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Questions
1. Generally, to be a CPA one must meet certain education requirements, and pass the
CPA exam.
The CPA examination is prepared and graded twice each year. It is generally
recognized as an academic examination. It includes multiple-choice questions
in the following subjects namely, Theory of Accounts, Practical Accounting I,
Practical Accounting II, Auditing Theory, Auditing Problems, Management
Services, Business Law and Taxation.
3. Refer to page 110 (Section 28 of the Philippine Accountancy Act of 2004) of the
textbook.
4. Competencies include both what individual auditors know and what individual
auditors and audit teams do. Competencies are evidenced by auditors applying
their skills in the delivery of services to clients or supporting the delivery of
those services. These competencies categorized as “High Opportunity
Competencies” and “Low Opportunity Competencies” are as follows:
Questions
5. The following are the most sought - after services among professional
accountants.
A. Assurance Services. Examples are:
1. Independent financial statement audit
2. Reviews
3. Other assurance services (e.g., CPA Web Trust, Business Performance
Measurement Service)
B. Non-Assurance Services. Examples are:
1. Agreed-upon procedures
2. Compilation
3. Tax
4. Management consultancy/advisory services
5. Accounting and data processing
6. Other non-assurance services (e.g., Information Technology System
Services)
Cases
1. (a) The purpose of CPA reporting on internal control is to provide assurance about
whether management’s assertion about internal control is fairly stated in all
material respects, based on the control criteria being followed. Thus, for
example, an examination provides the highest degree of assurance that
information produced by the system will be reliable.
(b) Suitable criteria are those that are objective and permit reasonably
consistent measurements. In addition, the criteria must be sufficiently
complete such that no relevant factors are omitted that would affect a
conclusion about the subject matter. Finally, the criteria must measure some
characteristic of the subject matter that is relevant to a user’s decision.
OVERVIEW OF AUDITING
Questions
2. This apparent paradox arises from the distinction between the function of
auditing and the function of accounting.
The rules of accounting are the criteria used by the auditor for evaluating the
presentation of economic events for financial statements and he or she must
therefore have an understanding of Philippine Financial Reporting Standards
(PFRS), as well as Philippine Standards on Auditing (PSA).
The accountant need not, and frequently does not, understand what auditors do,
unless he or she is involved in doing audits, or has been trained as an auditor.
6. The four primary causes of information risk are remoteness of information, bias
in motives of the provider, voluminous data, and existence of complex exchange
transactions.
Advantages Disadvantages
User verifies 1. User obtains information desired. 1. High cost of
information 2. User can be more confident of obtaining
the qualifications and activities information.
of the person getting the 2. Inconvenience to the person
information. providing the information
because large number of users
would be on premises.
Users share 1. No audit costs incurred. 1. Users may not be able to collect
information risk on losses.
with
management
Audited 1. Multiple users obtain 1. May not meet needs of
financial the information. certain users.
statements are 2. Information risk can usually 2. Cost may be higher than the
prepared be reduced sufficiently to benefits in some situations,
satisfy users at reasonable such as for a small company.
cost.
3. Minimal inconvenience to
management by having only
one
auditor.
9. Four factors that are likely to significantly reduce information risk in the next
five to ten years are:
• technological advances,
• more companies will go on–line, reducing the risk of investors
obtaining outdated information,
• new accounting and auditing standards, and
• auditors will find more efficient and effective audit techniques.
12. To add credibility to financial statements is to increase the likelihood that they
have been prepared following the appropriate criteria, usually the relevant and
applicable PAS. As such, an increase in credibility results in financial statements
that can be believed and relied upon by third parties.
13. Business risk is the risk that the investment will be impaired because a company
invested in is unable to meet its financial obligations due to economic conditions
or poor management decisions. Information risk is the risk that the information
used to assess business risk is not accurate. Auditors can directly reduce
information risk, but have only limited effect on business risk.
15. The first quoted sentence overstates the case. Although annual audits by CPA firms
are universal practice for large corporations, they are not essential to many small
businesses. The financial statements of large corporations go to many stockholders
(often hundreds of thousands) who demand the assurance of reliability supplied
through independent audits by CPA firms. Moreover the SEC and the stock
exchanges require that listed companies have annual audits.
