Auditing Theory Answer Key 1

CHAPTER 1
PROFESSIONAL PRACTICE OF ACCOUNTANCY
Questions
1. Generally, to be a CPA one must meet certain education requirements, and pass
the CPA exam.
The CPA examination is prepared and graded twice each year. It is generally
recognized as an academic examination. It includes multiple-choice questions
in the following subjects namely, Theory of Accounts, Practical Accounting I,
Practical Accounting II, Auditing Theory, Auditing Problems, Management
Services, Business Law and Taxation.
2. Refer to page 11 of the textbook.
3. Refer to page 110 (Section 28 of the Philippine Accountancy Act of 2004) of the
textbook.
4. Competencies include both what individual auditors know and what individual
auditors and audit teams do. Competencies are evidenced by auditors applying
their skills in the delivery of services to clients or supporting the delivery of
those services. These competencies categorized as High Opportunity
Competencies and Low Opportunity Competencies are as follows:
High Opportunity Competencies have a high likelihood of being building

blocks for selling or delivering new assurance services.
Analytical Skills
Business Advisory Skills
Business Knowledge
Capacity for Work
Comprehension of Clients Business Processes
Communication Skills
Efficiency
Intellectual Capability
Learning and Rejuvenation
Marketing and Selling
1-2 Solutions Manual Public Accountancy Profession
Model Building
People Development
Relationship Management
Responsiveness and Timeliness
Technology
Verification
Low Opportunity Competencies, while important to the delivery of current

assurance services, are less likely to be exploited in the development of future
services.
Accounting and Auditing Standards
Administrative Capability
Managing Audit Risk
6. The Philippine Accountancy Act of 2004 (R.A. 9298) Article I, Section 4,

paragraphs (a) to (d) spell out the scope of the practice of accountancy as
follows:
Practice of Public Accountancy
Practice in Commerce and Industry
Practice in Education/Academe
Practice in the Government
7. Refer to pages 8 to 10 of the textbook.

Professional Practice of Accountancy 1-3
12. This is brought about by the nature of accounting standards and the demand for
accounting-related information which have changed in several significant ways.
These changes include:
Global Harmonization of Accounting Standards
Expanded Accountability
More Detailed Reporting
Increased Risk Reporting
Global Audit Standards
13. (a) While university-level training is important, it is also necessary that

professionals continue their education throughout their careers, as
accounting and auditing standards will change. In this particular case, the
staff member would need to stay abreast of current developments in order to
meet the competence and capabilities element of the responsibilities
principle.
(b) Auditors need to be both independent in fact and independent in

appearance. While a small financial investment might not impair the
auditors actual state of mind (independence in fact), it is unlikely that
financial statement users will perceive the auditor to be independent
(independence in appearance). Professional standards would not consider
the auditor independent in this case, as no direct financial interests in clients
are permitted.
Multiple Choice Questions

1. D
2. C
3. B
4. B
CHAPTER 2
PRACTICE OF PUBLIC ACCOUNTANCY
Questions
5. The following are the most sought - after services among professional
accountants.
A. Assurance Services. Examples are:
1. Independent financial statement audit
2. Reviews
3. Other assurance services (e.g., CPA Web Trust, Business Performance
Measurement Service)
B. Non-Assurance Services. Examples are:
1. Agreed-upon procedures
2. Compilation
3. Tax
4. Management consultancy/advisory services
5. Accounting and data processing
6. Other non-assurance services (e.g., Information Technology System
Services)
6. In an assurance engagement, a practitioner aims to provide a high or moderate

level of assurance that an assertion being made by one party for use by another
party can be relied upon while in a consulting engagement, the practitioner aims
to provide professional advice on how the limited resources of an enterprise can
be put into optimal use in order to attain the companys objectives.
7. Examples of assurance engagements on information technology are:
a) CPA Web Trust Service
b) Information System Reliability Service
Refer to page 41 of the textbook for a brief discussion of these services.
14. Refer to pages 56 and 57 of the textbook.

1. C 6. C 11. D
2. A 7. D 12. C
3. D 8. D 13. D
4. D 9. D 14. C
5. D 10. C
Cases
1. (a) The purpose of CPA reporting on internal control is to provide assurance

about whether managements assertion about internal control is fairly stated
in all material respects, based on the control criteria being followed. Thus,
for example, an examination provides the highest degree of assurance that
information produced by the system will be reliable.
(b) When involved in performing an examination on the effectiveness of

internal control a practitioner should:
Plan the engagement.
Obtain an understanding of internal control.
Evaluate the design and operating effectiveness of internal control.
Form an opinion about the fairness of managements assertion on
internal control.
Practice of Public Accountancy 2-3
2. (a) PSA 100, Assurance Engagements, provide guidance for an engagement
such as one on customer satisfaction. They provide guidelines on audits
and related services such as examinations and reviews.
(b) Suitable criteria are those that are objective and permit reasonably
consistent measurements. In addition, the criteria must be sufficiently
complete such that no relevant factors are omitted that would affect a
conclusion about the subject matter. Finally, the criteria must measure some
characteristic of the subject matter that is relevant to a users decision.
(c) INDEPENDENT ACCOUNTANTS REPORT

We have examined the accompanying Schedule of Customer Satisfaction
Measures for the three years ended December 31, 2013. This schedule is
the responsibility of Gonzales, Inc.s management. Our responsibility is to
express an opinion on this schedule based on our examination.
Our examination was conducted in accordance with standards on assurance

engagements adopted in the Philippines and, accordingly, included
examining, on a test basis, evidence supporting the schedule and performing
such other procedures as we considered necessary in the circumstances. We
believe that our examination provides a reasonable basis for our opinion.
In our opinion, the Schedule of Customer Satisfaction Measures referred to

above presents fairly, in all material respects, the levels of customer
satisfaction for the three years ended December 31, 2013, in conformity
with the measurement and disclosure criteria set forth in Note 1.
Santos & Lopez, LLP

March 1, 2014
NOTE TO INSTRUCTOR: If the CPAs believe that the criteria are not
understandable by users other than management a paragraph must be added
to the report restricting its use.
CHAPTER 3
OVERVIEW OF AUDITING
Questions
1. One definition of auditing is that it is a systematic process by which a

competent, independent person objectively obtains and evaluates evidence
regarding assertions about economic actions and events to ascertain the degree
of correspondence between those assertions and established criteria and
communicating the results to interested users.
The Philippine Standards on Auditing (PSA) 120 Framework of Philippine

Standards on Auditing states the objective of an audit as follows:
The objective of an audit of financial statements is to enable the auditor to
express an opinion whether the financial statements are prepared in all material
respects, in accordance with an identified financial reporting framework.
2. This apparent paradox arises from the distinction between the function of
auditing and the function of accounting.
The accounting function is the process of recording, classifying and

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

Statements Audits Audits
Purpose To determine whether To determine whether To evaluate whether
the financial the client is following operating procedures
statements are specific procedures set are efficient and
presented in by higher authority. effective.
accordance with
PFRS.
Audits of Financial Compliance Operational
Statements Audits Audits
Users of Audit Different groups for Authority setting down Management of
Report different purposes procedures, internal or organization
many outside entities. external
Nature Highly standardized Not standardized, but Highly nonstandard;
very specific and often very subjective
usually objective
Performed by:
CPAs Almost universally Occasionally Frequently
COA Auditors Occasionally Frequently Frequently
BIR Auditors Never Universally Never
Internal Auditors Frequently Frequently Frequently
4. The major differences in the scope of audit responsibilities are:

1. CPAs perform audits in accordance with Philippine Standards on
Auditing of published financial statements prepared in accordance with
identified and applicable Statements of Financial Accounting
Standards.
2. COA auditors perform compliance or operational audits in order to
assure the Congress of the expenditure of public funds in accordance
with its directives and the law.
3. BIR agents perform compliance audits to enforce the tax laws as
defined by Congress, interpreted by the courts, and regulated by the
BIR law.
4. Internal auditors perform compliance or operational audits in order to
assure management or the board of directors that controls and policies
are properly and consistently developed, applied and evaluated.
5. An independent audit is a means of satisfying the need for reliable information

on the part of decision makers. Factors of a complex society which contribute to
this need are:
1. remoteness of information
a. owners (stockholders) divorced from management
b. directors not involved in day-to-day operations or decisions
c. dispersion of the business among numerous geographic locations
and complex corporate structures
2. bias and motives of provider
a. information will be biased in favor of the provider when his goals
are inconsistent with the decision maker.
3. voluminous data
a. possibly millions of transactions processed daily via sophisticated
computerized systems
Overview of Auditing 3-3
b. multiple product lines
c. multiple transaction locations
4. complex exchange transactions
a. new and changing business relationships lead to innovative
accounting and reporting problems
b. potential impact of transactions not quantifiable, leading to
increased disclosures
6. The four primary causes of information risk are remoteness of information, bias
in motives of the provider, voluminous data, and existence of complex exchange
transactions.
The three main ways to reduce information risk are:

1. User verifies the information itself.
2. The users share the information risk with management.
3. Have audited financial statements provided.
The advantages and disadvantages of each are as follows:
Advantages Disadvantages
User verifies 1. User obtains information desired. 1. High cost of obtaining
information 2. User can be more confident of information.
the qualifications and activities of 2. Inconvenience to the person
the person getting the providing the information
information. because large number of users
would be on premises.
Users share 1. No audit costs incurred. 1. Users may not be able to collect
information risk on losses.
with
management
Audited 1. Multiple users obtain the 1. May not meet needs of certain
financial information. users.
statements are 2. Information risk can usually be 2. Cost may be higher than the
prepared reduced sufficiently to satisfy benefits in some situations, such
users at reasonable cost. as for a small company.
3. Minimal inconvenience to
management by having only one
auditor.
7. Information risk is the possibility that information upon which a business

decision is made is inaccurate. Four causes of information risk are:
remoteness of information,
biases and motives of the provider,
voluminous data, and
complex exchange transactions.
8. Three primary ways users of information can reduce information risk are:
users can verify the information themselves,
users can share information risk with management, and
users can obtain audited financial statements.
9. Four factors that are likely to significantly reduce information risk in the next
five to ten years are:
technological advances,
more companies will go online, reducing the risk of investors
obtaining outdated information,
new accounting and auditing standards, and
auditors will find more efficient and effective audit techniques.
11. A report by an independent public accountant concerning the fairness of a

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

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

entity. Internal auditing is itself a control that operates by examining and
evaluating the adequacy and effectiveness of other controls. Independence is
such an important aspect of internal auditing that the fourth section of the
Statement of Responsibilities of Internal Auditing is devoted to independence.
Organizations create internal auditing to serve or benefit the organization.
The broad objective of internal auditing is to provide assistance to members of

the organization to enable the members to meet their responsibilities effectively.
Assistance may involve providing counsel or recommendations, analysis, or
information. One goal of internal auditing should be to achieve effective control
that is worth the cost.
In describing the nature of internal auditing, the Statement of Responsibilities of

Internal Auditing indicates that internal auditing functions by examining
controls. The scope limits internal auditings responsibility for examining and
evaluating performance to specific responsibilities that are assigned to
individuals or units. Internal auditing examines and evaluates performance to
compare the actual performance with plans, specified activities, standards,
objectives, policies, and goals. Such evaluations are really evaluations of
controls because plans, specified activities, standards, objectives, policies and
goals are controls. Internal auditors may be called on to examine areas for
which performance criteria have not been specified. When this occurs, internal
auditors may select measurable criteria and report their findings in terms of
those measurable criteria. For example, if internal auditors were called on to
evaluate a credit department, they might present historical information as well as
industry information to management as a basis for evaluating the credit
department.
20. Independence is the essence of auditing and enables auditors to render impartial
and unbiased judgments. The two conditions that contribute to an internal
auditors independence are organizational status and auditor objectivity. The
internal auditors status must be such that they are respected throughout the
organization. Generally, the more respect management gives to the internal
audit function, the greater the attention the whole organization pays to their
findings and recommendations. Giving the highest-level person in internal
auditing the status of vice president and having that person report to the board of
directors audit committee give sufficient status to the internal audit function.
Objectivity requires that internal auditors have an independent mental attitude
and an honest belief in their work product.
21. COA auditors perform operational or performance audits, compliance audits,

and financial audits.
22. An independent auditor is usually a CPA who has received a license to perform
the attest function. To be a CPA, one generally must meet certain educational
requirements and pass an examination.
Internal auditors are employees of the organization for which they do audits.
They may perform financial auditing, compliance auditing, or operational
auditing. They are not independent in the sense that external auditors are,
although they may attain a degree of independence by their position in the
organization.
Governmental auditors are employees of various government agencies who

perform financial, compliance, and operational auditing. For example, local
governments employ auditors to verify that businesses collect and remit sales
tax as required by law.

1. D 11. B 21. D 31. D
2. A 12. A 22. B 32. B
3. A 13. C 23. C 33. A
4. D 14. C 24. B 34. D
5. B 15. A 25. B 35. C
6. C 16. D 26. C 36. D
7. B 17. A 27. D 37. B
8. C 18. A 28. C 38. C
9. B 19. D 29. A 39. A
10. D 20. C 30. A 40. B
CHAPTER 4
REGULATION OF THE PRACTICE

OF PUBLIC ACCOUNTANCY
Questions
1. Refer to pages 110 (Section 28 of the Philippine Accountancy Act of 2004) of

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

2004) of the textbook.
3. Competencies include both what individual auditors know and what individual
auditors and audit teams do. Competencies are evidenced by auditors applying
their skills in the delivery of services to clients or supporting the delivery of
those services. These competencies categorized as High Opportunity
Competencies and Low Opportunity Competencies are as follows:
High Opportunity Competencies have a high likelihood of being building

blocks for selling or delivering new assurance services.
Analytical Skills
Business Advisory Skills
Business Knowledge
Capacity for Work
Comprehension of Clients Business Processes
Communication Skills
Efficiency
Intellectual Capability
Learning and Rejuvenation
Marketing and Selling
Model Building
People Development
Relationship Management
Responsiveness and Timeliness
Technology
Verification
Low Opportunity Competencies, while important to the delivery of current

assurance services, are less likely to be exploited in the development of future
services.
Accounting and Auditing Standards
Administrative Capability
Managing Audit Risk
4. Examples of typical lawsuits against CPAs are
a) Alleged misstatements that the auditor did not detect in the financial
statements involving
1) improper or inadequate disclosure
2) inappropriate valuations
b) Alleged failure to detect defalcation as a result of negligence in the
conduct of the audit
c) Alleged failure to complete the audit on the agreed-on date
d) Alleged inappropriate withdrawal from an audit
5. Indications That Noncompliance May Have Occurred

Examples of the type of information that may come to the auditors attention
that may indicate that noncompliance with laws or regulations has occurred are
listed below:
Investigation by government departments or payment of fines or
penalties.
Payments for unspecified services or loans to consultants, related
parties, employees or government employees.
Sales commissions or agents fees that appear excessive in relation to
those ordinarily paid by the entity or in its industry or to the services
actually received.
Purchasing at prices significantly above or below market price.
Unusual payments in cash, purchases in the form of cashiers checks
payable to bearer or transfers to numbered bank accounts.
Unusual transactions with companies registered in tax havens.
Regulation of the Practice of Public Accountancy 4-3
Payments for goods or services made other than to the country from
which the goods or services originated.
Payments without proper exchange control documentation.
Existence of an accounting system which fails, whether by design or by
accident, to provide an adequate audit trail or sufficient evidence.
Unauthorized transactions or improperly recorded transactions.
Adverse media comment.
7. PSA 260 (Clarified), Communication with Those Charged with Governance

deals with the auditors responsibility to communicate with those charged with
governance in relation to an audit of financial statements. Although this PSA
applies irrespective of an entitys governance structure or size, particular
considerations apply where all of those charged with governance are involved in
managing an entity, and for listed entities. This PSA does not establish
requirements regarding the auditors communication with an entitys
management or owners unless they are also charged with a governance role.
8. The increase in litigation against auditors seems to be happening for two

reasons: a general increase in litigation in society, and the fact that investors and
creditors who suffer losses will look for deep pockets to pay for those losses.
Most accounting firms appear to have deep pockets.
9. Due (professional) care is the standard by which the courts and the profession
expect a CPA to practice. A CPA who is found to have exercised due
professional care in an engagement should not have any liability to others.
10. The four gradations are none, negligence, gross negligence (sometimes referred
to as constructive fraud), and fraud. At one extreme is the auditor who performs
an appropriate audit and issues an appropriate report. This auditors degree of
wrongdoing is none. An auditor who commits fraud is at the other extreme,
since he or she knows that the financial statements are misstated and yet issues
an unqualified opinion. An auditor is negligent if he or she does not do what a
reasonably prudent auditor should do in the circumstances. An auditor is
grossly negligent if he or she consistently fails to follow the standards of the
profession on an engagement.
11. Auditors are responsible to clients for negligence, gross negligence, or fraud.

13. Most courts have held that an auditor has a higher responsibility to communicate
information beyond that required by PFRSs and PSAs. Courts have held that
compliance with PFRSs is persuasive but not conclusive evidence.
14. An auditor should (a) follow the Philippine Standards on Auditing, the Code of
Ethics for Professional Accountants in the Philippines, and where appropriate,
PFRSs; (b) establish and follow appropriate quality control procedures; (c)
evaluate whether a client has the necessary integrity and appropriate reputation
in the community; (d) evaluate carefully why a client wants an audit; (e) conduct
the audit with appropriate professional skepticism; (f) provide for appropriate
levels of consultation for issues; and (g) provide for appropriate review of the
audit.
15. The prudent man concept states that a man is responsible for conducting a job in
good faith and with integrity, but is not infallible. Therefore, the auditor is
expected to conduct an audit using due care, but does not claim to be a guarantor
or insurer of financial statements.
1. B 11. A 21. B 31. B

2. C 12. D 22. C
3. A 13. C 23. A
4. B 14. D 24. A
5. A 15. C 25. A
6. C 16. A 26. C
7. A 17. A 27. C
8. C 18. D 28. A
9. A 19. B 29. A
10. B 20. D 30. C
CHAPTER 5
CODE OF ETHICS FOR PROFESSIONAL ACCOUNTANTS

IN THE PHILIPPINES
Questions
1. There is a special need for ethical behavior by professionals to maintain public

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

unbiased attitude throughout the audit, whereas independence in appearance is
dependent on others interpretation of this independence and hence their faith in
the auditor.
Activities which may not affect independence in fact, but which are likely to
affect independence in appearance are: (Notice that the first two are violations
of the Code of Ethics.)
1. Ownership of a financial interest in the audited client.
2. Directorship or officer of an audit client.
3. Performance of management advisory or bookkeeping or accounting
services and audits for the same company.
4. Dependence upon a client for a large percentage of audit fees.
5. Engagement of the CPA and payment of audit fees by management.
3. In return for the faith placed in CPAs by the public, CPAs should continually
seek to demonstrate their dedication to professional excellence. The public
interest is defined as the communitys collective well-being. CPAs handle
ethical conflicts best by acting with integrity, objectivity, and due professional
care and by having a genuine interest in serving the public.
4. An ethical dilemma is a situation that a person faces in which a decision must be
made about the appropriate behavior. There are many possible ethical dilemmas
that one can face, such as finding a wallet containing money, or dealing with a
supervisor who asks you to work hours without recording them.
An ethical dilemma can be resolved using the six-step approach outlined below:
1. Obtain the relevant facts.
2. Identify the ethical issues from the facts.
3. Determine who is affected by the outcome of the dilemma and how
each person or group is affected.
4. Identify the alternatives available to the person who must resolve the
dilemma.
5. Identify the likely consequence of each alternative.
6. Decide the appropriate action.
5. Apparently, in ethical philosophy, the word conscience is used to describe the

undefinable mental process that yields moral decisions. A close kin in the
political science terms would be anarchy.
Conscience might not be a sufficient guide for personal ethics decisions because
the individuals undefinable mental processes may be based on caprice,
immaturity, ignorance, stubbornness, or misunderstanding. Conscience may fail
to show the consistency, clarity, practicability, impartiality, and adequacy
preferred in ethical standards and behavior. Exactly the same can be said about
professional ethics decisions because a nonhypocritical individual can no more
split his behavior between personal life and professional life than he can
voluntarily split his own personality.
6. A professional accountant must be prepared to be an agent, spectator, advisor,

instructor, judge, and critic.
7. Ethical responsibility for acts of non-CPAs under a CPAs supervision falls

under the latters jurisdiction. A CPA shall not permit others to carry out on his
behalf, either with or without compensation, acts which, if carried out by the
CPA, would place him in violation of the Code of Ethics.
8. The auditors gain from having an audit committee is a direct communication

pipeline to the board of directors.
9. Serving as a purchasing agent places Ben Santos father in an audit sensitive

position. Accordingly, Santos independence is impaired. Also, since Santos
is a managerial employee, he can no longer work in the Manila office of the
CPA firm. The CPA firm may retain its independence if Santos transfers to
another office (or resigns).
Code of Ethics for Professional Accountants in the Philippines 5-3
10. The CPA firms independence would not be impaired as long as Gary Angeles
did not personally participate in the audit of this particular client. Once Gary
rises to the position in which he becomes a managerial employee of the CPA
firm, however, he must be transferred to an office which does not participate in
this audit if the firm is to remain independent.
11. Historically, compensation for CPAs serving as expert witnesses had to be based
on a standard per diem rate or a fixed sum. However, under certain situations,
such contingent fees are allowed only from clients for which the CPA does not
also provide to the client financial statement audits, reviews or certain
compilations, or prospective financial information examinations.
12. Sanchez may only refer certain clients to his wife or to another life insurance
agent who will share such a commission with his wife provided that he does not
perform assurance as well as nonassurance services.

1. D 11. A 21. A
2. B 12. A 22. B
3. D 13. A 23. D
4. A 14. C 24. C
5. A 15. C 25. C
6. C 16. D 26. B
7. A* 17. A 27. D
8. A* 18. C
9. A* 19. A
10. A 20. A
*7. A fee for audit clients which is dependent upon the results achieved by the CPAs efforts
is a contingent fee and is prohibited for audit clients.
*8. An auditors independence would not be considered to be impaired with respect to a

financial institution in which the auditor maintains a checking account which is fully
insured.
*9. The declaration requires the preparer to acknowledge that the return is true, correct,
and complete...based on all information of which the preparer has any knowledge.
Cases
1. a. Interpretation Honorary Directorships and Trusteeships
Ela will not be considered independent unless:

1. the position is in fact purely honorary, and
2. listings of directors show she is an honorary director, and
3. she restricts participation strictly to the use of her name, and
4. she does not vote or participate in management functions.
b. Interpretation Retired Partners and Firm
Independence: Since Monte is still active with the firm as an ex-officio

member of the income tax advisory committee, meeting monthly, his
situation would impair the appearance of the firms independence. Monte
should either resign from the Palm board or cease his association with the
accounting firm.
c. Interpretation Accounting Services
CPA Benitez must be careful to know whether outsiders would perceive

relationships that would indicate status as an employee, hence impairing the
appearance of independence. In particular, CPA Benitez must
1. Not have any business connection with Hernan Corporation or with
Mike Hernan that would in fact impair independence, objectivity and
integrity, and
2. Impress Mike Hernan (and the board of directors) that they must be
able and willing to accept primary responsibility for the financial
statements as their own, and
3. Not take managerial responsibility for conducting operations of the
Hernan Corporation (although Benitezs supervision of the bookkeeper
seems to have this characteristics), and
4. Conduct the audit in conformity with PSA and not fail to audit records
simply because they were processed under Benitezs supervision.
d. Interpretation Effect of Family Relationships on Independence
Jacks wifes interest is attributed to him, and he would not be independent.

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

The financial interest is considered direct.
f. Interpretation
Still not enough. The grandfather (either Jacks father or his father-in-law)
is considered a nondependent close relative, but the appearance of
independence is impaired. The grandfathers investment is material (50
percent) in relation to his net financial resources.
2. a. Pee and Co. / United Furniture, Inc.: This is a judgment call. In this case,
the services can be considered temporary, mechanical in nature and
performed on a one-time emergency basis. For these reasons, the SEC
would probably not consider independence impaired.
b. Renson & Co. / Spectrum Corporation Laser Division: The SEC would
consider independence impaired because of the extent of the bookkeeping
services and the relative size of the Division. The only solution that might
work is to have another accounting firm audit the Laser Division financials
so that Renson & Co. can write a report in reliance on the work of other
independent auditors.
c. Reyes & Co. / Valley Bank: The SEC would consider independence
impaired because of the family relation of Annabelle, her connection with
Valleys financial statements and the fact that Kris is a member (partner)
in the audit firm. (The PICPA would probably also consider independence
impaired because of the apparent closeness of the two sisters and the audit
sensitivity of Annabelles job).
d. Cruz & Reyes / Jonas Tomas / Starex Money Market Fund: Jonas is a
member since he is a manager and will provide audit services to SMMF.
Cruz & Reyes independence is impaired since Jonas holds a direct
financial interest.
3. Violation of Code of Professional Ethics? Yes No
Since Bella had an employment relationship with the client during part of the
period covered by the financial statements, her independence is impaired.
4. Violation of Code of Professional Ethics? Yes No
This is a violation. It is a contingent fee agreement.
5. Although her decision will not be popular with the audit staff, Tracy Ong should
thank the client but decline the offer, both for her and for the staff. She should
explain that an outsider who had knowledge of all of the relevant facts might
view the free use of a condominium as a sizable gift to the auditors, which
might influence their independent mental attitude. Thus, we believe that to
maintain an appearance of independence, the auditors should not accept this
offer.
6. No. CPAs may refuse client access to their working papers for any valid
business purpose. Therefore, a CPA may require that fees be paid before
working papers including such adjusting entries and supporting analysis are
provided to the client.
7. The answers provided in this section are based on the assumption that the
traditional legal relationship exists between the CPA firm and the third party
user. That is, there is no privity of contract, the known versus unknown third
party user is not a significant issue, and high levels of negligence are required
before there is liability.
a. False. There was no privity of contract between Tan and Caada,
therefore, ordinary negligence will usually not be sufficient for a
recovery.
b. True. If gross negligence is proven, the CPA firm can and probably
will be held liable for losses to third parties.
c. True. See a.
d. False. Gross negligence (constructive fraud) is treated as actual fraud
in determining who may recover from the CPA.
e. False. JC is an unknown third party and will probably be able to
recover damages only in the case of gross negligence or fraud.
Assuming a liberal interpretation of the legal relationship between auditors and

third parties, the answers to a and d would probably both be true. The other
answers would remain the same.
8. Yes. Normally a CPA firm will not be liable to third parties with whom it has
neither dealt nor for whose benefit its work was performed. One notable
exception to this rule is fraud. When the financial statements were fraudulently
prepared, liability runs to all third parties who relied upon the false information
contained in them. Fraud can be either actual or constructive. Here, there was
no actual fraud on the part of Dantes or the firm in that there was no deliberate
falsehood made with the requisite intent to deceive. However, it would appear
that constructive fraud may be present. Constructive fraud is found where the
auditors performance is found to be grossly negligent. That is, the auditor
really had either no basis or so flimsy a basis for his or her opinion that he or she
has manifested a reckless disregard for the truth. Dantes disregard for standard
auditing procedures would seem to indicate such gross negligence and,
therefore, the firm is liable to third parties who relied on the financial statements
and suffered a loss as a result.
9. a. Yes. Carlos was a party to the issuance of false financial statements and as
such is a joint tortfeasor. The elements necessary to establish an action for
common law fraud are present. There was a material misstatement of fact,
knowledge of falsity (scienter), intent that the plaintiff bank rely on the false
statement, actual reliance, and damage to the bank as a result thereof. If the
action is based upon fraud there is no requirement that the bank establish
privity of contract with the CPA. Moreover, if the action by the bank is
based upon ordinary negligence, which does not require a showing of
scienter, the bank may recover as a third-party beneficiary (an exception to
the strict privity requirement). Thus, the bank will be able to recover its
loss from Carlos under either theory.
b. No. The lessor was a party to the secret agreement. As such, the lessor
cannot claim reliance on the financial statements and cannot recover
uncollected rents. Even if he or she was damaged indirectly, his or her own
fraudulent actions led to his or her loss, and the equitable principle of
unclean hands precludes him or her from obtaining relief.
c. Yes. Carlos had knowledge that the financial statements did not follow
financial reporting standards and willingly prepared an unqualified opinion.
The financial statements were not in accordance with financial reporting
standards. That is a criminal act because there was an intent to deceive.
10. a. Base, Umapas & Caada is potentially liable to its client because of the
possible negligence of its agent, the in-charge accountant on audit, in
carrying out duties that were within the scope of his or her employment.
Should there be a finding of negligence, liability would be limited to those
losses that would have been avoided had reasonable care been exercised.
There being no evidence of the assumption of a greater responsibility, the

in-charge accountants conduct is governed by the usual standard; that is,
that the accountant perform his or her duties with the professions standards
of competence and care. A question of fact arises as to whether the duty of
reasonable care was breached when the in-charge accountant failed to
investigate further after being apprised by a competent subordinate of
exceptions to 6 percent of the vouchers payable examined. Moreover, a
question of causation arises as to whether further actions by the in-charge
accountant would have disclosed the fraud. If both lack of due care and
causation are established, recovery for negligence will be available to the
client.
b. In a properly organized liability partnership, the partner(s) and staff

responsible for the engagement and the firm would be liable, as discussed in
part a. However, other partners would not be liable.
11. Ordinarily, users of financial statements, other than those who contracted for the
audit and those known in advance to the auditor, may not recover for ordinary
negligence by the auditor in the performance of an audit. Recovery of damages
by third parties must usually be based on fraud. Actual knowledge of falsity
(scienter) is also generally required for an action based on fraud; however, this
requirement may be satisfied by the auditors reckless disregard for the truth or
gross negligence.
It appears that the three deficiencies in the audit by Gonzales & Esteban might
be sufficient to satisfy either approach. Failure to check the existence of certain
receivables, collectibility of other receivables, and existence of security
investments, taken collectively if not individually, appear to show a reckless
disregard for the truth by the auditor. In fact, the audit probably lacks sufficient
competent evidential matter as a reasonable basis for an opinion regarding the
financial statements under examination.
The audit appears to have been conducted in a woefully inadequate fashion,

without regard to the usual auditing standards and procedures necessary to
exercise due professional care. Therefore, the auditors were grossly negligent in
the performance of their duties.
12. Corpuz has stated that the CPA firm has reviewed the books and records of
Flores Ventures, when in fact no such review has occurred. A review of
financial statements consists of limited investigatory procedures designed to
provide statement users with a limited degree of assurance that the financial
statements are in conformity with financial reporting standards. Corpuzs
actions are similar to issuing an auditors report without first performing an
audit. Such an action may well be considered an act of criminal fraud, intended
to mislead users of the financial statements. If the financial statements of Flores
Ventures turn out to be misleading, there is little doubt that any court would find
the CPA firm guilty of at least constructive fraud and liable to any third party
who sustains a loss as a result of reliance upon the statements.
The fact that Corpuz violated Vasquezs policy of submitting all reports for
Vasquezs review would not lessen the CPA firms liability. The concept of
mutual agency allows Corpuz, as a partner, to commit the firm to contracts,
including auditors reports and accountants reports. The fact that this report
was not submitted for Vasquezs review might be introduced as evidence against
Corpuz in the event he is accused of criminal fraud.
13. (1) Yes, but only to the extent of P70,000. Beta is a third-party beneficiary of
the contract between Mega and its auditors, and may therefore recover from
the auditors losses caused by the CPAs ordinary negligence. However, the
original P50,000 loan was made prior to Betas reliance upon the
negligently audited financial statements. Thus, the auditors negligence was
not the proximate cause of this portion of Betas loss. The auditors
negligence may, however, be considered the proximate cause of the
P70,000 loss incurred as a result of reliance upon the misleading statements.
(2) The prospects for Manilas recovery of its P30,000 loss are substantially
less than those of Beta. Manila was not a third-party beneficiary to the
contract. Thus, in many jurisdictions following Ultramares, Manila cannot
recover losses attributable to the CPAs ordinary negligence. Similarly, it is
doubtful that Manila would qualify as a foreseen third party as necessary
under the Restatement approach. Even in a jurisdiction accepting the
Rosenblum precedent, which allows third parties to recover losses caused by
the auditors ordinary negligence, Manila would have to prove that it was a
foreseeable third party relying upon the financial statements for routine
business purposes. It is questionable whether the loan by Manila was either
reasonably foreseeable or routine, as Manila was a customer of Mega,
not a lender.
CHAPTER 6
MANAGEMENT OF A
PUBLIC ACCOUNTANCY PRACTICE
Questions
1. The special function performed by the public accounting profession is the

attestation to the fairness of the financial statements of clients. The special
function ensures the reliability and integrity of the financial reporting system.
Judge Burger described the special function as "certifying the public reports that
collectively depict a corporation's financial status," which involves "a public
responsibility transcending any employment relationship with the client."
2. Complexity affects the demand for auditing services in that both users and
management need the expertise of professionals who understand the underlying
economic substance of transactions and financial instruments and, thus, who
have the ability to determine the appropriate accounting best to "fairly" portray
the economic substance of an organization's activities and financial condition.
The business environment in which the auditor must function is increasingly

complex. The major forms of complexity relate to:
a. Computer systems, which are becoming increasingly interdependent
across organizations.
b. Increased complexity of financial instruments and transactions entered
into by organizations.
c. The economic environment in which we all must operate. The changing
environment includes such items as the increased need to have a global
outlook in providing goods and services and the need to be attuned to
societal regulations in such areas as environmental protection.
3. For the most part, local CPA firms are subject to the same auditing and
accounting standards as the large international CPA firms. The differences relate
to whether the audit firms have (a) public clients, or (b) international clients. If
a firm has public clients, then the firm is subject to the standards of the PCAOB.
If a firm has clients that are domiciled in other countries, then they should utilize
international auditing standards. If the audit firm only has non-pubic clients,
then they are subject to auditing standards promulgated by the PICPA.
4. A network of accounting firms is a body to which individual CPA firms come
together to pursue common interests. The services generally provided by the
network include:
centralized staff that provides accounting and auditing expertise to its
members on a world-wide basis,
a referral service for audit firms that have clients in different parts of the
country or world,
a referral service for a firm to utilize when clients desire expertise or
consulting services that the audit firm does not provide.
standard audit programs and/or procedures manuals for the member audit
firms.
In some cases, the network can be a network of firms that are not otherwise
affiliated. In other cases, the network firms all operate under one common name,
e.g. Grant Thornton International.
5. a. Professional skepticism represents a state of mind that is characterized by

appropriate questioning and a critical assessment of audit evidence. When
employing professional skepticism, auditors will not simply accept all
evidence provided and assume that clients are unquestionably honest.
However, the statement that you really have to question everything the
client tells you is a bit exaggerative and goes beyond the concept of
professional skepticism.
b. It is correct that internal evidence is generally of lower quality than external

evidence. However, the necessary quality of evidence depends upon the risk
of material misstatement and the effectiveness of the clients internal
control. In this case, the staff auditors statement that internal evidence is
obtained because of time and cost considerations is not appropriate, unless
the risk of material misstatement permits lower quality of evidence because
of other reasons.
c. While appropriate planning will allow audits to be conducted on a timely

basis, it is not appropriate for auditors to ignore transactions and events
between the interim date (in this case, November 1) and the clients fiscal
year end. Some testing would need to be performed following the year end
for transactions occurring between November 1 and December 31.
d. While the primary purpose of evaluating internal control is to determine the

nature, timing, and extent of substantive tests, auditors must still conduct
some study of internal control to ensure that the condition of the clients
internal control has not changed from prior years. If it has, the substantive
tests performed by auditors may no longer be appropriate. In addition, for
Management of a Public Accountancy Practice 6-3
public companies, auditors are required to study internal control and report
on the effectiveness of the clients internal controls under Auditing
Standard No. 5.
e. For departures from PFRS, the choice among opinions would be between a
qualified opinion (for less material departures) and an adverse opinion (for
more material departures).
f. While the concept of materiality does consider dollar amounts and their
effects on users decisions, qualitative factors also need to be considered
when assessing materiality. For example, a small dollar amount (in absolute
terms) may influence a companys ability to meet its earnings expectations
or report higher earnings than in previous years. Situations such as this need
to be considered as well as the absolute dollar amount of an item in
assessing materiality.

