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Review Questions
1.
2.
AR is
0.009 or 0.9 percent
0.045 or 4.5 percent
0.063 or 6.3 percent
0.081 or 8.1 percent
0.090 or 9.0 percent
a.
b.
c.
d.
e.
14-2
Services
recorded documents if his objective is to audit the controls over transaction
validity.
3.
Assessing the control risk too low causes auditors to assign less control risk
(CR) in planning procedures than proper evaluation would cause them to assign.
The result could be (1) inadvertently conducting less audit work than properly
necessary and taking more audit risk (AR) than originally contemplated, perhaps
to the unpleasant results of failing to detect material misstatements (damaging
the effectiveness of the audit) or (2) discovering in the course of the audit work
that control is not as good as first believed, causing an increase in the audit
work, perhaps at a time when doing so is very costly (damaging the efficiency of
the audit).
4.
5.
=
=
=
1 (1 r) n
1 (1 0.02) 100
0.867 or 86.7 percent
All the elements of the risk model are products of auditors professional
judgments. Auditors must judge:
Inherent risk the probability that material errors or irregularities have entered
the accounting system used to develop financial statements.
14-3
Internal control risk the probability that clients system of internal control
policies and procedures will fail to detect material errors and irregularities,
provided any enter the data accounting system in the first place.
Analytical procedures risk the probability that auditors analytical procedures
will fail to produce evidence of material errors and irregularities, provided
any have entered the accounting system in the first place and have not been
detected and corrected by the clients internal control procedures.
Audit risk the probability that auditors will not discover by any means errors
and irregularities that cause an account balance to be materially misstated.
Test of detail risk appears at first glance to be the product of a formula and not a
professional judgment. However, everything in the risk model is a judgment, so
the test of detail derived from the model is no less a judgment.
6.
7.
Detection risk is the component of audit risk that is controllable by the auditor.
It may be raised or lowered by reducing or increasing the amount of substantive
audit testing. It is determined by the auditors assessment of inherent risk and
control risk.
8.
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.
9.
10. When the auditor assesses control risk at a level lower than maximum, the
auditor may generally perform fewer substantive tests.
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11. The audit risk model is useful in managing audit risk for assertions. By
determining planned audit risk for an assertion, assessing inherent and control
risks, an auditor can determine the allowable detection risk (the amount of
detection risk an auditor can allow) for an assertion. Allowable detection risk is
used to determine the nature, timing, and extent of audit procedures for the
assertion.
12. Detection risk exists because auditors (1) may use an inappropriate audit
procedure, (2) may misapply an audit procedure, (3) may misinterpret the
findings, or (4) do not examine 100 percent of an account balance or transaction
class.
13. The amount of audit evidence an auditor must gather varies inversely with
allowable detection risk. As allowable detection risk decreases, the amount of
evidence required increases, and vice versa. Chapter 12 introduces audit
procedures and discusses how auditors modify audit procedures to obtain
sufficient competent evidential matter by changing (1) the nature, (2) the timing,
or (3) the extent of procedures.
14. The audit risk model is
Audit risk (AR) = Inherent risk (IR) x Control risk (CR) x Detection risk (DR)
15. Risks identified at the financial statement level may have a substantial impact on
the assessment of inherent risk for specific assertions. For example, concern
about management integrity, identified as a risk at the financial statement level,
would cause an auditor to assess a higher level of inherent risk for existence of
sales.
II. Multiple Choice Questions
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
d
d
c
d
a
b
a
a
b
b
a
12.
13.
14.
15.
16.
17.
18.
19.
20.
21.
22.
d
a
d
d
c
b
a
a
b
d
a
23.
24.
25.
26.
27.
28.
29.
30.
31.
32.
33.
c
c
d
d
c
b
d
a
a
b
a
34.
35.
36.
37.
38.
39.
40.
41.
42.
c
d
b
d
d
c
a
c
d
14-5
Case 2. The factors that will affect Josefinas audit risk and business risk are (a) this is a
special audit, (b) the audit will be used to set the value of certain assets, (c) the
auditor is to evaluate any disputed amount (although this is a common provision
in purchase agreements, one might question whether auditors should agree to
such terms), and (d) the materiality level is set at P50,000, even though that is
considerably below an amount that might be determined using a percentage of
assets and/or income. These factors will increase the risk at the financial
statement level and potentially increase business risk.
Case 3. a.
(4) 3.33%
(5) 2.5%
In the third situation, the auditor does not have to accumulate any evidence
because inherent risk and control risk give the appropriate level of planned
audit risk.
b.
Case 4. a.
b.
(1) 3 (tied)
(2) 5
(3) 1
(4) 2
(5) 3 (tied)
(4) 2 (tied)
(5) 2 (tied)
14-6
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Case 5. 1.
a.
b.
2.
a.
b.
3.
a.
b.
4.
a.
b.
5.
a.
b.
Case 6. 1.
a.
b.
c.
2.
a.
b.
c.
3.
a.
b.
c.
4.
a.
b.
c.
14-7
CHAPTER 12
AUDIT PROCEDURES
I.
Review Questions
1.
2.
3.
4.
14-8
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5.
6.
Confirmations are usually considered more reliable because they are from
outside parties, while inquiries are made of client personnel.
7.
When equivalent procedures are available to satisfy the need for evidence, an
auditor may consider cost in selecting among the alternatives.
8.
c
d
3.
4.
c
a
5.
6.
c
c
7.
8.
a
d
9.
14-9
2.
3.
Confirmation by letter
* obtaining accounts receivable confirmations
* obtaining clients lawyers letter
4.
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.
Case 3. a.
b.
14-10
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Case 4. 1.
2.
3.
4.
5.
Case 5. a.
b.
c.
d.
e.
Case 6. a.
14-11
f
l
h
e
p
m
d
8.
9.
10.
11.
12.
13.
14.
n
k
c
a
g
b
j
Case 8.
1.
2.
3.
4.
5.
6.
7.
8.
observation
inspection (analytical procedures)
inspection (examination of documents)
inspection (examination of documents)
inquiry
inspection (mechanical accuracy tests)
inspection (examination of documents)
confirmation
14-12
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CHAPTER 13
audit evidence
I.