For a small business concern, the primary need for annual financial statements is
to support an application for a bank loan. If a small business does not need to
borrow, or can obtain borrowed funds without providing audited statements, the
cost of an audit may not be justified.
Often a small business can obtain from a CPA firm specialized services other
than an audit, which are more useful and may cost less. Examples are the
review or compilation of financial statements, installation of a computer based
accounting system, or a study of internal control. Thus, the second quoted
sentence, as well as the first, is too sweeping to be correct. A decision not to
have an audit is not always “false economy.”
16. (a) An example of possible bias on the part of the provider of financial
information is the situation in which an individual or business entity applies
for a bank loan. In such circumstances, there is an incentive to overstate
assets, income, and owner’s equity, and to overlook or minimize liabilities.
Distortions of this type give the appearance of greater financial strength.
(b) A bank loan officer may insist that a prospective borrower provide audited
financial statements. This provides assurance that the data in the financial
statements have been examined by independent competent persons.
17. Financial statements audits, operational audits, and compliance audits are similar
in that each type of audit involves accumulating and evaluating evidence about
information to ascertain and report on the degree of correspondence between the
information and established criteria. The differences between each type of audit
are the information being examined and the criteria used to evaluate the
information. An example of a financial statement audit would be the annual audit
of ABS-CBN Corporation, in which the external auditors examine ABS- CBN’s
financial statements to determine the degree of correspondence between those
financial statements and generally accepted accounting principles. An example of
an operational audit would be an internal auditor’s evaluation of whether the
company’s computerized payroll-processing system is operating efficiently and
effectively. An example of a compliance audit would be a BIR
auditor’s examination of an entity’s tax return to determine the degree of
compliance with the National Internal Revenue Code.
20. Independence is the essence of auditing and enables auditors to render impartial
and unbiased judgments. The two conditions that contribute to an internal auditor’s
independence are organizational status and auditor objectivity. The internal
auditors’ status must be such that they are respected throughout the organization.
Generally, the more respect management gives to the internal audit function, the
greater the attention the whole organization pays to their findings and
recommendations. Giving the highest-level person in internal auditing the status of
vice president and having that person report to the board of directors’ audit
committee give sufficient status to the internal audit function. Objectivity requires
that internal auditors have an independent mental attitude and an honest belief in
their work product.
21. COA auditors perform operational or performance audits, compliance audits, and
financial audits.
22. An independent auditor is usually a CPA who has received a license to perform the
attest function. To be a CPA, one generally must meet certain educational
requirements and pass an examination.
Internal auditors are employees of the organization for which they do audits.
They may perform financial auditing, compliance auditing, or operational
auditing. They are not independent in the sense that external auditors are,
although they may attain a degree of independence by their position in the
organization.
Questions
2. Refer to pages 112 (Sections 34 & 35 of the Philippine Accountancy Act of 2004)
of the textbook.
3. Competencies include both what individual auditors know and what individual
auditors and audit teams do. Competencies are evidenced by auditors applying
their skills in the delivery of services to clients or supporting the delivery of
those services. These competencies categorized as “High Opportunity
Competencies” and “Low Opportunity Competencies” are as follows:
• Technology
• Verification
a) Alleged misstatements that the auditor did not detect in the financial
statements involving
1) improper or inadequate disclosure
2) inappropriate valuations
b) Alleged failure to detect defalcation as a result of negligence in the
conduct of the audit
c) Alleged failure to complete the audit on the agreed-on date
d) Alleged inappropriate withdrawal from an audit
9. Due (professional) care is the standard by which the courts and the profession
expect a CPA to practice. A CPA who is found to have exercised due professional
care in an engagement should not have any liability to others.
10. The four gradations are none, negligence, gross negligence (sometimes referred
to as constructive fraud), and fraud. At one extreme is the auditor who performs
an appropriate audit and issues an appropriate report. This auditor’s degree of
wrongdoing is “none.” An auditor who commits fraud is at the other extreme,
since he or she knows that the financial statements are misstated and yet issues
an unqualified opinion. An auditor is negligent if he or she does not do what a
reasonably prudent auditor should do in the circumstances. An auditor is
grossly negligent if he or she consistently fails to follow the standards of the
profession on an engagement.