1. D
2. D
3. D
4. D
5. A
Cases
1. (1) Auditing does not involve the creation of goods. However, it does serve a
worthwhile purpose in our society because it enhances the flow of reliable
financial information needed to conduct commerce in our economy. It also
assists in the conduct of government by providing reliable information for
tax purposes and regulatory purposes. Audits have been legally mandated to
ensure objective information. However, research has indicated that audits
would be required even if not mandated. The initial audits performed in
conjunction with the settlement of the new world arose because of owners'
need to have an independent assessment of the returns earned by their
managers.
(2) The accounting profession did provide early warning signals of the potential
problems within many industries. However, it clearly failed in other areas.
Some of the problems were related to the impreciseness of accounting
principles (e.g. Enron) while others were more closely related to regulatory
failures (e.g. Savings & Loan Industry). However, many of the failures were
due to systematic problems in the accounting profession that has been
addressed by Sarbanes-Oxley.
(3) Finding fraud may be important. However, many misstatements that are
made in conjunction with an organization's financial statements are not
intentional but are simply the result of errors. The audit function is designed
to detect material misstatements -- whether they are due to errors or fraud.
Thus, the audit function is actually broader than the colleague had desired.
Ensuring that a financial statement contains no material misstatements also
ensures that the auditor addresses the likelihood that material fraud may
also have occurred.
(4) There is a potential problem with the auditors being hired by management.
The Sarbanes-Oxley Act requires companies that are publicly traded to have
an audit committee composed of independent directors (nonmembers of
management) that have the responsibility for evaluating the performance of
the auditors. The audit committee should exist to present the views and
interests of outside owners of the organization and provide effective
insulation against undue pressure by management on the audit function. The
SEC is very cognizant of independence issues and periodically addresses
actions or relationships that they believe may impair the auditors
independence.
(5) PFRS represents rules and conventions that are acceptable at one point in
time. Much of the diversity in accounting principles is necessary to reflect
real economic differences between organizations and the types of
transactions in which the organization is engaged. Beyond this argument,
differences such as Weighted Average / FIFO accounting have evolved over
the years. The profession attempts to mitigate the potential problems
associated with the diversity by providing disclosure of the differences and
by developing other procedures to make it difficult for firms to change
accounting principles. Thus, the financial statements of a company should
be comparable over a period of time.
(6) It seems that this individual really wants to have a career in auditing.
External auditing has changed; in today's environment, the auditor must
thoroughly understand a company's business in order to audit it. A key
function of internal auditors is to add value through their recommendations.
(7) The external audit is designed to present an opinion on the fairness of a

companys financial statement in accordance with PFRS. It is not directly
designed to assess the performance of management, although the financial
statements may provide some evidence on the performance of management.
(8) Auditors operate in an environment in which they must have a sense of trust
with management at least to the extent that confidential or proprietary
information is not made public. Thus, if all recommendations made to
management were to be made public, management might simply ask that
Management of a Public Accountancy Practice 6-5
recommendations no longer be made. Further, it must be recognized that
many of the recommendations made to improve operations are informal in
nature and might not be based on thorough study of a particular area.
Auditors may justifiably fear litigation from recommendations made public
that were made only on informal observations.
(9) Congress, in developing the Sarbanes-Oxley Act believes this statement is

true. Maintaining adequate controls is a significant part of corporate
governance. Congress believes the owner (shareholder) should receive
reports on the quality of controls implemented by management. In the first
three years of public reports on internal control, there has been a dramatic
change in the quality of controls in many organizations. During the first
year of Sarbanes-Oxley, approximately 16% of the companies received
adverse reports on the quality of their internal controls. This percentage has
gone down dramatically.
2. (a) There seems to be a misinterpretation on the part of many users that a

"clean" audit opinion means that the company is in good health. This,
unfortunately, is a miscommunication. A "clean" audit opinion means only
that the financial statements are fairly presented, not that they represent a
company that is in good financial health. The audit function provides data
that are "fairly presented" in accordance with PFRS, but such information
alone does not constitute all the information an informed user should know
about a company.
(b) The auditor is a guarantor only of following auditing standards in

determining whether the statements are fairly presented, in all material
respects, in accordance with financial reporting standards. Fair presentation
is guaranteed only within the context of PFRS.
(c) This question and should encourage a widely ranging discussion by users.
Topics that might be addressed include these:
1. The potential deficiencies in PFRS.
2. The ability to detect fraud when management has attempted to cover
it up.
3. The responsibilities of users to perform their own work and to not
expect someone else to make decisions for them.
4. The overall responsibility of management for the integrity of the
financial statements.
5. The value of reports on internal control.
6. The difficulty of measuring the economics of complex transactions.
CHAPTER 7
SYSTEM OF QUALITY CONTROL FOR PUBLIC

ACCOUNTANCY FIRMS
Questions
4. a. Leadership responsibilities for quality within the firm

b. Engagement performance
c. Human resources
d. Monitoring
e. Human resources
f. Relevant ethical requirements
g. Acceptance and continuance of clients
h. Leadership responsibilities for quality within the firm
i. Engagement performance

1. A 6. B 11. D 16. C
2. D 7. A 12. B 17. B
3. D 8. D 13. C 18. C
4. B 9. B 14. C 19. D
5. C 10. C 15. D
Cases
1. MORALES, CABRERA, & CO., CPAs

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

b. To ensure personnel are qualified to do the tasks they are assigned.
c. An in-charge accountant must have served as a staff auditor on an audit in
the clients industry.
3. a. Skills and Competence

b. To ensure that personnel continue to be updated on changes in accounting
or auditing standards.
c. Personnel will participate in forty hours of continuing education per year.
4. a. Consultation
b. To ensure that personnel have access to persons with more experience in
dealing with problems they have encountered.
c. For each industry for which the office has a client, a specialist will be
identified.
5. a. Independence
b. To ensure that personnel meet PICPA guidelines for independence.
c. Firm personnel must list their investments. Personnel must report any stock
acquisitions.
6. a. Supervision
b. To ensure that work performed meets the firms standard of quality.
c. Staff personnel are to follow firm guidelines for working paper
development.
7. a. Inspection / Review
b. To verify that quality control procedures are being followed.
c. Inspect the audit programs for all engagements.
8. a. Acceptance and retention of clients

b. To minimize the risk associated with clients.
c. New clients must be investigated by a private investigative agency.
System of Quality Control for Public Accountancy Firms 7-3
9. a. Assigning personnel to engagements
b. To ensure that personnel posses the degree of technical training and
proficiency required for an engagement.
c. To be eligible to be senior on an engagement, a person must have had
experience in the industry.
2. Auditing standards indicate that auditors should report major issues discussed with
the entitys management prior to being retained as auditor, including discussions
regarding the application of accounting principles and auditing standards.
Discussion of such matters may place pressure on the auditor to yield to
managements view. Making the audit committee members aware of such matters
should enable them to better monitor the auditors independence. Standards do not
preclude clients from making suggestions about audit staff. Clients frequently make
requests to have persons on the audit who have experience in the industry. If a client
requests that minority persons not be assigned to an audit, however, the auditor must
carefully consider the ethical implications of that request.
CHAPTER 8
PHILIPPINE STANDARDS ON AUDITING
Questions
1. Foreign public accounting firms have found that to retain their multinational
clients, they have had to develop the capacity to provide services worldwide.
Although the roots of at least two of the big firms in the United States are
traceable to European ancestry, public accounting firm involvement in
international activities has paralleled the gradual involvement of businesses in
international activities. In the early 1900s, some public accounting firms
established representative offices in foreign countries. As business activity
expanded, the firms opened offices in foreign cities. During the 1970s, some
countries forced these firms to close their offices. To be able to serve their
clients, the firms established correspondent relationships with locally owned
accounting firms; in these relationships, local partners remain separate, local,
autonomous organizations. Because domestic and foreign partners in a
correspondent relationship agree to follow a common code of ethics and practice
guidelines, each is able to rely on the work the other performs. A big firm
auditing a U.S. business with significant activities in France, for example, would
rely on its Paris office to audit the activities of the business in France.
The largest firms have organized worldwide partnerships to achieve a greater

uniformity of quality, to facilitate management of personnel, and to coordinate
research and professional development of personnel. Many small public
accounting firms establish correspondent relationships with foreign public
accounting firms or join a federation. Firms in a federation call on one another
to perform services for clients, following agreed-upon standards in conducting
the work they do for one another.
2. Yes. According to paragraph 10 of the Preface to Philippine Standards on

Auditing and Related Services, an auditor may, in exceptional circumstances,
judge it necessary to depart from a PSA in order to more effectively achieve the
objective of an audit. When such a situation arises, the auditor should be
prepared to justify the departure.
3. No. According to paragraph 14 of the Preface to the Philippine Standards on

Auditing and Related Services, PAPSs are issued to provide practical
assistance to auditors in implementing the PSAs or to promote good practice.
These Statements are not intended to have the authority of the PSAs.
4. Refer to page 329, paragraph 6 of PSA 120.

5. Refer to page 329, paragraph 6 of PSA 120.
6. Refer to pages 329 and 330, paragraphs 8, 9 and 10 of PSA 120.

1. D 6. C 11. D
2. B 7. C
3. B 8. D
4. D 9. D
5. C 10. A*
* b and d are also options available to the auditor
Cases
1. The PICPA currently develops independence and ethical standards, quality

control standards, and auditing and attestation standards that apply to its
members. However, PICPA standards are applicable to the audits and auditors
of nonpublic clients based on general acceptance by the courts, and adoption by
state boards of accountancy and other regulatory bodies. The AICPA also has a
voluntary peer review program, and enforces its standards on its members.
The PCAOB was given the legal authority to develop independence and ethical
standards, quality control standards, and auditing and attestation standards that
apply to public company auditors and integrated audits. The PCAOB also is
charged with performing inspections of registered audit firms, and may sanction
the firms for noncompliance with its standards and the provisions of Sarbanes-
Oxley Act.
The state boards of accountancy regulate CPA firms and CPAs in the various
states and jurisdictions. They have the authority to establish their own
standards, but have generally adopted the standards of other bodies such as the
PICPA and the PCAOB. A state board enforces its standards in its state or
jurisdiction and has the authority to revoke a CPA firm or individual CPAs
right to practice in the state.
2. Applicable Technical and Professional Standards
It was inappropriate for Arnold to hire the two students to conduct the
audit. The audit must be conducted by persons with proper education
and experience in the field of auditing. Although a junior assistant has
not completed his formal education, he or she may help in the conduct
of the audit as long as there is proper supervision and review.
Philippine Standards on Auditing 8-3
Because of the financial interest in whether the bank loan is granted,
Arnold is not independent.
Arnold did not review the work or the judgments of the assistants and
clearly failed to adhere to this standard.
Arnold accepted the engagement without considering the availability of
competent staff. Arnold failed to supervise the assistants and did not
adequately plan the work.
Arnold and the assistants did not obtain the require understanding of
the entity and its environment, including internal control.
Arnold acquired no evidence that would support the financial
statements. Merely checking the mathematical accuracy of the records
and summarizing the accounts is inadequate.
Arnold's report makes no reference to applicable reporting framework.
Because Arnold did not conduct a proper audit, the report should state
that no opinion can be expressed.
In this case both the statements and the auditor's report lack adequate
disclosures.
Although Arnolds report contains an expression of opinion, such opinion is not

based on the results of a proper audit. Arnold should disclaim an opinion
because he failed to conduct an audit in accordance with Philippine Standards on
Auditing (PSAs).
3. (a) When the auditors discover illegal acts by a public client, they should
consider three major factors. First, the auditors should consider the effect
of the acts on the client's financial statements, including the possibility of
fines and loss of business. To comply with the applicable reporting
framework, the financial statements must reflect the material effects of
illegal acts.
Second, the illegal acts may affect the auditors' assessment of the integrity
of management. In deciding whether to continue to serve the client, the
auditors should consider the nature of the illegal acts and management's
response to the acts after they are uncovered.
Third, the auditors should consider whether the occurrence of the illegal act
indicates that there is a material weakness in the companys internal control
over financial reporting.
(b) The following courses of action are available to the auditors:
(1) The auditors could issue an unqualified opinion and take no further
steps regarding the illegal activities. This course of action could be
argued on the basis that the effect of the acts on the financial
statements is not material. If the auditors take this course of
action, they should also consider whether the illegal act and related
actions by management and the board indicate a material weakness
exists that would affect their report on internal control over
financial reporting.
(2) The auditors could issue a qualified opinion because the financial
statements depart from the applicable reporting framework, in that
they fail to disclose the illegal acts. This course of action could be
argued on the basis that any illegal activities by the client are
material, especially when management fails to take any steps to
prevent the acts. If the auditors take this course of action, they
should also consider whether the illegal act and related actions by
management and the board indicate a material weakness exists that
would affect their report on internal control over financial
reporting.
(3) The auditors could withdraw from the engagement, because the cli-
ent's failure to take actions to prevent such activities indicates that
Generic's management lacks sufficient integrity.
(c) We believe that the auditors should consider withdrawing from the
engagement. Generic's top management seems far too complacent
regarding these activities. Their refusal to take any action to prevent the
acts in the future provides a signal to lower level management that top
management approves of illegal acts. The auditors clearly should question
the integrity of management in this situation.
4. The following memorandum summarizes the response of Alice Borromeo, CPA,

to the request of a client for extension of the attest function to the problem of
pollution control.
Dear Jenny:
As much as I support your strenuous efforts to minimize air and water
pollution from the manufacturing operations of your company, there are specific
reasons which make it impossible for me as a CPA to attest to the extent of your
accomplishments in this area along the lines you have suggested. When we
perform the attest function with respect to your financial statements each year,
we are expressing our professional opinion that your financial statements are
prepared in conformity with certain standards, or applicable reporting
framework.
Philippine Standards on Auditing 8-5
In order for us to attest to the effectiveness of your pollution control
program, recognized standards would have to be established in this field. No
such standards presently exist for a factory to the best of my knowledge. Of
course the national government has set standards for exhaust emissions on
automobile engines and we could, by retaining independent consulting
engineers, obtain a basis for attesting to the compliance of a given automobile
engine to those standards.
We are quite willing to extend the attest function in various directions
if we can find a basis for objective comparison of a given operation with a
clearly defined standard. Perhaps your engineering department can develop
some specific quantitative data on the industrial waste from your operations.
We might then be able to perform the necessary examination of such data to
enable us to attest to the validity of your representations as to your operations.
Of course, this would not be the same thing as providing your relative position
in the industry. After reviewing this possibility with your engineering staff, if
you would like to discuss the matter further with us, we will be glad to meet
with you.
Sincerely,
Alice Borromeo
CHAPTER 9
OVERVIEW OF RISK-BASED
AUDIT PROCESS
Questions
1. In their investigation of a prospective client, the CPAs should assess the

backgrounds and reputations of the prospect and its major shareholders,
directors, and officers. Thus, inquiries are made of underwriters, bankers, and
attorneys that conduct business with the prospective client. Also, the CPAs are
required to make inquiries of the prospect's predecessor auditors to obtain
information that might enter into the acceptance decision, such as information
regarding the integrity of management. The prospect's financial reports, SEC
filings, credit reports, and tax returns are used as sources of financial
background information.
2. An engagement letter is sent to the client by the auditors to make clear the
nature of the engagement, any limitations on the scope of the audit, work to be
performed by the client's staff, and the basis for computing the auditors' fee.
The engagement letter represents the written contract for the engagement, and its
primary objective is to prevent possible misunderstandings between the client
and the auditors. It constitutes an executory contract between the auditors and
the client.
3. Shopping for accounting principles is a practice whereby management

changes auditors to a CPA firm that is more likely to allow an accounting
principle that has been the subject of dispute with the companys prior auditors.
A number of mechanisms serve to discourage the practice, including: (1) the
requirements under PAS No. 84 for the successor auditors to inquire of the
predecessors about the reasons for the change in auditors, (2) the SEC 8-K
requirements for management to report the reasons for a change in auditors
which also require the auditors to express their agreement with the details, and
(3) the requirements under PAS No. 97 that require accountants who are being
asked to provide a report on the accounting treatment of an prospective or
completed transaction to consult with the clients auditors to ensure that they
have a complete understanding of the form and substance of the transaction. In
addition, the Sarbanes-Oxley Act of 2002 requires the audit committee to
assume responsibility for engaging, compensating, and overseeing the auditors.
4. The approach described in the statement is not appropriate. Materiality depends

on both the dollar amount and the nature of the item. For example, auditors
apply a more rigorous standard of materiality in evaluating transactions between
related parties and potentially illegal acts than they apply to misstatements in
accounts.
5. The two types of misstatements due to fraud are (1) misstatements arising from
fraudulent financial reporting, and (2) misstatements arising from
misappropriation of assets (sometimes referred to as defalcation). Fraudulent
financial reporting is of more concern to the auditors because it typically results
in effects that are much more material to the financial statements. Defalcations
often are not material to the financial statements.
6. A business risk is a treat to achieving managements objectives. There are many

examples of business risks that may result in a risk of material misstatement of
the financial statements. Two are shown below:
Business Risk Risk of Material Misstatement

Rapidly changing technology in the Inventory may be overvalued because
clients industry may threaten to it is not valued at net realizable value.
cause the clients products to become
obsolete.
Economic conditions in the industry Accounts receivable may be
may result in significant uncollectible overvalued because the allowance for
accounts receivable. uncollectible accounts is not
adequate.
7. The audit procedures to be followed in a given engagement depend upon such

factors as the risks of material misstatement of the financial statements, the
assumption about the effectiveness of internal control, the auditors' estimates of
materiality, the nature of the accounting records, the caliber of accounting
personnel, and any special objectives of the engagement. Consequently, a
separate, tailor-made audit program should be prepared for each audit
engagement.
8. The quotation is misleading because it implies that an audit program is no more

than a checklist of instructions for inexperienced auditors. Actually, audit
programs are essential to assessing that all work is performed and are used on
virtually all audit engagements regardless of the amount of experience of the
auditor. Also, a written audit program is required for all audits.
9. The risk of material misstatement is the probability that an account, class of

transactions, or disclosure is materially misstated. It consists of inherent risk
(the risk of material misstatement without considering internal control) and
control risk (the risk that internal control will fail to prevent or detect and correct
the material misstatement).
Overview of Risk-Based Audit Process 9-3
10. Significant risks often relate to nonroutine transactions and estimation
transactions. Such transactions typically involve more subjective judgment than
routine transactions and, therefore, they often have a higher risk of material
misstatement. Significant risks may also be fraud risks.
11. Factors which may cause an audit engagement to exceed the original time
estimate include the following:
(1) Accounting records may not be up to date and complete.
(2) Inadequacies in internal control may be discovered necessitating a more
detailed audit than anticipated.
(3) A significant risk, such as a fraud risk, may be discovered requiring an
extension of audit procedures.
(4) Fraud may be discovered, and an extended investigation may be
authorized by the client to clarify the situation.
(5) Inadequate supervision of audit staff may permit unnecessary or mis-
directed work to be performed.
(6) Findings during the course of the audit may cause the client to request
extension of the scope of the work.
In some engagements, clients are charged at agreed daily or hourly rates for the
time used to perform the audit. The difficulty of forecasting time requirements
is a principal reason for the use of per diem rates rather than quoting a fee for
the entire engagement. For many engagements, a maximum fee is agreed upon;
this plan may, of course, force the auditing firm to absorb part of the cost of
unexpected amounts of work. A decision as to charging the client for unusual
amounts of time will involve consideration of all aspects of the engagement and
prior relations with the client. Generally, however, the client should not be
billed for excessive time attributed to audit inefficiencies (e.g. item (5) above).
12. Underreporting of time results in the CPA firm not billing the client for all of the
time actually involved in rendering the professional services. Thus, the firm's
revenue is being restricted. In addition, the underreporting will cause the firm to
underestimate the amount of time required for future engagements. Thus,
auditors on future engagements will be expected to perform audit procedures in
an unrealistically short period of time. This interferes with the performance of
an effective audit as well as the realistic evaluation of firm personnel.
Cases
1. a. Prior to acceptance of the engagement, Argante & Tan should have

communicated with the predecessor auditor regarding:
Facts that might bear on the integrity of management.
Disagreements with management concerning accounting
principles, auditing procedures, or other significant matters.
The predecessors understanding about the reason for the change.
Any other information that may be of assistance in determining
whether to accept the engagement.
b. The form and content of engagement letters may vary, but they would
generally contain information regarding:
The objective of the audit.
The estimated completion date.
Managements responsibility for the financial statements.
The scope of the audit.
Other communication of the results of the engagement.
The fact that because of the test nature and other inherent
limitations of any system of internal control, there is an
unavoidable risk that even some material misstatement may remain
undiscovered.
Access to whatever records, documentation, and other information
may be requested in connection with the audit.
Arrangements with respect to client assistance in the performance
of the audit engagement.
Expectation of receiving from management written confirmation
concerning representations made in connection with the audit.
Notification of any changes in the original arrangements that might
be necessitated by unknown or unforeseen factors.
Request for the client to confirm the terms of the engagement by
acknowledging receipt of the engagement letter.
The basis on which fees are computed and any billing
arrangements.
2. a. Typical engagement letter generally includes the following:

The name and address of the person or persons who retained the
auditor to perform the auditing services.
An opening paragraph that confirms the understanding of the
auditor and the client.
A summary of significant events that lead to the retention of the
services of the auditor.
A general description of the CPA firm that will conduct the
examination.
A statement that the examination will be performed in accordance
with auditing standards.
A description of the scope of the services to be rendered, which
should establish the nature of the engagement.
Any scope restrictions or special limitations and their effect on the
auditors report.
A statement regarding the auditors responsibility for the detection
of fraud.
An indication of the possible use of client personnel in connection
with the audit work to be performed.
A statement that the auditor will provide a management letter if
required in the circumstances.
The method and timing of billings as well as billing rates and fee
arrangements.
Space for the client representatives signature, which indicates
acceptance of the letter and the understandings, therein.
b. The benefits of preparing an engagement letter include the avoidance of

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

preparing for future engagements.
c. The CPA usually prepares the engagement letter as a follow-up to a verbal

understanding that he and his client have reached. It is desirable that the
client endorse and return an approved copy of the engagement letter to the
CPA. It also is acceptable for the client to prepare his own letter
summarizing his understanding of the nature of the engagement.
d. Preferably the engagement letter should be sent at the beginning of the
engagement so that misunderstandings, if any, can be remedied.
e. Obviously, the engagement letter will be most useful in clarifying

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

engagement include the following:
(1) Francis should explain to Nikolai the need to inquire of Jo and should
request permission to make such inquiries.
(2) Francis should request that Nikolai authorize Jo to respond fully to all
of Francis inquiries since Jo would be prohibited from disclosing
confidential information obtained in the course of his professional
engagement with Nikolai.
(3) Francis should advise Jo of Nikolais decision to change auditors as an
act of professional courtesy.
(4) Francis should make reasonable inquiries of Jo regarding matters that
will aid in deciding whether to accept the engagement. (Francis
inquiries should include questions regarding facts which might bear on
the integrity of management, disagreements with management as to
accounting principles, auditing procedures or other significant matters,
and Jos understanding of the reason(s) for the change of auditors.)
(5) Francis should weigh all the information received from Jo. If Jo does
not respond fully to Francis questions, Francis should consider the
implications of the limited response in deciding whether to accept the
engagement.
(6) After weighing all information received from Jo, Francis should inform
Nikolai that a first-time audit is more time-consuming than a recurring
audit because the new auditor is generally unfamiliar with clients
operations and does not have the benefit of past knowledge of company
affairs to use a guide.
(7) A discussion with Nikolai of the estimated required audit time and fee
arrangement should be coordinated with a clear explanation of the
purpose and scope of the audit. Any work that can be done by client
personnel should also be discussed so that excess audit time might be
eliminated and proposed report deadlines can be reasonably met.
(8) To satisfy Francis quality control objectives, Francis should use
procedures such as reviewing the financial statements of Nikolai;
inquiring of third parties such as Nikolais banks, legal counsel,
investment bankers, and others in the business community as to
Nikolais reputation; and evaluating his ability to serve Nikolai
properly with reference to industry expertise, size of engagement, and
available staff.
(9) If Francis has no reservations, after all significant factors have been
considered, discussed, and agreed to, Francis should accept the
engagement and confirm the understanding in an engagement letter.
b. Francis procedures on this first-time audit should include the following:

(1) Francis should review the workpapers of Jo to obtain information that
will help plan the audit work.
(2) Francis should make arrangements as early as possible for the initial
meeting with key company personnel who will be contacted
throughout the engagement.
(3) Since basic information about the company is not readily available to
Francis on this first-time audit, information of a general nature should
be obtained as early in the planning stage as possible. (Such
information should include company history, nature of the business,
credit policies, financing methods, sales methods and terms, seasonal
business patterns, products, services, plant locations, internal
procedures, accounting policies, tax status, etc. Client procedures
manuals and manuals of accounts should be read to obtain such
information.)
(4) Francis should immediately start obtaining the data needed to create a
permanent working paper file. (The file should include items such as
articles of incorporation, minutes, internal audit reports, deeds of trust,
pension agreements, loan agreements, leases, important contracts, and
other pertinent data.)
(5) Francis must determine the scope of work necessary to verify the
opening balances. Such balances must be reviewed to determine
whether they are stated on a basis comparable with those of the period
under review. If Francis cannot verify the opening balances, Francis
should consider disclaiming an opinion on the earnings statement and
statement of changes in financial position.
(6) The composition of all important accounts should be reviewed. Francis
should limit his examination of prior period accounts to a review or
survey of such accounts, without a detailed examination, unless the
results of Francis survey and analyses indicate the need for further
investigation of accounting methods in the prior years.
(7) Francis must consider whether the financial statements are prepared
using financial reporting standards that were consistently applied. If,
after performing necessary audit procedures, Francis cannot be satisfied
as to consistency, considerations must be given to qualifying the
auditors report as to consistency.
Francis should use professional judgment to determine the extent of reliance

that should be placed on the work of Jo. The scope of Francis work may
be reduced as a result of Francis consultation with Jo and a review of the
prior-year workpapers of Jo.
4. a. A CPA can use the following sources of information to help decide whether
to accept a new audit client.
Financial information prepared by the prospective client:

Annual reports to shareholders
Interim financial statements
Securities registration statements
Annual report on SEC
Reports to regulatory agencies
Inquiries directed to the prospects business associates:

Banker
Legal counsel
Underwriter
Other persons, e.g., customers, suppliers
Predecessor auditor, if any, communication, re:

Integrity of management, Disagreements with management
Analysis:
Special or unusual risk related to the prospect
Need for special skills (e.g., computer or industry expertise)
Internal search for relationships that would comprise independence
b. Students can decide this acceptance question either way, although the brief
facts prejudice the conclusion toward nonacceptance. The CPAs own firm
decided to resign only 10 years ago, presumably over matters of owner-
manager integrity. Yet, Mr. Sello appears to be a respected member of his
new community. Maybe his fast and loose accounting past is behind him.
Maybe not.
5. Benefits of engagement letters are:
Helps establish an understanding between client and auditor of the terms of
the engagement and the nature of the work.
Helps avoid quarrels and misunderstandings between client and auditor.
Helps avoid disputes over the audit fee.
Helps avoid legal liability assertions based on failure to do work that the
CPA may not have contemplated or agreed to do.
CHAPTER 10
UNDERSTANDING THE ENTITY
Questions
1. A business risk is a treat to achieving managements objectives. There are many

examples of business risks that may result in a risk of material misstatement of
the financial statements. Two are shown below:
Business Risk Risk of Material Misstatement
Rapidly changing technology in the Inventory may be overvalued because

clients industry may threaten to it is not valued at net realizable value.
cause the clients products to become
obsolete.
Economic conditions in the industry Accounts receivable may be

may result in significant uncollectible overvalued because the allowance for
accounts receivable. uncollectible accounts is not
adequate.
2. An audit plan provides essential background information for an audit

assignment, and outlines the objectives, timing, staffing, special risks and
considerations, and other requirements of the engagement. An audit program is
a detailed outline of the auditing work to be performed, specifying the
procedures to be followed in verification of each item in the financial
statements. Although both the audit plan and the audit program are technically
plans, the audit plan serves more as a broad overview of the engagement, while
the audit program is more specific and limited in scope.
3. The purpose of the team meeting on fraud risk is designed to allow the more
experienced team members to share insights and exchange ideas about how and
where the entitys financial statements might be susceptible to material
misstatement due to fraud, to discuss how to design appropriate tests to detect
the misstatements, and to emphasize the importance of maintaining the proper
degree of professional skepticism regarding the possibility of fraud.
4. During the planning process, the auditors make preliminary estimates of both
risk and materiality for the engagement. The auditors must plan their
engagements to reduce the audit risk of issuing an unqualified opinion on
materially misstated financial statements to a relatively low level. At the
account balance level, audit risk actually has three components: (1) inherent
risk, (2) control risk, and (3) detection risk. On audits where the risk of
misstatement is relatively high, the auditors must compensate by increasing the
effectiveness of their audit procedures. They may design more effective
procedures, increase the number of items selected for testing, or perform more
procedures at the balance sheet date rather than at an interim date. They may
also add an element of unpredictability to the procedures.
The auditors' preliminary estimates of levels of materiality also affect the nature,
timing, and extent of their planned procedures. Materiality levels determine
which accounts are significant enough to require audit, affect the size of the test
samples, and determine the dollar amount of individual items that warrant
examination.
5. (a) Auditors must obtain an understanding of the client and its environment in
order to determine whether the client should be accepted and to plan the
audit. This understanding encompasses the following:
(1) The nature of the client, including the clients application of accounting
policiesThe auditors understanding of this area will include the
clients competitive position, organizational structure, accounting
policies and procedures, ownership, capital structure, and product lines.
The understanding will also encompass an understanding of the clients
business model and its major business processes.
(2) The industry, regulatory, and other external factorsThe factors

included here are industry conditions, such as the competitive
environment, supplier and customer relationships, and technological
developments. They also include the regulatory, legal, and political
environment, and general economic conditions.
(3) Objectives and strategies and related business risksThe auditors

obtain an understanding of the operating and financing strategies of
management. They also obtain an understanding of managements risk
assessment process. This assists the auditors in identifying significant
business risks that may create risks of material misstatement of the
(4) Methods of measuring and reviewing performanceThe auditors

obtain an understanding of the methods management uses to measure
and review performance at various levels within the organization.
These methods are important to determining incentives of management
and other employees. The measures may also be used in designing
effective analytical procedures.
(5) Internal controlThe auditors understanding of internal control assists

them in planning the audit and assessing control risk.
Understanding the Entity 10-3
(b) Sources of information on prospective clients include trade publications,
and governmental agency publications. Previous audit reports, annual
reports to stockholders, SEC filings, and prior years' tax returns are
excellent sources of financial background information. Informal
discussions between the auditors and key officers can provide information
about the history, size, operations, accounting records, and controls of the
enterprise. Inquiries of others within the organization can provide
information that confirms inquiries of management, and provides more
detailed information about risks and business processes. Inspection of
internal documents and records can provide information about the nature of
the clients operations and internal control. The predecessor auditor may
also provide information.
(c) Knowledge of the client and its environment helps the auditors in:
(1) Identifying areas that may need special consideration.

(2) Identifying significant business risks that may result in risks of material
misstatement of the financial statements.
(3) Assessing inherent risk and making preliminary assessments of control
risk.
(4) Making judgments about the appropriateness of accounting principles
in use and the adequacy of disclosures.
(5) Evaluating the reasonableness of estimates, such as depreciation lives
and the allowance for doubtful accounts.
(6) Evaluating the reasonableness of management representations.
(7) Developing an efficient audit strategy.
(8) Determining the staffing requirements of the engagement.
6. During the tour of the client's plant facilities, Sison inspects all inventory areas
and makes note of the location, types, security, "housekeeping," and general
condition of the inventories. He also visits the receiving and shipping
departments and reviews the types of documents maintained. His observations
in these areas enable him to form a preliminary impression of the adequacy of
internal controls for inventories, and possible problems with respect to obsolete
or slow-moving inventories. He also can begin formulating plans for staffing
and carrying out the physical inventory observation.
Sisons observation of the productive processes will acquaint him with the
client's physical plant facilities and layout, the nature of the products and
computer applications employed in the production process. He may also obtain
information on the client's documentation such as for production orders, raw
materials requisitioned to production, direct and indirect labor, and inspection
and testing of finished products. He meets the supervisory personnel, engineers,
and other key personnel responsible for production, and through inquiries and
conversations learns of any unique production problems, including excessive
spoilage and scrap. As a result, he will be in a position to evaluate the client's
cost accounting system during the course of the audit. He will also inquire
about the details of the clients business processes.
Throughout the tour, Sison will add to his impression of the client's business
processes, control procedures and accounting records. He will notice, for
example, what personnel have access to computer terminals and accounting
records, whether plant assets have identification tags, and whether documents
such as production orders and receiving reports are serially numbered or
controlled by the computer.
7. (a) Misstatements due to fraudulent financial reporting are intentional

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

by assigning more experienced staff to the engagement. Also the
extent of the supervision of the staff should be adjusted to reflect
the fraud risks.
(c) Giving further consideration to the appropriateness of the
accounting principles used by the client.
(d) Incorporating an added element of unpredictability in the selection
of auditing procedures.
(2) An alteration in the nature, timing and extent of the procedures
performed. For example, Shin might apply procedures that provide
more reliable evidence, shift more audit tests to year-end, or increase
sample sizes for certain substantive tests.
(3) Perform procedures to further address the possibility of management
override of internal control, including (1) examining journal entries and
other adjustments for evidence of fraud, (2) reviewing accounting
estimates for biases, and (3) evaluating the business rationale for
significant unusual transactions.
(b) Whenever the auditors believe that there is evidence that fraud may exist,
the matter should be brought to the attention of an appropriate level of
management. Fraud involving senior management and fraud that causes a
material misstatement of the financial statements should be reported directly
to the audit committee. In very serious situations the auditors should
consider resigning the engagement.
1. d 6. d
2. a 7. d
3. d 8. d
4. d 9. d
5. d 10. d
Cases
1. (1) (a) There is an increased risk of fraudulent financial reporting by

subsidiary management. More specifically, subsidiary management
would likely attempt to increase revenue or decrease expenses.
(b) The auditors would probably respond by performing more procedures

at the subsidiary location. Additional tests of revenue would be
performed and the auditors would likely decide to observe inventory at
year-end. In addition, some of the procedures may be performed on an
unannounced basis.
(2) (a) There is an increased risk of fraudulent financial reporting by

management related to revenue.
(b) The auditors would likely respond by utilizing more experienced audit
team members. Specifically, audit staff that had experience with
complex revenue contracts in the telecommunications industry. They
would also likely increase the extent of the substantive tests of revenue.
(3) (a) There is an increased risk that the futures traders will fraudulent
overstate the value of the contracts to increase their compensation.
(b) The auditors would likely respond to this situation by bringing in a

specialist to assist in valuing the contracts. In addition, they would do
extensive testing of the valuation of the contracts.
(4) (a) There is an increased risk that management may be fraudulently

overstating income at one or more of the stores.
(b) The auditors would likely respond by doing increased testing of

revenue and inventory at the stores. The auditors could use the results
of the analytical procedures to identify stores that are more likely to
have fraudulent reported results (e.g., those with unusually high profit
margins). The auditors also may not disclose the locations that they
intend to visit for inventory observation.
2. Mr. Gian Lee
President
Palace Corporation
Dear Mr. Lee:
Our recent tour of Palace's plant was a most pleasant and interesting
experience. The information obtained on this tour and during the discussion of
your financial statements and accounting records has enabled us to plan the
scope of an audit especially suited to your needs.
Our fees are based on the time spent on the engagement by various
members of our audit staff, and will be billed at our established rates. The total
time required for an initial engagement is usually somewhat greater than in
repeat examinations, since the latter do not require analysis of past years'
transactions. Considerable savings in the cost of the audit may be made by
utilizing the services of your accounting staff to help us in certain phases of the
work. We can arrange for your employees to prepare for us a number of
working papers. If you approve, we shall indicate to your chief accountant the
exact nature of the working papers to be prepared.
Our audit will be performed in accordance with generally accepted auditing

standards and will include all procedures which we consider necessary to
provide a basis for expression of our opinion on the fairness of the financial
statements. The audit will include:
(1) A consideration of the internal control.