Review Questions
1.
2.
3.
4.
5.
6.
7.
8.
a.
Having the confirmation letters printed on the clients letterhead and signed by a
client officer.
Being careful to be assured of reliable addresses for recipients; that is, being
assured that the confirmations are not misdirected (for example, to a 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
b.
d.
e.
9.
14-13
of deposit with accrued interest, for which people usually do not keep their
own accounting records).
Controlling the mailing and return of confirmations so the client cannot
tamper with them.
Receiving the reply directly, so the client cannot intercept and alter them.
Factual evidence is direct evidence, in that conclusions may be drawn from the
evidence without further corroboration. An example of factual audit evidence is
physical observation of inventory for existence. Inferential evidence is indirect,
in that direct conclusions cannot be drawn from the evidence. The auditor
typically examines other evidence to further corroborate the inferences drawn.
An oral statement by a product manager that one or more products are fully
saleable and not obsolete is an example of inferential evidence. The auditor may
perform inventory turnover tests and/or determine the date of last sale of the
product to further corroborate the product 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
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likelihood of material misstatements in the estimates, whether the accounting
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.
II. Multiple Choice Questions
1.
2.
3.
d
d
c
4.
5.
6.
c
a
d
7.
8.
9.
d
b
d
10. d
11. a
12. b
13. b
Case 2. 1.
in reliability rank
1. External
2. External-internal
3. Internal
4. Mathematical (based on
unaudited data)
2.
c.
a.
d.
b.
1.
2.
3.
4.
Mathematical (based on
unaudited data)
External
External-internal
Internal
14-15
CHAPTER 14
audit working papers
I.
Review Questions
1.
2.
3.
4.
5.
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.
14-16
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9.
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.
14-17
(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.
13. Refer to page 535, 1st and 2nd paragraphs of the textbook.
14. Refer to page 535, 3rd paragraph of the textbook.
II. Multiple Choice Questions
1.
2.
3.
4.
5.
6.
7.
8.
d
d
c
a
d
c
c
d
9.
10.
11.
12.
13.
14.
15.
16.
b
b
a
d
d
b
d
d
17.
18.
19.
20.
21.
22.
23.
24.
d
c
c
d
b
d
a
b
25.
26.
27.
28.
29.
30.
31.
32.
b
d
d
c
d
c
d
d
(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.
14-18
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3.
4.
5.
c.
d.
Case 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.
14-19
1.
2.
3.
4.
a.
DEFICIENCY
Tick mark explanation tested
does not indicate specifically
what was done.
5.
c.
SPREADSHEET SOLUTION
b.
IMPROVEMENT
Should have separate tick marks
meaning:
Agreed to confirmation
Footed
Traced to cash receipts journal
Recomputed, etc.
Explain all tick marks on the same
page of the working paper.
Recompute portions of notes which are
long-term.
Column should say date paid to and
this should be confirmed.
Include due dates on working paper
for these notes.
2.
14-20
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14-21
Schedule
Prepared by
Approved by
Account # 110 Notes Receivable
Maker
Alba Co.
c*
Barrios, Inc.
c*
C.C. Co.
c*
P. Pablo
c*
Martin Cruz
c*
Tetra Co.
c*
Date
Made /
Due
6/15/02 /
6/15/04
11/21/02 /
Demand
11/1/02 /
4/1/08
(P200/Mo.)
7/26/03 /
8/1/05
(P1000/Mo.
)
5/12/02 /
Demand
9/3/03 /
2/1/06
(P400/Mo.)
Interest
Rate /
Date Paid to
5% /
None pd.
5% /
12/31/03
5% /
12/31/03
Balance
12/31/02
4000
tp
3591
tp
12780
tp
Value of
Security
None
3591
None
13180
24000
5% /
9/30/03
25000
50000
25000
r
5000
r
20000
5% /
12/31/03
6% /
11/30/03
2100
None
10000
12000
r
2100
r
1600
r
12000
2100
tp
0
22471
37000
f
tp
0
0
Payments
1000
r
3591
r
2400
r
Date
1/21/04
2/15/04
Interest
Face
Amount
5000
Additions
0
N-1
JD
PP
Balance
12/31/03
3000
Receivable
12/31/02
104
tp
0
tp
24
tp
Receivable
12/31/03
279
Earned
175
<
102
<
577
<
Received
0
102
r
601
r
468
<
200
r
268
105
<
162
<
105
r
108
r
10400
0
tp
0
15691
43780
128
1589
1116
601
f, cf
wtb
f
tb
f
op
f, cf
wtb
0
10380
54
Review Questions
1.
Refer to page 548, 3rd paragraph and page 549, 1st paragraph of the textbook.
2.
3.
4.
All internal control systems, due to the human factor, contain certain inherent
limitations. Because of these inherent limitations, internal control provides
reasonable, but not absolute, assurance as to the achievement of control
objectives.
5.
6.
7.
18-22
9.
10. Any internal control system, regardless of how sound it is, has certain inherent
limitations. The system can be circumvented by collusion among two or more
employees; management can override the structure; and the procedures can
break down temporarily causing a lag in the adaptation of the controls. For
these reasons, an effective system of internal control provides reasonable, but
not absolute assurance as to the prevention and detection of material errors or
irregularities. Auditors, therefore, must not rely totally on a sound control
system as support for their audit opinion. Rather, they must recognize the
inherent limitations and, at the very least, perform a minimum amount of
substantive audit testing.
11. Small entities, typically, cannot afford the degree of separation of functional
responsibilities existing in larger firms. Also, small firms, typically, cannot
support a separate internal audit staff. For these reasons, compensating controls
are necessary in smaller organizations. Such compensating controls ordinarily
require that the owner/manager assume an active role in reviewing transactions,
examining documents, reconciling bank accounts, and otherwise performing
many of the tasks normally done by internal auditors in larger organizations.
12. Separating recordkeeping from custody of the related assets provides an
independently maintained record which may periodically be reconciled with
assets on hand. This independent record holds the personnel of a custodial
department accountable for assets entrusted to their care. If the accounting
records were maintained by the custodial department, opportunity would exist
for that department to conceal its errors or shortages by manipulating the
records.