11. Auditors are responsible to clients for negligence, gross negligence, or fraud.
14. An auditor should (a) follow the Philippine Standards on Auditing, the Code of
Ethics for Professional Accountants in the Philippines, and where appropriate,
PFRSs; (b) establish and follow appropriate quality control procedures; (c)
evaluate whether a client has the necessary integrity and appropriate reputation
in the community; (d) evaluate carefully why a client wants an audit; (e) conduct
the audit with appropriate professional skepticism; (f) provide for appropriate
levels of consultation for issues; and (g) provide for appropriate review of the
audit.
15. The prudent man concept states that a man is responsible for conducting a job in
good faith and with integrity, but is not infallible. Therefore, the auditor is
expected to conduct an audit using due care, but does not claim to be a guarantor
or insurer of financial statements.
Questions
Activities which may not affect independence in fact, but which are likely to
affect independence in appearance are: (Notice that the first two are violations
of the Code of Ethics.)
1. Ownership of a financial interest in the audited client.
2. Directorship or officer of an audit client.
3. Performance of management advisory or bookkeeping or accounting
services and audits for the same company.
4. Dependence upon a client for a large percentage of audit fees.
5. Engagement of the CPA and payment of audit fees by management.
3. In return for the faith placed in CPAs by the public, CPAs should continually seek
to demonstrate their dedication to professional excellence. The public interest is
defined as the community’s collective well-being. CPAs handle ethical conflicts
best by acting with integrity, objectivity, and due professional care and by having a
genuine interest in serving the public.
Code of Ethics for Professional Accountants in the Philippines 5-3
4. An ethical dilemma is a situation that a person faces in which a decision must be
made about the appropriate behavior. There are many possible ethical dilemmas
that one can face, such as finding a wallet containing money, or dealing with a
supervisor who asks you to work hours without recording them.
An ethical dilemma can be resolved using the six-step approach outlined below:
1. Obtain the relevant facts.
2. Identify the ethical issues from the facts.
3. Determine who is affected by the outcome of the dilemma and how each
person or group is affected.
4. Identify the alternatives available to the person who must resolve the
dilemma.
5. Identify the likely consequence of each alternative.
6. Decide the appropriate action.
Conscience might not be a sufficient guide for personal ethics decisions because
the individual’s undefinable mental processes may be based on caprice,
immaturity, ignorance, stubbornness, or misunderstanding. Conscience may fail to
show the consistency, clarity, practicability, impartiality, and adequacy preferred in
ethical standards and behavior. Exactly the same can be said about professional
ethics decisions because a nonhypocritical individual can no more split his
behavior between personal life and professional life than he can voluntarily split
his own personality.
7. Ethical responsibility for acts of non-CPAs under a CPA’s supervision falls under
the latter’s jurisdiction. A CPA shall not permit others to carry out on his behalf,
either with or without compensation, acts which, if carried out by the CPA, would
place him in violation of the Code of Ethics.
11. Historically, compensation for CPAs serving as expert witnesses had to be based
on a standard per diem rate or a fixed sum. However, under certain situations,
such contingent fees are allowed only from clients for which the CPA does not also
provide to the client financial statement audits, reviews or certain compilations, or
prospective financial information examinations.
12. Sanchez may only refer certain clients to his wife or to another life insurance
agent who will share such a commission with his wife provided that he does not
perform assurance as well as nonassurance services.
*7. A fee for audit clients which is dependent upon the results achieved by the CPA’s efforts
is a contingent fee and is prohibited for audit clients.
*9. The declaration requires the preparer to acknowledge that the return is “true, correct,
and complete...based on all information of which the preparer has any knowledge.”
5-4 Solutions Manual – Public Accountancy Profession
Cases
e. Interpretation
Still not enough. The grandfather (either Jack’s father or his father-in-law) is
considered a nondependent close relative, but the appearance of independence
is impaired. The grandfather’s investment is material (50 percent) in relation
to his net financial resources.