(2) Tests of the financial statement accounts and balances to the extent we
consider necessary, based on our consideration of risks and internal
control.
(3) Preparation of the federal and state income tax returns.
(4) Issuance of our auditor's report upon your financial statements.
If our investigation indicates the desirability of any changes in internal

control procedures, we shall prepare a report on this subject for your
consideration. However, an audit cannot be relied upon to identify all
weaknesses in internal control. The purpose of our audit is to enable us to
express an opinion on the fairness of the financial statements; the audit is
designed to provide reasonable, but not absolute, assurance of detecting material
fraud and defalcations, and we will notify you if our audit does bring them to
light.
Although it is not possible to determine in advance the exact number of

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

CHAPTER 11
CONSIDERATION OF INTERNAL CONTROL

IN A FINANCIAL STATEMENTS AUDIT
Questions
1. An auditor obtains an understanding of a clients internal control structure as a

part of the control risk assessment process in order (1) to plan the nature, timing,
and extent of subsequent substantive audit procedures, and (2) to obtain
information about reportable conditions (control deficiencies) to report to the
client.
2. The primary reason for conducting an evaluation of a clients existing internal

control system is to give the auditors a basis for finalizing the details of the
account balance audit program to determine the nature, timing and extent of
subsequent substantive audit procedures.
A secondary purpose for conducting an evaluation of internal control is to be

able to make constructive suggestions for improvements. Officially, the
profession considers these suggestions a part of the audit function and does not
define the work as a MAS consultation.
Another purpose of the evaluation is to report to management and the board of

directors or its audit committee any discovery of any reportable conditions of
internal control deficiencies.
3. Refer to page 590, 1st paragraph of the textbook.
4. 1. Advantages of control questionnaire:

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

Can explain the precise controls applicable to the particular client.
(precise tailoring)
Requires penetrating analysis.
Minimizes tendency toward perfunctory review.
Disadvantages:
Hard to write. Often lengthy.
Hard to revise in subsequent years.
3. Advantages of flowchart:
Graphic presentation of systems.
Shows the steps required and the flow of forms and documents.
Easy to read and analyze.
Easy to update in subsequent years.
Disadvantages:
Takes some time to draw neatly.
5. Observation, in a test of control procedure, refers to auditors looking to see

whether client personnel stamped, initialed, or left other signs that their assigned
control procedures had been performed.
Reperformance, in a test of control procedure, refers to auditors doing again

the control that was supposed to have been performed by the client personnel
(recalculating, looking up the right price, comparing quantities, and so forth).
6. Written reports on internal accounting control (IAC) for external use.
Type of Engagement Character of Report

Special IAC study Report on IAC with opinion on IAC
system taken as a whole.
Service auditor engaged to report for A special-purpose report on IAC can
benefit of user auditor and their take special forms, the main feature of
mutual client. which includes an opinion relating to
the controls applied by the service
organization to the client
organizations transactions.
7. The auditor must obtain a sufficient understanding of the clients system of

internal financial controls to identify the types of potential material
misstatements of financial statement components, and the risks associated with
each. Such understanding is obtained by gathering evidence relating to the basic
elements of the clients internal financial controls.
8. The auditor obtains an initial understanding of the clients financial controls by

studying the organizational structure, inquiring of management, and studying
last years working papers if a recurring audit.
9. The documentation of the auditors understanding must provide clear evidence

of support for the auditors conclusions regarding the assessed level of control
risk. This is especially necessary if control risk is assessed below the maximum
Consideration of Internal Control in a Financial Statements Audit 11-3
level. The documentation at this point typically consists of some combination of
narrative memoranda, questionnaires or checklists, and internal control
flowcharts, as well as documentation of the auditors conclusions, and the
reason(s) for assessing control risk below maximum, if applicable.
10. Testing of internal financial controls may permit the auditor to further reduce the
assessed level of control risk. This, in turn, should lead to a decrease in the
nature, timing, and/or extent of substantive audit testing in the circumstances.
11. The following factors may cause the auditor to decide not to test the clients
internal financial controls beyond obtaining an initial understanding:
a. Controls may already have been evaluated as ineffective;
b. Further testing is not cost effective (i.e., the cost of further testing is
greater than the cost savings resulting from reduced substantive testing)
12. Some combination of the following means is typically utilized by the auditor in
testing a clients internal financial controls:
a. Reprocessing transactions through the clients system;
b. Observation of controls; and
c. Document examination and testing.
13. Misrepresentation is a form of financial statement misstatement caused by

intentional efforts by management to distort reported financial position and/or
results of operations. Misappropriation is a form of fraud whereby one or more
employees effect a transfer of assets from employer to employee, accompanied
by concealment in the form of account or substance alteration.
14. The following are some examples of internal control weaknesses and suggested
expanded substantive testing, given the weaknesses:
a. Perpetual inventory records not maintained: Expand test counts during
inventory observation
b. Bank accounts not reconciled: Expand year-end audit of cash accounts
c. Customer exceptions to monthly statements not investigated and
cleared: Expand accounts receivable confirmation at year-end.
15. Reportable conditions are matters coming to the auditors attention, as a result of
his/her study and evaluation of the clients internal financial controls, relating to
significant deficiencies in the design or operation or of the internal controls that
could adversely affect the organizations ability to record, process, summarize,
and report financial data consistent with the assertions of management in the
financial statements. The purpose of the reportable conditions letter is to inform
the audit committee, or similar body within the organization, of weaknesses for
which they may not be aware. Such communication increases the likelihood
that the weaknesses will be corrected on a timely basis.
16. Use of any one of the approaches to studying and documenting a clients
internal financial controls, by itself, is inadequate. Each approach adds a needed
dimension to the analysis. The memorandum requires depth of analysis not
found in the flowchart. The flowchart, on the other hand, promotes ease of
understanding and ready identification of strengths and weaknesses in controls.
The questionnaires and checklists add the dimension of completeness of
coverage. By using the three tools in combination, the auditor is able to gain a
deeper and clearer understanding of each of the subsets of the transaction cycles,
including major control strengths and weaknesses, thereby permitting more
accurate control risk assessments and more useful substantive audit programs
based on such assessments.
1. b 8. a 15. d 22. a
2. a 9. b 16. c 23. a
3. b 10. c 17. b 24. d
4. d 11. b 18 b 25. b
5. b 12. a 19. a 26. d
6. b 13. b 20. d 27. b
7. b 14. b 21. a 28. d
Cases
1. a. Given identified financial control weaknesses, the auditor may elect to

expand the extent of substantive testing, or search for and test compensating
controls. In the present case, the following errors and irregularities may
occur, given the control weaknesses in the payroll subset of the expenditure
cycle:
1. Hours may be in error, inasmuch as the time cards are prepared by
employees and not reviewed. This could lead to overstatement or
understatement of wages expense in the income statement. This
could also affect the carrying value of finished goods inventories if
Quicky is a manufacturing company.
2. The payroll could be padded inasmuch as signed checks are
returned to the department supervisors for distribution. This could
result in overstatements of salaries and wages expense on the
income statement. It could also cause a finished goods inventory
overstatement.
b. If, based on the initial understanding, controls are thought to be adequate,

the auditor should consider the following alternatives:
Consideration of Internal Control in a Financial Statements Audit 11-5
1. Document the understanding, assess control risk below maximum,
as considered appropriate, and document the basis for conclusions;
or
2. Document the understanding and test controls as a means for
further reduction in the assessed level of control risk. This
alternative would be chosen if the following conditions exist:
a. Controls are thought to be effective; and
b. Cost reductions through reduced substantive testing
exceed cost of further testing of controls.
c. 1. Auditors must study and evaluate internal control each year because the
environment within which the client operates is subject to constant
change; and controls must adapt to these changes if the system is to
remain effective. The auditor must identify the environmental changes
and determine that the relevant control points remain covered after the
changes.
2. A minimum audit is necessary, even under conditions of excellent

internal control, because of the following inherent limitations in all
internal control systems:
Internal control assumes the nonexistence of collusion;
Management can override the financial controls;
Temporary breakdowns in the control system may occur and
produce material errors;
Given that these inherent limitations could produce material financial

statement misstatements, and given that the audit report provides
reasonable assurance that the financial statements do not contain
material misstatements, the auditor must perform a minimum audit,
even under conditions of excellent internal control if such assurance is
to be provided.
2.
ISLANDER DRUG STORE, INC.
Processing Cash Collections
Internal Control Questionnaire
-Question Yes No
Are customers who pay by check identified via store I.D. card or
other means?
Does company policy prohibit accepting checks for anything
except merchandise sales plus a nominal cash amount?
Is a receipt produced by the cash register given to each
customer?
Is the reading of each cash register taken periodically by an
employee who is independent of the handling of cash
receipts?
Are cash counts made on a surprise basis by an individual who is
independent of the handling of cash receipts?
Is the reading of each cash register compared regularly to the
cash received?
Is a summary listing of cash register readings prepared by an
employee who is independent of physically handling cash
receipts?
Are receipts forwarded to an independent employee who makes
the bank deposits?
Are each days receipts deposited intact daily?
Is the summary listing of cash register receipts reconciled to the
duplicate deposit slips authenticated by the bank?
Are entries to the cash receipts journal prepared from duplicate
deposit slips or the summary listing of cash register
readings?
Are the entries to the cash receipts journal compared to the
deposits per bank statement?
Are areas involving the physical handling of cash reasonably
safeguarded?
Are employees who handle receipts bonded?
Are charged back items (NSF checks, etc.) directed to an
employee who does not physically handle receipts or have
access to the books?
CHAPTER 12
FRAUD AND ERROR
Questions
1. Holding a belief that a potential conflict of interests always exists causes

auditors to perform procedures to search for errors or irregularities that would
have a material effect on financial statements. This tends to make audits more
extensive for the auditor and more expensive for the client. The situation is not
a desirable one in the vast majority of audits where no errors or irregularities
exist.
2. Errors and irregularities: Auditors are required to plan the audit to detect errors
and irregularities that would have a material effect on the financial statements.
Clients illegal acts: Auditors are not required to search for illegal acts, but they
are warned to be alert to any that might be detected in the ordinary course of an
audit.
3. Seven major assertions in financial statements:
a. Existence assertion:
The practical objective is to establish with evidence that assets, liabilities
and equities actually exist and that sales and expense transactions actually
occurred. Cut-off can be considered an aspect of the existence assertion.
b. Occurrence assertion:
The practical objective is to establish with evidence that recorded
transactions or events that occurred during a given accounting period
pertained to the entity.
c. Completeness assertion:
The practical objective is to establish with evidence that all transactions of
the period are in the financial statements and all transactions that properly
belong in the preceding or following accounting periods are excluded.
Another term for these aspects of completeness is cut-off.
Completeness also refers to proper inclusion in financial statements of all

assets, liabilities, revenue, expense, and related disclosures.
d. Rights and Obligations assertion:
The practical objectives related to rights and obligations are to establish
with evidence that assets are owned (or rights such as capitalized leases are
shown) and liabilities are owed.
e. Measurement assertion:
The practical objective is to establish with evidence that a transaction or
event is recorded at the proper amount and revenue or expense is allocated
to the proper period.
f. Valuation assertion:
The practical objective is to establish with evidence that proper values have
been assigned to things (assets, liabilities, equities and related disclosures)
and events (revenues, expenses and related disclosures). Auditing
Standards refer to the practical objective of obtaining evidence about
valuations achieved by cost allocations such as depreciation and
inventory costing methods.
g. Presentation and Disclosure assertion:

The practical objective is to establish with evidence that accounting
principles used by management are appropriate in the circumstances and are
applied properly, and that disclosures contain all information required by
generally accepted accounting principles.
4. Benefits of preliminary assessment of materiality:

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

review procedures in 27.1% of the cases in a set of audits, and another 18.5%
discovery rate was attributed to prior expectations and discussions.
Fraud and Error 12-3
6. In assessing inherent risk and control risk, the auditor must consider the types of
errors or irregularities that might occur and their impact on the financial
statements (materiality.) In evaluating materiality, the auditor should consider
the impact of errors and irregularities both individually and in the aggregate.
Auditing Standards require that the auditor design the audit to provide
reasonable assurance of detecting errors and irregularities that are material to the
financial statements. Auditing Standards require that audit risk and materiality
be considered both in planning the audit and in evaluating audit results.
Control risk and inherent risk are also directly related to the setting of
materiality thresholds. If, for example, application of analytical procedures
(inherent risk analysis) leads the auditor to suspect earnings inflation, individual
item materiality thresholds should be reduced accordingly (i.e., either the
materiality percentage or the amount of unaudited income should be decreased.)
Similarly, if control risk analysis leads the auditor to suspect numerous errors,
aggregate materiality thresholds need to be lowered accordingly.
7. An auditors reaction to an immaterial error may differ from his or her reaction
to an immaterial irregularity. Auditors generally accumulate the amount of
individual immaterial errors to be sure that the aggregate of all errors is not
material. In addition, the auditor is concerned about whether an error came from
a misunderstanding or other cause that would have resulted in yet more errors
during the period. An auditor is expected to report all irregularities to the audit
committee or the board of directors and senior management.
11. The factors that should be considered are the peso amount of the account, the
likelihood of error, and the cost of auditing the account.
12. The auditor deals with both inherent risk and control risk during the planning
phase of the audit. Inquiry of client personnel, study of the business and
industry, application of analytical procedures, and documentation of the
auditors initial understanding of internal control are all performed during the
planning phase of the audit. Further study of internal control procedures may
occur after the planning phase if the auditor wishes to further reduce the
assessed level of control risk, and considers it economically feasible to do so.
1. d 11. d 21. b 31. b 41. b 51. a 61. a

2. c 12. a 22. d 32. a 42. d 52. a 62. c
3. c 13. c 23. d 33. d 43. a 53. b 63. d
4. b 14. c 24. c 34. a 44. c 54. a
5. d 15. a 25. d 35. d 45. c 55. c
6. a 16. a 26. a 36. d 46. d 56. d
7. c 17. a 27. b 37. c 47. d 57. b
8. d 18. d 28. a 38. b 48. c 58. d
9. c 19. b 29. a 39. a 49. b 59. d
10. d 20. d 30. b 40. a 50. d 60. c
Cases
1. a. Antonios activity is an irregularity (intentional distortion of financial

statements) rather than error (unintentional mistake). It is also an illegal act
on Antonios individual part.
b. The problem does not describe the kind of related party transactions
discussed in PSA 550.
c. Yes, a weakness in internal control exists. It may be considered a material

weakness because the compensating control (internal auditors work on
slow-moving inventory) did not operate in a timely enough manner to detect
the irregularity before it had gotten large.
If a material weakness in internal control exists, Brava & Campos are

obligated to report it to management and/or the board of directors.
d. The problem description indicates that this element of the audit was
conducted in a negligent manner. Theres nothing wrong about auditing a
sample of the transactions, but Campos follow-up and explanation of the
missing receiving reports leaves much to be desired. At the very least he
could have reviewed the reports produced by Antonio at a later date, and he
could have traced the purchases to the inventory records and perhaps
noticed an over-stocking condition. The auditors had some evidence that an
irregularity might exist, but they failed to apply extended audit procedures
properly.
2. a. Yes. Nicolas was a party to the issuance of false financial statements and as
such is a joint tortfeasor. The elements necessary to establish an action for
common law fraud are present. There was a material misstatement of fact,
knowledge of falsity (scienter), intent that the plaintiff bank rely on the false
statement, actual reliance and damage to the bank as a result thereof. If
Fraud and Error 12-5
action is based upon fraud there is no requirement that the bank establish
privity of contract with the CPA. Moreover, if the action by the bank is
based upon ordinary negligence, which does not require a showing of
scienter, the bank may recover as a third-party beneficiary (an exception to
the strict privity requirement). Thus, the bank will be able to recover its
loss from Nicolas under either theory.
b. No. The lessor was a party to the secret agreement. As such, the lessor
cannot claim reliance on the financial statements and cannot recover
uncollected rents. Even if he was damaged indirectly, his own fraudulent
actions led to his loss, and the equitable principle of unclean hands
precludes him from obtaining relief.
c. Nicolas was not independent. His report is improper and he is probably

subject to disciplinary action by the professional organization or regulatory
body. According to the ethics interpretation on actual or threatened
litigation:
An expressed intention by the present management to commence litigation

against the auditor alleging deficiencies in audit work for the client is
considered to impair independence if the auditor concludes that there is a
strong possibility that such a claim will be filed.
CHAPTER 13
CORPORATE GOVERNANCE AND AUDITS
Questions
1. Corporate governance is defined as:

a process by which the owners and creditors of an organization exert
control and require accountability for the resources entrusted to the
organization. The owners (stockholders) elect a board of directors to
provide oversight of the organizations activities and accountability
back to its stakeholders.
The key players in corporate governance are the stockholders (owners), board of
directors, audit committees, management, regulatory bodies, and both internal
and external auditors.
2. In the past decade, all parties failed to a certain extent. For detailed analysis, see
exhibit in the chapter and repeated here:
Corporate Governance Responsibilities and Failures
Overview of Corporate Governance Failures

Party Overview of Responsibilities
Stockholders Broad Role: Provide effective oversight through Focused on short-term prices; failed to perform
election of Board process, approve major initiatives, buy long-term growth analysis; abdicated all
or sell stock. responsibilities to management as long as stock
price increased.
Board of Broad Role: the major representative of stockholders to Inadequate oversight of management.
Directors ensure that the organization is run according to the Approval of management compensation
organization charter and there is proper accountability. plans, particularly stock options that provided
Specific activities include: perverse incentives, including incentives to
Selecting management. manage earnings.
Reviewing management performance and Non-independent, often dominated by
determining compensation. management.
Declaring dividends Did not spend sufficient time or have
Approving major changes, e.g. mergers sufficient expertise to perform duties.
Approving corporate strategy Continually re-priced stock options when
Overseeing accountability activities. market price declined.
Management Broad Role: Operations and Accountability. Managing Earnings management to meet analyst
the organization effectively and provide accurate and expectations.
timely accountability to shareholders and other Fraudulent financial reporting.
stakeholders. Pushing accounting concepts to achieve
Specific activities include: reporting objective.
Formulating strategy and risk appetite. Viewed accounting as a tool, not a
Implementing effective internal controls. framework for accurate reporting.
Developing financial reports.
Developing other reports to meet public,
stakeholder, and regulatory requirements.
Audit Broad Role: Provide oversight of the internal and Similar to Board members did not have
Committees of external audit function and the process of preparing the expertise or time to provide effective
the Board of annual accuracy financial statements and public reports oversight of audit functions.
Directors on internal control. Were not viewed by auditors as the audit
Specific activities include: client. Rather the power to hire and fire the
Selecting the external audit firm. auditors often rested with management.
Approving any non-audit work performed by
audit firm.
Selecting and/or approving the appointment of
the Chief Audit Executive (Internal Auditor),
Reviewing and approving the scope and
budget of the internal audit function.
Discussing audit findings with internal auditor
and external auditor and advising the Board
(and management) on specific actions that
should be taken.
Self-Regulatory Broad Role: Setting accounting and auditing standards AICPA: Peer reviews did not take a public
Organizations: dictating underlying financial reporting and auditing perspective; rather than looked at standards
AICPA, FASB concepts. Set the expectations of audit quality and that were developed and reinforced
accounting quality. internally.
Specific roles include: AICPA: Leadership transposed the
Establishing accounting principles organization for a public organization to a
Establishing auditing standards trade association that looked for revenue
Interpreting previously issued standards enhancement opportunities for its members.
Implementing quality control processes to AICPA: Did not actively involve third
ensure audit quality. parties in standard setting.
Educating members on audit and accounting FASB: Became more rule-oriented in
requirements. response to (a) complex economic
transactions; and (b) an auditing profession
that was more oriented to pushing the rules
rather than enforcing concepts.
FASB: Pressure from Congress to develop
rules that enhanced economic growth, e.g.
allowing organizations to not expense stock
options.
Corporate Governance 13-3
Other Self- Broad Role: Ensuring the efficiency of the financial Pushed for improvements for better corporate
Regulatory markets including oversight of trading and oversight of governance procedures by its members, but
Organizations, companies that are allowed to trade on the exchange. failed to implement those same procedures
e.g. NYSE, Specific activities include: for its governing board, management, and
NASD Establishing listing requirements including trading specialists.
accounting requirements, governance
requirements, etc.
Overseeing trading activities,
Regulatory Broad Role: Ensure the accuracy, timeliness, and Identified problems but was never granted
Agencies: the fairness of public reporting of financial and other sufficient resources by Congress or the
SEC information for public companies. Specific activities Administration to deal with the issues.
include:
Reviewing all mandatory filings with the SEC,
Interacting with the FASB in setting
accounting standards,
Specifying independence standards required of
auditors that report on public financial
statements,
Identify corporate frauds, investigate causes,
and suggest remedial actions.
External Broad Role: Performing audits of company financial Pushed accounting concepts to the limit to
Auditors statements to ensure that the statements are free of help organizations achieve earnings
material misstatements including misstatements that may objectives.
be due to fraud. Promoted personnel based on ability to sell
Specific activities include: non-audit products.
Audits of public company financial Replaced direct tests of accounting balances
statements, with a greater use of inquiries, risk analysis,
Audits of non-public company financial and analytics.
statements, Failed to uncover basic frauds in cases such
Other accounting related work such as tax or as WorldCom and HealthSouth because
consulting. fundamental audit procedures were not
performed.
Internal Broad Role: Perform audits of companies for Focused efforts on operational audits and
Auditors compliance with company policies and laws, audits to assumed that financial auditing was
evaluate the efficiency of operations, and audits to addressed sufficiently by the external audit
determine the accuracy of financial reporting processes. function.
Specific activities include: Reported primarily to management with little
Reporting results and analyses to effective reporting to the audit committee.
management, (including operational In some instances (HealthSouth, WorldCom)
management), and audit committees, did not have access to the corporate financial
Evaluating internal controls. accounts.
3. The board of directors is often at the top of the list when it comes to
responsibility for corporate governance failures. Some of the problems with the
board of directors included:
o Inadequate oversight of management.

o Approval of management compensation plans, particularly stock
options that provided perverse incentives, including incentives to
manage earnings.
o Non-independent, often dominated by management.
o Did not spend sufficient time or have sufficient expertise to perform
duties.
o Continually re-priced stock options when market price declined.
4. Some of the ways the auditing profession was responsible were:

Too concerned about creating revenue enhancement opportunities for
the firm, and less concerned about their core services or talents
Were willing to push accounting standards to the limit to help clients
achieve earnings goals
Began to use more audit shortcuts such as inquiry and analytical
procedures instead of direct testing of account balance.
Relied on management representations instead of testing management
representations.
Were too often advocates of management rather than protectors of
users
5. Users should expect auditors to have the expertise, independence, and

professional skepticism to render an unbiased and justified opinion on the
financial statements. Auditors are expected to gather sufficient applicable
evidence to render an independent opinion on the financial statements.
6. Management is responsible for issued financial statements. Although other

parties may be sued for what is contained in the statements, management is
ultimately responsible. Ownership is important because it establishes
responsibility and accountability. Management must set up and monitor
financial reporting systems that help it meet its reporting obligations. It cannot
delegate this responsibility to the auditors.
7. An audit committee is a subcommittee of the board of directors that is composed

of independent, outside directors. The audit committee has oversight
responsibility (on behalf of the full board of directors and its stockholders) for
the outside reporting of the company (including annual financial statements); risk
monitoring and control processes; and both internal and external audit functions.
8. An outside director is not a member of management, legal counsel, a major
vendor, outside service provider, former employee, or others who may have a
personal relationship with management that might impair their objectivity or
independence.
The audit committee is responsible for assessing the independence of the

external auditor and engage only auditors it believes are independent. Auditors
are now hired and fired by audit committee members, not management. The
intent is to make auditor accountability more congruent with stockholder and
third-party needs.
9. The external auditor should discuss any controversial accounting choices with
the audit committee and must communicate all significant adjustments made to
the financial statements during the course of the audit. In addition, the processes
used in making judgments and estimates as well as any disagreements with
management should be communicated. Other items that need to be
communicated include:
All adjustments that were not made during the course of the audit,
Difficulties in conducting the audit,
The auditors assessment of the accounting principles used and overall
fairness of the financial presentation,
The clients consultation with other auditors,
Any consultation with management before accepting the audit engagement,
Significant deficiencies in internal control.
10. The auditor might utilize the following procedures in determining the actual
level of governance in an organization:
observe the functioning of the audit committee by participating in the

meetings, noting the quality of the audit committee questions and responses,
interactions with management regarding issues related to the audit, e.g.
o providing requested information on a timely basis,
o quality of financial personnel in making judgments,
o accounting choices that tend to push the limits towards
aggressiveness or creating additional reported net income,
o the quality of internal controls within the organization.
review the minutes of the board of directors meetings to determine that they
are consistent with good governance,
review internal audit reports and especially determine the actions taken by
management concerning the internal auditors findings and recommendations,
review the compensation plan for top management,
review management expense reimbursements to determine (a) completeness
of documentation, (b) appropriateness of requested reimbursement, and (c)
extent of such requests.
review managements statements to the financial press to determine if they
are consistent with the companys operations.

1. d
2. d
3. a
4. d
5. d
Cases
1. a. The auditor might use the following approaches to determine whether a

corporate code of ethics is actually followed:
observe corporate behavior in tests performed during the audit, e.g.

approaches the company takes to purchasing goods, promoting
personnel, and so forth,
observe criteria for promoting personnel; for example does
performance always take on greater importance than how things are
done,
observe corporate plans to communicate the importance of ethical
behavior, e.g. webcasts, emails, and so forth to communicate the
importance of ethics,
review activity on the clients whistleblowing website, or a
summary of whistleblowing activities reported by the internal
auditor,
read a sample of self-evaluations by corporate officers, the board,
and the audit committee and compare with the auditors
observations of behavior,
examine sales transactions made during the end of quarters to
determine if the sales reflect performance goals as opposed to the
companys code of ethics.
b. Are auditors equipped to make subjective judgments? This should be a
great discussion question because many young people are attracted to the
accounting profession because there are rules and relative certainty as to
how things are done. However, as the profession is evolving, more
judgments are required in both auditing and accounting. Audit personnel
need to be equipped to make judgments on whether the companys
governance structure operates as intended and whether there are deficiencies
in internal control when it does not operate effectively. The profession
believes that auditors can make such judgments.
c. Assessing the competence of the audit committee can occur in a number of

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

where the audit committee is perceived to be weak. There are a number of
reasons including:
The lack of good governance most likely influences the

organizations culture and is correlated with a lack of
commitment to good internal control.
The auditor has less protection from the group that is designed
to assist the auditor in achieving independence.
The company may be less likely to be fully forthcoming in
discussions with the auditor regarding activities that the
auditor might question.
d. Internal auditing is an integral part of good corporate governance. It

contributes to corporate governance in three distinct ways:
It assists the audit committee in its oversight role by

performing requested audits and reporting to the audit
committee,
It assists senior management in assessing the continuing
quality of its oversight over internal control throughout the
organization,
It assists operational management by providing feedback on
the quality of its operations and controls.
2. a. Corporate governance is defined as:
a process by which the owners and creditors of an organization

exert control and require accountability for the resources
entrusted to the organization. The owners (stockholders) elect
a board of directors to provide oversight of the organizations
activities and its accountability to stakeholders.
The key players in corporate governance are the stockholders

(owners), board of directors, audit committees, management,
regulatory bodies, and auditors (both internal and external).
b. In the past decade especially, all parties failed to a certain extent. For
detailed analysis, see exhibit 2.2 in the chapter and reproduced below:
Corporate Governance Responsibilities and Failures
Overview of Corporate Governance

Party Overview of Responsibilities Failures
Stockholders Broad Role: Provide effective oversight through Focused on short-term prices; failed to
election of Board process, approve major perform long-term growth analysis;
initiatives, buy or sell stock. abdicated all responsibilities to
management as long as stock price
increased.
Board of Broad Role: the major representative of Inadequate oversight of management.

Directors stockholders to ensure that the organization is run Approval of management compensation
according to the organization charter and there is plans, particularly stock options that
proper accountability. provided perverse incentives, including
Specific activities include: incentives to manage earnings.
Selecting management. Non-independent, often dominated by
Reviewing management performance and management.
determining compensation. Did not spend sufficient time or have
Declaring dividends sufficient expertise to perform duties.
Approving major changes, e.g. mergers Continually re-priced stock options
Approving corporate strategy when market price declined.
Overseeing accountability activities.
Management Broad Role: Operations and Accountability. Earnings management to meet analyst
Managing the organization effectively and provide expectations.
accurate and timely accountability to shareholders Fraudulent financial reporting.
and other stakeholders. Pushing accounting concepts to achieve
Specific activities include: reporting objective.
Formulating strategy and risk appetite. Viewed accounting as a tool, not a
Implementing effective internal controls. framework for accurate reporting.
Developing financial reports.
Developing other reports to meet public,
stakeholder, and regulatory requirements.
Audit Broad Role: Provide oversight of the internal and Similar to Board members did not
Committees of external audit function and the process of have expertise or time to provide
the Board of preparing the annual accuracy financial statements effective oversight of audit functions.
Directors and public reports on internal control. Were not viewed by auditors as the
Specific activities include: audit client. Rather the power to hire
Selecting the external audit firm. and fire the auditors often rested with
Approving any non-audit work performed management.
by audit firm.
Selecting and/or approving the
appointment of the Chief Audit Executive
(Internal Auditor),
Reviewing and approving the scope and
budget of the internal audit function.
Discussing audit findings with internal
auditor and external auditor and advising
the Board (and management) on specific
actions that should be taken.
Self- Broad Role: Setting accounting and auditing AICPA: Peer reviews did not take a
Regulatory standards dictating underlying financial reporting public perspective; rather than looked at
Organizations: and auditing concepts. Set the expectations of standards that were developed and
AICPA, FASB audit quality and accounting quality. reinforced internally.
Specific roles include: AICPA: Leadership transposed the
Establishing accounting principles organization for a public organization to
Establishing auditing standards a trade association that looked for
Interpreting previously issued standards revenue enhancement opportunities for
Implementing quality control processes to its members.
ensure audit quality. AICPA: Did not actively involve third
Educating members on audit and parties in standard setting.
accounting requirements. FASB: Became more rule-oriented in
response to (a) complex economic
transactions; and (b) an auditing
profession that was more oriented to
pushing the rules rather than enforcing
concepts.
FASB: Pressure from Congress to
develop rules that enhanced economic
growth, e.g. allowing organizations to
not expense stock options.
Other Self- Broad Role: Ensuring the efficiency of the Pushed for improvements for better
Regulatory financial markets including oversight of trading corporate governance procedures by its
Organizations, and oversight of companies that are allowed to members, but failed to implement those
e.g. NYSE, trade on the exchange. Specific activities include: same procedures for its governing
NASD Establishing listing requirements board, management, and trading
including accounting requirements, specialists.
governance requirements, etc.
Overseeing trading activities,
Regulatory Broad Role: Ensure the accuracy, timeliness, and Identified problems but was never
Agencies: the fairness of public reporting of financial and other granted sufficient resources by Congress
SEC information for public companies. Specific or the Administration to deal with the
activities include: issues.
Reviewing all mandatory filings with the
SEC,
Interacting with the FASB in setting
accounting standards,
Specifying independence standards
required of auditors that report on public
financial statements,
Identify corporate frauds, investigate
causes, and suggest remedial actions.
External Broad Role: Performing audits of company Pushed accounting concepts to the limit
Auditors financial statements to ensure that the statements to help organizations achieve earnings
are free of material misstatements including objectives.
misstatements that may be due to fraud. Promoted personnel based on ability to
Specific activities include: sell non-audit products.
Audits of public company financial Replaced direct tests of accounting
statements, balances with a greater use of inquiries,
Audits of non-public company financial risk analysis, and analytics.
statements, Failed to uncover basic frauds in cases
Other accounting related work such as tax such as WorldCom and HealthSouth
or consulting. because fundamental audit procedures
were not performed.
Internal Broad Role: Perform audits of companies for Focused efforts on operational audits
Auditors compliance with company policies and laws, and assumed that financial auditing was
audits to evaluate the efficiency of operations, and addressed sufficiently by the external
audits to determine the accuracy of financial audit function.
reporting processes. Reported primarily to management with
Specific activities include: little effective reporting to the audit
Reporting results and analyses to committee.
management, (including operational In some instances (HealthSouth,
management), and audit committees, WorldCom) did not have access to the
Evaluating internal controls. corporate financial accounts.
c. There is an inverse relationship between corporate governance and risk

to the auditor i.e. the better the quality of corporate governance, the
lower the risk to the auditor. This relationship occurs because lower
levels of corporate governance implies two things for the auditor:
There is more likelihood that the organization will have

misstatements in its financial statements because the
commitment to a strong organizational structure and oversight
is missing,
There is greater risk to the auditor because the governance
structure is not designed to prevent/detect such misstatements,
and will likely not be as forthcoming when the auditor
questions potential problems.
3.
Audit Activity to
Element of Poor Determine if Governance Risk Implication of Poor
Corporate Governance is actually Poor Governance
The company is in the This is not necessarily poor The lack of good risk
financial services sector governance. However, the management by the
and has a large number of auditor needs to determine organization increases the
consumer loans, the amount of risk that is risk that the financial
inherent in the current loan statements will be
including mortgages,
portfolio and whether the misstated because of the
outstanding. risk could have been difficulty of estimating the
managed through better risk allowance for loan losses.
management by the The auditor will have to
organization. focus increased efforts on
estimating loan losses,
including a comparison of
how the company is doing
in relation to the other
companies in the financial
sector.
The CEO and CFOs This is a rather common In combination with other
compensation package and, things, the use of
Audit Activity to
compensation is based on by itself, is not necessarily significant stock options
three components: (a) poor corporate governance. may create an incentive for
base salary, (b) bonus However, in combination management to potentially
based on growth in assets with other things, the use of manage reported earnings
significant stock options in order to boost the price
and profits, and (c)
may create an incentive for of the companys stock.
significant stock options. management to potentially
manage reported earnings The auditor should
in order to boost the price carefully examine if the
of the companys stock. companys reported
The auditor can determine earnings and stock price
if it is poor corporate differs broadly from
governance by determining companies in the same
the extent that other sector. If that is the case,
safeguards are in place to there is a possibility of
protect the company. earnings manipulation and
the auditor should
investigate to see if such
manipulation is occurring.
The audit committee There is a strong indicator This is an example of poor