18-23
18-24
d
d
b
7.
8.
9.
b
a
d
10. a
11. c
12. c
Case 1.
RELEVANT TO
AUDIT?
ASSERTION
AFFECTED
HOW
AFFECTED?
a.
Yes
Completeness
Valuation
b.
Yes
Existence
Valuation
c.
No
N/A
N/A
d.
Yes
Valuation
Presentation
e.
Yes
f.
Yes
Completeness
Valuation
g.
Yes
Presentation
h.
Yes
Existence
Valuation
i.
No
N/A
N/A
18-25
Case 2.
INHERENT OR CONTROL
WEAKNESS
TYPE OF INHERENT OR
CONTROL REMEDY
a.
Inherent
b.
Control
c.
Inherent
Management override.
d.
Control
e.
Control
f.
Inherent
Collusion
Case 3. a.
The planned assessed level of control risk is the level the auditors intend to
use in performing the audit for a particular financial statement assertion.
For example, after obtaining the understanding of internal control necessary
to plan the audit, the auditors will project a planned assessed level of
18-26
b.
Case 4. a.
b.
Prepare flowchart
Prepare checklists
Prepare questionnaires
Perform walk-through of transactions
Perform some tests of controls
Case 5. Since Vasquezs consideration of the internal control structure shows that
controls are very weak, he may omit performing tests of controls. He must,
however, have an adequate understanding of internal control to plan the
remainder of the audit. At a minimum, Vasquez should obtain a basic
understanding of the control environment, accounting system, and important
control procedures. He should document this understanding, and also document
that control risk is assessed at the maximum level.
18-27
b. Even though internal control appears to be strong, the auditors are required
to conduct tests of controls. Just because policies and procedures are prescribed
does not mean that the clients personnel are adhering to those requirements.
Employees may not understand their assigned duties, or may perform those
duties in a careless manner, or other factors may cause the internal controls
actually in place to differ from those prescribed.
18-28
STORES
Start
Clerk
Prepares
Requisition
Goods
from
Supplier
Stock-in
Report
Storeskeep
er Prepares
Stock-in
Report
Posts
Perpetual
Inventory
Records
Stock-in
Report
Filed
by
date
MANUFACTURING
Inventory
Records at
Standard
Cost
Filed
by
date
Requisitio
n
1
Supervisor
Approves
Requisition
Approved
Requisitio 1
n
2
Approved
Requisitio
n
Reviews
for
Completeness
3
18-29
Posts Transfer
to Perpetual
Inventory
Records
Inventory
Records at
Standard
Cost
Filed
by
date
Filed
by Job
Order
Case 8. a.
The quantity of serially numbered tickets issued during the shift of each
cashier is multiplied by the price per ticket to determine the amount of cash
which the cashier should have on hand at the end of the shift.
Two employees participate in each transaction. The withholding cash
receipts would require collusion between the cashier and the door attendant
because the door attendant does not have access to cash and the cashier
cannot cause a patron to be admitted without issuing to him a serially
numbered ticket.
b.
The following steps should be taken by the manager to make these controls
work effectively:
(1) Maintain careful control over unused rolls of tickets.
(2) Make a record of the serial number of the first and last ticket issued on
each cashiers shift.
(3) Count the cash in possession of cashier at beginning and end of shift.
In addition to these regular routines, the manager should take the following
steps at unannounced intervals:
(4) Observe that the cashier never has loose tickets in his or her possession
and does not sell tickets in any manner other than ejecting them from the
ticket machine.
(5) Verify by inspection of tickets being presented by patrons to the door
attendant that only recently issued tickets (current serial numbers) are
being used.
c. Collusion by the cashier and door attendant to abstract cash receipts often
consists of the door attendant pocketing whole tickets presented by patrons
rather than tearing the ticket in half. He or she may then give these unused
tickets to the cashier; the cashier may then resell the tickets to customers at the
box office rather than punching out new tickets on the machines. The cashier
withholds the cash received from sales of these used tickets and divides it with
the door attendant.
d.
18-30
CHAPTER 16
CONSIDERATION OF INTERNAL CONTROL
IN A FINANCIAL STATEMENTS AUDIT
I.
Review Questions
1.
2.
3.
4.
1.
18-31
3.
5.
Advantages of flowchart:
Graphic presentation of systems.
Shows the steps required and the flow of forms and documents.
Easy to read and analyze.
Easy to update in subsequent years.
Disadvantages:
Takes some time to draw neatly.
6.
7.
Character of Report
Report on IAC with opinion on IAC
system taken as a whole.
18-32
9.
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.
b.
12. Some combination of the following means is typically utilized by the auditor in
testing a clients internal financial controls:
a.
b.
c.
18-33
b
a
b
d
b
b
b
8.
9.
10.
11.
12.
13.
14.
a
b
c
b
a
b
b
15.
16.
17.
18
19.
20.
21.
d
c
b
b
a
d
a
22.
23.
24.
25.
26.
27.
28.
a
a
d
b
d
b
d
18-34
b.
c.
2.
b.
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.
18-35
Case 2.
ISLANDER DRUG STORE, INC.
Processing Cash Collections
Internal Control Questionnaire
-Question
Are customers who pay by check identified via store I.D. card or
other means?
Does company policy prohibit accepting checks for anything
except merchandise sales plus a nominal cash amount?
Is a receipt produced by the cash register given to each
customer?
Is the reading of each cash register taken periodically by an
employee who is independent of the handling of cash
receipts?
Are cash counts made on a surprise basis by an individual who is
independent of the handling of cash receipts?
Is the reading of each cash register compared regularly to the
cash received?
Is a summary listing of cash register readings prepared by an
employee who is independent of physically handling cash
receipts?
Are receipts forwarded to an independent employee who makes
the bank deposits?
Are each 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?
18-36
Yes
No
CHAPTER 17
BASIC AUDIT SAMPLING CONCEPTS
I.
Review Questions
1.
2.
3.
4.
