, repair expenses showed a gradual
increase from .72% to .90% of sales. Because of this upward trend, it is recommended that Lakeside use .
95% of sales for estimating repair expenses for the last six months of 2009.
B
Sales during the last six months of 2009 are still under warranty. These sales total $3,601,500 for an
estimated repair expense of $34,214 based on .95% (see A above). During the last six months of 2009,
$13,424 in repairs were made in connection with these sales. As of December 31, 2009, an estimated
liability of $20,790 (=$34,214-$13,424) remains. Lakeside's accrual of $45,465 should be adjusted
($45,465 recorded balance - 20,790 desired balance =$24,675 overstatement).
AJE #13- Proposed Adjustment
220-1
680-1
2467524675-
Audit Conclusion:
Accrued product warranty expense is fairly stated, after adjustment, in accordance with GAAP.
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LAKESIDE COMPANY
W.P. No. M-4
Estimated Accrued Product Warranty Expense
2
12/31/09
Accountant:
AH
Date: 2/2/10
A: Sales not under warranty
Historical Data
1/08
Sales for month
582000
Repairs:
Month of Sales
193
1 month after
533
2 months after
837
3 months after
875
4 months after
343
5 months after
571
6 months after
457
Total repair expense 3809
Repair expense as a .72%
percentage of sales
2/08
316000
3/08
359000
4/08
479000
5/08
486000
6/08
414000
7/08
371000
8/08
460000
9/08
442000
10
53
137
388
319
662
320
205
251
2282
.72%
177
329
481
658
456
228
202
2531
.71%
222
369
480
591
702
812
517
3693
.77%
147
514
625
441
1029
698
220
3674
.76%
61
276
429
797
735
490
272
3060
.74%
256
313
569
541
512
456
199
2846
.77%
284
497
462
639
604
675
391
3552
.77%
210
559
629
664
594
699
140
3495
.79%
29
58
66
91
62
50
58
41
.78
B:
Sales still under warranty
Historical Data Cont.
Sales for month
Repairs:
Month of Sales
1 month after
2 months after
3 months after
4 months after
5 months after
6 months after
Total repair expense
Repair expense as a
percentage of sales
1/09
610500
2/09
381000
3/09
346000
4/09
557000
5/09
590000
6/09
409000
7/09
422000
8/09
550000
9/09
511000
10
60
323
969
861
915
1028
808
485
5884
.88%
336
366
397
580
549
519
305
3052
.80%
234
351
410
527
292
468
644
2926
.85%
335
670
766
1054
718
575
670
4788
.86%
421
736
684
947
1894
999
579
5260
.89%
368
442
516
664
627
553
516
3686
.90%
599
337
375
749
824
524
251
752
1203
852
602
277
738
830
876
22
76
93
3408
3660
2721
19
13,424
returns to date for products still with warranty.
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(2)
This question has been included to emphasize the audit report as the end
product of the auditor's work. As this text has been an exploration of the attest
function rather than a full-scale audit, determination of an appropriate opinion for
2009 is not feasible. Presented below are two possible conclusions for this case.
The first is based on an unqualified opinion on the 2009 statements because
Abernethy and Chapman either believes the potential impairment of value on
Store Six is not material, or that its likelihood is only remote. The second
possible conclusion is that disclosure is needed in connection with the problems
encountered with Store Six, and that Rogers is unwilling to make this disclosure.
In both cases, the assumption is made that King and Company, the predecessor
auditor, continues to believe that a qualified opinion is still appropriate for the
2008 statements. Since comparative statements are being published, Abernethy
and Chapman also have to provide information about this previous opinion.
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UNQUALIFIED OPINION
INDEPENDENT AUDITOR'S REPORT
We have audited the accompanying balance sheet of the Lakeside
Company as of December 31, 2009, and the related statements of income,
retained earnings, and cash flows for the year then ended. These financial
statements are the responsibility of the Company's management.
Our
responsibility is to express an opinion on these financial statements based on our
audit. The financial statements of Lakeside Company as of December 31, 2008
were audited by other auditors whose report dated March 15, 2009, on those
statements included a qualified opinion due to inadequate disclosure of a
potential impairment of value for one of Lakeside's stores.
We conducted our audit in accordance with auditing standards
generally accepted in the United States of America. Those standards require
that we plan and perform the audit to obtain reasonable assurance about
whether the financial statements are free of material misstatement. An audit
includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements. An audit also includes assessing the
accounting principles used and significant estimates made by management, as
well as evaluating the overall financial statement presentation. We believe that
our audit provides a reasonable basis for our opinion.
In our opinion, the 2009 financial statements referred to above present
fairly, in all material respects, the financial position of the Lakeside Company as
of December 31, 2009, and the results of its operations and its cash flows for the
year then ended, in conformity with accounting principles generally accepted in
the United States of America.
Abernethy and Chapman
Certified Public Accountants
Richmond, Virginia
February 15, 2010
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QUALIFIED OPINION
INDEPENDENT AUDITOR'S REPORT
We have audited the accompanying balance sheet of the Lakeside
Company as of December 31, 2009, and the related statements of income,
retained earnings, and cash flows for the year then ended. These financial
statements are the responsibility of the Company's management.