meets semi-annually. It of poor corporate governance because (1) it
is chaired by a retired governance. If the audit signals that the
CFO who knows the committee meets only twice organization has not made
a year, it is unlikely that it a commitment to
company well because
is devoting appropriate independent oversight by
she had served as the amounts of time to its the audit committee, (2) the
CFO of a division of the oversight function, lack of financial expertise
firm before retirement. including reports from both means that the auditor does
The other two members internal and external audit. not have someone
are local community independent that they can
members one is the There is another problem in discuss controversial
President of the Chamber that the chair of the audit accounting or audit issues
of Commerce and the committee was previously that arise during the course
other is a retired employed by the company of the audit. If there is a
and would not meet the disagreement with
executive from a
definition of an management, the audit
successful local independent director. committee does not have
manufacturing firm. the expertise to make
Finally, the problems with independent judgments on
the other two members is whether the auditor or
Audit Activity to
that there is no indication management has the
that either of them have appropriate view of the
sufficient financial accounting or audit issues.
expertise.
The company has an The good news is that the The bad news is that a staff
internal auditor who organization has an internal of one isnt necessarily as
reports directly to the audit activity. large or as diverse as it
CFO, and makes an needs to be to cover the
major risks of the
annual report to the audit
organization. The external
committee. auditor will be more
limited in determining the
extent that his or her work
can rely on the internal
auditor.
The CEO is a dominating A dominant CEO is not The centralization of power

personality not unusual especially unusual, but the in the CEO is a risk that
in this environment. He centralization of power in many aspects of
has been on the job for 6 the CEO is a risk that many governance, as well as
aspects of governance, as internal control could be
months and has decreed
well as internal control overridden. This increases
that he is streamlining the could be overridden. The the amount of audit risk.
organization to reduce auditor should look at
costs and centralize policy manuals, as well as
authority (most of it in interview other members of
him). management and the board
especially the audit
committee.
The Company has a loan The auditor should observe There are a couple of
committee. It meets the minutes of the loan elements in this statement
quarterly to approve, on committee to verify its that carries great risk to the
an ex-post basis all loans meetings. The auditor audit and to the
should also interview the organization. First, the
that are over $300 million
chairman of the loan loan committee only meets
(top 5% for this committee to understand quarterly. Economic
institution). both its policies and its conditions change more
attitude towards controls rapidly than once a quarter,
and risk. and thus the review is not
Audit Activity to
timely. Second, the only
loans reviewed are (a) large
loans that (b) have already
been made. Thus, the loan
committee does not act as a
control or a check on
management or the
organization. The risk is
that many more loans than
would be expected could
be delinquent, and need to
be written down.
The previous auditor has The auditor should contact This is a very high risk
resigned because of a the previous auditor to indicator. The auditor
dispute regarding the obtain an understanding as would look extremely bad
accounting treatment and to the factors that led the if the previous auditor
previous auditor to either resigned over a valuation
fair value assessment of
resign or be fired. The issue and the new auditor
some of the loans. auditor is also concerned failed to adequately address
with who led the charge to the same issue.
get rid of the auditor.
Second, this is a risk factor
because the organization
shows that it is willing to
get rid of auditors with
whom they do not agree.
This is a problem of auditor
independence and
coincides with the above
identification of the
weakness of the audit
committee. This action
confirms a generally poor
quality of corporate
governance.
4. a&b. Cookie jar reserves are essentially funds that companies have stashed
away to use when times get tough. The rationale is that the reserves
are then used to smooth earnings in the years when earnings needs a
boost. Smooth earnings typically are looked upon more favorably by
the stock market. An example of a cookie jar reserve would be over-
estimating an allowance account, such as allowance for doubtful
accounts. The allowance account is then written down (and into the
income statement) in a bad year.
Auditors may have allowed cookie jar reserves because they are known
to smooth earnings, and smooth earnings are rewarded by the market.
On the flip side, fluctuating earnings are penalized, and present more
risk to the company of bankruptcy or other problems.
The Sarbanes-Oxley Act addressed the issue by creating an oversight

body, the PCAOB, but also addressed the issue in other ways. For
example, Congress felt that creating more effective Boards would
decrease the use of earnings management.
Allowing improper revenue recognition is one thing that auditors
may have done in their unwillingness to say no to clients. For
example, companies shipped out goods to customers at the end of the
year for deep discounts and allowed returns at the beginning of the next
year. This practice is known as channel stuffing. Since the goods had a
great chance of being returned, it would be improper to recognize all as
revenue.
Again, auditors were unwilling to say no to clients. Greed is
probably the reason here. If companies claim more revenue, their stock
would grow in the short-term, making management richer, and making
management more willing to give pay raises to their auditors.
With the establishment of stronger audit committees and certification of
financial statements in the Sarbanes-Oxley Act, this kind of accounting
trickery will certainly decrease.
Creative accounting for M&A included the use of the pooling
method of accounting. Pooling allowed acquiring companies to value
existing assets at historical costs and did not require the recognition of
goodwill for the acquisition. Because true costs (values) were not
shown on the financial statements, management was often encouraged
to bid up prices for acquisitions with the result that many of them were
not economic. The creative accounting also shielded the income
statement from charges that would have otherwise hit income including:
goodwill amortization, depreciation, and depletion expenses.
Greed, the same reasons as the revenue recognition issue, was most
likely the motivation for this creative accounting.
Discussion between an educated audit committee and auditor plus
certification of financial statements required by Sarbanes-Oxley will
certainly address this issue.
Assisting management to meet earnings. Too often, auditors
confused financial engineering with value-adding. In other words,
auditors often sought to add value to their clients by finding ways to
push accounting to achieve earnings objectives sought by management.
These earnings objectives then played a major role in escalating stock
prices all desired because of the heavy emphasis of management
compensation on stock options.
Incentives were misaligned. Most of management compensation came
in the form of stock options.
5. a. This is intended to be an open-ended discussion. There are a number

of factors that have been mentioned in the discussions regarding auditor
independence. The following is representative of some issues
discussed:
The audit firms policy for rotating auditors in charge of the

engagement,
Whether or not the client has hired personnel from the audit firm
for significant financial or management positions in the company,
such as the Chief Financial Officer was the former partner in
charge of the audit engagement,
The nature of non-audit services provided by the audit firm,
The existence of any social or other relationships with
management,
Audit committee experience with the audit firm in other situations,
such as the auditor provides services for other entities with which
the audit committee member has an association,
The existence of any charges brought against the auditing firm by
the SEC,
The audit firms involvement in significant lawsuits where their
judgment has been questioned,
The amount of fees charged by the auditing firm. If the audit fees
are too low, the audit committee should question the thoroughness
and independence of the work. If fees from non-audit work are
high, the audit committee will want to question that relationship
and possible effect on judgments made by the auditor.
The manner in which individual audit partners are compensated by
the public accounting firm. For example, if an audit partners
compensation is determined significantly by whether or not a client
is retained, then there might be questions about what the auditor
would do to retain the client.
The general reputation of the firm.
The firms policies and procedures for attracting and retaining
talented audit personnel.
The process of assigning personnel to an audit.
The firms expertise in the industry.
b. The main way that the audit committee can influence the independence
of the internal audit department is by choosing who is in charge of the
department. The tone at the top in the internal audit department will
go a long way. Further, the audit committee ought to approve the scope
of the internal audit charter, approve annual audit plans, as well as
annual budgets.
c. 1. Tax Return for Company: Approval argument. The auditor is

already aware of all the information, so can efficiently prepare the
return. Tax accounting is different than audit accounting, so
accounting treatments can be different in both settings and will not
affect each other.
Non-Approval: On the other hand, some argue that tax preparation

is a consulting activity, i.e. the auditor would need to be a client
advocate and thereby should not prepare the tax return.
2. Tax Return for Management and Board Members: Approval:

The auditor is an expert. The services can be viewed as a benefit
for management and the board.
Not Approve: Performance of the tax services too closely aligns

the auditor with management and the board. The auditor has to be
a client advocate in developing the tax returns. This may mentally
conflict with the auditors need to be objective in all other work
involving the client.
3. Tax Return paid for by Managers, not company: Approval:

This is an independent service not paid for by the company.
Not Approve: The argument is the same as #2 above. Although

paid for by the individuals, there is still the possibility of conflict.
4. Overseas Assistance for Internal Audit Department: Do not

approve. It is the responsibility of management to prepare a review
of internal control, and the auditor does an independent analysis.
Further, the performance of internal audit work is one of the areas
that have been explicitly prohibited by the SEC.
5. Security Audit of Information Systems: Approve. This is not a

conflict of interest as it is an audit or assurance service.
6. Train Operating Personnel on Internal Controls: Approve.

Auditors are experts on this area. There is no direct conflict with
the performance of the audit. Better trained personnel should
imply better internal controls beneficial for both
management and the auditor.
Not Approve. The PCAOB is explicit that management has the

responsibility to design, implement, and evaluate internal control.
Thus, training personnel is a management task that cannot be
performed by the auditor. It could, however, be performed by a
different public accounting firm.
7. Perform Internal Audit Work for the Company: Do not

approve. It is the responsibility of management to prepare a review
of internal control, and the auditor does an independent analysis.
Usually internal audit is responsible for managements end of
assessing internal controls. The audit of effectiveness and
efficiency is akin to consulting and would be interpreted by most
people as compromising the auditors independence.
8. Provide, at no cost, Seminars to Audit Committee Members.

Approve. The audit committee can make a decision as to whether a
particular member will attend the seminar. It is one way that an
audit committee member can keep up on the profession. The only
potential problem would occur if the audit committee only relied
on the audit firm for updates on accounting and audit issues.
9. Seminars for both Audit and Non-Audit Clients. Recommend

Approval. The key is whether the audit committee feels that it may
lose some of its objectivity in performing its oversight role.
CHAPTER 14
DESIGNING AN EFFECTIVE
RESPONSE TO ASSESSED RISKS
Questions
1. Inspection techniques include physical examination of assets, examination of

documents and records, performance of mechanical accuracy tests, and
analytical procedures.
2. Vouching and tracing are two types of commonly performed documentation.

Vouching involves the examination of documents that served as a basis for
recording the transaction. Vouching usually starts with a recorded transaction
and works back to the documents and addresses existence. Tracing involves
determining whether source documents have been recorded properly in the
accounting records. By tracing, an auditor can obtain evidence that the
recording of the transaction is complete.
3. An inquiry involves requesting information from client personnel and receiving

their response. The request and response may be either written or oral. A
confirmation is a response a third party makes directly to the auditor on the
request of a client. The response includes information about certain
transactions, relationships, and/or balances that have an impact on a specific
financial statement assertion.
4. Confirmations are usually considered more reliable because they are from
outside parties, while inquiries are made of client personnel.
5. When equivalent procedures are available to satisfy the need for evidence, an
auditor may consider cost in selecting among the alternatives.
6. Vouching is relevant to testing the existence of sales; tracing is not. Tracing is

relevant to testing the completeness of sales, but vouching is not.
1. c 3. c 5. c 7. a 9. d
2. d 4. a 6. c 8. d
Cases
1. Types of procedures used by auditors in general, with examples:

1. Recalculation by the auditor
* recomputing the clients calculation of depreciation expense
2. Observation by the auditor
* observation, test-counting of clients physical inventory-taking
3. Confirmation by letter
* obtaining accounts receivable confirmations
* obtaining clients lawyers letter
4. Inquiry and written representations
* ask client personnel about accounting events
* complete an internal control questionnaire
* obtain written client representation letter
5. Vouching
* find brokers invoices and cancelled checks showing agreement with
record amounts for securities investments
6. Tracing
* select a sample of shipping documents and trace them to sales invoices,
sales journal recording and posting to general ledger
7. Scanning
* scan expense accounts for credit entries
* scan payroll check lists for unusually large checks
8. Analytical procedures any example that fits one of these:
* compare financial information with prior periods
* compare financial information with budgets and forecasts
* study predictable financial information patterns (e.g., ratio analysis)
* compare financial information to industry statistics
* study financial information in relation to nonfinancial information
2. a. A material decline in sales may indicate unrecorded sales; a decrease in cost

of goods sold may be due to unrecorded purchases; and an increase in cost
of good sold may be the result of omissions from the ending inventory. An
increase or decrease in gross profit will result from any one or a
combination of the above omissions.
b. A decline in the miscellaneous revenue account balance, or the absence of a

previously existing source of miscellaneous revenue, could be attributable
to a failure to record miscellaneous revenue.
Designing an Effective Response 14-3
c. Unrecorded accounts payable at year-end would cause an increase in
calculated accounts payable turnover.
d. An apparent increase in accounts receivable turnover may, in fact, be the

result of failure to record credit sales transactions.
e. A higher than average operating return may be indicative of unrecorded

purchases or operating expenses; a lower than average return could result
from unrecorded sales.
CHAPTER 15
AUDIT EVIDENCE
Review Questions
1. Refer to page 614, 2nd and 4th paragraphs of the textbook.
2. Refer to page 614, 3rd paragraph of the textbook.
4. Refer to page 6177, 1st paragraph of the textbook.
5. Refer to page 617, 2nd paragraph of the textbook.
6. Refer to page 618, 4th paragraph of the textbook.
7. External documentary evidence is evidential matter obtained from the other

party to an arms-length transaction or from outside independent agencies.
External evidence reaches the auditor directly and does not pass through the
hands of the client.
External-internal documentary evidence is documentary material that originates

outside the bounds of the clients data processing system but which has been
received and processed by the client.
Internal documentary evidence consists of documentary material that is

produced, circulates, and is finally stored within the clients information system.
Such evidence is not touched by outside parties at all or is several steps removed
from third-party attention.
8. Auditors can help the effectiveness of confirmation requests by:

a. Having the confirmation letters printed on the clients letterhead and signed
by a client officer.
b. Being careful to be assured of reliable addresses for recipients; that is, being
assured that the confirmations are not misdirected (for example, to a clients
accomplices in fraud).
c. Asking confirmation of information that recipient can supply, like the
amount of a balance or the amounts of specified invoices or notes (not the
balances of homeowners mortgages or financial amounts, like certificates
of deposit with accrued interest, for which people usually do not keep their
own accounting records).
d. Controlling the mailing and return of confirmations so the client cannot
tamper with them.
e. Receiving the reply directly, so the client cannot intercept and alter them.
9. Factual evidence is direct evidence, in that conclusions may be drawn from the
evidence without further corroboration. An example of factual audit evidence is
physical observation of inventory for existence. Inferential evidence is indirect,
in that direct conclusions cannot be drawn from the evidence. The auditor
typically examines other evidence to further corroborate the inferences drawn.
An oral statement by a product manager that one or more products are fully
saleable and not obsolete is an example of inferential evidence. The auditor may
perform inventory turnover tests and/or determine the date of last sale of the
product to further corroborate the product managers statement.
10. Sufficiency of audit evidence is a matter of audit judgment. Materiality and the
quality of internal control are important ingredients in determining sufficiency.
If internal control produces over sales processing and cash receipts, for example,
are effective, the auditor may elect to confirm fewer customers accounts
receivables than under conditions of weak internal control.
11. Physical evidence tests the existence assertion. Examples of physical evidence
are inventory observation, examination of securities, inspection of plant asset
additions, and count of cash on hand.
12. The quality of existing internal control is the major factor supporting the
strength of documentary evidence. A voucher produced under conditions of
strong internal control over the processing of vendors invoices, for example,
possesses greater validity and is therefore stronger evidence than vouchers
produced under weak control conditions.
13. Auditing standards define an accounting estimate as an approximation of a

financial statement element, item or amount. Estimates are used because (1) an
amount is uncertain pending specific future events or (2) relevant data cannot be
accumulated on a timely, cost-effective basis. Examples of accounting estimates
include allowance for uncollectible accounts, obsolete inventory, useful lives
and residual values of fixed assets, natural resources and intangibles, accruals
for taxes on real and personal property, accruals based on actual assumptions in
pension plans, contract revenue using percentage of completion method,
litigation losses, fair values in nonmonetary exchanges, and current values in
personal financial statements.
14. In evaluating the reasonableness of accounting estimates, an auditor should

consider the internal controls related to the estimates in order to reduce the
likelihood of material misstatements in the estimates, whether the accounting
Audit Evidence 15-3
estimates are reasonable given the situation, and whether the accounting
estimates are presented in accordance with appropriate accounting principles.
15. Evidence is persuasive if the auditor considers the evidence to be sufficient and
competent enough to afford a reasonable basis for an opinion.
1. d 4. c 7. d 10. d 13. b
2. d 5. a 8. b 11. a
3. c 6. d 9. d 12. b
Cases
1. a. Evidential matter obtained from independent sources outside an enterprise

provides greater assurance of reliability (competency) than that which is
secured solely within the enterprise.
b. Accounting data and financial statements developed under satisfactory

conditions of internal control are more reliable (competent) than those
which are developed under unsatisfactory conditions of internal control.
c. Direct personal knowledge obtained by the independent auditor through

physical examination, observation, computation, and inspection is more
persuasive than information obtained indirectly.
2. 1. Types of evidence
Evidential items/sources in reliability rank

d. Letter from creditor 1. External
a. Monthly statements 2. External-internal
b. Voucher register 3. Internal
c. Audit computation of discounts 4. Mathematical (based on
unaudited data)
2.
c. Audit computation of expense 1. Mathematical (based on
amounts unaudited data)
a. Letter from bond trustee 2. External
d. Cancelled checks 3. External-internal
b. Minutes of directors meetings 4. Internal
CHAPTER 16
BASIC AUDIT SAMPLING CONCEPTS
Review Questions
4. Audit conclusions can be made only about the population from which the
sample was drawn, and a conclusion can only be valid if the sample on which it
is based actually shows the characteristics of the population. Auditors can
attempt to achieve representativeness, but they cannot guarantee it. Sampling
risk the probability that the sample does not adequately reflect the population
always exists.
5. Refer to page 656, 2nd paragraph; page 657, 1st paragraph of the textbook.
7. Refer to page 662, paragraphs 1 to 4 of the textbook.
8. Refer to page 662, paragraphs 3 and 4 of the textbook.
9. Refer to page 663, 4th paragraph & page 664, 1st to 3rd paragraph of the textbook.
10. Sampling risk is the probability that the auditors conclusions concerning the
population will be in error. In terms of conclusions regarding internal control,
sampling risk consists of two subsets:
Alpha risk, the risk that the auditor will assess control risk too high and
perform more substantive testing than is necessary under the circumstances;
and
Beta risk, the risk that the auditor will assess control risk too low and
perform less substantive testing than is necessary.
For control testing purposes, the auditor is more concerned with beta risk than
alpha risk, because beta risk poses the threat of underauditing and is therefore
the basis for the audit opinion. The auditor controls this risk by setting beta risk
sufficiently low as to maintain overall audit risk at a level less than or equal to
10%.
11. Refer to pages 675 of the textbook.
12. Refer to pages 670 of the textbook.
1. b 3. d 5. d 7. a 9. a
2. c 4. c 6. b 8. d 10. c
Comprehensive Cases
1. a. Areas requiring the auditors to make judgment decisions when statistical

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

areas in which the auditors must make judgment decisions.
b. If the CPAs sample shows an unacceptable deviation rate, they may take
the following actions:
(1) They may enlarge their sample to increase the precision of their
estimate.
Basic Audit Sampling Concepts 16-3
(2) They may isolate the type of deviation and expand examination as it
relates to the transactions that give rise to that type of misstatement.
(3) The auditors usual response to an unacceptably high deviation rate is
to increase their assessed level of control risk. Accordingly, the
auditors would increase the intensity of their substantive tests.
c. Techniques for selecting an unstratified random sample of accounts payable

vouchers include the following:
Random Sample. A random sample is a sample of a given size drawn from

a population in a manner such that every possible sample of that size is
equally likely to be drawn. Items may be selected randomly by:
(1) Table of Random Numbers. Use one of a number of published tables.
Using four columns in the table, select the first 80 numbers which fall
within the range of 1 to 3,200. The starting point in the table should be
selected randomly and the path to be followed through the table should
be set in advance and followed consistently.
(2) Random Number Generator: Using generalized audit software,
generate a list of 80 random numbers.
Systematic Sample. A systematic sample is drawn by selecting every nth

item beginning with a random start.
(1) Every nth item. Select every 40th voucher after selecting the initial
voucher (from 1 to 40) randomly.
(2) Several random starting points. For example, use two random starting
points and select 40 of the 80 vouchers from each of the two sequences.
Select every 80th voucher (3,200/40) after each of the two random
starting points between 1 and 80 for each of the two sequences.
2. a. (1) Since the results of tests of controls typically play a significant role in
determining the nature, timing, and extent of other audit procedures, the
auditors usually specify a low level of risk of assessing control risk too
low. It is usually set at 5 or 10 percent.
(2) In determining the tolerable deviation rate, an auditor should consider

the planned assessed level of control risk and the extent of assurance
desired from the evidential matter included in the sample.
(3) In determining the expected population deviation rate, an auditor

should consider the results of prior years tests, the overall control
environment, or utilize a preliminary sample.
b. (1) There is a decrease in sample size if the acceptable level of the risk of
assessing control risk too low is increased.
(2) There is a decrease in sample size if the tolerable deviation is increased.
(3) There is an increase in sample size if the population deviation rate is

increased.
c. Using a statistical sampling approach, Figure 17.4 reveals that 7 deviations

in a sample of size 100 results in an achieved upper deviation rate of 12.8%,
well in excess of the tolerable deviation rate (8%). The sample results
should thus be interpreted as not supporting the planned assessed level of
control risk.
Using a nonstatistical sampling approach, the 7% estimated population

deviation rate identified in the sample (7 deviations / 100 sample items)
approaches the tolerable deviation rate of 8%. Therefore, using a
nonstatistical approach, the sample result would also be interpreted as not
supporting the planned assessed level of control risk.
d. Statistical sampling allows the auditors to quantify sampling risk. As

described in part (c), only when statistical sampling is used do the auditors
know that the achieved upper deviation rate is 12.8%.
CHAPTER 17
AUDIT SAMPLING FOR TESTS OF CONTROLS
Questions
1. A test of control procedure is a statement of

a. Identification of a population from which sampling units are to be drawn.
b. Expression of an action taken to produce evidence about a client control
procedure.
2. Compliance deviations should be defined in advance so auditors will know what

to look for and will know one when they see it.
Seven Examples Based on Seven General Control Objectives:
Objective Example
1. Validity 1. Sale recorded without supporting shipping
orders.
2. Authorization 2. Lack of credit manager approval for a credit
sale.
3. Accuracy 3. Mathematical errors in sales invoice
calculations.
4. Classification 4. Sales classified in wrong product line revenue
account.
5. Proper Period 5. Sales recorded in month (quarter, year) before
the actual shipment.
6. Accounting 6. Sales charges fail to be posted to a customers
account.
7. Completeness 7. Shipments fail to be billed to customers and
recorded as sales and receivables.
3. Judgments affecting sample size for test of controls auditing.
Judgment Influence on sample size

1. Acceptable risk of Inverse. The greater the acceptable risk,
assessing control risk the smaller the sample.
too low
2. Acceptable risk of Inverse. The greater the acceptable risk,

assessing control risk the smaller the sample.
too high
3. Tolerable deviation Inverse. The higher the tolerable rate, the
rate smaller the sample.
4. Expected population Direct. The higher the expected rate, the
deviation rate (an larger the sample.
estimate rather than a
judgment)
The sample size is also directly related to the population size, although the
influence is generally minor. The larger the population, the larger the sample,
but not much.
4. The risk of assessing the control risk too low has the potential of affecting audit
effectiveness, thus damaging the quality of the audit for users. Professionally,
in light of responsibility to users, effectiveness is more important than efficiency,
which is affected by the risk of assessing the control risk too high.
5. Expanded risk model: AR = IR x CR x AP x TD

Solve for TD, when: .048 = 1.0 x .4 x .6 x TD
TD =
.048 = .2
1.0 x .4 x .6
The tolerable misstatement (P10,000) and estimated standard deviation (P25.00)

are noise in the question.
6. The connection is a direct relationship between control risk and the tolerable
deviation rate. (1) When larger values are planned for control risk (say, 0.95,
0.90) in an audit plan, more analytical procedure and test of detail work will be
done. Auditors will not rely very much on internal controls. Therefore, not
much help is expected from the controls anyway, so the tolerable deviation rate
can be larger. The direct relation is: The higher the control risk, the higher the
tolerable deviation rate can be. (2) When lower values are assigned to control
risk (say, 0.10, 0.20) in an audit plan, less analytical procedure and test of detail
work will be done. Auditors intend to rely on internal accounting controls.
Therefore, effective compliance with control policies and procedures is
important, and the tolerable deviation rate ought to be low. The direct relation
is: The higher the planned control risk, the higher the tolerable deviation rate
can be.
Audit Sampling for Tests of Controls 17-3
7. Based on the specifications of risk of assessing control risk too low, tolerable
deviation rate and expected population deviation rate, sample sizes would be
determined independently for the two populations in the subdivision. If the
criteria are at least as stringent for each of the two as they would be for the
undivided population, the sum of the two sample sizes would be at least twice
the size of the sample figured for the single population (provided both
subdivided populations have 1,000 or more units).
8. Further reduction of the assessed level of control risk is justified only when the
upper occurrence limit is <= the tolerable occurrence rate. Recall that the
tolerable occurrence rate is that rate of error beyond which the auditor cannot
justify further reduction in the assessed level of control risk. A calculated rate
which exceeds the tolerable rate, therefore, would suggest a level of error which
precludes any lowering of assessed control risk.
9. Expected occurrence rate is the anticipated error rate in a population. It is set on

the basis of one or a combination of: The prior years audit; the auditors initial
understanding of internal control policies and procedures relative to the
transaction cycle subset; or a pilot sample of documents. The expected
occurrence rate has a positive effect on sample size.
The tolerable occurrence rate is the maximum error rate which the auditor
would accept while still lowering assessed control risk below maximum. The
auditor bases the tolerable rate on materiality of the attribute being tested. The
more critical an attribute to effective internal control, the lower the tolerable
occurrence rate. The tolerable occurrence rate has an inverse effect on sample
size.
10. Inherent risk is the risk that, in the absence of internal control, material errors or
irregularities will occur.
Control risk is the risk that internal financial control policies and procedures will
fail to prevent or detect material errors and irregularities.
Detection risk is the risk that material errors and irregularities, which are not
prevented or detected by internal financial control policies and procedures, will
not be detected by the independent audit.
1. d 6. a 11. b 16. d 21. d

2. b 7. a 12. d 17. d 22. c
3. a 8. b 13. c 18. b
4. d 9. c 14. a 19. d
5. c 10. b 15. b 20. b
Cases
1. a. Control testing may be approached in three different ways, depending on

the nature of the controls. If a visible audit trail exists in the form of
documentation, the auditor examines documents, as appropriate, for the
purpose of evaluating the operating effectiveness of internal control
procedures. Evidence as to whether transactions have been executed in
accordance with managements authorization and recorded in accordance
with GAAP is gathered through such examination. In the absence of a
visible audit trail, the auditor tests controls through observation or
reprocessing. The auditor observes the control environment and control
procedures, such as physical safeguards. In the presence of complex EDP
systems, the auditor may find transaction reprocessing the most effective
means for testing selected controls. Statistical sampling methods, involving
attribute sampling, are commonly applied to the first form of control testing.
Observation and reprocessing ordinarily do not require the use of statistical
sampling, although reprocessing may involve judgment sampling in
developing hypothetical transactions to process through the system.
b. 1. attribute sampling application;

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

1. Positive effect (but only in population sizes under 2,000)
2. Positive effect
3. Inverse effect
4. Inverse effect.
Audit Sampling for Tests of Controls 17-5
b. How determined:
2. Prior years audit; initial understanding of internal control; pilot
sample.
3. Materiality;
4. Materiality (but normally not to exceed 10%).
3. a. The remaining steps are as follows:

4. Define the attributes (characteristics) of interest to be tested (including
the criteria for establishing the existence of errors or deviant
conditions).
5. Set the tolerable occurrence rate that would support the initial
assessment.
6. Select a confidence level (quantify the risk of underassessment).
7. Estimate the population error rate (expected occurrence rate).
8. Determine the sample size.
9. Choose a method for randomly selecting a sample.
10. Perform the tests of control procedures.
b. Statistical sampling methodology helps the auditor (a) to design an efficient

sample, (b) to measure the sufficiency of the evidential matter obtained, and
(c) to evaluate the sample results. By using a statistical sampling
methodology, the auditor can quantify sampling risk to assist in limiting it
to an acceptable level.
CHAPTER 18
AUDIT SAMPLING FOR SUBSTANTIVE TESTS
Questions
1. An incorrect acceptance decision directly impairs the effectiveness of an audit.

Auditors wrap up the work and the material misstatement appears in the
An incorrect rejection decision impairs the efficiency of an audit. Further

investigation of the cause and amount of misstatement provides a chance to
reverse the initial decision error.
2. The two methods of projecting the known misstatement to the population are the
average difference method and the ratio method. Refer to Chapter 19 for
formula expressions of each.
3. The important thing is to audit all the sample units. You cannot simply discard
one that is hard to audit in favor of adding to the sample a customer whose
balance is easy to audit. This action might bias the sample. If considering the
entire balance to be misstated will not alter your evaluation conclusion, then you
do not need to work on it any more. Your evaluation conclusion might be to
accept the book value, as long as the account counted in error is not big enough
to change the conclusion. Your evaluation conclusion might already be to reject
the book value, and considering another account to be misstated just reinforces
the decision.
If considering the entire balance to be misstated would change an acceptance

evaluation to a rejection evaluation, you need to do something about it. Since
the example seems to describe a dead end, you may need to select more
accounts (expand the sample) and perform the procedures on them (excluding
confirmation) and reevaluate the results.
4. Two main reasons for stratifying a population when sampling for variables
(peso) measurement:
a. Some units may be individually significant (e.g., large) and taking sampling
risk with respect to them is not a good idea.
b. Auditors may want to achieve audit coverage of a large proportion of pesos
in the balance by choosing the largest units (a protective sampling
objective, which is closely related to avoiding sampling risk).
5. The tolerable misstatement (judged for the audit of a particular account balance)
must be less than the monetary misstatement considered material to the overall
financial statements. Also, the aggregation of multiple tolerable misstatement
amounts for several different balances under audit must be equal to or less than
the amount of monetary misstatement considered material to the overall
statements.
6. The appropriate general set of objectives is the objective(s) of obtaining

evidence about each of the clients assertions in the financial balance. In
general, the assertions are about:
Existence (and cutoff)
Occurrence (and cutoff)
Completeness (and cutoff)
Rights and obligations (ownership, owership)
Valuation
Measurement
Presentation and disclosure
7. Influence on sample size:
Sample Size Relationships: Audit of Account Balances
Predetermined Sample Size Will Be:

High Rate or Low Rate or Sample Size
Sample Size Influence Large Amount Small Amount Relation
1. Risk of incorrect Smaller Larger Inverse
acceptance
2. Risk of incorrect Smaller Larger Inverse
rejection
3. Tolerable Smaller Larger Inverse
misstatement
4. Expected Larger Smaller Direct
misstatement
5. Population Larger Smaller Direct
variability
6. Population size Larger Smaller Direct
8. The three basic steps in quantitative evaluation are these:

1. Figure the total amount of actual misstatement found in the sample. This
amount is called the known misstatement.
2. Project the known misstatement to the population. The projected amount is
called the likely misstatement.
3. Compare the likely misstatement (also called the projected misstatement) to
the tolerable misstatement for the account, and consider the
Audit Sampling for Substantive Tests 18-3
a. Risk of incorrect acceptance that likely misstatement could be less than
tolerable misstatement even though the actual misstatement in the
population is greater, or the
b. Risk of incorrect acceptance that likely misstatement could be greater
than tolerable misstatement even though the actual misstatement in the
population is smaller.
9. Nonstatistical measurements described in Chapter 19 (page 718) leave only one

avenue for accounting for further misstatement: Apply experience and
professional judgment to decide if further misstatement could be large enough to
prevent an acceptance decision. If the projected likely misstatement is a great
deal less than the amount considered material, an auditor could judge that
further misstatement, if known, would not affect acceptance. If projected likely
misstatement is close to the amount considered material, maybe acceptance is
not warranted.
10. Account balances also can be audited, at least in part, at an interim date. When
account balance audit work is done before the companys year-end date, auditors
must extend the interim-date audit conclusion to the balance-sheet date. The
process of extending the audit conclusion amounts to nothing more (and nothing
less) than performing substantive-purpose audit procedures on the transactions
in the remaining period and on the year-end balance to produce sufficient
competent evidence for a decision about the year-end balance.
Additional considerations include:

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

Subsequently, efforts must be made to ascertain whether controls continue to be
strong. You must scan the transactions of the remaining period, audit any new
large balances, and update work on collectibility, especially with analysis of
cash received after the year-end.
11. Classical variables sampling estimates the value of a population by calculating

the mean and standard deviation of a sample and imputing the results to the
population. Probability proportional to size sampling uses the results of
sampling to calculate an estimated upper error limit and compares this with a
preset tolerable error limit. Although used for substantive testing purposes, PPS
sampling is actually a variation for attribute sampling.
12. Detection (or beta) risk affects sample size inversely for substantive testing
purposes. That is, the higher the acceptable detection risk, the smaller the
sample size; and the lower the acceptable detection risk, the larger the sample
size.
13. Precision is the range + within which the true answer most likely falls. It is
set by the auditor as a function of materiality and those levels of beta and alpha
risk deemed acceptable. Reliability is the likelihood that the sample range
contains the true value. Also referred to as the confidence level, reliability is set
by the auditor on the basis of overall audit risk.
14. PPS sampling is restricted to populations for which the auditor suspects a few
errors of overstatement only.
15. Several statistical software packages are available to facilitate audit sampling
applications. In addition to calculating sample size and evaluating sample
results, these packages can also assist in the following sampling areas:
a. Stratify populations for sampling purposes;
b. Generate random numbers to facilitate sample selection;
c. Draw the sample, given computerized data bases.
1. b 5. c 9. d 13. a 17. d
2. a 6. b 10. a 14. a 18. b
3. c&d 7. b 11. a 15. c 19. c
4. b 8. d 12. c 16. d 20. d
Supporting Computations:
Audited Value 47,520 490,000 x 0.99 = 485,100
3. c. = 0.99 ;
Book Value 48,000 490,000 485,100 = P4,900
P480
d. = P4
120
1,200 x P4 = P4,800
P 17,500
7. = 3.5%
P500,000
P450,000 x 3.5% = P157,500

Cases
1. a. Alpha risk is the risk of rejecting a population that is essentially correct.