Audit conclusions can be made only about the population from which the
sample was drawn, and a conclusion can only be valid if the sample on which it
is based actually shows the characteristics of the population. Auditors can
attempt to achieve representativeness, but they cannot guarantee it. Sampling
risk the probability that the sample does not adequately reflect the population
always exists.
5.
Refer to page 646, 2nd paragraph; page 647, 1st paragraph of the textbook.
6.
7.
8.
9.
Refer to page 653, 4th paragraph & page 654, 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:
18-37
b
c
3.
4.
d
c
5.
6.
d
b
7.
8.
a
d
9. a
10. c
18-38
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.
(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.
Case 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
18-39
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.
d.
18-40
CHAPTER 18
APPLICATION OF QUANTITATIVE TECHNIQUES IN
PLANNING, CONTROL AND DECISION MAKING II
I.
Questions
1. PERT is superior to Gantt Charts in complex projects because:
a. PERT charts are flexible and can reflect slippage or changes in plans,
but Gantt charts simply plot a bar chart against a calendar scale.
b. PERT charts reflect interdependencies among activities; Gantt charts
do not.
c. PERT charts reflect uncertainties or tolerances in the time estimates
for various activities; Gantt charts do not.
2. The use of PERT provides a structured foundation for planning complex
projects in sufficient detail to facilitate effective control.
A workable sequence of events that comprise the project are first
identified.
Each key event should represent a task; then the
interdependent relationships between the events are structured.
After the network of events is constructed, cost and time parameters are
established for each package. Staffing plans are reviewed and analyzed.
The critical path computation identifies sequence of key events with
total time equal to the time allotted for the projects completion. Jobs
which are not on the critical path can be slowed down and the slack
resources available on these activities reallocated to activities on the
critical path.
Use of PERT permits sufficient scheduling of effort by functional areas
and by geographic location. It also allows for restructuring scheduling
efforts and redeployment of workers as necessary to compensate for
delays or bottlenecks. The probability of completing this complex
project on time and within the allotted budget is increased.
3. Time slippage in noncritical activities may not warrant extensive
managerial analysis because of available slack, but activity cost usually
increases with time and should be monitored.
18-41
18-42
(C)
(N)
(P)
(C)
Stockout costs
(P)
Storage costs charged per unit in inventory
(C)
Fire insurance on inventory
(C)
Fire insurance on warehouse
(N)
Obsolescence costs on inventory
(C)
Shipping costs per shipment
(P)
P 2.80
2.05 (P102.25 x 2%)
P 4.85
P102.25
1.50
P103.75
II. Problems
18-43
P201.65
21.45
80.20
122.00
P425.30
2 + 8 + 10 + 14
2+8+7+5+3
2 + 26 + 9 + 3
=
=
=
34
25
40*
* critical
Requirement (b)
40 - 3 - 5 = 32
Requirement (c)
If path 4 - 7 has an unfavorable time variance of 10, this means it takes a
total time of 15 to finish this activity rather than 5. This gives the path 0 - 1 3 - 4 - 7 - 8 a total time of 35, but since this is less than the critical path of 40,
it has no effect.
Requirement (d)
The earliest time for reaching event 5 via 0 - 1 - 2 - 5 is 20, the sum of the
expected times.
Problem 3
No, they didnt make a right decision, since they included fixed costs which
do not differ in the short run. If they had used contribution margin instead of
gross margin, they would have had P5 for G1 and P6.50 for G2, therefore
they would have decided to produce G2 exclusively.
18-44
Hobbing
Order 1
Machining X X X X
10
11
12
Order 3
Order 1
X X
13
14
15
16
17
Order 4
Order 3
18
19
20
21
22
23
24
25
26
27
28
Order 2
X
___________
X Dead Time
Requirement (b)
28 days are required for the four orders.
18-45
Order 4
Order 2
Insurance
P860
Out-of-pocket
costs
Cost of capital
on inventory
P65
20% x P222
P18
P878
P119.40
a. Carrying costs:
QS
2
Order costs:
AP
=
Q
250 x P109.40
2
P13,675.00
1,500 x P878
250
P 5,268.00
P18,943.00
Total
b. Economic order quantity:
Q* =
2 x 1,500 x P878
P109.40
= 24,077
Carrying costs:
QS
2
155 x P109.40
2
P 8,478.50
Order costs:
AP
=
Q
1,500 x P878
155
P 8,496.77
P16,975.27
Total
18-46
155 units
11-47
Problem 5
It is necessary to evaluate the annual carrying costs and expected stockout
costs at each safety-stock level. The carrying cost will be P24.40 for each
unit in safety stock. With the given order size, there are 15 orders placed a
year (i.e., 39,000/2,600 = 15). Based on these computations, we prepare the
following schedule:
Safety
Stock
0
150
175
250
Carrying Costs
of Safety Stock
0
150 x P24.40 = P3,660
175 x P24.40 = P4,270
250 x P24.40 = P6,100b
Expected Stockout
Costs
0.50 x 15a x P1,650 = P12,375
0.20 x 15a x P1,650 = P 4,950
0.05 x 15a x P1,650 = P 1,273.5
0.01 x 15a x P1,650 = P 247.5
Total
Costs
P12,375
8,610
5,507.5 (optional)
6,347.5
Additional computations:
a
b
C
B
D
B
D
C
A
A
A
C
11.
12.
13.
14.
15.
16.
17.
18.
19.
20.
21.
D
C
A
A
A
C
C
D
C
D
21.
22.
23.
24.
25.
26.
27.
28.
29.
30.
31.
18-47
D
C
C
D
D
B
D
E
B
A
31.
32.
33.
34.
35.
36.
37.
38.
C
D
A
C
D
C
D
D
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Services
CHAPTER 19
AUDIT SAMPLING FOR SUBSTANTIVE TESTS
I.
Review Questions
1.
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).
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11-49
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.
7.
Sample Size
Relation
Inverse
Smaller
Larger
Inverse
Smaller
Larger
Inverse
Larger
Smaller
Direct
Larger
Smaller
Direct
Larger
Smaller
Direct
8.
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.
Compare the likely misstatement (also called the projected misstatement) to the
tolerable misstatement for the account, and consider the
3.