2. a. Pee and Co. / United Furniture, Inc.: This is a judgment call. In this case,
the services can be considered temporary, mechanical in nature and performed
on a one-time emergency basis. For these reasons, the SEC would probably
not consider independence impaired.
b. Renson & Co. / Spectrum Corporation Laser Division: The SEC would
consider independence impaired because of the extent of the bookkeeping
services and the relative size of the Division. The only solution that might
work is to have another accounting firm audit the Laser Division financials so
that Renson & Co. can write a report “in reliance on the work of other
independent auditors.”
c. Reyes & Co. / Valley Bank: The SEC would consider independence impaired
because of the family relation of Annabelle, her connection with Valley’s
financial statements and the fact that Kris is a “member” (partner) in the
audit firm. (The PICPA would probably also consider independence impaired
because of the apparent closeness of the two sisters and the “audit sensitivity”
of Annabelle’s job).
d. Cruz & Reyes / Jonas Tomas / Starex Money Market Fund: Jonas is a
“member” since he is a manager and will provide audit services to SMMF.
Cruz & Reyes’ independence is impaired since Jonas holds a direct
financial interest.
Since Bella had an employment relationship with the client during part of the
period covered by the financial statements, her independence is impaired.
5. Although her decision will not be popular with the audit staff, Tracy Ong should
thank the client but decline the offer, both for her and for the staff. She should
explain that an outsider who had knowledge of all of the relevant facts might
view the free use of a condominium as a sizable “gift” to the auditors, which
might influence their independent mental attitude. Thus, we believe that to
maintain an appearance of independence, the auditors should not accept this
offer.
6. No. CPAs may refuse client access to their working papers for any valid business
purpose. Therefore, a CPA may require that fees be paid before working papers
including such adjusting entries and supporting analysis are provided to the client.
7. The answers provided in this section are based on the assumption that the
traditional legal relationship exists between the CPA firm and the third party user.
That is, there is no privity of contract, the known versus unknown third party user
is not a significant issue, and high levels of negligence are required before there is
liability.
a. False. There was no privity of contract between Tan and Cañada,
therefore, ordinary negligence will usually not be sufficient for a
recovery.
b. True. If gross negligence is proven, the CPA firm can and probably
will be held liable for losses to third parties.
c. True. See a.
d. False. Gross negligence (constructive fraud) is treated as actual fraud
in determining who may recover from the CPA.
e. False. JC is an unknown third party and will probably be able to
recover damages only in the case of gross negligence or fraud.
8. Yes. Normally a CPA firm will not be liable to third parties with whom it has
neither dealt nor for whose benefit its work was performed. One notable
exception to this rule is fraud. When the financial statements were fraudulently
prepared, liability runs to all third parties who relied upon the false information
contained in them. Fraud can be either actual or constructive. Here, there was
no actual fraud on the part of Dantes or the firm in that there was no deliberate
falsehood made with the requisite intent to deceive. However, it would appear that
constructive fraud may be present. Constructive fraud is found where the auditor’s
performance is found to be grossly negligent. That is, the auditor really had
either no basis or so flimsy a basis for his or her opinion that he or she has
manifested a reckless disregard for the truth. Dantes’ disregard for standard
auditing procedures would seem to indicate such gross negligence and, therefore,
the firm is liable to third parties who relied on the financial statements and
suffered a loss as a result.
9. a. Yes. Carlos was a party to the issuance of false financial statements and as such
is a joint tortfeasor. The elements necessary to establish an action for common
law fraud are present. There was a material misstatement of fact, knowledge
of falsity (scienter), intent that the plaintiff bank rely on the false statement,
actual reliance, and damage to the bank as a result thereof. If the action is
based upon fraud there is no requirement that the bank establish privity of
contract with the CPA. Moreover, if the action by the bank is based upon
ordinary negligence, which does not require a showing of scienter, the bank
may recover as a third-party beneficiary (an exception to the strict privity
requirement). Thus, the bank will be able to recover its loss from Carlos
under either theory.
b. No. The lessor was a party to the secret agreement. As such, the lessor
cannot claim reliance on the financial statements and cannot recover
uncollected rents. Even if he or she was damaged indirectly, his or her own
fraudulent actions led to his or her loss, and the equitable principle of
“unclean hands” precludes him or her from obtaining relief.
c. Yes. Carlos had knowledge that the financial statements did not follow
financial reporting standards and willingly prepared an unqualified opinion.