Beta risk is the risk of accepting a population that is materially incorrect.
Alpha risk affects audit efficiency because overauditing results from
incorrectly rejecting a population. Beta risk impacts audit effectiveness
because underauditng results from incorrectly accepting a population.
Collectively, alpha and beta risk comprise sampling risk, defined as the
probability that the auditor will draw erroneous conclusions about a
population.
b. Attention to, and quantification of, alpha and beta risk assist the auditor in
applying an audit risk approach to substantive testing. During the audit
planning stage, the auditor identifies areas of high audit risk and sets
detection (beta) risk low for these areas. The result is that more substantive
testing is devoted to the high risk areas relative to the lower risk areas. This
approach enhances both audit efficiency and audit effectiveness.
c. Because it is closely related to the basis for the auditors opinion, alpha risk
is usually set equal to overall audit risk. Beta risk is set on the basis of the
auditors evaluation of inherent risk and control risk. The greater these risk
factors, as determined by the auditor during the audit planning stages, the
lower the beta risk set by the auditor. The lower the acceptable beta risk,
the larger the sample sizes for substantive testing purposes. Alpha and beta
risk, therefore, provide the necessary link between audit risk analysis and
substantive audit testing.
2. a. (1) Mean-per-unit estimates the total value of a population by (1) using the
sample mean as an estimate of the true population mean, and (2)
extending this estimated population mean by the number of items in the
population. The computations are as follows:
(1) Estimated population mean =
P582,000 / 200 lots = P2,910 per lot
(2) Estimated total value =
P2,910 per lot x 2,000 lots = P5,820,000
(2) Ratio estimation estimates total population value by (1) using the ratio
of the sample audited values to book values as an estimate of the ratio
of population audited value to book value, and (2) applying the
estimated ratio to the population book value. The computations are as
follows:
(1) Estimated ratio of audited to book value =
P582,000 / P600,000 = 97%
97% x P5,900,000 = P5,723,000
(3) Difference estimation estimates total population values by (1) using the
average difference between the audited and book values of sample
items as an estimate of the average difference for all population items,
(2) extending the estimated average difference by the number of items
in the population, and (3) using the resulting estimate of the total
difference between audited and book value to compute the estimated
total value. The computations are as follows:
(1) Estimated average difference in audit and book values:
(P582,000 - P600,000) / 200 lots = - P90 per lot
(2) Estimated total difference =
- P90 per lot x 2,000 lots = - P180,000
P5,900,000 - P180,000 = P5,720,000
b. The sample contains an element of sampling error with respect to the

average peso value of production lots. The mean book value of the
population is P2,950 (P5,900,000 / 2,000 lots), while the mean book value
in the sample is P3,000 (P600,000 / 200 lots). Mean-per-unit estimation
uses the mean value of the sample as the basis for estimating total value.
Thus, if the sample contains a disproportionate number of higher (or lower)
priced items, this sampling error will affect the estimate of the total
population value.
The estimate of total value developed in ratio estimation is based upon the
ratio of audited values to book values, rather than upon mean peso value. If
this ratio has no tendency to vary with the peso value of the lot, the estimate
of total value is not affected by the mean value of items in the sample.
However, sampling error may still be present if the sample lots are not
representative of the population with respect to the ratio of audited values
to book values.
3. The auditors would project the misstatement found in the sample to the
population using either the ratio or difference approach. The ratio approach
would result in a projected misstatement of P65,500. This may be computed by
first calculating the ratio of the audited to book value as 1.0131 [P23,100 /
P22,800 (since there is a net understatement of P300, the audited value is
P23,100)] and estimating the audited value of the population as:
1.0131 x P5,000,000 = P5,065,500 (rounded)
The projected misstatement is thus P65,500 under the ratio method.
The difference approach results in an average difference of P1.50 (P300 net

difference divided by 200 items). Multiplying by the 100,000 invoices indicates
a projected misstatement of P62,400 (P1.50 x 41,600).
4. The audit risk (ultimate risk) of material misstatement in the financial statements
(AR) is the product of:
(1) Inherent risk (IR), the risk of material misstatement in an assertion,
assuming there were no related internal controls.
(2) Control risks (CR), the risk of material misstatement occurring in an
assertion, and not being prevented or detected on a timely basis by the
internal control structure.
(3) Detection risk (DR), the risk that the auditors procedures will lead them to
conclude an assertion is not materially misstated, when in fact such
misstatement does exist.
In equation form, this relationship is expressed as follows:
AR = IR x CR x DR
This equation may be restated to solve for the allowable detection risk as
follows:
DR = AR / (CR x IR)
Using the risk levels set forth in the problem, the allowable risk of reliance upon
substantive tests is computed as illustrated below:
DR = .02 / (.2 x .5) = .20
Thus the risk of incorrect acceptance should be limited to 20 percent if the

auditors are to achieve their objective of holding audit risk to 2 percent.
5. a. (1) Required sample size is calculated as follows:
Recorded amount of population

x Reliability factor
Sample size =
Tolerable misstatement
(Expected misstatement x Expansion factor)
P500,000 x 3
Sample size = = 69
P25,000 (P2,000 x 1.6)
Note: The reliability factor is from the zero misstatements row of the
PPS sampling table given in the case.
(2) The sampling interval is calculated simply by dividing the book value
of receivables by the sample size, as follows:
Sampling interval = Recorded receivables / Sample size

= P500,000 / 69 = P7,246
b. The results may be evaluated as follows:
(1) Projected misstatement =
Book Audited Tainting Sampling Projected

Value Value Misstatement % Interval Misstatement
P 50 P 47 P 3 6% P7,246 P 435
800 760 40 5% 7,246 362
8,500 8,100 400 NA NA 400
P1,197
(2) Basic precision = Reliability factor x Sampling interval
= 3.0 x P7,246 = P21,738
(3) Incremental allowance =
Reliability Projected Incremental

Factor Increment (Increment 1) Misstatement Allowance
3.00
4.75 1.75 .75 P435 P326
6.30 1.55 .55 362 199
P525
(4) Upper limit on misstatement = P1,197 + P21,738 + P525
= P23,460
NOTES:
Projected misstatement
(a) Tainting percentages are calculated as the difference between book
and audited value divided by book value (e.g., (P50 P47) / P50 =
6%).
(b) No tainting percentage is calculated for items in excess of the
sample interval and the actual misstatement is extended to
projected misstatement (as for the third error).
Basic precision is always the reliability factor for zero misstatements

multiplied times the sampling interval.
Incremental allowance
(a) Reliability factors are read from the PPS sampling table given in
the case, starting at zero misstatements.
(b) Increment 1 is the difference in the two adjacent reliability
factors minus 1 (e.g., 4.75 3.00 1.00 = .75).
(c) Misstatements in excess of the sampling interval are not
considered in the incremental allowance. This is because the
nature of the process requires that all items in excess of the
sampling interval be included in the sample therefore no
allowance for items not in the sample is necessary.
c. The results obtained in part b would indicate that the auditors may accept
the population as not containing a tolerable misstatement at the 5 percent
level of risk of incorrect acceptance. The auditors would also consider the
results obtained in conjunction with other audit tests.
6. a. The advantages of probability-proportional-to-size (PPS) sampling over

classical variables sampling are as follows:
PPS sampling is generally easier to use than classical variables
sampling.
The size of a PPS sample is not based on the estimated variation of
audited amounts.
PPS sampling automatically results in a stratified sample.
Individually significant items are automatically identified.
If no misstatements are expected, PPS sampling will usually result
in a smaller sample size than classical variables sampling.
A PPS sample can be easily designed and sample selection can
begin before the complete population is available.
b. Sampling interval = Recorded receivables / Sample size
= P300,000 / 60 = P5,000
c. Projected misstatement =
Book Audited Tainting Sampling Projected

Value Value Misstatement % Interval Misstatement
P 400 P 320 P 80 20% P1,000 P 200
500 0 500 100% 1,000 1,000
3,000 2,500 NA NA NA 500
P1,700
CHAPTER 19
TESTS OF CONTROLS
Questions
1. Directly. Higher levels of control risk induce auditors to audit larger samples of
receivables, with confirmation date closer to the fiscal year end date. As for
nature of the procedures: higher levels of control risk induce auditors to use
positive confirmations instead of negative confirmations, and to consider
vouching subsequent payments by the customers.
2. A walk through is the process of following a transaction from its initiation

(customer order in the Revenue Cycle) through all the various processing steps
until it is recorded in the formal accounting records (accounts receivable and
sales). Usually samples of all documents are collected (sales order, sales
invoices, sales return slip, credit memo, shipping document, remittance advice
and daily remittance report) and notes are made of procedures each person
performs.
The purpose of the walk through is to obtain an understanding of the

transaction flow, the control procedures and populations of documents that may
be utilized in test of controls auditing.
3. The review (obtaining an understanding) of the control structure is primarily a

process of identifying control procedures (strengths) and lack of controls
(weaknesses) which will affect subsequent substantive procedures.
4. The internal auditors should, through periodic checks, ensure that the control
account is periodically reconciled to the customer subsidiary accounts, bank
statements are reconciled and that all prenumbered documents, especially
invoices, have all numbers accounted for. Some internal auditors also confirm
accounts receivable. Internal auditors also might review and evaluate customer
complaints for signs of weaknesses in the procedures leading to errors in
accounts receivable.
5. The features of a cash receipts internal control system which would be expected
to prevent an employee from absconding with company funds and covering with
funds from the employee pension fund is the prohibition against one employee
having custody of company funds and noncompany funds. The auditor can
detect such transfers by controlling and counting both funds simultaneously.
To prevent the cash receipts journal and recorded cash sales from reflecting
more than the amount shown on the daily deposit slip, the internal control
system should provide that receipts be recorded daily and intact. A careful bank
reconciliation by an independent person could detect such errors.
6. The evaluation after the review phase was to determine which controls appeared
adequate as a basis for justifying a low control risk assessment. The final
assessment after test of controls auditing is to determine if the controls are
actually operating as well as they appeared to be.
7. The objectives of internal control relate to transactions, and by category are:

validity, completeness, authorization, accuracy, classification, accounting and
proper period. The objectives expensed in general terms and specific terms
applied to cash receipts are as follows:
Example of Cash Receipts
General Objective Specific Objective
1. Recorded transactions are valid 1. Recorded cash receipts are
and documented. supported by remittance advices.
2. All valid transactions are recorded 2. All cash receipts are entered in the
and none omitted. daily remittance list, deposited
intact and recorded in the accounts
receivable control account.
3. Transactions are authorized by 3. Cash receipts for transactions other
company policy. than merchandise sales (scrap
sales, sales of fixed assets) are
properly authorized.
4. Transaction peso amounts are 4. Cash receipts are compared to
properly calculated. invoice terms to determine proper
cash discounts.
5. Transactions are properly 5. Cash receipts for nonmerchandise
classified in the accounts. sales are posted to proper accounts.
6. Transaction accounting is 6. All cash receipts for credit sales are
complete. posted to customer individual
accounts.
7. Transactions are accounted in the 7. Cash receipts are deposited daily
proper period. intact and recorded as of date
received.
8. If the credit limits are set and entered incorrectly, the credit approval process
will be systematically deficient.
9. The functions which should be separated to maintain internal control in a

purchasing system include (1) custody of the goods (receiving and stores
departments), (2) authority to initiate a transaction (purchasing department) and
Tests of Controls 19-3
(3) bookkeeping (accounts payable department, inventory record-keeping
department).
10. The walk through of a purchase transaction would begin with the preparation
of the requisition by the Stores department, through the bidding process and
preparation of the purchase order by the purchasing agent, to receipt of vendors
invoices and receiving report by the purchasing agent and finally to accounts
payable voucher preparation. Procedures would be observed and notations
made on document samples of procedures followed.
Documents are collected to note where documentary evidence exists or control

procedures being followed. The following documents would be collected:
requisition, purchase order, receiving report and voucher. The walk through
and sample documents would assist the auditor in understanding the flow of
transactions.
11. a. Blank vouchers kept in secure location available only to authorized

personnel.
b. Blank supporting documents (invoices, receiving reports, requisitions,
purchase orders) kept in secure locations available only to authorized
personnel.
c. Supporting documents canceled by Cash Disbursement function when
checks are prepared.
d. Separation of duties of preparers of supporting documents, preparation of
vouchers, check preparation, and check signing.
e. Vouchers and other supporting documents reviewed by check signers.
f. Checks mailed directly by signer and not returned to accounts payable.
12. Authorization for vouchers payable recording mainly consist of an approved

purchase order, a receiving report, and an accurate vendor invoice. Auditors
should look for purchase approval signatures, receiving approval signatures, and
approval of the vendor invoice checks by client for proper quantity, price, and
discount.
13. The point of this quotation is to generate discussion on the source of errors and
therefore the controls necessary when an accounting process is computerized.
Discussion items might include the following:
1. People have bad days and make mistakes; computers do not have bad days.
2. Murphys Law If it is possible to make an error, someone will find a way
to do it.
3. People initiate the transactions and will make errors.
4. All controls should be considered together (manual and computer).
Excellent computer controls cannot be relied upon if the related manual
controls are weak.
5. In computer systems, it is extremely important to establish extensive input
validation controls to prevent people errors from getting into the processing
(GIGO garbage in, garbage out).
6. People can prevent a good computer system from working well if they are
not convinced it is in their best interests.
7. People will rarely question computer printed output, even though it may not
be correct.
8. Most computer controls are to prevent, detect, or correct errors made by
people.
14. The purpose of the auditors search for unrecorded liabilities is to gather
evidence as to whether the liability assertion is true. The same concern exists in
the internal control objective all valid transactions are recorded and none are
omitted. From an evidence gathering perspective, it is much more difficult to
gather evidence on unrecorded transactions than to gather evidence that recorded
transactions (and account balances) are proper.
The search for unrecorded liabilities includes procedures in other audit areas
such as questions on bank and insurance confirmations and vouching the source
of funds for asset additions. Specific audit procedures in the search for
unrecorded liabilities include:
1. Obtain vendors invoices (or accounts payable vouchers) recorded for
several days after the balance sheet date to determine if the liability relates
to the balance sheet period under audit.
2. Scan cash disbursements for several days subsequent to year-end and vouch
to support to determine if cutoff was proper. Scan all cash disbursements
until the end of field work for unusual amounts and payees to determine if
amounts paid represent liabilities of the balance sheet period.
3. Examine BIR tax reports and correspondence and the audit reports of tax
authorities and trace additional tax assessments to the accounts.
4. Confirmation of accounts payable.
5. Use analytical procedures such as trend comparisons of accounts payable to
sales, sales taxes to sales, payroll taxes to gross payroll and interest expense
to average notes payable.
15. A walk through involves following a transaction from initiation through the
various steps until the transaction is recorded in the formal accounting records.
In the conversion cycle, the following would constitute a complete walk
through:
Step Documents Collected Controls Noted
Prepare production Production Order (P.O.) Support for P.O.
orders
Prepare bill of materials Bill of materials (B.M.) Separation planning
and manpower needs Manpower needs (M.N.) from production.
Assign job order and Note separation

foreman production supervisor
from foreman duties.
Job tickets and material Job tickets (JT) Production foreman
requisitions prepared Material requisition (MR) duties separated from
authorization.
Raw material records Issue slip (IS) Materials not issued
updated, issue slips without MR. IS
prepared prepared for all materials
released.
Observe time entered Approval by foreman of
and foreman approval on hours.
JT
Direct labor report Labor report (LR) Job tickets support L.R.
prepared
Observe timekeeping, Reconciliation hours per
compare job tickets to clock cards to hours per
clock cards J.T.
Material used report Material used report Issue slips and
prepared (MUR) requisitions support
MUR.
Observe matching issue Records from sources
slips and material used reconciled.
report
Observe matching job Records from separate
time tickets (or labor sources reconciled.
distribution) to labor
report
Enter costs in job cost Job cost sheets (JCS) Support for all entries in
sheets JCS.
Summary entry Summary entry form Job cost sheets support
prepared. summary entries.
Trace summary entry to Separation of duties; cost
General Ledger posting accounting and general
ledger.
Preparation of Report of units Independent report of
completion report completed (RUC) production completed.
Observe units compared Independent check of
to RUC, post finished RUC.
records
Products received report Products received report Independent records of

prepared (PRR) units put into finished
goods inventory.
Observe comparison Records from separate
RUC and PRR sources reconciled.
Job sheets closed out, Summary entry form Closed job sheets, RUC
summary entry prepared and PRR support
summary entries.
Trace summary entry to Separation of duties; cost
General Ledger posting accounting and general
ledger.
16. Weaknesses (lack of control where auditors believe one is necessary) are not
audited because auditors do not rely upon weaknesses to prevent, detect or
correct material errors. Auditors must consider the financial impact of
weaknesses on financial statements and plan substantive tests accordingly.
A control strength may be identified in interviews during the review phase (or in
preparing the flowcharts or questionnaires), but during test of controls auditing,
found to be nonexistent or operating ineffectively. For example, in the
conversion cycle the production management may state that foremen approve
workers job time tickets. However, when a sample of job time tickets are
examined by auditors for evidence of approval, none is found. Thus, a weakness
is not found until the control is tested. Therefore, control risk should not be
assessed low until evidence is gathered that the control is operating effectively.
17. The purpose of this review question is to foster discussion toward what
information an independent auditor needs to know. Items relevant to the
quotation might include:
1. Reference to the standard regarding adequate technical training and
proficiency as an auditor.
2. Reference to the standard regarding due professional care.
3. Obviously, the auditor must be knowledgeable about cost accounting to
audit a manufacturing company.
4. In a manufacturing company, the inventories most likely will be a major
asset which will require substantial audit work.
5. A proficient auditor must be knowledgeable in all phases of the business,
including production, marketing, finance as well as accounting data
processing.
18. The surprise observation enables the auditor to see how the distribution system
really works and increases his chances of detecting fraud. Such an observation
involves taking control of paychecks, then accompanying a client representative
as the distribution takes place. The auditor checks to see that each employee is
identified and that only one check is given to each individual. Unclaimed
checks are controlled and examined to detect any fictitious persons on the
payroll.
19. A walk through of a personnel and payroll transaction would include

discussions with each person handling personnel and payroll records. The
following illustrates the steps and documents collected.
Steps Document(s) Collected

Hiring personnel dept. Authorization to hire and rate assignment
Deductions personnel Personnel forms, employee authorization for
dept. deductions
Timekeeping Clock card
Shops Job time ticket
Cost distribution Labor distribution sheet
Accounts payable Payroll voucher
Cash disbursement Payroll checks
If the payroll is processed by computer, the clock cards and job time tickets
would be traced to batch control in the timekeeping and production departments,
to data preparation (keying to machine sensible form), to edit and validation
error reports and other computer output indicating control and finally to
computer prepared checks, labor distribution reports and summary general
ledger entries.
1. c 5. a 9. d 13. b 17. d
2. c 6. c 10. b 14. a 18. d
3. b 7. c 11. a 15. c 19. c
4. c 8. b 12. a 16. d 20. b
Cases
1. 1. Controlled access to blank sales invoices.

a. Observation. Visit the storage location yourself and see if unauthorized
persons could obtain blank sales invoices. Pick some up yourself to see
what happens.
b. Someone could pick up a blank and make out a fictitious sale.
However, getting it recorded would be difficult because of the other
controls such as matching with a copy from the shipping department.
(Thus a control access deficiency may be compensated by other control
procedures.)
2. Sales invoices check for accuracy.
a. Vouching and Recalculation. Select a sample of recorded sales
invoices and vouch quantities thereon to bills of lading, vouch prices to
price lists, and recalculate the math.
b. Errors on the invoice could cause lost billings and lost revenue or
overcharges to customers which are not collectible (thus overstating
sales and accounts receivable).
3. Duties of accounts receivable bookkeeper.

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

a. Recalculation. Review the clients working paper showing the
balancing/reconciliation. Do the balancing yourself.
b. Accounting entries could be made inaccurately or incompletely and the
control account may be overstated or understated.
2. The discussion could take several directions, including some or all of the
following:
1. Material Weakness. The facts seem to suggest a condition in which
specific control features (few or none are described) or the degree of
compliance with them do not reduce to a relatively low level the risk that
errors or irregularities in amounts that could be material to the financial
statements may occur and not be detected within a timely period by
employees in the normal course of performing their assigned functions.
Castro has authority and influence over too many interrelated activities.
Nothing he does seems to be subject to review or supervision. He even is
able to exclude the internal auditor.
An identification of the potential irregularities will illustrate the misdeeds

he can perpetrate almost single-handedly.
2. Potential irregularities include:

a. Castro can collude with customers to rig low bids and take kickbacks,
thereby depriving the company of legitimate revenue.
b. Castro can direct purchases to favored suppliers, pay unnecessarily
high prices and take kickbacks. He might even set up a controlled
dummy company to sell overpriced materials to the company. No
competitive bidding control prevents these activities.
c. Castro, through the control of physical inventory, can (i) remove
materials for himself, and (ii) manipulate the inventory accounts to
conceal shortages.
d. Castro can order truck shipping services for his own purposes and
cause the charges to be paid by the company.
e. Castro can manipulate the customer billing (similar to a above) to
deprive the company of legitimate revenue while taking an
unauthorized commission or kickback.
3. Almost every desirable characteristic of good internal control has been

circumvented:
a. Segregation of Functional Responsibilities. Castro has authorization
and custodial responsibilities.
b. Authorization, Supervision. Castro is apparently subject to no
supervision or review. The accounting staff is probably powerless to
challenge transactions because of Samuels apparent approval of
Castros powers.
c. Controlled Access. The whole situation gives Castro access to
necessary papers, records, and assets to carry out his one-man show.
d. Periodic Comparison. No one else apparently has any access to the
materials inventory in order to conduct an actual count for comparison
to the book value (recorded accountability) of the inventory.
3. The purpose of this question is to get the student to consider where the functions
that are considered incompatible in a manual system occur in a computer
system.
The functions should be separated in a manual or computer accounting system

such that different people authorize the sales transactions, record the
transactions, have custody to the assets (inventory) and reconcile the books to
the assets.
Different people should: indicate the sales order source document (authorize),
prepare the computer program (authorize and record), operate the computer
(record), have custody of inventory and correct errors (reconciliation).
4. If the credit limits are set and entered incorrectly, the credit approval process
will be systematically deficient.
5. Memorandum
TO: Board of Directors, The Potter Art League

FROM: (Students name)
DATE:
SUBJECT: Control weaknesses related to Cash Admission Fees
You requested a report which identifies the weaknesses in the existing system of cash
admission fees and my recommendations. Below are the weaknesses that exist and my
recommendations for procedures that overcome these weaknesses. I will be pleased to
discuss these at the next board meeting and offer further explanations that may be necessary.
Weakness: There is no segregation of duties between persons responsible for collecting

admission fees and persons responsible for authorizing admission.
Recommendation: One clerk (hereafter referred to as the collection clerk) should collect
admission fees and issue prenumbered tickets. The other clerk (hereafter referred to as the
admission clerk) should authorize admission upon receipt of the ticket or proof of
membership.
Weakness: An independent count of paying patrons is not made.

Recommendation: The admission clerk should retain a portion of the prenumbered admission
ticket (admission ticket stub).
Weakness: There is no proof of accuracy of amounts collected by the clerks.

Recommendation: Admission ticket stubs should be reconciled with cash collected by the
treasurer daily.
Weakness: Cash receipts are not promptly prepared.

Recommendation: The cash collections should be recorded by the collection clerk daily on a
permanent record that will serve as the first record of accountability.
Weakness: Cash receipts are not promptly deposited. Cash should not be left undeposited
for a week.
Recommendation: Cash should be deposited at least once each day.
Weakness: There is no proof of accuracy of amounts deposited.

Recommendation: Authenticated deposit slips should be compared with daily cash collection
records. Discrepancies should be promptly investigated and resolved. In addition, the
treasurer should establish a policy that includes an analytical review of cash collections.
Weakness: There is no record of the internal accountability of cash.

Recommendation: The treasurer should issue a signed receipt of all proceeds received from
the collection clerk. These receipts should be maintained and should be periodically checked
against cash collection and deposit records.
6. a. The purposes of these audit procedures are:
1. To substantiate the validity of the asset cash in the balance sheet, as it
may substantially consist of cash in transit from several sales
divisions.
2. To determine proper cash cutoff, i.e., to detect any unintentional
errors overstating or understating cash between the current and the
following accounting period.
3. To disclose kiting (if any), e.g., perpetrated by the home office
cashier in collusion with one or more sales divisions employees.
b. Audit Program for Sales Divisions Audit Steps

1. Prepare a schedule of transfer payments made by the branch for a
period covering two weeks prior and two weeks after the end of the
fiscal period showing:
Check number
Date of entry in cash disbursements book
Amount of check
Date of perforation by paying bank
Transfer checks outstanding at the date of cutoff
Transfer checks outstanding at the date of reconciliation.
2. Compare dates of issue on canceled checks and of entries.
3. Trace and compare dates of perforation and dates of payment on the
bank statement and the cutoff statement.
4. Compare dates of issue of checks to date of perforation looking for:
a. unusual delays in payment
b. discrepancy in accounting periods for the two dates.
5. Scan cancelled checks and cash disbursements records during the year
for:
a. names of payees,
b. consecutive numbers of checks to determine whether any payments
other than regular transfers to main office were made from this
account.
6. Reconcile individually several transfers during the year to
corresponding collections presumed to be transferred as of each
individual date.
7. Reconcile total collections for the year to total transfers.
7. 1. a. Recorded payroll transactions are valid (no fictitious employees).
b. Paychecks might be delayed and terminated workers might continue to
be paid (with theft of check by someone else) if payroll is not
promptly notified of new hires and terminations.
2. a. Recorded payroll deductions are valid.

b. Incorrect amounts might be deducted from pay.
3. a. Recorded payroll transactions are valid and authorized.

b. If payroll department personnel were also responsible for time records,
they would have effective control over transaction authorization (i.e.,
hours worked approval) and could overpay themselves or friends.
4. a. Payroll and labor cost transactions are complete.

b. Cost accounting records might contain more or fewer pesos than
actually paid (per payroll data). Simple errors in cost analyses might
occur.
CHAPTER 20
SUBSTANTIVE TESTS OF
TRANSACTIONS AND BALANCES
Questions
1. The cutoff bank statement is a bank statement sent by the bank directly to the
auditor, and it is usually for a fifteen or twenty day period following the
reconciliation date. The basic use of the statement by the auditor is to determine
whether outstanding checks were actually mailed before the reconciliation date.
2. All cash funds (and negotiable investment stock and bond certificates) should be
counted at the same time (simultaneously) so that money (or securities) cannot
be shifted from one location to another to conceal a shortage. If simultaneous
count cannot be made, as each fund (or each negotiable asset) is counted, it
should be locked and sealed until all are counted.
3. Kiting is the practice of recording a deposit of an interbank transfer in one

period, but delaying the recording of the disbursement until the next period
thus double counting the amount of the transfer. It is used to cover up a cash
shortage. Auditors schedule all bank transfers around the year-end and examine
the dates deposited and disbursed per books and the dates deposited and
disbursed per bank. Thus, the auditors can determine if both sides of the
transfers are recorded in the same period and the proper period.
4. A positive confirmation is a request for a response from an independent party

who the auditor has reason to expect is able to reply. A negative confirmation
is a request for a response from the independent party only if the information is
disputed. Negative confirmations should also be sent only if the recipient can be
expected to detect error and reply accordingly.
5. Generally, vouching of documentation underlying receivables balances is

deferred until after confirmation. Then vouching is performed in regard to
accounts for which confirmations were mailed but no replies received.
Additionally, vouching may be used to gather evidence about account
discrepancies and disputes indicated on confirmation responses.
6. Sales cutoff is audited by selecting sales invoices, shipping documents, and

contracts created in the period (usually 10 days to two weeks) before and after
the fiscal year-end. The transactions are traced to the sales and receivables
accounts to prove whether they were recorded in the proper period. Similarly,
recorded sales in this period may be vouched to underlying documents to
determine whether recording was in the proper period.
7. Refer to pages 458 to 460; 824 to 825; 827 to 828.
8. To prevent embezzlement through creation of fictitious credit memos, the

internal control system should provide that all credit memos be prenumbered,
controlled, and approved by a party independent of the preparer. Additionally,
credit memos should be approved only with proper supporting documentation,
e.g., a receiving report or correspondence.
9. Auditors get in the most trouble by missing overstated assets and understated
liabilities. Therefore, they need to audit for the existence of assets and the
completeness of liabilities.
10. Notes payable audit evidence obtained from a standard bank confirmation used
in the audit cash. Sales tax liability derived partially from the audit of sales
revenue (also commissions payable and excise taxes payable). Income tax
liability is derived from the net income number (audit of all revenue and
expense accounts).
11. The types of fraud and material misstatement with respect to cash disbursements
include:
1. The sending of checks to a fictitious person or company to accomplices
outside (coupled with internal record alterations).
2. The increasing (altering) of amounts payable to outside accomplices.
3. The intercepting of payments to a bank (coupled with internal record
alterations).
4. The drawing of checks payable to cash or bearer for ones own use.
The procedures auditors use most frequently to detect cash disbursement

embezzlement schemes include:
1. A proof of cash a recalculation which reconciles cash receipts and
disbursements per the bank statement with receipts and disbursements
recorded in the accounts. The auditor will satisfy himself as to the propriety
of all checks payable to cash or bearer, NSF checks, and checks drawn to
officers and other employees.
2. The confirmation with all bank creditors of amounts owed, terms and
activity during the period.
3. The auditors test of purchase transactions vouching, tracing and
recalculation in regard to purchase orders, supplier invoices, cash
disbursement journal and voucher register.
4. The auditors obtaining satisfaction of the proper separation of functions:
To establish that a proper separation exist, the auditor will not only examine
Substantive Tests of Transactions and Balances 20-3
internal records purporting a proper separation, he will also examine
documents for compliance and observe personally the flow of operations
and activities.
12. The characteristics that the auditor is looking for in his review of the clients
inventory-taking instructions include:
1. Names of client personnel responsible for the count.
2. Dates and times of inventory-taking.
3. Names of client personnel who will participate in the inventory-taking.
4. Detail instructions for recording accurate descriptions of inventory items,
for count and double-count, and for measuring or translating physical
quantities.
5. Detail instructions for making notes of obsolete or worn items.
6. Detail instructions for the use of tags, punched cards, count sheets, or other
media devices, and for their collection and control.
7. Plans for shutting down plant operations or for taking inventory after store
closing hours, and plans for having goods in proper places.
8. Plans for counting or controlling movement of goods in receiving and
shipping areas if those operations are not shut down during the count.
9. Detail instructions for compiling the count media (e.g., tags and punched
cards) into final inventory listings or summaries.
10. Detail instructions for pricing the inventory items.
11. Detail instructions for review and approval of the inventory count, notations
of obsolescence, or other matters by supervisory personnel.
13. As is true in other areas of a financial audit, verbal inquiry is a valuable tool for
obtaining preliminary evidence in the audit of inventory and cost of sales. For
example, the auditor can gain information such as the locations of inventory,
dates for the physical count, inventory held by consignees and public
warehouses, the cost-flow assumption used to price cost of goods sold and
inventories, and the pledging of inventory as collateral on loans.
In addition to providing preliminary evidence, verbal inquiry frequently

provides information about the status and value of slow-moving inventory,
apparently worn, damaged or obsolete inventory, and the existence of large
inventory stockpiles.
14. Cost of goods sold is generally audited through a combination of limited

vouching and extensive analytical procedures.
Inventory balances are generally audited through heavy reliance on observation,

vouching and recalculation, with much less emphasis on analytical procedures.
15. The auditor can obtain preliminary evidence through physically observing plant
facilities and making verbal inquiries; for example, evidence can be obtained
regarding the quantity and size of assets, their location and apparent physical
condition, the activity surrounding them, and ownership of the facilities.
Further preliminary evidence of existence may be gained by a review of internal

management reports. Examples of such reports include capital expenditure
proposals, capital budgets, construction cost or acquisition cost postanalysis,
maintenance and repair reports, reports of sales or retirements, and insurance
and property tax analyses.
The preliminary evidence should be corroborated by auditor tracing to the

detailed records to ascertain that existing assets are recorded. Further, new asset
acquisitions should be traced to directors authorizations for expenditures and to
the capital budget.
16. To obtain relevant audit data about investment securities, auditors procedures
include:
1. Inspecting the securities in the presence of a responsible client officer.
2. Personally examining the securities while other negotiable fund sources are
sealed off or are being examined simultaneously.
3. Obtaining a written statement from the clients representative that the
securities were returned intact.
4. Obtaining the information by confirmation from an independent party (e.g.,
trustee) who holds the securities.
17. Investment cost can be vouched to brokers advices, monthly statements and
canceled checks. The auditors can similarly vouch the price of securities sold
and investment income to this documentary evidence and then trace amounts to
income, gain and loss, and cash accounts.
18. If investments are sold at substantial losses early in the period following year-
end, there is evidence that the securities were overvalued at the balance sheet
date. Accordingly, the auditor will consider whether such securities should be
written down in the financial statements of the period under audit.
19. The long-term liabilities (and fixed assets and owners equity) are characterized
by a few large transactions, unlike the current assets and liabilities which have
numerous small transactions. Except for the initial year of an audit, the entire
balance is not verified each year. Only the changes in the account that occurred
in the current period need to be audited. The results of the audit of prior years
changes are recorded in carry-forward working papers for these accounts.
20. By vouching open purchase orders, inquiry of purchase personnel, and

confirmation with suppliers, the auditor is seeking to learn of commitments to
purchase inventories at fixed prices. If the client faces significant losses on
fixed-price purchase commitments, appropriate provision for the losses should
be made in the periods financial statements.
21. Off-balance sheet information refers to information that relates to obligations

and commitments assumed by the clients that do not appear on the balance sheet
as current or long-term liabilities. Such information should be disclosed by the
client in the footnotes to the financial statements. Therefore, the auditors must
be alert to these items and gather evidence that will allow the auditors to
determine if the footnote disclosure is adequate. Such information includes:
leases, endorsements on discounted notes or others obligations, guarantees,
repurchase or remarketing agreements, commitments to purchase at fixed prices,
commitments to sell at fixed prices, legal judgment, litigation, pending
litigation.
22. The following matters are usually covered during the conference with the client
at audit completion:
a. Proposed audit adjustments;
b. Material internal financial control weaknesses;
c. Recommended footnote disclosures;
d. Type of audit report to be rendered.
1. b 5. c 9. b 13. c 17. d
2. b 6. c 10. c&d 14. d 18. a
3. d 7. c 11. b 15. d 19. a
4. d 8. b 12. b 16. c 20. c
Cases
1. a. The CPAs test of the sales cutoff at June 30 should include the following
steps:
1. Determine what JETOs cutoff policy is, review the policy for
reasonableness, and compare it to the prior year for consistency.
2. Select a sample of sales invoices (including the last serial invoice
number) from those recorded in the last few days of June and the first
few days of July.
3. Trace these sales invoices to shipping documents and determine that
sales have been recorded in the proper period in accordance with
company cutoff policy.
4. Determine that the cost of goods sold has been recorded in the period of
sale.
5. Select a sample of shipping documents for the same period and trace
these to the sales invoice. Determine that the sale and the cost of goods
sold have been recorded in the proper period.
6. Review the cutoff for sales returns and allowances, determine that it
has been based upon a consistent policy and that there have not been
abnormal sales returns and allowances in July; this might indicate
either an overstatement of sales during the audit period or the need for a
valuation account at June 30 to provide for future returns and
allowances.
b. (1) The CPA will use the July 10 cutoff bank statement in his review of the
June 30 bank reconciliation to determine whether:
(a) The opening balance on the cutoff bank statement agrees with the
balance per bank on the June 30 reconciliation.
(b) The June 30 bank reconciliation includes those canceled checks
that were returned with the cutoff bank statement and are dated or
bear bank endorsements prior to July 1.
(c) Deposits in transit cleared within a reasonable time.
(d) Interbank transfers have been considered properly in determining
the June 30 adjusted bank balance.
(e) Other reconciling items which had not cleared the bank at June 30
(such as bank errors) clear during the cutoff period.
(2) The CPA may obtain other audit information by:

(a) Investigating unusual entries on the cutoff bank statement.
(b) Examining canceled checks, particularly noting unusual payees or
endorsements.
(c) Reviewing other documentation supporting the cutoff bank
statement.
2. The procedure followed appears to be appropriate except that the examination of

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

1. Review the companys method of sales cutoff at year-end and test billings
and shipments (including returns) for an adequate period before and after
year-end to establish that cut-off procedures have been adhered to.
2. Examine collections in early part of subsequent period to determine if a
substantial portion of the receivables has been collected.
3. Examine agreements entered into with the distributors. If price protection
clauses are included, review the current price position and distributor
inventory positions to determine whether a reserve for such protection is
needed.
4. When a company deals with a limited number of customers, it is dependent
upon the continued solvency of all such customers.
5. Obtain a representation letter from appropriate company officials covering
the receivables.
3. 1. a. Notes payable are authorized according to company policy (proper

authorization).
b. For each note outstanding or paid during the year, vouch to written
authorizing document.
c. Funds might be borrowed in the companys name without the
knowledge of responsible officers.
2. a. Recorded notes payable are valid and documented (separation of

duties).
b. Observe the client personnel record-keeping duties.
c. Someone might intercept a check made out to a bank and convert
company funds to his or her own use. Notes payable records could be
falsified for a short time to hide the theft.
3. a. Valid liabilities are recorded and none omitted (sound error checking
practices).
b. Observe client personnel making comparisons. Review correcting
journal entries that result from the comparison.
c. Purchases or other liabilities may fail to be recorded and the error not
detected by any other means.
4. a. Recorded liabilities and cash disbursements valid and documented

(sound record keeping).
b. Inspect notes to see if they are marked paid.
c. Notes may get paid a second time if put back through the cash
disbursements system (intentionally or inadvertently).
4. a. The fact that the client made a journal entry to record vendors invoices
which were received late should simplify the CPAs audit for unrecorded
liabilities and reduce the possibility of a need for a further adjustment, but
the CPAs audit is nevertheless required. If the client has not journalized
late invoices, the CPA is compelled in his testing to substantiate what will
ultimately be recorded as an adjusting entry. In this examination the CPA
should audit entries in the 2004 voucher register to ascertain that all items
which according to dates of receiving reports or vendors invoices were
applicable to 2004 have been included in the journal entry recorded by the
client.
b. No. The CPA should obtain a letter in which responsible executives of the
clients organization represent that to the best of their knowledge all
liabilities have been organized. However, this is done as a normal audit
procedure to afford additional assurance to the CPA and it does not relieve
him of the responsibility for doing his own audit work.
c. Whenever a CPA is justified in relying on work done by an internal auditor,

he should curtail (but not eliminate) his own audit work. In this case, the
CPA should have ascertained early in his examination that Ozones internal
auditor is qualified by being both technically competent and reasonably
independent. Once satisfied as to these points, the CPA should discuss the
nature and scope of the internal audit program with the internal auditor and
review his working papers in order that the CPA may properly coordinate
his own program with that of the internal auditor. If the Ozone internal
auditor is qualified and has made tests for unrecorded liabilities, the CPA
may limit his work in this audit area.
d. In addition to the 2005 voucher register, the CPA should consider the
following sources for possible unrecorded liabilities:
1. Unentered vendors invoice file.
2. Status of tax returns for prior years still open.
3. Discussions with employees.
4. Representations from management.
5. Comparison of account balances with preceding year.
6. Examination of individual accounts during the year.
7. Existing contracts and agreements.
8. Minutes.
9. Attorneys bills and letter of representation.
10. Status of renegotiable business.
11. Correspondence with principal suppliers.
12. Audit testing of cutoff date for reciprocal accounts, e.g., inventory and
fixed assets.
5. a. Lourdes should find in the audit working papers a planning memo

describing the clients inventory-taking plan and notes about the auditors
first-hand observation of the instructions being given to counters, along
with a memo about the auditors observation of the counting. This memo
should tell about supervision of the audit staff, and the working papers (test
counts) should show the review signatures of the supervising auditors.
b. Working papers should document performance of these substantive

procedures for the existence and completeness assertions:
1. Conduct an observation of the companys physical inventory count.
2. Scan the inventory compilation for items added from sources other than
the physical inventory count. . .
3. At year end, obtain the number of the last shipping and receiving
documents . . . Use these to scan the sales, inventory/cost of sales, and
accounts payable entries for proper cutoff.
4. Confirm or inspect inventories held in public warehouses.
6. The three categories of major losses or manipulations in the area of investments

are: theft of diversion of funds, manipulation of accounting, and business
espionage. Business espionage is generally outside the sphere of independent
auditors interest.
7. a. The objectives (specific assertions) for the audit of non-current investment

securities are to obtain evidence regarding the:
Existence of the investment securities at the balance sheet date.
Ownership of the investment securities.
Cost and carrying value of the investment securities.
Proper presentation and disclosure of the investment securities in
the financial statement.
Proper recognition of interest income.
Proper recognition of investment gains and losses.
b. The following audit procedures should be undertaken with respect to the

audit of Tess investment securities:
Inspect and count securities in the companys safe and safe deposit
box.
Examine brokers statements to obtain assurance that all
transactions were recorded.
Examine documents in support of purchases and sales of
investment securities.
Inspect the minutes of the board of directors meetings.
Review the audited financial statements of the (25 percent)
investee.
Verify the equity method of accounting was used for carrying
value of the investment in Dee Industrial.
Obtain a client representation letter that confirms the clients
representations concerning the noncurrent investment securities.
Verify the calculation of interest income.
Review the propriety of the presentation and disclosure of the
securities in the financial statements.
Make certain that the client representation letter includes the
proper assertions concerning accounts payable.
Investigate and resolve confirmation exceptions and other matters
requiring follow-up.
8. a. The audit objectives in the examination of long-term debt are to determine
that:
1. All liabilities were properly recorded.
2. Items recorded as liabilities are bona fide obligations.
3. Interest expense and/or amortization was properly computed and
recorded.
4. The client is not in violation of restrictions or requirements imposed on
it by the terms of the loan agreement.
5. Satisfactory authority existed to enter into long-term obligation
agreements.
6. All long-term obligations are properly classified in the balance sheet.
7. Assets pledged as security are adequately disclosed.
b. The following procedures should be included in an audit program for the

examination of the long-term note between Odette and First National Bank:
1. Confirm the loan and terms of the agreement with the bank.
2. Review the agreement between Odette and the bank to determine that:
a. The debt is long-term (by reference to dates).
b. Provisions of the agreement have not been violated, e.g., that
Odette is complying with any restrictions on the payment of
dividends, on the amount of working capital to be maintained, or
on the uses to which the funds may be employed and is
maintaining the plant pledged as security for the loan.
c. The agreement was signed by person(s) having authority.
3. Trace the receipt of funds into the bank account and cash receipts book.
4. Check the computation of interest expense for the period May 1 to June
30, and trace the recording of the expense and the accrual on the books.
5. Determine that authority to borrow was granted and is recorded in the
board of directors minutes.
CHAPTER 21
AUDIT DOCUMENTATION
Questions
2. The major function of audit workpapers is to provide evidence of conformance

with auditing standards. As a body, the workpapers are the principal record of
the evidence which the auditor has gathered and evaluated in support of the
audit opinion.
5. With electronic spreadsheets, audit adjustments need only be entered once in

the supporting schedule. The adjustments are then automatically reflected in
lead schedules and in the working trial balance through equations entered in
appropriate cells. The cell equations link the workpapers such that an
adjustment need be entered only once in order for all affected workpapers to be
automatically updated.
6. Permanent files contain information that is of a continuing interest to the

auditor. A permanent file typically contains (1) copies or abstracts of significant
company documents and (2) auditor- or client-prepared information on accounts.
Current-year files contain working papers prepared to support the assertions
embodied in the financial statements.
7. Client personnel may prepare working papers to reduce the time spent by the
auditor on the engagement. When client personnel prepare working papers, the
auditor should give the client personnel detailed instructions. Working papers
prepared by the client should be identified as PBC (prepared by client) and
should involve no decision making. The auditor should test completed working
papers against underlying documentation.
8. The lead schedule, especially on larger engagements, is designed to bridge the

gap between the working trial balance and the general ledger by listing all
general ledger accounts that are reported as one account in the financial
statements. Supporting schedules is a term for working papers that support the
amounts presented in the financial statements by providing support for a detailed
account on a lead schedule. Supporting schedules represent the bulk of working
papers.
9. In general, a properly prepared working paper should meet firm policy, have a
proper heading, clearly indicate the work performed, clearly meet the audit
objective for which it was designed, and clearly state the auditors conclusion.
10. The prior years audit working papers are a useful guide to staff assistants
because the audit procedures performed in the prior year usually are similar to
those of the current year. By referring to last years working papers, the
assistant can see how the procedures were documented and is given a possible
format for organizing the current years working paper. In addition, exceptions
noted in last years working papers may alert the assistant to possible problems
in the current year. Finally, the prior years working papers contain information
substantiating the beginning balances for the current year.
11. The more common types of audit working papers and their principal purposes
may be summarized as follows:
(1) Audit administrative working papers aid the auditors in planning and
administration of the audit, and include such items as the audit programs,
questionnaires and flowcharts, decision aids, time budgets, and
engagement letters.
(2) Working trial balance represents the backbone of the auditors working
papers, for it contains the balances of the ledger accounts, the adjustments
and reclassifications deemed necessary by the auditors, and the adjusted
amounts that appear in the financial statements. It also contains references
to all supporting schedules and analyses, thus serving to control the other
types of working papers.
(3) Lead schedules working papers that serve to combine similar general
ledger accounts, the total of which appears on the working trial balance.
(4) Adjusting journal entries material misstatements in the accounts
disclosed by the auditors investigation are corrected by means of adjusting
journal entries. These appear on the auditors working trial balance, and in
addition, a list of such entries is turned over to the client at the conclusion
of the audit with the request that they be approved and entered in the
accounting records.
(5) Reclassification entries entries necessary to properly reflect financial
results but not representing misstatements in the financial records of the
client.
(6) Supporting schedules although the term schedule is at times applied to
various types of working papers, the preferred usage is to designate a
listing of the details or elements comprising the balance in an account at a
specified date. Preparation of such a listing is often an essential step in
determining the nature of an account.
Audit Documentation 21-3
(7) Analyses consist of working papers showing the changes which occurred
in an account during a given period. By analyzing an account, the auditors
determine its nature and contents.
(8) Reconciliations working papers that prove the relationship between two
amounts obtained from different sources.
(9) Computational working papers used to verify such data as interest
expense, income taxes, and earnings per share.
(10) Corroborating documents working papers that provide support for
specific representations made in the financial statements, such as letters of
representations from clients, lawyers letters, audit confirmations, and
copies of the contracts.
12. Audit working papers are the property of the auditor; however, they must not
violate the confidential relationship between client and auditors by making the
papers available to outsiders or even to the clients employees without specific
permission from the client.
1. d 9. b 17. d 25. b
2. d 10. b 18. c 26. d
3. c 11. a 19. c 27. d
4. a 12. d 20. d 28. c
5. d 13. d 21. b 29. d
6. c 14. b 22. d 30. c
7. c 15. d 23. a 31. d
8. d 16. d 24. b 32. d
Cases
1. a. (1) The functions of audit working papers are to aid the CPA in the
conduct of his work and to provide support for his opinion and his
compliance with auditing standards.
(2) Working papers are the CPAs records of the procedures performed,
and conclusions reached in the audit.
b. The factors that affect the CPAs judgment of the type and content of the
working papers for a particular engagement include:
1. The nature of the auditors report.
2. The nature of the clients business.
3. The nature of the financial statements, schedules or other information
upon which the CPA is reporting and the materiality of the items
included therein.
4. The nature and condition of the clients records and internal controls.
5. The needs for supervision and review of work performed by assistants.
c. Evidence which should be included in audit working papers to support a

CPAs compliance with generally accepted auditing standard includes:
1. Evidence that the financial statements or other information upon which
the auditor is reporting were in agreement or reconciled with the
clients records.
2. Evidence that the clients system of internal control was reviewed and
evaluated to determine the nature, timing, and extent of audit
procedures.
3. Evidence of the auditing procedures performed in obtaining evidential
matter for evaluation
4. Evidence of how exceptions and unusual matters disclosed by auditing
procedures were resolved or treated.
5. Evidence of the auditors conclusions on significant aspects of the
engagement with appropriate commentaries.
d. The CPA should perform an adequate examination at minimum cost and

effort and the preceding years programs will aid in doing this. The
preceding years audit programs ordinarily contain information useful in the
current examination (such as descriptions of the unique features of a clients
operations or records, a formalized sequence of audit steps in logical order,
and approximate time requirements to perform various phases of the work).
The auditor should decide whether to use the old program or prepare a new
one.
2. In general, the working paper is not set up in a logical manner to show what the
auditor wants to accomplish. The primary objective of the working paper is to
verify the ending balance in notes receivable and interest receivable. A
secondary objective is to account for all interest income, cash received and cash
disbursed for new notes, collateral as security, and other information about the
notes for disclosure purposes.
Audit Documentation 21-5
Specific deficiencies of the working paper presented in the question are:
a. b.
DEFICIENCY IMPROVEMENT
1. Tick mark explanation tested Should have separate tick marks
does not indicate specifically meaning:
what was done. Agreed to confirmation
Footed
Traced to cash receipts journal
Recomputed, etc.
2. Explanation of some tick marks is Explain all tick marks on the same
not given. page of the working paper.
3. Classification of long-term Recompute portions of notes which are
portion indicates no verification. long-term.
4. Paid-to-date row is confusing. Column should say date paid to and
this should be confirmed.
5. Due dates are missing for C.C. Include due dates on working paper
Co., P. Pablo and Tetra Co. for these notes.
c. SPREADSHEET SOLUTION
The purpose of using an Excel spreadsheet in this problem is to give the
student some experience in preparing a simple working paper using an
Excel spreadsheet. It should be explained to students that this type of
working paper may or may not be prepared in actual practice, and that often
templates are used to prepare more time-consuming working papers. Also,
whether or not tick marks are computerized is a matter to be decided. The
advantage is that the completed audit work can then be stored and reviewed
electronically, a direction many firms are going. On the other hand, it may
be more efficient to indicate audit work manually as it is performed, and a
contrast in the color of the tick marks through use of a colored pencil may
be desirable.
The formulas used are self-evident, so no listing is provided. Two items

deserve comment:
1. An advantage of using a spreadsheet program for these types of
analyses is that footing and crossfooting are done automatically.
2. When auditor tick marks are done by computer, a problem arises as
to how to place them on the worksheet. One could use narrow
columns inserted between the scheduled client data, or, as done
here, the tick marks are placed in blank rows beneath the related
data.
FOURTH PACIFIC COMPANY Schedule N-1 Date

A/C # 110 NOTE RECEIVABLE Prepared by JD 1/21/14
12/31/13 Approved by PP 2/15/14
Account # 110 Notes Receivable Interest

Date Interest
Made / Rate / Face Value of Balance Balance Receivable Receivable
Maker Due Date Paid to Amount Security 12/31/12 Additions Payments 12/31/13 12/31/12 Earned Received 12/31/13
Alba Co. c* 6/15/12 / 5% / 5000 None 4000 0 1000 3000 114 175 0 279
6/15/14 None pd. tp r tp <
Barrios, Inc. c* 11/21/12 / 5% / 3591 None 3591 0 3591 0 0 112 112 0
Demand 12/31/13 tp r tp < r
C.C. Co. c* 11/1/12 / 5% / 13180 24000 12780 0 2400 11380 24 577 601 0
4/1/18 12/31/13 tp r tp < r
(P200/Mo.)
P. Pablo c* 7/26/13 / 5% / 25000 50000 0 25000 5000 20000 0 468 200 268
8/1/15 9/30/13 r r < r
(P1000/Mo.)
Martin Cruz c* 5/12/12 / 5% / 2100 None 2100 0 2100 0 0 105 105 0
Demand 12/31/13 tp r tp < r
Tetra Co. c* 9/3/13 / 6% / 12000 10000 0 12000 1600 11400 0 162 108 54
2/1/16 11/30/13 r r < r
(P400/Mo.)
22471 37000 15691 43780 128 1589 1116 601
f f f f, cf f f f f, cf
tp wtb tb op wtb
Legend of Auditors Tick Marks

f Footed
cf Crossfooted
tp Traced to prior year working papers
wtb Traced total to working trial balance
op Traced total to operations working paper OP6
* Examined note for payee, made and due dates, interest rate, face amount, and value of
security. No exceptions noted.
c Received confirmation, including date interest paid to, interest rate, interest paid during 2013,
note balance, and security. No exceptions noted.
r Traced to cash receipts journal
< Recomputed for the year
CHAPTER 22
AUDIT EVIDENCE EVALUATION
Questions
3. The objective of evaluating misstatements is to determine the effect on the audit

and whether there is a need to perform additional audit procedures. Revisions to
the audit strategy and detailed audit plans may be required when:
The nature of circumstances of identified misstatements indicate that
other misstatement(s) may exist that, when aggregated with known
misstatements, could exceed performance materiality; or
The aggregate of identified and uncorrected misstatements come close
to or exceeds performance materiality.
4. a. Omissions or Fraud Some transactions may not be recorded, either by

mistake or deliberately, the latter of which would constitute fraud.
b. Significant Transactions A lack of business rationale for significant
transactions (unusual or outside the normal course of business) could be
intended to manipulate the financial statements or to conceal
misappropriation of assets.
c. Journal Entries Inappropriate or unauthorized journal entries may have
occurred throughout the period or at period end. These could be used to
manipulate amounts reported in the financial statements.
d. Errors in Estimates Management estimates may calculate incorrectly,
overlook or misinterpret certain facts, use faulty assumptions, or contain
some element of bias if the entitys estimate falls outside an acceptable
range. Estimates could also be deliberately misstated to manipulate
financial statement results.
e. Errors in Fair Values There may be disagreements with managements
judgments with respect to the fair value of certain assets, liabilities, and
components of equity required to be measured or disclosed at fair values in
accordance with the financial framework.
f. Selection and Application of Accounting Policies There may be
disagreements with management with regard to the selection and use of
certain accounting policies.
g. Uncorrected Misstatements in Opening Equity Uncorrected misstatements
from prior periods would be reflected in opening equity. If not adjusted,
they may also cause a misstatement in the current period financial
statements.
h. Revenue Recognition Overstatement or understatement of revenues (e.g.,
premature revenue recognition, recording fictitious revenues, or improperly
shifting revenues to a later period).
5. a. Materiality of Misstatements How significant is a misstatement in the

assertion being addressed, and what is the likelihood of it having a material
effect (individually or aggregated with other potential misstatements) on the
financial statements?
b. Management Responses How responsive is management to audit findings,
and how effective is the internal control in addressing risk factors?
c. Previous Experience What has been the previous experience in
performing similar procedures, and were any misstatements identified?
d. Results of Performed Audit Procedures Do the results of performed audit
procedures support the objectives, and is there any indication of fraud or
error?
e. Quality of Information Are the source and reliability of the available
information appropriate for supporting the audit conclusions?
f. Persuasiveness How persuasive (convincing) is the audit evidence?
g. Understanding the Entity Does the evidence obtained support or
contradict the results of the risk assessment procedures (which were
performed to obtain an understanding of the entity and its environment,
including internal control)?
6. Audit matters that should be communicated by the auditor to those charged with
governance are:
Accounting policies
Prior period communications
Risks of material misstatement
Material uncertainties
Concerns
Significant difficulties encountered
Comments on entity management
Audit adjustments
Uncorrected misstatements
The auditors report
Agreed-upon matters
Other matters
CHAPTER 23
COMPLETING THE AUDIT AND

POST-AUDIT RESPONSIBILITIES
Questions
1. Many of the revenue and expense accounts are not material in relation to the
financial statements and may be combined with other accounts in the financial
statements. These accounts can be audited through analytical procedures. Such
procedures compare the account balance to related statement of financial
position accounts, to sales, to industry averages or to a multiple-year trend to
ascertain whether any unusual fluctuations are present. Unusual or unexpected
items would have to be investigated and material items vouched to supporting
documents.
2. The primary purpose of the client representation letter is to impress upon

management its ultimate responsibility for the adequacy of the financial
statements and related disclosures.
With respect to receivables, such letters typically state that all receivables are
valid and include proper amounts; also stated is the amount written off in the
past year and the current provision for uncollectibles.
In connection with inventories, the client represents that the peso amount of
inventories reflects physical quantities determined by a count and priced by a
stated accounting method. The client also represents that provision has been
made by the company for all obsolete and damaged inventory.
In regard to minutes, the client represents that all minutes of meetings of
stockholders, directors, and executive committees which have been transmitted
to the auditor are complete and authentic records for the period under audit
(including the subsequent period).
The client letter of representation should state whether any events occurred
subsequent to the date of the financial statements that, in the clients opinion,
require adjustment or disclosure in the statements.
3. In addition to the attorneys letter, other procedures that are used to gather
evidence regarding contingencies include:
Standard bank confirmation.
Inquiry of client management.
Reading of the minutes of the board of directors.
Vouching to purchase and sales contracts.
Vouching to lease agreements, confirmation with lessor or lessee.
4. There are two types of subsequent events:
1. The first type consists of those events that provide additional evidence with
respect to conditions that existed at the date of the statement of financial
position and affect the estimates inherent in the process of preparing
financial statements. The use of the evidence requires an adjustment to the
2. The second type consists of those events that provide evidence with respect
to conditions that did not exist at the date of the statement of financial
position being reported on but arose subsequent to that date. These events
should not result in an adjustment of the financial statements. However,
disclosure may be required to prevent the financial statements from being
misleading. In some cases, pro forma financial statements may be required
to ensure adequate disclosure.
5. The purpose of dual dating is twofold: (1) To provide a means of inserting

important information in the financial statements even when learned after field
work is complete, while at the same time (2) to inform users that the auditor
takes full responsibility for subsequent events only up to the end of the field
work and for the specifically identified later event, but does not take
responsibility for other events which may have occurred after the end of field
work and before the date of the specifically identified subsequent event.
6. Loss contingencies from litigation, claims, and assessments can be accrued or

disclosed, depending on the events likelihood. When a loss contingency
involves an unasserted claim or assessment, disclosure is not required if no
evidence exists that the assertion of a claim is probable. When an unasserted
claim probably will be asserted and an unfavorable outcome is a reasonable
possibility, disclosure is required. When a loss contingency is likely and the
amount can be estimated, the contingency should be accrued.
7. When substantial doubt exists about the ability of an entity to continue in

operation for a year following the financial statements, an auditor should add a
paragraph calling attention to the fact that the statements have been prepared
assuming that the entity will continue as a going concern. If an auditor fails to
modify the report, however, and an entity ceases to exist as a going concern
within one year following the date of the audit, this does not in itself indicate
inadequate performance by the auditor.
8. Managements refusal to sign a representation letter would typically result in a

disclaimer of opinion because audit evidence was restricted by management.
Completing the Audit and Post-Audit Responsibilities 23-3
9. At the completion of the audit, an auditor must reconsider materiality and
determine an amount for materiality to be used in evaluating the estimated errors
in the financial statements. Also, an auditor should reconsider the audit risk.
As errors are found during the audit, the auditor generally shares them with the
client, and the client makes adjusting entries for material errors. If the client
refuses to correct a material error, the auditor must consider the materiality of
the combined known errors and likely errors. Known errors are individual
errors specifically identified by an auditor, whereas likely errors are an auditors
best estimate of other errors based on a projection of errors detected during
sampling. An auditor should compare projected error to materiality, both on an
account level and in the aggregate.
10. A financial statement disclosure checklist is a checklist an auditor uses to review

the financial statements to check that all necessary disclosures have been
included. In contrast, the auditor uses an engagement checklist to determine that
all auditing procedures have been performed.
11. Subsequent events are material events that occur after the statement of
financial position date but before the end of field work (and thus, before the
audit report date) that require disclosure in the financial statements and related
notes. Auditors (and management) are responsible for gathering evidence on
these subsequent events and evaluating the proposed disclosure.
Subsequent discovery of facts existing at the audit report date is knowledge

gained after the audit report is issued about an event or condition that existed at
the audit report date. Auditors have no responsibility to search for these facts
(as they do for subsequent events); however, once brought to the auditors
attention, their responsibility is to determine if the financial statements (and thus
their report) are misstated and take appropriate action.
12. The actions the partner should take if the client consents to disclose the
information (which existed at the audit report date and materially impacts the
financial statements) is to determine the method and timing of disclosure.
The actions the partner should take if the client refuses to make disclosure are:
Notify the client that the auditors report must no longer be associated with
the financial statements.
Notify regulatory authorities that the auditors report should no longer be
relied upon.
Notify users known to be relying on the financial statements that the
auditors report should no longer be relied upon. Such notification may be
to the SEC and the stock exchanges.
13. Once auditors have reported on audited financial statements, they have no
responsibility to carry out a retroactive review of their work. However, post-
issuance review may be made in connection with a firms internal quality
control monitoring program, peer review or otherwise, and the omission of an
auditing procedure may be discovered.
If an omitted procedure is found, the auditors should consult legal counsel and
take the following actions:
Assess the importance of the omitted procedure to the present ability to
support the previously expressed opinion.
Determine if there are persons currently relying or likely to rely on their
report.
If the omitted procedure impairs present ability to support the previously
expressed opinion, the omitted procedure should be applied or alternative
procedures applied that would provide a satisfactory basis for the opinion.
If, as a result of subsequent application of the omitted procedure or
alternative procedures, the auditors become aware of facts that existed at the
date of their report, they should refer to page 927 (Subsequent Discovery of
Facts Existing at the Date of the Auditors Report) for guidance.
14. In a cold review, a partner not otherwise associated with an engagement will
take the report (in draft copy) and all working papers and review the entire
engagement with a fresh start. The purpose of the review is to obtain the
unbiased view of a professional expert who is not committed to a particular
engagement or its problems. It is performed to aid in maintaining high standards
of professional practice.
15. A management letter is an extra audit service. Auditors write to the

management their recommendations about control, tax matters, operating
efficiencies, and other consulting subjects to impress on managers the benefits
of audits in addition to just an audit. The letter also serves to promote and sell
CPAs consulting services.
16. A good management letter can show the client some profit potential, and the
CPA may be hired to do the consulting work.
17. When the auditor learns of information existing at the date of a previously
issued audit report, that it, if known, would have altered the audit opinion, the
following steps are in order:
a. Determine whether the information is reliable and whether the facts existed
at the date of the audit report;
b. Request the client to make necessary disclosure to persons known to be
relying on the statements;
c. If the client refuses, the auditor has a duty to notify those known to be
relying on the audit report that such reliance is no longer justified (notifying
board of directors, SEC, and stock exchange usually satisfies this
requirement).
18. An auditor should investigate the new information as soon as practicable. When
an auditor determines that the information is reliable, that the facts existed at the
date of the report, and that the nature of the information and its effect on the
financial statements are such that the report would have been affected, the
auditor should consider whether persons are relying on the report. If the auditor
must take steps to prevent future reliance on the report, the preferred resolution
is for the client to issue revised financial statements and the auditor to issue a
revised report, unless the issuance of statements for a subsequent period is
imminent. When the effect on the financial statements of the subsequently
discovered information cannot be determined without a prolonged investigation,
the client should notify persons who are known to be relying on or who are
likely to rely on the financial statements and the related report. The clients
notification should state that (1) the statements should not be relied on and (2)
revised financial statements and auditors report will be reissued on completion
of an investigation. If applicable, the client should discuss the matter with the
Securities and Exchange Commission, stock exchanges, and appropriate
regulatory agencies.
19. If the client refuses to disclose the newly discovered facts, the auditor should
consult with his or her attorney and notify each member of the board of directors
of such refusal and of the fact that, in the absence of such disclosure, the auditor
will take steps to prevent future reliance on the audit report. These steps may
include
notifying the client that the audit report must no longer be associated
with the financial statements.
notifying the appropriate regulatory agencies that the audit report
should no longer be relied on.
notifying each person known to the auditor to be relying on the
financial statements that the audit report should no longer be relied on.
If such notification is impracticable, the auditor may request a
regulatory agency having jurisdiction over the client to take whatever
steps it deems appropriate.
20. When an auditor concludes that an auditing procedure considered necessary at

the time of the audit was omitted, auditing standards require the auditor to assess
the importance of the omitted procedure to his or her present ability to support
the previously expressed opinion. An auditor may review the working papers
and discuss the matter with other engagement personnel to evaluate whether
other applied procedures compensate for the omitted procedure. If the auditor
concludes that omission of the procedure impairs his or her present ability to
support the previously expressed opinion, and if persons are currently relying on
or are likely to rely on the report, the auditor should promptly undertake to apply
the omitted procedure or alternative procedures that would provide a satisfactory
basis for the opinion. If the auditor is unable to do so, he or she should consult a
lawyer to determine the proper course of action.
When performing the omitted procedures supports the opinion that was
previously released, the auditor has no further responsibility. However, if while
performing the procedures the auditor becomes aware that facts regarding the
financial statements existed at the date of the report that would have affected the
report had he or she had been aware of them, the auditor should follow
notification procedures to prevent further reliance on the report.
1. c 12. b 23. a
2. b 13. c 24. c
3. a 14. a 25. a
4. c 15. b 26. a
5. d 16. b 27. b
6. b 17. b 28. a
7. d 18. c 29. a
8. d 19. a 30. c
9. d 20. b 31. d
10. c 21. d 32. c
11. d 22. a 33. a
Cases
1. a. (1) The objectives of the engagement letter are to:

a. Make sure that the CPA and his client are in agreement about the
nature of the engagement.
b. Inform the client about the scope of the CPAs work and what may
be expected to result.
c. Provide a written record of the responsibilities assumed by the
CPA and those retained by the client. (This understanding protects
both the CPA and his client).
(2) The CPA usually prepares the engagement letter as a follow-up to a

verbal understanding that he and his client have reached. It is desirable
that the client endorse and return an approved copy of the engagement
letter to the CPA. It also is acceptable for the client to prepare his own
letter summarizing his understanding of the nature of the engagement.
(3) Preferably, the engagement letter should be sent at the beginning of the
engagement so that misunderstandings, if any, can be remedied.
(4) Obviously, the engagement letter will be most useful in clarifying
misunderstanding on a first engagement. But it is desirable that the
letter be renewed periodically. Client personnel or the nature of the
engagement may change, and the resubmission of the letter gives both
parties an opportunity to review the circumstances. Accordingly, for
recurring examinations of financial statements, it is appropriate to
prepare an engagement letter at the start of each examination. For other
continuing engagements, the engagement letter also should be updated
periodically probably on a yearly basis.
b. (1) The objectives of the clients representation letter are to:

confirm oral representations given to the auditors, indicate and
document the appropriateness of such representations, and reduce
the possibility of misunderstandings.
(2) The clients representation letter should be prepared by the auditors (to
ensure all items are included) and signed by members of management
whom the auditors believe are responsible for and knowledgeable about
matters covered by the representations. Normally, the chief executive
officer and chief financial officer should sign.
(3) The clients representation letter should be obtained at the end of the
audit work and should be dated as of the date of the auditors report
(the date of the end of field work).
(4) The clients representation letter should be prepared for each

examination as the representations apply to one periods financial
statements. The items that need representation will change from one
period or another, as will the people who should sign the letter.
c. (1) The CPAs should obtain an engagement letter when performing

accounting services involving unaudited financial statements, such as in
a compilation or review engagement. The engagement letter is
probably more important in unaudited engagements that in audited
engagements because as there is more likelihood of misunderstanding.
The engagement letter should include: a description of the nature and

limitations of the services to be performed, a description of the report, a
statement that the engagement cannot be relied upon to disclose errors,
irregularities or illegal acts, and that the CPAs will inform the client of
any matters that come to their attention.
(2) The CPAs are not required to obtain a clients representation letter
when performing engagements involving unaudited financial
statements. However, the CPAs may wish to obtain such a letter.
2. a. A subsequent event is an event or transaction that occurs subsequent to the
statement of financial position date but prior to the issuance of the financial
statements and auditors report that has a material effect on the financial
statements and therefore requires adjustment or disclosure in the financial
statements.
b. The occurrence of subsequent events that provide additional evidence

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

occurrence of subsequent events are these:
Read the latest available interim financial statements, compare
them with the financial statements being reported upon, and make
any other comparisons considered appropriate in the
circumstances. Inquire of officers and other executives having
responsibility for financial and accounting matters whether the
interim statements have been prepared on the same basis as that
used for the statements under examination.
Inquire of and discuss with officers and other executives having
responsibility for financial and accounting matters (limited, where
appropriate, to major locations) regarding:
a. Whether any substantial contingent liabilities or commitments
existed at the date of the statement of financial position being
reported on or at the date of inquiry.
b. Whether there was any significant change in the capital stock,
long-term debt, or working capital to the date of inquiry.
c. The current status of items in the financial statements being
reported on that were accounted for on the basis of tentative,
preliminary, or inconclusive data.
d. Whether any unusual adjustments have been made during the
period from the statement of financial position date to the date
of inquiry.
Read the available minutes of meetings of stockholders, directors,
and appropriate committees; inquire about matters dealt with at
meetings for which minutes are not available.
Obtain from the clients legal counsel a description and evaluation
of any litigation, impending litigation, claims, and contingent
liabilities (of which counsel has knowledge) that existed at the date
of the statement of financial position being reported on, together
with a description and evaluation of any additional matters of such
nature that have come to counsels attention up to the date the
information is furnished.
Obtain letter of representation, dated as of the date of the auditors
report, from appropriate officials (generally the chief executive
officer and chief financial officer) regarding whether any events
occurred subsequent to the date of the financial statements being
reported on by the independent auditor that, in the officers
opinion, would require adjustment or disclosure in these
statements.
Make such additional inquiries or perform such procedures as
considered necessary and appropriate to dispose of questions that
arise in carrying out the foregoing procedures, inquiries, and
discussions.
3. a. (1) A contingent liability is an existing condition situation, or set of

circumstances, involving uncertainty as to a possible loss to an
enterprise that will ultimately be resolved when one or more future
events occur or fail to occur.
The business enterprise must have already sustained an event which

exposed it to a loss but all aspects of the event have not yet been
concluded. The ultimate effect of the event will not be known with
certainty until the occurrence of some future event which will conclude
the transaction and resolve the current contingency.
(2) A loss contingency should be accrued only if the information available

prior to issuance of the financial statements indicates that it is probable
that a liability has been incurred at the date of the financial statements,
and the amount of the loss can be reasonably estimated.
A loss contingency should be disclosed in a footnote when it is
probable that a liability has been incurred but the amount cannot be
estimated. A loss contingency for which it is only reasonably possible
that a liability has been incurred and for which no amount can be
estimated should be disclosed in a footnote. Where the probability that
a liability has been incurred is remote, no disclosure is required.
b. Subsequent events may provide new and important information about

known or unknown contingency losses as of the statement of financial
position date. The subsequent event may very well modify the
circumstances surrounding the contingent loss thereby changing the
reporting method from no disclosure to footnote disclosure or accrual. For
example, a contingent loss may have been recorded as a footnote disclosure
because, at the statement of financial position date, the company had only a
reasonable possibility that a loss may be incurred. A subsequent event
occurs which in the accountants judgment makes it probable that a
contingent liability has been incurred. The contingent liability will now
have to be accrued in the financial statements (provided an amount can be
estimated).
4. Other matters that J. Cees representation letter should specifically confirm

include whether or not
a. Management acknowledges responsibility for the fair presentation in the
financial statements of financial position, results of operations, and cash
flows in conformity with financial reporting standards (or other
comprehensive basis of accounting).
b. All material transactions have been properly reflected in the financial
statements.
c. There are other material liabilities or gain or loss contingencies that are
required to be accrued or disclosed.
d. The company has satisfactory title to all owned assets, and whether there
are liens or encumbrances on such assets or any pledging of assets.
e. There are related party transactions or related amounts receivable or payable
that have not been properly disclosed in the financial statements.
f. The company has complied with all aspects of contractual agreements that
would have a material effect on the financial statements in the event of
noncompliance.
g. Events have occurred subsequent to the statement of financial position date
that would require adjustment to or disclosure in, the financial statements.
h. The accountant has been advised of all actions taken at meetings of
stockholders, board of directors, and committees of the board of directors
(or other similar bodies) that may affect the financial statements.
i. Management is aware of irregularities that could have a material effect on
the financial statements or that involve management or employees who
have significant roles in the system of internal control.
j. All financial records and data were made available.
k. Provision, when material, has been made to reduce excess or obsolete
inventories to their estimated net realizable value.
l. Provision has been made for any material loss to be sustained in the
fulfillment of, or from inability to fulfill, any sales commitments.
m. Provision has been made for any material loss to be sustained as a result of
purchase commitments for inventory quantities in excess of normal
requirements or at prices in excess of the prevailing market prices.
5. The auditors search for subsequent events is an important set of auditing