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11-50
Services
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.
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.
18-50
11-51
b
a
c&d
b
5.
6.
7.
8.
c
b
b
d
9.
10.
11.
12.
Supporting Computations:
Audited Value 47,520
3. c. Book Value
48,000
d.
7.
P480
120
1,200 x P4
P 17,500
P500,000
d
a
a
c
P4
= P4,800
=
3.5%
18-51
13.
14.
15.
16.
a
a
c
d
17.
18.
19.
20.
d
b
c
d
11-52
Services
P450,000 x 3.5% =
III. Comprehensive Cases
P157,500
Case 1. a.
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.
Case 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
18-52
11-53
18-53
11-54
Services
representative of the population with respect to the ratio of audited values
to book values.
Case 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).
Case 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
18-54
11-55
Case 5. a.
Sample size =
Sample size =
P500,000 x 3
P25,000 (P2,000 x 1.6)
69
Note: The reliability factor is from the zero misstatements row of the
PPS sampling table given in the case.
(2) The sampling interval is calculated simply by dividing the book value
of receivables by the sample size, as follows:
Sampling interval = Recorded receivables / Sample size
= P500,000 / 69 = P7,246
b.
Audite
d Value
P 50
800
8,500
P 47
760
8,100
Misstatemen
t
P 3
40
400
=
Tainting
%
6%
5%
NA
Samplin
g
Interval
P7,246
7,246
NA
Projected
Misstatemen
t
P 435
362
400
P1,197
3.0
P7,246
P21,738
Projected
18-55
Incremental
11-56
Services
Factor
3.00
4.75
6.30
.75
.55
Allowance
P435
362
P326
199
P525
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.
Case 6. a.
18-56
b.
c.
11-57
P300,000
/ 60
P5,000
Projected misstatement =
Book
Value
Audite
d Value
P 400
500
3,000
P 320
0
2,500
Misstatemen
t
P 80
500
NA
Tainting
%
20%
100%
NA
Samplin
g
Interval
P1,000
1,000
NA
Projected
Misstatemen
t
P 200
1,000
500
P1,700
CHAPTER 20
THE COMPUTER ENVIRONMENT
I.
Review Questions
1.
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11-58
Services
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 realtime system. Also, controls are more likely to be programmed in realtime systems, and for this reason, are more difficult to test.
3.
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, realtime 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 realtime system.
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.
5.
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.
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11-59
8.
d
c
a
a
5.
6.
7.
8.
c
c
c
b
9.
10.
11.
12.
c
c
d
c
13.
14.
15.
16.
c
d
a
a
17.
18.
19.
20.
c
a
b
a
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.)
CHAPTER 21
INTERNAL CONTROL IN THE
COMPUTER INFORMATION SYSTEM
I.
1.
Review Questions
The proper installation of IT can lead to internal control enhancements by
replacing manually-performed controls with computer-performed controls. IT-
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11-60
Services
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.
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11-61
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.
a.
Systems analysis: Personnel will design and direct the development of new
applications.
Programming: Other personnel will actually do the programming dictated by
the system design.
Operating: Other people will operate the computer during processing runs, so
that programmers and analysts cannot interfere with the programs designed
and executed, even if they produce errors.
Converting data: Since this is the place where misstatements and errors can be
made the interface between the hardcopy data and the machine-readable
transformation, people unconnected with the computer system itself do the
data conversion.
Library-keeping: Persons need to control others access to system and program
software so it will be used by authorized personnel for authorized purposes.
Controlling: Errors always occur, and people not otherwise connected with the
computer system should be the ones to compare input control information
with output information, provide for correction of errors not involving
system failures, and distribute output to the people authorized to receive it.
b.
c.
d.
e.
f.
6.
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Services
7.
8.
9.
Five things a person must have access to in order to facilitate computer fraud
are:
a.
b.
c.
d.
e.
c
a
d
b
d
d
7.
8.
9.
10.
11.
12.
b
b
c
a
b
a
13.
14.
15.
16.
17.
18.
c
c
c
a
b
a
18-62
19.
20.
21.
22
23.
24.
c
c
a
c
b
c
25.
26.
27.
28.
29.
30.
b
c
c
d
b
d
11-63
b.
1.
3.
1.
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Services
Checklists to ensure input arrived and on time
Case 3. a.
2.
3.
b.
18-64
11-65
b.
c.
Case 5. a.
b.
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11-66
Services
recommendations during system design is no different from auditor
recommendations for control improvements after the fact and documented
in the management letter.
c.
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 22
AUDITING IN A COMPUTER INFORMATION SYSTEMS
(CIS) ENVIRONMENT
I.
Review Questions
1.
2.
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11-67
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
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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.
Programs supplied by computer manufacturers or software houses.
Processing mode interactive data entry by users with most of the master file
accessible for inquiry and direct update.
2.
3.
Control Problems:
1.
2.
3.
4.
5.
6.
7.
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
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intermingled with the real transactions and run on the actual programs
processing actual data.
9.
11.
1.
2.
3.
4.
5.
6.
7.
Phases
Define the audit objectively
Feasibility
Planning
Application design
Coding
Testing
Processing
8. Evaluation
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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.
II. Multiple Choice Questions
1.
2.
3.
4.
a
c
c
d
5.
6.
7.
8.
d
d
c
b
9.
10.
11.
12.
b
d
b
b
13.
14.
15.
16.
c
a
d
b
17. b
18. c
19. d
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.
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(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.
Case 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.
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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.
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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.
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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.
c.
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phase auditing, ITF, tagging and tracing, SCARF, test data, and surprise
audit are examples of auditing through the computer.
d.
Case 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.
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(c) The integrated test facility approach permits the introduction of auditorselected test data into a computer system with actual or live data and then
traces the flow of transactions through the various system processing
functions for comparison to predetermined actual results. An ITF involves
the creation or establishment of a dummy entity (e.g., a branch or
division) to receive the results of the test processing. Therefore,
transactions are processed against the test entity together with actual
transactions. Test data must be removed from the 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.
Case 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
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CHAPTER 23
TESTS OF CONTROLS
I.
Review 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.
3.