Our
responsibility is to express an opinion on these financial statements based on our
audit. The financial statements of Lakeside Company as of December 31, 2008,
were audited by other auditors whose report dated March 15, 2009, on those
statements included a qualified opinion due to inadequate disclosure of a
potential impairment of value for one of Lakeside's stores.
We conducted our audit in accordance with auditing standards
generally accepted in the United States of America.. Those standards require
that we plan and perform the audit to obtain reasonable assurance about
whether the financial statements are free of material misstatement. An audit
includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements. An audit also includes assessing the
accounting principles used and significant estimates made by management, as
well as evaluating the overall financial statement presentation. We believe that
our audit provides a reasonable basis for our opinion.
During 2007, the company made a $186,000 investment in a retail store
located in the eastern sector of Richmond, Virginia. This store has failed to reach
a break-even sales point to date, and total recovery of the Company's investment
is highly uncertain. In our opinion, the chances are reasonably possible that the
asset's value has been permanently impaired and should be reduced to the net
realizable value in conformity with generally accepted accounting principles.
In our opinion, except for the effects of not recording or disclosing the
impairment of value of the asset, as discussed in the preceding paragraph, the
aforementioned financial statements present fairly, in all material respects, the
financial position of the Lakeside Company at December 31, 2009, and the
results of its operations and its cash flows for the year then ended in conformity
with accounting principles generally accepted in the United States of America.
Abernethy and Chapman
Certified Public Accountants
Richmond, Virginia
February 15, 2010
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CASE 13
SUGGESTED ANSWERS TO DISCUSSION QUESTIONS
(1)
The authoritative auditing literature describes a material internal control
weakness as a condition where a company's systems fail to reduce to a relatively
low level the risk that a material error or irregularity will both occur and avoid
being detected within a timely period by employees in the normal course of
performing their assigned duties. If any such weakness does exist, the company
is exposed to the danger that an error or irregularity will occur, go undetected,
and then directly affect reported financial figures.
The auditor's role is to accumulate sufficient, competent evidence on which to
form an opinion as to the fair presentation of the client's financial statements.
However, during this investigation, one or more material control weaknesses may
be discovered. A description of these problems should be immediately
communicated to the client. In this way, management has the opportunity to
reduce the possibility that subsequent errors and irregularities will go undetected.
This report can also protect the auditor from legal responsibility if losses are
incurred by the client at a future point in time because of the weakness.
Consequently, if Abernethy and Chapman discovers a material weakness in
Lakeside's internal control, this information must be conveyed to the client as
soon as possible so that corrective actions can be taken. The description is to be
communicated either orally or in writing and should go to the senior management
of the company as well as the board of directors (or its audit committee).
(2)
Many individuals in business are skilled in one particular industry: audio
equipment, car dealerships, fashion design, etc. Others are trained in one
general aspect of business such as marketing, personnel, shipping, etc.
Although these people may be extremely efficient and productive, they are not
necessarily knowledgeable about computers and computer applications. In the
past, they may have focused their attention on a particular function and limited
their thinking to the methods that have historically proven successful. Any time
that a new approach is put forth, especially one with the complexity of modern
technology, human nature seems to resist the change. Rogers has built a large
company without a large computer component; he may be skeptical about
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of a new accounting information system. Listed below are a few examples of the
types of suggestions that students may provide:
-
Payroll
The names and pay rates for all employees are programmed into the
computer. At the end of each pay period, the number of hours worked by
every hourly employee is also entered along with sales figures for individuals
being paid on commission. The computer automatically calculates the gross
pay for each employee. The amount to be paid to salaried workers is based
on individual contract rates while the salary for each hourly and commission
worker is determined from the information entered for the period. Federal
and state income tax withholding figures are also computed as well as Social
Security payments and any other payroll deductions. A net wage for each
individual is then derived with the computer printing out the actual
paychecks.
Credit File
Information is accumulated about all of the customers to whom credit sales
are made. A review board is established by Lakeside to approve or reject the
continuation of credit to these customers as well as the extension of credit to
new customers. An approved customer list is then entered into the computer
and updated as needed. Whenever a sales order is received by the
company and processed, the computer scans this file to ensure that credit
should be given. The computer also reviews the amount and age of any
balances already owed by this same customer. If an excessive amount is
presently outstanding or if a balance is past due, credit approval can be
rescinded even if the customer is listed in this file.
Perpetual Inventory
All inventory balances are monitored by a computer program. At the time
merchandise is transferred to a customer, the identity of the specific items is
entered into the computer along with the quantity, perhaps using point-of-sale
technology. The computer is programmed to reduce the appropriate account
balances and automatically warns of any merchandise that is at an
unacceptably low level. Whenever goods are delivered to Lakeside, a
description of the newly acquired inventory is similarly entered. Again, the
computer updates the information stored in the perpetual records for each of
these particular items, thus providing ongoing data about the inventory on
hand.
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Testing of all programs should be performed before the client relies on them.
For a time, as an example, the company may want to run parallel processing
where all functions are carried out both manually as well as through the new
information system to ensure that the output is accurate. In addition,
Lakeside should process test (or erroneous) data using the various computer
systems to further verify the reliability of the output.
Where possible, validity checks could be installed within the various systems
so that data must be verified independently before being processed. A
customer name, as an example, has to be on an approved customer list
before a sale is authorized and merchandise shipped. Likewise, an
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