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

a. Obtaining a letter from the clients legal counsel Added information
concerning litigation pending at the statement of financial position date may
provide a basis for an audit adjustment recognizing a loss contingency or a
footnote describing uncertainty.
b. Reading the minutes of directors meetings held subsequent to the statement
of financial position date may reveal the following subsequent events:
1. Approval of bonus applicable to year under audit (Type I)
2. Decision to dispose of a segment (Type II)
3. Approval of restructuring agreement (Type II)
4. Approval of major recapitalization plan (Type II)
c. Reading the latest interim financial statements may disclose events such as
the following:
1. Major adjustments correcting for prior years earnings inflation (e.g.,
reversal of fabricated revenue through abnormal sales returns entries)
(Type I)
2. Major uninsured casualty loss occurring after the statement of financial
position date (Type II)
3. Reappearance of officers loans purported to have been paid or
collected prior to the statement of financial position date (Type I)
6. (1) If an omitted procedure is found, the auditors should consult legal counsel
and take the following actions:
Assess the importance of the omitted procedure to the present
ability to support the previously expressed opinion.
Determine if there are persons currently relying or likely to rely on
their report.
If the omitted procedure impairs present ability to support the
previously expressed opinion, the omitted procedure should be
applied or alternative procedures applied that would provide a
satisfactory basis for the opinion.
If as a result of subsequent application of the omitted procedure or
alternative procedures, the auditors become aware of facts that
existed at the date of their report, they should refer to page 927
(Subsequent Discovery of Facts Existing at the Date of the
Auditors Report) for guidance.
(2) If after reevaluating the scope of the examination and reviewing the
completed audit workpapers, procedures were found that tend to
compensate for the omitted procedure, the omitted procedure would not
have to be performed. The auditors should document their decision and
their support for this decision.
(3) If in subsequently applying the omitted procedure, the auditors become

aware of material new information that should have been disclosed in the
financial statements, they should follow the provisions of auditing standards
(refer to page 927 subsequent discovery of a fact existing at the date of the
auditors report).
7. a. The following accounting changes require a fourth paragraph explaining the

lack of inconsistency, given the change:
1. Change in accounting principle;
2. Change in reporting entity;
3. Correction of an error in principle;
4. Change in principle inseparable from change in estimate.
b. To be in conformity with PFRS, management must demonstrate that the

new principle is preferable to the old. The auditor, therefore, must establish
preferability in evaluating whether the change is justified. If preferability
cannot be established, the auditor should render an except for
qualification on the basis that the financial statements contain a departure
from PFRS.
8. 1. d. The management representation letter documents managements

acknowledgment of responsibility for the assertions made in the financial
statements. Typically, one of managements assertions is a statement that
all material transactions have been recorded properly. This statement
relates to the completeness and valuation categories of management
assertions.
2. i. The audit inquiry letter to legal counsel seeks to confirm with the clients
lawyer assertions furnished by management about pending or threatened
litigation, unasserted claims and assessments, and other contingencies.
3. d. The management representation letter documents managements
acknowledgement of responsibility for the assertions made in the financial
statements. One of managements assertions may be that a provision has
been made for any material loss to be sustained in the fulfillment of, or from
the inability to fulfill, any sales commitments. This statement relates to the
valuation and presentation and disclosure categories of management
assertions.
4. c. The audit engagement letter documents the contract between the client
and the auditor. This documentation also includes the basis of fees for
services to be provided.
5. c. The audit engagement letter documents the contract between the client
and the auditor. The letter should indicate the objective of the engagement.
6. d. Managements assertions, as documented in the management
representation letter, often deny the existence of any irregularities, such as
those caused by employees, that may cause the financial statements to be
materially misstated.
7. b. The successor auditor should make specific and reasonable inquiries of
the predecessor auditor regarding matters that the successor believes will
assist him or her in determining whether to accept the engagement. The
inquiries should include specific questions regarding, among other things,
facts that might bear on the integrity of management.
8. a. The partners engagement review program is designed to confirm that
the audit was conducted in accordance with PSA. This review program is
also designed to identify any problems that may have arisen during the
audit, such as differences of opinion between an auditor and a specialist or
other consultant.
9. e. The standard financial institution confirmation request asks the
institution to confirm the accounts and account balances of the client. The
form also allows the institution to include exceptions to managements
assertions, such as the existence of an undisclosed outstanding loan.
10. c. The auditors engagement letter outlines the auditors expectations of
management, including compliance with requests for written
representations.
11. d. Management assertions, as documented in the management
representation letter, often deny the existence of any plans or intentions to
materially alter the financial statements.
12. g. An additional paragraph may be added to the otherwise unmodified
audit report to emphasize a matter, for example, significant transactions
with related parties.
13. f. Any serious difficulty encountered in completing the audit, such as
managements delays in providing information, should be communicated to
the audit committee.
14. j. Accounts receivable confirmations seek to confirm account balances
with a clients debtors and customers. This excerpt is from a negative
confirmation, which requests a reply from a debtor or customer only if a
discrepancy exists.
15. g. Substantial doubt on the part of an auditor about an entitys ability to
continue as a going concern is presented in an explanatory paragraph of the
auditors report.
CHAPTER 24
FORMING AN OPINION AND REPORTING

ON FINANCIAL STATEMENTS
Questions
1. The entire audit process culminates in the preparation of the auditors report.
The auditors report is the primary product of the audit. The auditor should
review and assess the conclusions drawn from the audit evidence obtained as the
basis for the expression of an opinion on the financial statements. This review
and assessment involves considering whether the financial statements have been
prepared in accordance with an acceptable financial reporting framework. It may
also be necessary to consider whether the financial statements comply with
statutory requirements. The auditors report should contain a clear written
expression of opinion on the financial statements taken as a whole.
2. In order to form that opinion, the auditor shall conclude as to whether the
auditor has obtained reasonable assurance about whether the financial
statements as a whole are free from material misstatement, whether due to fraud
or error. That conclusion shall take into account:
(a) The auditors conclusion, in accordance with PSA 330 (Clarified),
whether sufficient appropriate audit evidence has been obtained;
(b) The auditors conclusion, in accordance with PSA 450 (Clarified),
whether uncorrected misstatements are material, individually or in
aggregate; and
(c) The evaluations required by paragraphs 12 to 15.
3. The auditor shall evaluate whether the financial statements are prepared, in all
material respects, in accordance with the requirements of the applicable
financial reporting framework. This evaluation shall include consideration of the
qualitative aspects of the entitys accounting practices, including indicators of
possible bias in managements judgments.
4. In particular, the auditor shall evaluate whether, in view of the requirements of

the applicable financial reporting framework:
(a) The financial statements adequately disclose the significant accounting
policies selected and applied;
(b) The accounting policies selected and applied are consistent with the
applicable financial reporting framework and are appropriate;
(c) The accounting estimates made by management are reasonable;
(d) The information presented in the financial statements is relevant,
reliable, comparable and understandable;
(e) The financial statements provide adequate disclosures to enable the
intended users to understand the effect of material transactions and
events on the information conveyed in the financial statements; and
(f) The terminology used in the financial statements, including the title of
each financial statement, is appropriate.
5. When the financial statements are prepared in accordance with a fair

presentation framework, the evaluation required by paragraphs 12 to 13 of PSA
700 (Clarified) shall also include whether the financial statements achieve fair
presentation. The auditors evaluation as to whether the financial statements
achieve fair presentation shall include consideration of:
(a) The overall presentation, structure and content of the financial
statements; and
(b) Whether the financial statements, including the related notes, represent
the underlying transactions and events in a manner that achieves fair
presentation.
The auditor shall evaluate whether the financial statements adequately refer to or
describe the applicable financial reporting framework.
6. The auditor shall express an unmodified opinion when the auditor concludes that
the financial statements are prepared, in all material respects, in accordance with
the applicable financial reporting framework.
7. If the auditor:
(a) concludes that, based on the audit evidence obtained, the financial
statements as a whole are not free from material misstatement; or
(b) is unable to obtain sufficient appropriate audit evidence to conclude
that the financial statements as a whole are free from material
misstatement.
The auditor shall modify the opinion in the auditors report in accordance with
PSA 705 (Clarified).
If financial statements prepared in accordance with the requirements of a fair

presentation framework do not achieve fair presentation, the auditor shall
discuss the matter with management and, depending on the requirements of the
applicable financial reporting framework and how the matter is resolved, shall
determine whether it is necessary to modify the opinion in the auditors report in
Forming an Opinion and Reporting on Financial Statements 24-3
accordance with PSA 705 (Clarified).
9. The introductory paragraph in the auditors report shall:

(a) Identify the entity whose financial statements have been audited;
(b) State that the financial statements have been audited;
(c) Identify the title of each statement that comprises the financial
statements;
(d) Refer to the summary of significant accounting policies and other
explanatory information; and
(e) Specify the date or period covered by each financial statement
comprising the financial statements.
10. Managements responsibility for the financial statements paragraph in the

audit report is important because it describes the responsibilities of those in the
organization that are responsible for the preparation of the financial statements.
The auditors report need not refer specifically to management, but shall use
the term that is appropriate in the context of the legal framework in the
particular jurisdiction. In some jurisdictions, the appropriate reference may be to
those charged with governance.
11. The auditors report shall include a section with the heading Auditors
Responsibility.
The auditors report shall state that the responsibility of the auditor is to express
an opinion on the financial statements based on the audit.
The auditors report shall state that the audit was conducted in accordance with
PSAs. The auditors report shall also explain that those standards require that the
auditor comply with ethical requirements and that the auditor plan and perform
the audit to obtain reasonable assurance about whether the financial statements
are free from material misstatement.
12. The auditors report shall be dated no earlier than the date on which the auditor
has obtained sufficient appropriate audit evidence on which to base the auditors
opinion on the financial statements, including evidence that:
(a) All the statements that comprise the financial statements, including the
related notes, have been prepared; and
(b) Those with the recognized authority have asserted that they have taken
responsibility for those financial statements.
1. B 6. C
2. A 7. B
3. D 8. D
4. D 9. B
5. C
Cases
1. You must determine whether an unqualified opinion satisfies the PSA reporting
standard, in particular:
a. Determine whether the financial statements are presented in conformity
with PFRS.
1. Read the footnote description of accounting policies.
2. Use a PFRS checklist.
3. Review the working papers for any indication of accounting policies
not described in the footnote or ones apparently not in conformity with
PFRS.
4. Determine if:
(i) The accounting principles are generally acceptable, having
authoritative support.
(ii) The accounting principles are appropriate in the circumstances.
(iii) The financial statements are informative.
(iv) The information is reasonably summarized.
(v) Material adjustments have not been waived without good reasons.
b. Determine whether any accounting changes have been made and whether
accounting principles have been applied consistently.
c. Determine whether the footnote disclosures are adequate to inform users of
any material information evident in the working papers.
2. 1. Title. The report needs a title referring to Rose as the independent auditor
or independent accountant.
2. Notice of audit. The report does not give the proper declaration of an audit
of the financial statements, especially the part about in accordance with
your instructions, which suggest that Rose surrendered some audit
independence. The reference to a complete audit is ill advised because it
Forming an Opinion and Reporting on Financial Statements 24-5
suggests a 100% investigation, which is contradicted by the sentence about
tests of the sales records.
3. Responsibilities. The report says nothing about the auditors responsibility
for the audit report.
4. Opinion. The opinion sentence should not be modified with the phrase
with the explanation given above.
5. Opinion. The opinion sentence should not mention minor errors we
consider immaterial, but it should contain the phrase presents fairly in all
material respects.
6. Opinion/Identification of Financial Statements. The opinion should not
include reference to cash flows because the introductory paragraph did not
state that the cash flow statement was audited. This may be a deficiency in
the identification of the financial statements that were actually audited.
7. Opinion. The opinion paragraph refers improperly to ASC
pronouncements. It should refer to generally accepted accounting
principles.
8. Date. The date accompanying Roses signature should be September 23
the day the field work was completed not the companys fiscal year-end
date.
9. Other. The commentary on the economy and the strike are not generally
appropriate for an audit report. Even if the auditor wanted to draw attention
to these matters, their relevance for understanding the financial statements
and their manner of expression are both questionable.
10. Other. The negative assurance (concerning the recording of sales) is not
permitted in audit reports.
CHAPTER 25
MODIFICATIONS TO THE
INDEPENDENT AUDITORS REPORT
Questions
1. Major reasons for departure from the standard unqualified report

1. Disagreement with management regarding the acceptability of the
accounting policies selected, the method of their application or the
adequacy of financial statement disclosure.
2. Limitation on scope of the audit (resulting in a lack of evidence).
3. Using extra paragraph(s) to emphasize significant matters.
4. Different opinion on prior year comparative statements.
5. Relying on the work and reports of other independent auditors.
6. Required supplementary data omitted or departs from guidelines.
7. Other information inconsistent with financial statements or contains
material misstatement of fact.
8. Auditor is not independent.
2. Students may identify more than one description of the most important
distinction between an opinion and a disclaimer. All the following are valid,
although (a) is intended to be the Most Important:
a. An opinion (unqualified, qualified or adverse) is an explicit statement of the
auditors conclusion(s), while a disclaimer is an (empty) assertion of no
conclusion.
b. An (unqualified) opinion is the highest level of assurance, while a
disclaimer is the lowest level (no assurance).
c. An opinion requires evidence as a basis, while a disclaimer results from
lack of evidence.
d. Auditors must be independent to give an opinion, while a disclaimer can
result from a CPAs lack of independence.
3. A material scope restriction occurs when the auditor is unable to gather

sufficient competent evidence to support an unqualified opinion on the financial
statements. Scope restrictions may be client-imposed or they may result from
other circumstances, e.g., appointment of the auditor after the clients physical
inventory has been taken. A material scope restriction need not result in a
modification of the auditors opinion provided the auditor can obtain satisfaction
by alternate means.
4. The principal auditors reference in his report to another auditor is not a
qualification in scope. The reference only shows the divided responsibility for
the audit work.
5. When an auditor is not independent with respect to a client, a disclaimer of

opinion must be rendered. The disclaimer must be issued because the
statements cannot be audited in accordance with auditing standards. (An
accountant, not an auditor, is the person associated with compiled and reviewed
financial statements. An accountant can give a compilation disclaimer
report on compiled unaudited financial statements).
6. The auditor may decide to disclaim an opinion when confronted by a material

scope limitation that precludes gathering sufficient evidence to support an
opinion as to overall fairness of financial presentation. The auditor may also
disclaim an opinion if his/her name is associated with financial statements for
which an audit was not intended (e.g., compilations and reviews), or if the
auditor is not independent.
7. The audit opinion does not extend to the other information, and therefore, the
opinion is not affected by omission or inconsistency or incorrect supplemental
information.
8. Upon learning of a change in accounting principle, the auditor should first

determine the materiality and appropriateness of the change. If material and the
auditor agree with the clients justification for the change, an explanatory
paragraph should be added following the opinion paragraph. The paragraph will
refer to the footnote describing the change. If the change is not properly
accounted for or is inadequately disclosed, the auditor should consider issuing a
qualified or adverse opinion.
1. C 11. D 21. C
2. D 12. C 22. D
3. C 13. A 23. D
4. D 14. A 24. A
5. A 15. C 25. D
6. B 16. C 26. B
7. C 17. B
8. C 18. B
9. C 19. C
10. A 20. B
Modifications to the Independent Auditors Report 25-3
Cases
1.
Independent Auditors Report
To the shareholders and board of directors of Various Fabrics, Inc.:
We have audited the accompanying statement of financial positions of Various Fabrics,
Inc. as of January 31, 2013 and 2012 and the related statements of income, retained
earnings, and cash flows for the years then ended. These financial statements are the
responsibility of the companys management. Our responsibility is to express an opinion
on these financial statements based on our audits.
We conducted our audits in accordance with auditing standards. Those standards
require that we plan and perform the audit to obtain reasonable assurance about whether
the financial statements are free of material misstatement. An audit includes examining,
on a test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis for our
opinion.
In our opinion, the financial statements referred to above present fairly, in all material
respects, the financial position of Various Fabrics, Inc. as of January 31, 2013 and 2012
and the results of its operations and its cash flows for the years then ended in conformity
with generally accepted accounting principles.
Aya de Jesus, CPA

March 2, 2013
2. 1. F, L 5. B, I
2. B, I 6. B, I
3. B, Q 7. E, J
4. A, J
3. A. 1, 7c.
B. 2, 7a.
C. 4.
D. 1.
E. 6.
F. 5.
G. 2 (Note: The change in principle should be described in the descriptive
paragraph following the scope paragraph.)
H. 3, 7c.
I. 2, 7b.
J. 3, 7d.
K. 6. (given the materiality of property, plant, and equipment)
L. 1, 7e.
M. 1, 7b and 7e.
CHAPTER 26
THE COMPUTER ENVIRONMENT
Questions
1. In a batch processing system, documents evidencing transactions and events are

gathered and processed by groups. The days sales invoices, for example, may
be converted to machine-readable form and processed the next morning. In a
real time system, transactions are input into the system and processed as they
occur. A branch sale, for example, may be input into the system via a terminal
at a remote location. The computer checks for product availability, customer
authenticity, customer credit approval, and shipping terms; and if all conditions
are met, the sale is processed immediately and the sales invoice and shipping
order are produced.
2. In a real-time system, much of the data are stored internally and documentation
is often not as extensive as in a batch system. Retrieval and audit of transaction
data, therefore, are often more difficult in a real-time system. Also, controls are
more likely to be programmed in real-time systems, and for this reason, are
more difficult to test.
3. Inasmuch as computer processing requires increased dependence on the

computer systems and software for the accuracy and completeness of
processing, documentation assumes major significance relative to effective
control. Documentation facilitates reviewing and updating systems and
programs as the environment changes; and it also minimizes the probability of
unauthorized system and program changes which could result in loss of control
and decreased reliability of financial data.
4. In a batch system, files are stored off-line for the most part, and access control
assumes the form of safeguarding the programs, transaction files, and master
files by assigning responsibility for the files to a librarian and instituting a
formal checkout system. Only those persons authorized to process transactions
(computer operators) are permitted access to transaction and master files; and
programmers are permitted access to programs only for testing and debugging
purposes. In an on-line, real-time system, transactions and master files are
stored internally, often in a system of integrated data bases. Access control in
this type of data environment assumes the form of controlling access to data
bases and fixing of responsibility for the data base components. Assigning a
password to an individual who is responsible for the data base component
accessible by that password, canceling passwords of former employees, and
frequent changing of existing employees passwords are examples of access
controls in a real-time system.
5. Recording forms and transaction logs assure consistency and completeness of
data inputs. The form or log should include codes describing such transaction
components as employee number, customer number, vendor number,
department number, stock number, purchased part number, or job number. The
form should also provide for quantities, prices, dates, and usually a short
narrative description of products, parts, materials, or services for purchase and
sales transactions.
6. A transaction file is the batch of entered data that has been converted into
machine-readable form. A transaction file may contain payroll information for a
specific period of time. It is similar to a journal in a manually prepared system.
A master file contains updated information through a particular time period. It
is similar to a ledger in a manual system.
7. Small businesses have found that microcomputers or personal computer systems

are cost effective for processing accounting data. In small businesses, one
would expect to find microcomputers (or personal computers) using
commercially available software.
8. In the computerized system, documents to support a transaction may not be

maintained in readable form, requiring associated performance of controls.
However, the computerized system will enable processing of transactions to be
done more consistently, duties to be consolidated, and reports to be generated
more easily.
1. d 5. c 9. c 13. c 17. c
2. c 6. c 10. c 14. d 18. a
3. a 7. c 11. d 15. a 19. b
4. a 8. b 12. c 16. a 20. a
Cases
An auditor should have the following concerns about the Box system:
Does the system have any flaws or incompatibilities? (No one appears to
have tested the software or found out about others satisfaction with it.)
The computer sits out in the open. (Anyone could have access to and
damage the hardware.)
Anyone could come up with the password by guessing.
The backup disks are not stored in a safe place.
Was the conversion appropriately executed, with no data lost or added?
CHAPTER 27
INTERNAL CONTROL IN THE

COMPUTER INFORMATION SYSTEM
Questions
1. The proper installation of IT can lead to internal control enhancements by

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

are new risks specific to IT environments that must be considered. Key risks
include the following:
Reliance on the functioning capabilities of hardware and software. The

risk of system crashes due to hardware or software failures must be
evaluated when entities rely on IT to produce financial statement
information.
Visibility of audit trail. The use of IT often converts the traditional paper
trail to an electronic audit trail, eliminating source documents and paper-
based journal and records.
Reduced human involvement. The replacement of traditional manual
processes with computer-performed processes reduces opportunities for
employees to recognize misstatements resulting from transactions that
might have appeared unusual to experienced employees.
Systematic versus random errors. Due to the uniformity of processing
performed by IT based systems, errors in computer software can result in
incorrect processing for all transactions processed. This increases the risk
of many significant misstatements.
Unauthorized access. The centralized storage of key records and files in
electronic form increases the potential for unauthorized on-line access from
remote locations.
Loss of data. The centralized storage of data in electronic form increases
the risk of data loss in the event the data file is altered or destroyed.
Reduced segregation of duties. The installation of IT-based accounting
systems centralizes many of the traditionally segregated manual tasks into
one IT function.
Lack of traditional authorization. IT-based systems can be programmed to
initiate certain types of transactions automatically without obtaining
traditional manual approvals.
Need for IT experience. As companies rely to a greater extent on IT-based
systems, the need for personnel trained in IT systems increases in order to
install, maintain, and use systems.
3. General controls relate to all aspects of the IT function. They have a global
impact on all software applications. Examples of general controls include
controls related to the administration of the IT function; software acquisition and
maintenance; physical and on-line security over access to hardware, software,
and related backup; back-up planning in the event of unexpected emergencies;
and hardware controls. Application controls apply to the processing of
individual transactions. An example of an application control is a programmed
control that verifies that all time cards submitted are for valid employee ID
numbers included in the employee master file.
4. The most significant separation of duties unique to computer systems are those
performed by the systems analyst, programmer, computer operator, and data
base administrator. The idea is that anyone who designs a processing system
should not also do the technical work, and anyone who performs either of these
tasks should not also be the computer operator when real data is processed.
5. Typical duties of personnel:

a. Systems analysis: Personnel will design and direct the development of new
applications.
b. Programming: Other personnel will actually do the programming dictated
by the system design.
c. Operating: Other people will operate the computer during processing runs,
so that programmers and analysts cannot interfere with the programs
designed and executed, even if they produce errors.
d. Converting data: Since this is the place where misstatements and errors can
be made the interface between the hardcopy data and the machine-
readable transformation, people unconnected with the computer system
itself do the data conversion.
Internal Control in the Computer Information System 27-3
e. Library-keeping: Persons need to control others access to system and
program software so it will be used by authorized personnel for authorized
purposes.
f. Controlling: Errors always occur, and people not otherwise connected with
the computer system should be the ones to compare input control
information with output information, provide for correction of errors not
involving system failures, and distribute output to the people authorized to
receive it.
6. Documentation differs significantly as to inclusion of program flowcharts,

program listings, and technical operating instructions. File security and
retention differs because of the relatively delicate form of the magnetic media
requiring fireproof vault storage, insulation from other magnetic fields,
safeguards from accidental writing on data files, and so forth.
7. Auditors review documentation to gain an understanding of the system and to

determine whether the documentation itself is adequate for helping manage and
control the computer processing.
8. Responsibilities of the database administrator (DBA) function are:

Design the content and organization of the database, including logical
data relationships, physical storage strategy and access strategy.
Protect the database and its software, including control over access to
and use of the data and DBMS and provisions for backup and recovery
in the case of errors or destruction of the database.
Monitor the performance of the DBMS and improve efficiency.
Communicate with the database users, arbitrate disputes over data
ownership and usage, educate users about the DBMS and consult users
when problems arise.
Provide standards for data definition and usage and documentation of
the database and its software.
9. Five things a person must have access to in order to facilitate computer fraud
are:
a. The computer itself.
b. Data files.
c. Computer programs.
d. System information (documentation).
e. Time and opportunity to convert assets to personal use.
10. Because many companies that operate in a network environment decentralize

their network servers across the organization, there is an increased risk for a lack
of security and lack of overall management of the network operations. The
decentralization may lead to a lack of standardized equipment and procedures.
In many instances responsibility for purchasing equipment and software,
maintenance, administration, and physical security, often resides with key user
groups rather than with features, including segregation of duties, typically
available in traditionally centralized environments because of the ready access to
software and data by multiple users.
1. c 7. b 13. c 19. c 25. b

2. a 8. b 14. c 20. c 26. c
3. d 9. c 15. c 21. a 27. c
4. b 10. a 16. a 22 c 28. d
5. d 11. b 17. b 23. b 29. b
6. d 12. a 18. a 24. c 30. d
Cases
1. Does access to on-line files require specific passwords to be entered to identify

and validate the terminal user?
POSSIBLE ERRORS OR IRREGULARITIES unauthorized access may be obtained to
processing programs or accounting data resulting in the loss of assets or other
company resources.
Are control totals established by the user prior to submitting data for
processing?
POSSIBLE ERRORS OR IRREGULARITIES sales transactions may be lost in data
conversion or processing, or errors made in data conversion or processing.
Are input totals reconciled to output control totals?

POSSIBLE ERRORS AND IRREGULARITIES (same as above). Control totals are
useless unless reconciled to equivalent controls created during processing.
2. a. 1. Input control objectives

Transactions have been recorded properly (neither double-counted nor
omitted that is, control over validity and completeness)
Transactions are transmitted from recording point to processing point
Transactions are in acceptable form
2. Processing control objectives
Loss or nonprocessing of data is detected
Arithmetic functions are performed accurately
Transactions are posted properly
Errors detected in the processing of data are controlled until corrected
and processed
3. Output control objectives
Processed data are reported correctly and without unauthorized
alteration
Output is required by the user
Output is distributed only to persons authorized to receive it
b. 1. Control procedures input source data

Registration at point of entry
Sequential numbering
Grouping (batching) with control totals
Key verification
Programmed edits
Edits for completeness and reasonableness
Checklists to ensure input arrived and on time
2. Control procedures processing controls
Prevention of loss or nonprocessing of data (e.g., control totals)
Performance of arithmetic functions
Assurance of proper posting (sample test of postings)
Correction of errors
Exclusion of unauthorized persons from operating areas (e.g.,
programmers)
3. Control procedures output controls
Review performed by originating area of the reports and other output
data
Sampling and testing of individual transactions
Use of control totals obtained independently from prior processing or
original source data
Distribution lists used to route output only to authorized persons
Making inquiries as to whether the output is desired by the recipient
3. a. The primary internal control objectives in separating the programming and

operating functions are achieved by preventing operator access to the
computer or to input or to output documents, and by preventing operator
access to operating programs and operating program documentation, or by
preventing operators from writing or changing programs.
Programmers should not be allowed in the computer room during

production processing. They should submit their tests to be scheduled and
run by the operators as any other job.
Operators should not be allowed to interfere with the running of any

program. If an application fails, the operators should not be allowed to
attempt to fix the programs. The failed application should be returned to
the programmers for correction.
b. Compensating controls usually refer to controls in user departments
(departments other than computer data processing). In a small computer
installation where there are few employees, segregation of the programming
and operating functions may not be possible (as in a microcomputer or
minicomputer environment). An auditor may find compensating controls in
the user department such as: (1) manual control totals compared to
computer output totals and (2) careful inspection of all output. Such
compensating controls in a simple processing system could provide
reasonable assurance that all transactions were processed, processing was
proper and no unauthorized transactions were processed.
An auditor may find the following compensating controls that are

particularly important when the programming and operating functions are
not separate:
1. Joint operation by two or more operators.
2. Rotation of computer duties.
3. Comparison of computer times to an average or norm.
4. Investigation of all excess computer time (errors).
5. Adequate supervision of all computer operations.
6. Periodic comparison of a program code value to a control value.
7. Required vacations for all employees.
4. a. Input editing is the process of including, in EDP systems, programmed

routines for computer checking as to validity and accuracy of input. Types
of input editing controls are: tests for valid codes; tests for reasonableness;
completeness tests; check digits; and tests for consistency of data entered in
numeric and alphabetic fields.
b. Examples of payroll input editing controls are:

Test for validity of employee number;
Test for proper pay rate;
Test for reasonableness of hours worked.
Examples of sales input editing controls are:

Test for validity of customer number;
Test for credit approval;
Credit limit test;
Sales price list.
c. As EDP system complexity increases, documentation, as well as manual

checking decreases. To provide reasonable assurance as to completeness,
existence, and accuracy of processed transactions under these
circumstances, input editing becomes increasingly necessary.
5. a. Most commonly associated with supervisory programs contained in on-line
real-time systems, design phase auditing involves the auditor in system
design. The goal is to ensure inclusion of controls that will detect
exceptions or unusual conditions and record and log information about the
initiating transactions. Once the necessary controls have been designed and
incorporated into the system, frequent visits by the auditor to the clients
premises are necessary to determine that the controls are functioning
properly.
b. Some individuals and groups have suggested that independence may be

impaired, given auditor monitoring and reviewing a system which he/she
has helped to design. The PICPA has taken the position that making control
recommendations during system design is no different from auditor
recommendations for control improvements after the fact and documented
in the management letter.
c. In some complex EDP systems, a computer audit specialist may be needed

to assist in designing the necessary controls, as well as monitoring and
reviewing the control functions. A computer audit specialist is an
employee of the CPA firm who, typically, will have served on the audit
staff for a period of time, followed by specialized training in computer
system design and control, and EDP auditing.
d. The auditor may rely on the computer audit specialist to whatever degree
considered necessary to assure proper control installation and
implementation. The in-charge field auditor must keep in mind, however,
that use of a computer audit specialist does not compensate for the field
auditors lack of understanding of the internal control, including the EDP
applications.
CHAPTER 28
AUDITING IN A COMPUTER INFORMATION SYSTEMS

(CIS) ENVIRONMENT
Questions
1. Additional planning items that should be considered when computer processing

is involved are:
The extent to which the computer is used in each significant accounting
application.
The complexity of the computer operations used by the entity,
including the use of an outside service center.
The organizational structure of the computer processing activities.
The availability of data.
The computer-assisted audit techniques to increase the efficiency of
audit procedures.
The need for specialized skills.
2. Understanding the control environment is a part of the preliminary phase of

control risk assessment. Computer use in data processing affects this
understanding in each of the parts of the control environment as follows:
The organizational structure should include an understanding of the

organization of the computer function. Auditors should obtain and evaluate: (a)
a description of the computer resources and (b) a description of the
organizational structure of computer operations.
Methods used to communicate responsibility and authority should include the

methods related to computer processing. Auditors should obtain information
about the existence of: (a) accounting and other policy manuals including
computer operations and user manual and (b) formal job descriptions for
computer department personnel. Further, auditors should gain an understanding
of: (a) how the clients computer resources are managed, (b) how priorities for
resources are determined and (c) if user departments have a clear understanding
of how they are to comply with computer related standards and procedures.
Methods used by management to supervise the system should include

procedures management uses to supervise the computer operations. Items that
are of interest to the auditors include: (a) the existence of systems design and
documentation standards and the extent to which they are used, (b) the existence
and quality of procedures for systems and program modification, systems
acceptance approval and output modification, (c) the procedures limiting access
to authorized information, (d) the availability of financial and other reports and
(e) the existence of an internal audit function.
3. The audit trail is the source documents, journal postings and ledger account
postings maintained by a client in order to keep books. These are a trail of the
bookkeeping (transaction data processing) that the auditor can follow forward
with a tracing procedure or back ward with a vouching procedure.
In a manual system this trail is usually visible to the eye with posting
references in the journal and ledger and hard-copy documents in files. But in a
computer system, the posting references may not exist, and the records must be
read using the computer rather than the naked eye. Most systems still have
hard-copy papers for basic documentation, but in some advanced systems even
these might be absent.
4. The audit trail (sometimes called management trail as it is used more in daily
operations than by auditors) is composed of all manual and computer records
that allow one to follow the sequence of processing on (or because of) a
transaction.
The audit trail in advanced systems may not be in a human-readable form and
may exist for only a fraction of a second.
The first control implication is that concern for an audit trail needs to be
recognized at the time a system is designed. Techniques such as integrated test
facility, audit files and extended records must be specified to the systems
designer. The second control implication is that if the audit trail exists only
momentarily in the form of transaction logs or master records before destructive
update, the external auditor must review and evaluate the transaction flow at
various times throughout the processing period. Alternatively, the external
auditor can rely more extensively on the internal auditor to monitor the audit
trail.
5. Major characteristics:
1. Staff and location of the computer operated by small staff located within
the user department and without physical security.
2. Programs supplied by computer manufacturers or software houses.
3. Processing mode interactive data entry by users with most of the master
file accessible for inquiry and direct update.
Control Problems:
1. Lack of segregation of duties.
2. Lack of controls on the operating system and application programs.
Auditing in a Computer Information Systems (CIS) Environment 28-3
3. Unlimited access to data files and programs.
4. No record of usage.
5. No backup of essential files.
6. No audit trail of processing.
7. No authorization or record of program changes.
6. Auditing through the computer refers to making use of the computer itself to test
the operative effectiveness of application controls in the program actually used
to process accounting data. Thus the term refers only to the proper study and
evaluation of internal control. Auditing with the computer refers both to the
study of internal control (the same as auditing through) and to the use of the
computer to perform audit tasks.
7. Both are audit procedures that use the computer to test controls that are included
in a computer program. The basic difference is that the test data procedure
utilizes the clients program with auditor-created transactions, while parallel
simulation utilizes an auditor-created program with actual client transactions. In
the test data procedure the results from the client program are compared to the
auditors predetermined results to determine whether the controls work as
described. In the parallel simulation procedures the results from the auditor
program are compared to the results from the client program to determine
whether the controls work as described.
8. The test data technique utilizes simulated transactions created by the auditor,
processed by actual programs but at a time completely separate from the
processing of actual, live transactions. The integrated test facility technique is
an extension of the test data technique, but the simulated transactions are
intermingled with the real transactions and run on the actual programs
processing actual data.
9. User identification numbers and passwords prevent unauthorized access to

accounting records and application programs. The transaction log does not
prevent unauthorized access but may be reviewed to detect unauthorized access.
Even then, responsibility could not be traced to a particular individual without
user identification numbers and passwords. The transaction log is more
important to establish the audit trail than to detect unauthorized access.
10. Generalized audit software is a set of preprogrammed editing, operating, and

output routines that can be called into use with a simple, limited set of
programming instructions by an auditor who has one or two weeks intensive
training.
11.
Phases Noncomputer auditor involvement
1. Define the audit objectively 1. Primary responsibility
2. Feasibility 2. Evaluate alternatives
3. Planning 3. Review with computer auditor
4. Application design 4. none
5. Coding 5. none
6. Testing 6. Review final test results, compare to plan
7. Processing 7. Actual computer processing none
Use of results depends on application
8. Evaluation 8. Full responsibility
12. Automated microcomputer work paper software generally consists of trial

balance and adjustment worksheets, working paper (lead schedule) forms, easy
facilities for adjusting journal entries, and electronic spreadsheets for various
analyses.
13. A microcomputerized electronic spreadsheet can be used instead of paper and

pencil to create the form of a bank reconciliation, with space provided for text
lists of outstanding items (using the label input capability), and math formulas
inserted for accurate arithmetic in the reconciliation. Printing such a
reconciliation is easy (and much prettier than most accountants handwriting!).
14. With either data base or spreadsheet software packages, macros (sets of
instructions) can be developed for retrieving data from the working trial balance
and converting this data into classified financial statements. If one or more
subsidiaries are to be included, the consolidated process can also be automated
by the inclusion of special modules designed for that purpose. The standard
audit report, as well as recurring footnotes, can be included in the data base, and
modified to fit the circumstances of the current years audit results.
15. Relational data base packages have all the advantages of spreadsheets, and, in
addition, have the capacity to store and handle larger quantities of data. They
are especially useful in manipulating large data bases, such as customer accounts
receivable, plant assets, and inventories.
1. a 5. d 9. b 13. c 17. b
2. c 6. d 10. d 14. a 18. c
3. c 7. c 11. b 15. d 19. d
4. d 8. b 12. b 16. b
Cases
1. a. Auditing around the computer generally refers to examinations of

transactions in which a representative sample of transactions is traced from
the original source documents, perhaps through existing intermediate
records in hard copy, to output reports or records, or from reports back to
source documents. Little or no attempt is made to audit the computer
program or procedures employed by the computer to process the data. This
audit approach is based on the premise that the method of processing data is
irrelevant as long as the results can be traced back to the input of data and
the input can be validated. If the sample of transactions has been handled
correctly, then the system outputs can be considered to be correct within a
satisfactory degree of confidence.
b. The CPA would decide to audit through the computer instead of around
the computer (1) when the computer applications become complex or (2)
when audit trails become partly obscured and external evidence is not
available.
Auditing around the computer would be inappropriate and inefficient in

the examination of transactions when the major portion of the internal
control system is embodied in the computer system and when accounting
information is intermixed with operation information in a computer
program that is too complex to permit the ready identification of data inputs
and outputs. Auditing around the computer will also be ineffective if the
sample of transactions selected for auditing does not cover unusual
transactions that require special treatment.
c. (1) Test data is usually a set of data in the form of punched cards or
magnetic tape representing a full range of simulated transactions, some
of which may be erroneous, to test the effectiveness of the programmed
controls and to ascertain how transactions would be handled (accepted
or rejected) and if accepted, the effect they would have on the
accumulated accounting data.
(2) The auditor may use test data to gain a better understanding of what the
data processing system does, and to check its conformity to desired
objectives. Test data may be used to test the accuracy of programming
by comparing computer results with results predetermined manually.
Test data may also be used to determine whether errors can occur
without observation and thus test the systems ability to detect
noncompliance with prescribed procedures and methods.
Assurance is provided by the fact that if one transaction of a given type

passes a test, then all transactions containing the identical test
characteristics will if the appropriate control features are functioning
pass the same test. Accordingly, the volume of test transactions of a
given type is not important.
d. In addition to actually observing the processing of data by the client, the