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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.
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8.
If the credit limits are set and entered incorrectly, the credit approval process
will be systematically deficient.
9.
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.
b.
c.
d.
e.
f.
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should look for purchase approval signatures, receiving approval signatures, and
approval of the vendor invoice checks by client for proper quantity, price, and
discount.
13. The point of this quotation is to generate discussion on the source of errors and
therefore the controls necessary when an accounting process is computerized.
Discussion items might include the following:
1.
2.
3.
4.
5.
6.
7.
8.
People have bad days and make mistakes; computers do not have bad days.
Murphys Law If it is possible to make an error, someone will find a way
to do it.
People initiate the transactions and will make errors.
All controls should be considered together (manual and computer).
Excellent computer controls cannot be relied upon if the related manual
controls are weak.
In computer systems, it is extremely important to establish extensive input
validation controls to prevent people errors from getting into the processing
(GIGO garbage in, garbage out).
People can prevent a good computer system from working well if they are
not convinced it is in their best interests.
People will rarely question computer printed output, even though it may not
be correct.
Most computer controls are to prevent, detect, or correct errors made by
people.
14. The purpose of the 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.
2.
3.
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15. A walk through involves following a transaction from initiation through the
various steps until the transaction is recorded in the formal accounting records.
In the conversion cycle, the following would constitute a complete walk
through:
Step
Documents Collected
Controls Noted
Prepare production
Production Order (P.O.) Support for P.O.
orders
Prepare bill of materials
and manpower needs
Separation planning
from production.
Note separation
production supervisor
from foreman duties.
Approval by foreman of
hours.
Labor report (LR)
Observe timekeeping,
compare job tickets to
clock cards
Material used report
prepared
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report
Enter costs in job cost
sheets
Summary entry
prepared.
Independent check of
RUC.
Products received report
(PRR)
Observe comparison
RUC and PRR
Job sheets closed out,
summary entry prepared
Independent report of
production completed.
Independent records of
units put into finished
goods inventory.
Records from separate
sources reconciled.
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.
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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.
Document(s) Collected
Authorization to hire and rate assignment
Personnel forms, employee authorization for
deductions
Clock card
Job time ticket
Labor distribution sheet
Payroll voucher
Payroll checks
If the payroll is processed by computer, the clock cards and job time tickets
would be traced to batch control in the timekeeping and production departments,
to data preparation (keying to machine sensible form), to edit and validation
error reports and other computer output indicating control and finally to
computer prepared checks, labor distribution reports and summary general
ledger entries.
II. Multiple Choice Questions
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1.
2.
3.
4.
c
c
b
c
5.
6.
7.
8.
a
c
c
b
9.
10.
11.
12.
d
b
a
a
13.
14.
15.
16.
b
a
c
d
17.
18.
19.
20.
d
d
c
b
2.
3.
4.
Case 2. The discussion could take several directions, including some or all of the
following:
1.
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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.
c.
d.
e.
3.
Castro can collude with customers to rig low bids and take kickbacks,
thereby depriving the company of legitimate revenue.
Castro can direct purchases to favored suppliers, pay unnecessarily
high prices and take kickbacks. He might even set up a controlled
dummy company to sell overpriced materials to the company. No
competitive bidding control prevents these activities.
Castro, through the control of physical inventory, can (i) remove
materials for himself, and (ii) manipulate the inventory accounts to
conceal shortages.
Castro can order truck shipping services for his own purposes and
cause the charges to be paid by the company.
Castro can manipulate the customer billing (similar to a above) to
deprive the company of legitimate revenue while taking an
unauthorized commission or kickback.
c.
d.
Case 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.
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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).
Case 4. If the credit limits are set and entered incorrectly, the credit approval process
will be systematically deficient.
Case 5. Memorandum
TO:
FROM:
DATE:
SUBJECT:
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.
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Case 6. a.
b.
2.
3.
2.
3.
4.
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a.
b.
5.
Scan cancelled checks and cash disbursements records during the year
for:
a.
b.
names of payees,
consecutive numbers of checks to determine whether any payments
other than regular transfers to main office were made from this
account.
6.
7.
Case 7. 1.
a.
b.
2.
a.
b.
3.
a.
b.
4.
a.
b.
CHAPTER 24
SUBSTANTIVE TESTS OF
TRANSACTIONS AND BALANCES
I.
Review Questions
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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.
4.
5.
6.
7.
8.
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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 procedures auditors use most frequently to detect cash disbursement embezzlement
schemes include:
1.
12. The characteristics that the auditor is looking for in his review of the clients
inventory-taking instructions include:
1.
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4.
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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.
17. Investment cost can be vouched to brokers advices, monthly statements and
canceled checks. The auditors can similarly vouch the price of securities sold
and investment income to this documentary evidence and then trace amounts to
income, gain and loss, and cash accounts.
18. If investments are sold at substantial losses early in the period following yearend, there is evidence that the securities were overvalued at the balance sheet
date. Accordingly, the auditor will consider whether such securities should be
written down in the financial statements of the period under audit.
19. The long-term liabilities (and fixed assets and owners equity) are characterized
by a few large transactions, unlike the current assets and liabilities which have
numerous small transactions. Except for the initial year of an audit, the entire
balance is not verified each year. Only the changes in the account that occurred
in the current period need to be audited. The results of the audit of prior 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:
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b
b
d
d
5.
6.
7.
8.
c
c
c
b
9.
10.
11.
12.
b
c&d
b
b
13.
14.
15.
16.
c
d
d
c
17.
18.
19.
20.
d
a
a
c
The CPAs test of the sales cutoff at June 30 should include the following
steps:
1.
2.
3.
4.
5.
6.
Determine what JETOs cutoff policy is, review the policy for
reasonableness, and compare it to the prior year for consistency.
Select a sample of sales invoices (including the last serial invoice
number) from those recorded in the last few days of June and the first
few days of July.
Trace these sales invoices to shipping documents and determine that
sales have been recorded in the proper period in accordance with
company cutoff policy.
Determine that the cost of goods sold has been recorded in the period of
sale.
Select a sample of shipping documents for the same period and trace
these to the sales invoice. Determine that the sale and the cost of goods
sold have been recorded in the proper period.
Review the cutoff for sales returns and allowances, determine that it
has been based upon a consistent policy and that there have not been
abnormal sales returns and allowances in July; this might indicate
either an overstatement of sales during the audit period or the need for a
valuation account at June 30 to provide for future returns and
allowances.
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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.
Case 2. The procedure followed appears to be appropriate except that the examination of
detail transactions for three months might be considered to be excessive in view
of the exceptionally good internal control. A lighter test of such transactions,
designed to test the effectiveness of the control procedures, might be devised.
The procedures followed should be supplemented by the following:
1.
2.
3.
4.
5.
Case 3. 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.
Examine collections in early part of subsequent period to determine if a
substantial portion of the receivables has been collected.
Examine agreements entered into with the distributors. If price protection
clauses are included, review the current price position and distributor
inventory positions to determine whether a reserve for such protection is
needed.
When a company deals with a limited number of customers, it is dependent
upon the continued solvency of all such customers.
Obtain a representation letter from appropriate company officials covering
the receivables.
a.
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a.
b.
c.
3.
a.
b.
c.
4.
a.
b.
c.
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For each note outstanding or paid during the year, vouch to written
authorizing document.
Funds might be borrowed in the companys name without the
knowledge of responsible officers.
Recorded notes payable are valid and documented (separation of
duties).
Observe the client personnel record-keeping duties.
Someone might intercept a check made out to a bank and convert
company funds to his or her own use. Notes payable records could be
falsified for a short time to hide the theft.
Valid liabilities are recorded and none omitted (sound error checking
practices).
Observe client personnel making comparisons. Review correcting
journal entries that result from the comparison.
Purchases or other liabilities may fail to be recorded and the error not
detected by any other means.
Recorded liabilities and cash disbursements valid and documented
(sound record keeping).
Inspect notes to see if they are marked paid.
Notes may get paid a second time if put back through the cash
disbursements system (intentionally or inadvertently).
Case 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.
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auditor is qualified by being both technically competent and reasonably
independent. Once satisfied as to these points, the CPA should discuss the
nature and scope of the internal audit program with the internal auditor and
review his working papers in order that the CPA may properly coordinate
his own program with that of the internal auditor. If the Ozone internal
auditor is qualified and has made tests for unrecorded liabilities, the CPA
may limit his work in this audit area.
d.
In addition to the 2005 voucher register, the CPA should consider the
following sources for possible unrecorded liabilities:
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
Case 5. a.
b.
Case 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
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b.
Case 8. a.
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.
The audit objectives in the examination of long-term debt are to determine
that:
1.
2.
3.
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4.
5.
6.
7.
b.
3.
4.
5.
Confirm the loan and terms of the agreement with the bank.
Review the agreement between Odette and the bank to determine that:
a. The debt is long-term (by reference to dates).
b. Provisions of the agreement have not been violated, e.g., that
Odette is complying with any restrictions on the payment of
dividends, on the amount of working capital to be maintained, or
on the uses to which the funds may be employed and is
maintaining the plant pledged as security for the loan.
c. The agreement was signed by person(s) having authority.
Trace the receipt of funds into the bank account and cash receipts book.
Check the computation of interest expense for the period May 1 to June
30, and trace the recording of the expense and the accrual on the books.
Determine that authority to borrow was granted and is recorded in the
board of directors minutes.
CHAPTER 25
AUDITING FAIR VALUE MEASUREMENTS
AND DISCLOSURES
I. Review Questions
1. Refer to page 856, paragraph 1 of the textbook.
2. Refer to page 854, paragraph 4 of the textbook.
3. Refer to page 856, paragraph 1 of the textbook.
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7.
b
b
d
d
c
CHAPTER 26
USING THE WORK OF OTHERS
I.
Review Questions
1.
2.
The principal auditors must perform one or more of the following procedures:
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3.
While the external auditor has sole responsibility for the audit opinion expressed
and for determining the nature, timing, and extent of external audit procedures,
certain parts of internal auditing work may be useful to the external auditor.
The external auditor should obtain a sufficient understanding of internal audit
activities to assist in planning the audit and developing an effective audit
approach.
Effective internal auditing will often allow a modification in the nature and
timing, and a reduction in the extent of procedures performed by the external
auditor but cannot eliminate them entirely. In some cases, however, having
considered the activities of internal auditing, the external auditor may decide
that internal auditing will have no effect on external audit procedures.
The external auditors preliminary assessment of the internal audit function will
influence the external auditors judgment about the use which may be made of
internal auditing in modifying the nature, timing and extent of external audit
procedures.
c
b
3.
4.
d
b
5.
6.
b
c
Tan should ask San Nicolas to authorize Andres to respond fully to her inquiries.
If San Nicolas refuses or limits the responses, Tan should request San
Nicolas to explain the reasons. After obtaining the explanation, Tan should
consider whether to continue pursuing the engagement.
b. Tan will have to (1) obtain additional information about the client and
possibly about the industry, which Andres would have obtained in prior
years, (2) make a more detailed evaluation of whether to accept this
client, (3) obtain information about the clients internal control, which
Andres would have obtained in prior years, and (4) obtain evidence about
beginning balance sheet balances, which Andres would have obtained in
prior years.
CHAPTER 28
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Review Questions
1.
Scope paragraph
(a) The objects of the audit are the financial statements balance sheet(s), income
statement(s), and cash flow statement(s), and related footnote disclosure,
not the books and records.
(b) The description of the audit means:
(1)
(2)
(3)
(4)
(5)
(6)
(7)
Professional judgment was exercised in performing the tests and choosing the
procedures to perform in the circumstances.
2.
Unqualified opinion
Adverse opinion
Opinion qualified for a
departure from SFAS
Paragraph for
inconsistent GAAP
application
Paragraph for an
uncertainty
Disclaimer of opinion
3.
Fully sufficient
competent
evidence
X
X
Isolated
evidence
deficiency
Pervasive lack
of evidence
X
X
X
X
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1.
4.
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.
5.
6.
A principal auditor is one who has examined the major portion of the combined
entity.