CPA can satisfy himself that the computer program tapes presented to him
are actually being used by the client to process its accounting data by
requesting the program of a surprise basis from a computer librarian and
using it to process test data.
The CPA may also request, on a surprise basis, that the program be left in
the computer at the completion of processing data so that he can use the
program to process his test data. This procedure may reveal computer
operation intervention. If, so, ensures that a current version of the program
is being audited, an important procedure in computer installations newly
installed and undergoing many program changes. To gain further assurance
about this matter, the CPA should inquire into the clients procedures and
controls for making program changes and erasing superseded program
tapes, and should examine log tapes where available.
2. a. Document retention
IMPACT ON THE INTERNAL CONTROL SYSTEM: In on-line real time
systems and EDI systems, the audit trail is frequently modified in the form
of reduced documentation. To compensate, internal controls should provide
for adequate input editing, as well as some form of transaction log as
documentation at the input stage.
IMPACT ON THE INDEPENDENT AUDIT: In examining internal
control, under these circumstances, the auditor must rely more on
observation, inquiry, and reprocessing of transactions for control testing
purposes, and less on document testing. If documents are retained for only
a short period, the auditor should also consider the feasibility of frequent
visits for both substantive and control testing purposes.
b. Uniformity of processing
IMPACT ON THE INTERNAL CONTROL SYSTEM: The impact of this
internal control characteristic is to generally strengthen control by
increasing the consistency of processing. Once the proper controls are
installed and tested, processing consistency increases the accuracy of
transaction processing over that which exists in manual systems.
IMPACT ON THE INDEPENDENT AUDIT: The auditor must emphasize
control study and testing at the point of transaction input and processing to
determine that the necessary controls exist and are functioning. Upon
determining that the necessary input and processing controls are in place
and functioning properly, the auditor may elect to perform little or no
document testing.
c. Concentration of functions
IMPACT ON THE INTERNAL CONTROL SYSTEM: In manual systems,
separation of functional responsibilities provides a double-check for the
purpose of enhancing processing accuracy. In EDP accounting systems,
consistency of processing removes the need for double-check.
IMPACT ON THE INDEPENDENT AUDIT: The auditor must determine
that the necessary input editing controls are in place and functioning to
ensure that transactions are accurately introduced into the processing
stream. Moreover, to ensure checks and balances within the electronic data
processing function, the auditor should study the organizational structure of
the EDP group to ascertain proper separation among the following
functions:
Systems analysis and design
Program design, development, and testing
Computer operations involving data processing
Distribution of EDP output and reprocessing of errors
d. Access to data bases

IMPACT ON THE INTERNAL CONTROL SYSTEM: The greater the
number of input terminals providing access to data bases, and the more
integrated the data base, the greater the danger of unauthorized access. To
protect the data bases under these circumstances, the internal control
policies and procedures should provide for effective control over
identification codes and passwords permitting access to data bases; and the
control policies should also fix responsibility in designated individuals for
specified elements of data bases.
In batch systems, access to magnetic tape and disk files and programs
should be secured by assigning responsibility over these files to one or more
individuals designated as librarians, and instituting a formal checkout
system for releasing and reacquiring files and programs.
IMPACT ON THE INDEPENDENT AUDIT: The auditor should
determine that proper control over I.D. codes and passwords exists, that
codes and passwords are changed frequently and voided upon termination
of employment, and that responsibility for elements of data bases has been
appropriately fixed.
In batch systems, the auditors should determine that tape and disk files and
programs stored off-line are properly secured.
3. a. Test data approach: The auditor prepares simulated input data (both valid
and invalid transactions) that are processed, under the auditors control, by
the clients processing system.
Advantage: A good way of testing existing controls for proper functioning.

Disadvantage: Difficulty in designing comprehensive test data; Difficulty
in ascertaining whether the programs tested are the same programs used by
the client in processing actual transactions and events during the year.
ITF approach: The auditor creates a fictitious entity within the clients
actual data files, and processes simulated data during live processing by
client. The auditor then compares the results of processing with anticipated
results.
Advantage: Greater assurance that programs tested are programs used by

the client (the approach can be applied at different points in time during the
year).
Disadvantage: Difficult to remove test data from the system without
harming clients files.
Tagging and tracing: This is a technique whereby an identifier or tag is

affixed to a transaction record; and the tag triggers snapshots during the
processing of transactions. Following the tagged transactions through the
system permits the auditor to evaluate the logic of the processing steps and
the adequacy of programmed controls.
Advantage: The use of actual data eliminates the need for removing data
from the clients processing system.
Disadvantage: The auditor analyzes the transactions only after processing
is completed.
SCARF: A systems control audit review file is an audit log used to collect
information for subsequent analysis and review. An imbedded audit
module monitors selected transactions as they pass by specific processing
points. The module then captures the input data so that relevant
information, accessible only by the auditor, is displayed at key points in the
processing system.
Advantage: Utilizes real- rather than simulated-transaction data, and does

not require reversing the entries.
Disadvantage: Does not necessarily capture erroneous data.
Surprise audit: The auditor, on an unannounced basis, requests copies of
clients programs, and compares them with auditors copy of authorized
versions.
Advantage: Assists the auditor in determining whether client personnel are

using authorized versions of programs in processing data.
Disadvantage: Auditor may not always be notified by the client when
program changes are made, thus making the comparison irrelevant.
b. Inasmuch as each of the above alternatives have distinct advantages and

disadvantages, a combination approach overcomes the disadvantages
resulting from using a single approach. Using ITF, for example on a few
simulated transactions, while applying the tagging and tracing or SCARF
approach for numerous actual transactions, provides effective testing of
control procedures for error prevention and detection, without requiring the
reversal of a large number of simulated transactions from the clients
system.
c. In auditing around the computer, the auditor predetermines the processing

results (output) of selected input data, and compares the predetermined
results with actual computer output. The advantage of this approach is its
ease of application; a significant disadvantage is that the auditor gains no
understanding of how the computer processes data, nor of the controls
which have been incorporated into the computer programs.
In auditing through the computer, the auditor actually tests the programmed
controls used in processing specific applications. Such techniques as design
phase auditing, ITF, tagging and tracing, SCARF, test data, and surprise
audit are examples of auditing through the computer.
d. Parallel simulation is an automated version of auditing around the computer

in that the auditor creates a set of application programs that simulate the
processing system, and compares output from the real and simulated
systems. Comparison of input with output ignores the essential
characteristics of the processing system and assumes that if the outputs are
identical, the system is processing transactions accurately.
The auditor might elect to use parallel simulation in combination with

design phase auditing. Design phase auditing ensures that the necessary
controls are installed during system design. By permitting the auditor to
test large volumes of transactions, parallel simulation helps to confirm
whether these controls are working.
4. (a) Test decks, also called test data, are sets of computer input data which
reflect a variety of auditor-identified transactions for verification through
actual computer processing to detect invalid processing of results (i.e.,
existing programs run test data). Ideal test data should present the
application under examination with every possible combination of
transactions, master file situations, and processing logic which could be
encountered during actual comprehensive processing. Test data are usually
processed separately from actual data using copies of master files. Test
decks are most feasible when the variety of transactions processing and
controls is relatively limited (i.e., fairly simple files).
Uses include checking and verifying: (1) input transaction validation

routines, error detection, and application system controls, (2) processing
logic, and controls associated with creation and maintenance of master files,
(3) computational routines such as interest and asset depreciation, and (4)
incorporation of program changes.
(b) Parallel simulation consists of the preparation of a separate computer

application that performs the same functions as those used by the actual
application programs. The simulation programs read the same input data as
the application programs, use the same files, and attempt to produce the
same results (e.g., real data run through test programs). These simulated
results are matched with those from the live programs, providing a means
for testing through comparison.
Uses include all those cited for test decks.
(c) The integrated test facility approach permits the introduction of auditor-
selected test data into a computer system with actual or live data and then
traces the flow of transactions through the various system processing
functions for comparison to predetermined actual results. An ITF involves
the creation or establishment of a dummy entity (e.g., a branch or
division) to receive the results of the test processing. Therefore,
transactions are processed against the test entity together with actual
transactions. Test data must be removed from the entitys records upon
completion of the test. Uses are identical to the test deck technique.
(d) Tagging and tracing and SCARF are forms of transaction tracking provided
only for auditor selected computer inputs carrying a special code. If the
capability is provided in the application system in advance, the attachment
of a code to any input transaction can be made to generate a printed
transaction trail for that item following each step of the application
processing.
Uses include: (1) determining the impact of specific transactions on master
records or calculations in high volume systems, (2) flagging unusual or
abnormal transactions, and (3) debugging application programs.
5. In an audit of a computer-based system, adequate training and experience must

be directly related to EDP. In particular, the auditor should be knowledgeable of
what computer systems do, how to test the operations of an EDP system, and
how to use EDP-unique documentation.
The training and proficiency standard contributes to satisfaction of the

independence standard by enabling the auditor to make his own decisions and
judgments. Otherwise, he might tend to subordinate his judgment to other
persons, possibly to client personnel. When the auditor lacks training and
proficiency, it is virtually impossible to maintain an operational independence
over audit decisions. An independence of mental attitude is futile if actual
decisions are subordinated to others.
The exercise of due audit care requires a critical review at every level of audit
supervision of the work done and the decisions made by auditors. Lacking the
requisite skills and lacking independent decisions, the due care expected of an
auditor at operational, supervisor, and review levels cannot be delivered.
The Philippine Standards on Auditing require adequate planning and supervision

of assistants. Training and proficiency in computer systems auditing is
necessary in order to plan access to computerized records, programs, and to
obtain machine time for conducting audit procedures. The planning should
provide for an early examination of the computer system so that further
procedures involving non-computer control and accounting features may be
planned should they depend upon computer control procedures.
Training and proficiency are very important for being able to obtain an
understanding of the internal control structure in a computer system. Client
personnel will expect audit personnel to be capable of working with a computer
system.
The Philippine Standards on Auditing also require the auditor to obtain

sufficient competent evidential matter to provide a basis for an opinion on
financial statements. Documentary evidence relating to a computer system
includes program flow charts, logic diagrams, and decision tables that are not
normally used in non-computer systems. Since these types of documentation are
a part of the evidence, they must be understood by the auditor, and
understanding of them comes through training and proficiency in their use.
CHAPTER 29
PROCEDURES AND REPORTS ON SPECIAL PURPOSE

AUDIT ENGAGEMENTS
Questions
1. The report simply states: The financial statements are not intended to be
presented in conformity with financial reporting standards. The opinion
expression thereafter refers to a description of the comprehensive basis used.
Non-PFRS accounting bases include:

1. Statutory or regulatory accounting requirements
2. Tax basis accounting
3. Cash and modified cash bases
4. General price level-adjusted statements
5. Any other basis having substantial support (Auditing standards do not
explain how non-PFRS accounting can have substantial support. In
practice, accountants will report on any reasonable accounting basis, which
explains why reports exist on diverse types of current value financial
statements.)
2. The following are four comprehensive bases of accounting other than PFRS:
1. A basis of accounting to comply with the requirements of a governmental
regulatory agency (for example, insurance companies use a basis of
accounting pursuant to the rules of the insurance commission)
2. A basis of accounting used to file an income tax return
3. The cash receipts and disbursements basis of accounting (cash basis) and
modifications to the cash basis, such as recording depreciation on fixed
assets or accruing income tax.
4. A definite set of criteria having substantial support that is applied to all
material items in the financial statements, such as the price-level basis of
accounting.
3. A CPA may be asked to report on the application of PFRS by another auditors

client who disagrees with the auditors view of proper accounting for the
transaction. Auditing standards apply when a CPA in public practice, either in
connection with a proposal to obtain a new client or otherwise, provides oral or
written advice on the application of accounting principles to a specific
transaction or the type of opinion that may be rendered on an entitys financial
statements. In forming a judgment, the CPA should perform the following
procedures:
Obtain an understanding of the form and substance of the
transaction(s).
Review applicable PFRS.
If appropriate, consult with other professionals or experts.
If appropriate, perform research or other procedures to ascertain and
consider the existence of creditable precedents or analogies.
The reporting CPA is required to consult with an entitys continuing
CPA to ascertain all the relevant facts. The continuing CPA can
provide information about the form and substance of the transaction,
how management has applied accounting principles to similar
transactions, and whether the method of accounting recommended by
the continuing CPA is disputed by management.
4. The following difficulties might arise:
Prior-year statements were unaudited: The auditor should label the prior-year
columns Unaudited and modify the report by adding a paragraph that
disclaims an opinion on the statements.
Audited by another auditor:

Alternative 1: Predecessor auditor reissues report.
Alternative 2: If predecessors report is not presented, the auditor
indicates in the introductory paragraph (1) that the financial statements
of the prior period were audited by another auditor (but does not name
the predecessor auditor), (2) the date of the report, (3) the type of report
issued by the predecessor auditor, and (4) if the report was not a
standard unqualified report, the substantive reasons therefor. When
the predecessor auditors report is not presented, the audit report would
have an added sentence at the end of the first paragraph, and the
opinion paragraph would refer only to the current-year statements.
Different reports on comparative statements: An auditor may issue modified

reports on either of the financial statements reported on comparatively. In this
situation, the auditor must exercise care to relate the opinion to the appropriate
years financial statements.
Procedures and Reports on Special Purpose Audit Engagements 29-3
1. b 5. b 9. a 13. d 17. b
2. a 6. a 10. a 14. a 18. c
3. c 7. a 11. d 15. a 19. b
4. a 8. a 12. d 16. a 20. a
Cases
1.
To the Board of Directors of Neiny Ltd.:
We have reviewed the accompanying statement of financial position of Neiny Ltd. as of
December 31, 2014, and the related statements of income, retained earnings, and cash flows
for the year then ended, in accordance with standards established by the Auditing Standards
and Practices Council. All information included in these financial statements is the
representation of the management of Neiny Ltd.
A review consists principally of inquiries of company personnel and analytical procedures
applied to financial data. It is substantially less in scope than an examination in accordance
with auditing standards, the objective of which is the expression of an opinion regarding the
financial statements taken as a whole. Accordingly, we do not express such an opinion.
Based on our review, we are not aware of any material modifications that should be made to
the accompanying 2014 financial statements in order for them to be in conformity with
financial reporting standards.
The financial statements for the year ended December 31, 2013, were audited by us, and we
expressed an unqualified opinion on them in our report dated February 27, 2014, but we have
not performed any auditing procedures since that date.
Modelle & Co.

March 3, 2016
2. a. The assertions that are incorrect and should otherwise be deleted are the
following:
1. Report should be addressed to Ms. Clean Corporations Board of
Directors.
2. Delete the entire paragraph describing the scope except for the
reference to cash in banks and accounts receivable.
3. Delete the opinion rendered on cash in banks and accounts receivable.
4. Delete the recommendation to acquire Ajacks.
b. The assertions that are missing and should be inserted are the following:
1. Date of the report.
2. Statement limiting the distribution of the report to Ms. Cleans
management.
3. Description of the procedures performed.
4. Statement that the agreed-upon procedures applied are not adequate to
constitute a PSA audit.
5. Description of the accountants findings.
6. Disclaimer of an opinion concerning cash in banks and accounts
receivable.
7. Statement limiting the report only to cash in banks and accounts
receivable and indicating that the report does not extend to the
financials taken as a whole.
3.
Independent Auditors Report
[Addressee]
We have audited the statement of assets, liabilities, and capital (income tax [cash] basis) of
Vanda & Corona, a partnership, as of December 31, 2014, and the related statements of
revenue and expenses (income tax [cash] basis) and statement of changes in partners
capital accounts (income tax [cash] basis) for the year then ended. These financial
statements are the responsibility of the companys management. Our responsibility is to
express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with auditing standards. Those standards require
that we plan and perform the audit to obtain reasonable assurance about whether the
financial statements are free of material misstatement. An audit includes examining, on a test
basis, evidence supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation. We believe
that our audits provide a reasonable basis for our opinion.
As described in Note X, the partnerships policy is to prepare its financial statements on the
accounting basis used for income tax purposes; consequently, certain revenue and related
assets are recognized when received rather than when earned, and certain expenses are
recognized when paid rather than when the obligation is incurred. Accordingly, the
accompanying financial statements are not intended to present financial position and results
of operations in conformity with financial reporting standards.
In addition, the company is involved in continuing litigation relating to patent infringement.
The amount of damages resulting from this litigation, if any, cannot be determined at this time.
In our opinion, the financial statements referred to above present fairly the assets, liabilities,
and capital of the Vanda & Corona partnership as of December 31, 2014, and its revenue and
expenses and changes in its partners capital accounts for the year then ended, on the
income tax (cash) basis of accounting as described in Note X, which basis has been applied
in a manner consistent with that of the preceding year.
[Sterling & Co.]

[Date]
CHAPTER 30
NONAUDIT ENGAGEMENTS:
PROCEDURES AND REPORTS
Questions
1. Examples of using what has held true in the past will hold true in the future:
(a) evaluating the collectibility of accounts receivable based on past collection
history,
(b) evaluating inventory obsolescence on the basis of past usage patterns,
(c) assessing the economic usefulness and useful lives of fixed assets based
upon experience with similar assets,
(d) relying on a control risk assessment for a period between the time of the
original assessment at interim and the fiscal year-end, and
(e) expecting to encounter classification and evaluation errors when
management has been known to have acted without sufficient decision
planning in the past.
2. Financial statements are unaudited if the CPA has not applied any auditing
procedures or has not applied procedures which produced sufficient evidence
upon which to base an opinion on the financial statements as a whole.
With respect to unaudited statements, in addition to a disclaimer of opinion

(public companies), the following guides should be followed:
1. If the CPA should learn that the statements are not in conformity with
financial reporting standards (including adequate disclosures), he should
explain the departures in the disclaimer.
2. If prior years unaudited statements are present, the disclaimer should cover
them as well as the current year statement.
3. Each page of the statements should be clearly labeled as unaudited.
3. Prospective financial statements are defined as complete financial statements in

the same form as traditional income statements, statement of financial positions
and statements of changes in financial position. However, an abbreviated
presentation constitutes prospective financial statements if its contains all of
these items (if applicable):
1. Sale or gross revenue
2. Gross profit
3. Unusual or infrequently occurring items
4. Provision for income taxes
5. Discontinued operations or extraordinary items
6. Net income
7. Primary and fully diluted earnings per share
8. Summary of significant changes in financial position
9. Summary of significant assumptions
10. Summary of significant accounting policies
Omission of any items 18 makes the presentation a partial presentation.
Omission of 9 or 10 makes it a deficient presentation.
4. Similarities and Differences

Audit Report
Examination Report on a Forecast on Historical Statements
a. Identification of financial a. Identification of statements
statements and what they intend to audited.
represent.
b. Warning about ultimate
attainment of prospective results.
c. Statement about review in c. Statement that audit was in
accordance with ASPC standards. accordance with PSA.
d. Opinion / assurance about d. Opinion about conformity with
presentation and reasonable PFRS.
assumptions.
e. Statement about no responsibility
to update the report.
Compilation Report
Compilation Report on a Forecast on Historical Statements
a. Identification of financial a. Identification of statements
statements and what they compiled.
represent.
b. Warning about ultimate b. Statement / warning that
attainment of prospective results. information is the representation
of management (owners).
c. Statement about compilation in c. Same kind of statement about
accordance with ASPC standards. compilation and ASPC standards.
d. Disclaimer of opinion / assurance. d. Disclaimer of opinion / assurance.
e. Statement about no responsibility
to update the report.
5. Both review service and compilation service engagements are less than an audit.
A comparison of the three amounts to a hierarchy of assurance:
1. Audit engagement Auditor obtains sufficient competent
evidence that serves as a basis for an
opinion on financial statements. The
auditor obtains reasonable assurance
within the inherent limitations of the audit
Nonaudit Engagements: Procedures and Reports 30-3
process.
2. Review engagement Accountant obtains limited assurance
through analytical procedures that there are
no material modifications that should be
made to financial statements.
3. Compilation engagement Accountant puts client information in
financial statement form without obtaining
any assurance (because no procedures are
performed) that material modification
should or should not be made to the
Additionally, an accountant who is not independent may report on a compilation

service (providing that lack of independence is disclosed), but not on a review
service or audit engagement.
6. A state of association exists whenever:

a. The CPAs name is used in a document containing the statements; or
b. The CPA has prepared or assisted in preparing the statements.
7. a. Compilation: In compiling financial statements for a client, the CPA

presents information that is the representation of management without
undertaking to express any assurance on the statements.
b. Review: More than a compilation, but less than an audit, a review consists
mainly of performing inquiry and analytical procedures. Such procedures
provide the CPA a basis for expressing limited assurance concerning
conformance with PFRS.
c. Audit: An audit provides reasonable assurance concerning conformance of
financial statements with PFRS. In addition to inquiry and analytical
procedures, an audit involves a study of the clients internal controls and
application of such evidence gathering procedures as confirmation,
observation, inspection, vouching, and examination.
8. The major procedures applied in a review consist of reading the financial

statements, inquiry as to accounting procedures, and analytical procedures. A
compilation, in contrast to a review, consists of obtaining an understanding of
industry accounting principles and practices and reading the financial
statements.
9. A CPA who lacks independence may compile financial statements; but may not
perform an audit, review, or any other form of attestation service.
10. Procedures to be applied in compiling prospective financial statements should

include the following:
a. Inquire about the accounting principles used in preparing the statements.
b. Ask how the key factors are identified and how the assumptions are
developed.
c. Obtain a list of assumptions and consider whether there are any omissions
or inconsistencies.
d. Test the mathematical accuracy of computations.
e. Read the statements for conformity with PSA presentation guidelines.
f. Obtain client representations concerning compliance with the guidelines.
1. c 5. a 9. a 13. b 17. c
2. c 6. b 10. d 14. b 18. d
3. b 7. a 11. a 15. a 19. a
4. b 8. c 12. b 16. b 20. b
Comprehensive Cases
1. a. Liability to Delcee and other stockholders:

Delcee in its own right may bring an action, or the other stockholders may
bring a derivative action against Canada and Canada on behalf of the
corporation, for negligent performance in failing to detect the fraud
(embezzlement).
A lawsuit based on constructive fraud might be asserted against C & C,

because the conduct of the review may be characterized as gross negligence
with reckless disregard for the truth. Individual shareholders and lending
institutions will claim this is the case, and if upheld, privity of contract will
not be a valid defense.
b. Liability to financial institutions:

Third-party financial institutions have rights to sue accountants for
negligence in performing review engagements. As a general rule, third
parties, even though not direct parties to an audit contract, may successfully
assert negligence if they can show that they are members of a class of
persons intended to benefit from the services performed by the CPA and
that their use of the statements was reasonably foreseeable by the CPA.
2.
Assumption Evidence Sources and Procedures
a. Sale of real estate 1. Determine market value of real estate:
* Review appraisals (if any), inquire of real
estate broker for the selling price of similar
pieces of land.
2. Determine cost and tax basis of land:
* Examine underlying documents (use
financial statement cost presentations, if
previously audited) deeds, purchase
contracts.
* Review National Internal Revenue Code and
appropriate publications to determine proper
tax basis, tax rates, treatment.
3. Determine after-tax profit and proceeds:
* Based on above information, compute profit
and proceeds. Compare amounts to client
representations to determine reasonableness.
4. Determine authority for use of proceeds:
* Examine minutes of directors and officers
meetings for evidence of authority to sell the
real estate and a formal plan for using the
proceeds to retire bonds.
b. Retire outstanding 1. Determine probable cost of repurchasing
debentures. bonds:
* Examine amount, terms of bonds
outstanding.
* Review current forecasted market for bonds,
in light of terms, amount.
* Compute estimated cost of repurchase.
2. Determine adequacy of funding for repurchase:
* Compare amount of proceeds [computed in
(a)] to amount estimated for repurchase.
3. Determine authority for retirement:
* Examine minutes of executives and
officers meetings for evidence of approval
of retirement.
c. Labor contract 1. Determine probable wage increase:
* Examine prior contract settlements,
including subjective analysis of labor-
management relations. Confer with union
officials.
* Examine documents, memos, and minutes
regarding upcoming labor negotiations.
* Examine managements proposed contract.
2. Determine effect of higher than predicted wage
settlement:
* Recompute effect of percent change in wage
increase to net income and correlate to
managements figures.
d. Sales projections 1. Determine estimated completion date of Tarlac
facility:
* Examine contract plans, consult with
contractor, observe facility.
* Examine contracts for machinery,
installation; consult with vendor dates,
type of equipment, product capacity.
* Compare auditor-estimated completion date
to managements for reasonableness.
* Consider if company can meet personnel
requirements of the new facility.
2. Estimate financial impact of Tarlac production:
* Compare productive capacity to forecasted
sales figure (presumed determined
reasonable by the auditor).
* Recompute probable effect of delay in
Tarlacs completion date and compare to
managements figures.
3. Nicky has no accounting staff and has little expertise in preparing financial
statements himself. However, he needs them occasionally, apparently for credit
purposes.
Three kinds of compiled financial statements are available:

1. Compilation Without Independence. Brother Kian can prepare the compiled
financial statements (with or without all disclosures), but he will need to
disclose in this report his lack of independence.
2. Compilation With Full Disclosure. CPA Bryan can compile the statements
and present them in the complete form used for audited financial
statements.
3. Compilation That Omits Substantially All Disclosures. CPA Bryan can
compile statements without footnote disclosures, but his report will indicate
the lack of disclosure and will warn users.
4. a. Yes, this is a negative assurance.
b. Negative assurance is generally prohibited in audit reports because the

profession wishes such reports to contain positive assertions based on
evidence instead of negative statements based on what did not come to my
attention.
c. A review service is less than an audit, hence the report can be less than
positive assurance. Clients get what they paid (less) for.
5.
To the Board of Directors of Francisco Company
I have reviewed the accompanying statement of financial position of Francisco Company
as of December 31, 2014, and the related statements of income, retained earnings, and
changes in financial position for the year then ended, in accordance with standards
established by the Auditing Standards and Practices Council. All information included in
these financial statements is the representation of the management of Francisco
Company.
A review consists principally of inquiries of company personnel and analytical procedures
applied to financial data. It is substantially less in scope than an examination in
accordance with auditing standards, the objective of which is the expression of an
opinion regarding the financial statements taken as a whole. Accordingly, I do not
express such an opinion.
Based on my review, I am not aware of any material modifications that should be made
to the 2014 financial statements in order for them to be in conformity with financial
reporting standards.
The accompanying 2013 financial statements of Francisco Company were compiled by
other accountants whose report dated January 11, 2014, stated that they did not express
any opinion or any other form of assurance of those statements.
Jo Cee, CPA
January 15, 2015
Note: This report presumes:

1. Jo Cee is independent.
2. Francisco and Associates, CPAs made no modifications in their
2003 compilation report.
3. Francisco and Associates, CPAs was independent.
4. The 2003 statements contained all necessary disclosures.
6.
Service Report Procedures
a. Compilation Compilation Read and inquire
b. Agreed upon Review As agreed and applied to
procedures specified elements
c. Review Review Read, inquire, and apply
analytical procedures
d. Examination Opinion Evaluate preparation
(attestation) Examine and evaluate
underlying assumptions
Determine whether
presentation is in
conformity with PSA
guidelines.
7. a.
Nature of Type of Principal
Engagement Report Procedures
a. Audit Opinion; positive Study and evaluate
internal control;
observe, examine,
confirm, reconcile,
calculate, and vouch.
b. Comprehensive Opinion; positive Same as (a)
basis other than
PFRS
c. Review; Review; limited Inquiry; analytical
nonpublic entity procedures
d. Compilation; Compilation; none Understand industry
nonpublic entity accounting practices;
read the financial
statements
e. Agreed-upon Review; limited As specified by
procedures engagement letter
f. Letter for Review; limited Inquiry-as specified by
underwriter agreement; read the
financial statements
g. Examination of Opinion; positive Examine evidence

prospective supporting assumptions;
financial determine whether
statements- assumptions provide a
projection reasonable basis for the
projection; evaluate
preparation and
presentation of
projected financial
statements.
h. Review of Review; limited Inquiry; analytical
interim financial procedures
information
b.
a. General.
b. Restricted to management, the board of directors, and the regulatory
commission.
c. General.
d. General (but a fourth paragraph must be added which states that the
CPA is not independent.)
e. Restricted to the parties named in the agreement.
f. Restricted to the underwriters, Candy and Lolli.
g. Restricted to management, the board of directors, and the prospective
lender.
h. General.

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CHAPTER 1

PROFESSIONAL PRACTICE OF ACCOUNTANCY

2. Refer to page 11 of the textbook.

High Opportunity Competencies have a high likelihood of being building

Low Opportunity Competencies, while important to the delivery of current

5. Refer to page 4 of the textbook.

6. The Philippine Accountancy Act of 2004 (R.A. 9298) Article I, Section 4,

7. Refer to pages 8 to 10 of the textbook.

8. Refer to page 11 of the textbook.

9. Refer to pages 13 to 14 of the textbook.

10. Refer to pages 14 to 15 of the textbook.

11. Refer to pages 16 to 17 of the textbook.

13. (a) While university-level training is important, it is also necessary that

(b) Auditors need to be both independent in fact and independent in

Multiple Choice Questions

PRACTICE OF PUBLIC ACCOUNTANCY

1. Refer to page 29 of the textbook.

2. Refer to pages 30 to 35 of the textbook.

3. Refer to page 37 of the textbook.

4. Refer to page 37 of the textbook.

6. In an assurance engagement, a practitioner aims to provide a high or moderate

Refer to page 41 of the textbook for a brief discussion of these services.

8. Refer to page 52 of the textbook.

9. Refer to pages 44 to 52 of the textbook.

10. Refer to page 38 of the textbook.

11. Refer to page 47 of the textbook.

12. Refer to pages 52 to 54 of the textbook.

13. Refer to page 36 of the textbook.

14. Refer to pages 56 and 57 of the textbook.

Multiple Choice Questions

1. (a) The purpose of CPA reporting on internal control is to provide assurance

(b) When involved in performing an examination on the effectiveness of

(c) INDEPENDENT ACCOUNTANTS REPORT

Our examination was conducted in accordance with standards on assurance

In our opinion, the Schedule of Customer Satisfaction Measures referred to

Santos & Lopez, LLP

1. One definition of auditing is that it is a systematic process by which a

The Philippine Standards on Auditing (PSA) 120 Framework of Philippine

The accounting function is the process of recording, classifying and

Audits of Financial Compliance Operational

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

5. An independent audit is a means of satisfying the need for reliable information

The three main ways to reduce information risk are:

The advantages and disadvantages of each are as follows:

7. Information risk is the possibility that information upon which a business

10. Refer to pages 84 and 85 of the textbook.

11. A report by an independent public accountant concerning the fairness of a

The report prepared after completion of an operational audit is usually directed

18. Refer to pages 83 to 84 of the textbook.

19. The text defines internal auditing as an independent appraisal activity in an

The broad objective of internal auditing is to provide assistance to members of

In describing the nature of internal auditing, the Statement of Responsibilities of

21. COA auditors perform operational or performance audits, compliance audits,

Governmental auditors are employees of various government agencies who

Multiple Choice Questions

REGULATION OF THE PRACTICE

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

2. Refer to pages 112 (Sections 34 & 35 of the Philippine Accountancy Act of

High Opportunity Competencies have a high likelihood of being building

Low Opportunity Competencies, while important to the delivery of current

4. Examples of typical lawsuits against CPAs are

5. Indications That Noncompliance May Have Occurred

6. Refer to page 119 of the textbook.

7. PSA 260 (Clarified), Communication with Those Charged with Governance