7.
When financial statements of the prior year are presented together with those of
the current year, a continuing auditor must report on both years. In updating
the prior years report, the auditor must decide whether to restate the report in its
same form or modify it to reflect current information not available at the date of
issuance of the prior report.
8.
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A principal auditor is the one who (a) audits a material portion of a reporting
entitys assets, liabilities, revenues and expenses (usually over 50 percent) and
(b) knows enough about the whole entity to sign the audit report.
10. 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.
11. 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 generally accepted 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).
12. When the going concern assumption is in doubt, auditors have serious
reservations about the recoverability and amounts of reported assets and the
amount and classification of reported liabilities. These opinions may be used,
depending on the circumstances:
a.
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13. According to PSA 700,
In certain circumstances, an auditors report may be modified by adding an
emphasis of matter paragraph to highlight a matter affecting the financial
statements which is included in a note to the financial statements that more
extensively discusses the matter. The addition of such an emphasis of matter
paragraph does not affect the auditors opinion. The paragraph would preferably
be included after the opinion paragraph and would ordinarily refer to the fact
that the auditors opinion is not qualified in this respect.
The auditor should modify the auditors report by adding a paragraph to
highlight a material matter regarding a going concern problem.
The auditor should consider modifying the auditors report by adding a
paragraph if there is a significant uncertainty (other than a going concern
problem), the resolution of which is dependent upon future events and which
may affect the financial statements. An uncertainty is a matter whose outcome
depends on future actions or events not under the direct control of the entity but
that may affect the financial statements.
14. Whether to divide responsibility or accept full responsibility is a function of:
a.
b.
15. 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.
16. Two conditions are necessary for an unqualified opinion:
a.
b.
17. An auditor may agree with a departure from a designated principle only when, in
his/her judgment, application of the designated principle would make the
financial statements materially misleading.
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18. 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.
19. The auditor must evaluate, on every audit, the ability of the entity to meet its
obligations on a continuing basis during a reasonable period (usually 12 months)
following the balance sheet date. Although the auditor is not required to apply
additional procedures in making the initial evaluation, if he/she has substantial
doubt as to ability of the client to continue, added procedures may have to be
applied to resolve the issues.
20. The auditor should add an explanatory paragraph regarding a material
uncertainty, provided the outcome of the events surrounding the uncertainty
cannot be reasonably estimated by management. If the probability of an
unfavorable outcome is remote, the explanatory paragraph is not needed. If a
material loss is probable, but is not susceptible to reasonable measurement, and
is properly footnoted, the auditor should add an explanatory paragraph directing
the readers attention to the footnote.
The greater the materiality, and the higher the probability of loss, the more
inclined will be the auditor to add the explanatory paragraph.
21. 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.
II. Multiple Choice Questions
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
c
d
a
c
c
c
c
a
d
c
11.
12.
13.
14.
15.
16.
17.
18.
19.
20.
c
b
d
a
b
d
d
a
b
c
21.
22.
23.
24.
25.
26.
27.
28.
29.
30.
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c
c
a
d
c
a
a
c
c
b
31.
32.
33.
34.
35.
36.
37.
38.
39.
40.
b
c
b
c
d
b
d
a
d
b
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III. Comprehensive Cases
Case 1. You must determine whether an unqualified opinion satisfies the GAAS
reporting standard, in particular:
a.
2.
3.
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.
Case 2. 1.
The auditor is reporting to the body that has engaged the auditing services.
While the report may be read and used by others who are indirect
beneficiaries of the audit, current custom is not to address the report to the
unknown class of users.
2.
3.
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4.
The alternative wording is similar to the typical British audit report, and
they seem to be able to live with it, but American auditors believe that
opinion connotes belief or judgment stronger than impression but less
strong than positive knowledge. American auditors do not wish to appear to
have full, positive knowledge about the statements on the grounds that its
not feasible to know all there is to know about the financial statements.
Also, the standard language leans heavily on GAAP as the criteria for fair
presentation whereas the alternative language contains no reference to
authoritative accounting criteria.
Case 3. 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
suggests a 100% investigation, which is contradicted by the sentence about
tests of the sales records.
3.
4.
Opinion. The opinion sentence should not be modified with the phrase
with the explanation given above.
5.
6.
7.
Opinion.
The opinion paragraph refers improperly to ASC
pronouncements. It should refer to generally accepted accounting
principles.
8.
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.
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Case 4.
Independent Auditors Report
To the shareholders and board of directors of Various Fabrics, Inc.:
We have audited the accompanying balance sheets of Various Fabrics, Inc. as of
January 31, 2004 and 2003 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 generally accepted 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, 2004 and 2003
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, 2004
Case 5. 1.
2.
3.
4.
F, L
B, I
B, Q
A, J
Case 6. A.
B.
C.
D.
E.
F.
G.
1,
2,
4.
1.
6.
5.
2
H.
I.
J.
K.
3,
2,
3,
6.
5.
6.
7.
B, I
B, I
E, J
7c.
7a.
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7e.
7b and 7e.
CHAPTER 29
PROCEDURES AND REPORTS ON SPECIAL PURPOSE
AUDIT ENGAGEMENTS
I.
Review Questions
1.
The report simply states: The financial statements are not intended to be
presented in conformity with generally accepted accounting principles. The
opinion expression thereafter refers to a description of the comprehensive basis
used.
Non-GAAP accounting bases include:
1.
2.
3.
4.
5.
2.
The following are four comprehensive bases of accounting other than GAAP:
1.
3.
2.
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.
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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:
4.
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situation, the auditor must exercise care to relate the opinion to the appropriate
years financial statements.
II. Multiple Choice Questions
1.
2.
3.
4.
b
a
c
a
5.
6.
7.
8.
b
a
a
a
9.
10.
11.
12.
a
a
d
d
13.
14.
15.
16.
d
a
a
a
17.
18.
19.
20.
b
c
b
a
Case 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.
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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 GAAS 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.
Case 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, 2004, 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 generally accepted 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 generally accepted accounting principles.
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, 2004, and its revenue and
expenses and changes in its partners capital accounts for the year then ended, on the
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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]
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