The financial statements were not in accordance with financial reporting
standards. That is a criminal act because there was an intent to deceive.
10. a. Base, Umapas & Cañada is potentially liable to its client because of the
possible negligence of its agent, the in-charge accountant on audit, in
carrying out duties that were within the scope of his or her employment.
Should there be a finding of negligence, liability would be limited to those
losses that would have been avoided had reasonable care been exercised.
It appears that the three deficiencies in the audit by Gonzales & Esteban might
be sufficient to satisfy either approach. Failure to check the existence of certain
receivables, collectibility of other receivables, and existence of security
investments, taken collectively if not individually, appear to show a reckless
disregard for the truth by the auditor. In fact, the audit probably lacks sufficient
competent evidential matter as a reasonable basis for an opinion regarding the
financial statements under examination.
12. Corpuz has stated that the CPA firm has “reviewed the books and records of Flores
Ventures,” when in fact no such “review” has occurred. A “review” of financial
statements consists of limited investigatory procedures designed to provide
statement users with a limited degree of assurance that the financial statements are
in conformity with financial reporting standards. Corpuz’s actions are similar to
issuing an auditors’ report without first performing an audit. Such an action may
well be considered an act of criminal fraud, intended to mislead users of the
financial statements. If the financial statements of Flores Ventures turn out to be
misleading, there is little doubt that any court would find the CPA firm guilty of at
least constructive fraud and liable to any third party who sustains a loss as a
result of reliance upon the statements.
The fact that Corpuz violated Vasquez’s policy of submitting all reports for
Vasquez’s review would not lessen the CPA firm’s liability. The concept of mutual
agency allows Corpuz, as a partner, to commit the firm to contracts, including
auditors’ reports and accountants’ reports. The fact that this report was not
submitted for Vasquez’s review might be introduced as evidence against Corpuz in
the event he is accused of criminal fraud.
13. (1) Yes, but only to the extent of P70,000. Beta is a third-party beneficiary of
the contract between Mega and its auditors, and may therefore recover from
the auditors losses caused by the CPAs’ ordinary negligence. However, the
original P50,000 loan was made prior to Beta’s reliance upon the
negligently audited financial statements. Thus, the auditors’ negligence was
not the proximate cause of this portion of Beta’s loss. The auditors’
negligence may, however, be considered the proximate cause of the
P70,000 loss incurred as a result of reliance upon the misleading statements.
(2) The prospects for Manila’s recovery of its P30,000 loss are substantially
less than those of Beta. Manila was not a third-party beneficiary to the
contract. Thus, in many jurisdictions following Ultramares, Manila cannot
recover losses attributable to the CPAs’ ordinary negligence. Similarly, it is
doubtful that Manila would qualify as a foreseen third party as necessary
under the Restatement approach. Even in a jurisdiction accepting the
Rosenblum precedent, which allows third parties to recover losses caused by
the auditors’ ordinary negligence, Manila would have to prove that it was a
“foreseeable third party relying upon the financial statements for routine
business purposes.” It is questionable whether the loan by Manila was either
“reasonably foreseeable” or “routine,” as Manila was a customer of Mega,
not a lender.
CHAPTER 6
MANAGEMENT OF A
PUBLIC ACCOUNTANCY PRACTICE
Questions
2. Complexity affects the demand for auditing services in that both users and
management need the expertise of professionals who understand the underlying
economic substance of transactions and financial instruments and, thus, who
have the ability to determine the appropriate accounting best to "fairly" portray
the economic substance of an organization's activities and financial condition.
3. For the most part, local CPA firms are subject to the same auditing and accounting
standards as the large international CPA firms. The differences relate to whether
the audit firms have (a) public clients, or (b) international clients. If a firm has
public clients, then the firm is subject to the standards of the PCAOB. If a firm
has clients that are domiciled in other countries, then they should utilize
international auditing standards. If the audit firm only has non-pubic clients,
then they are subject to auditing standards promulgated by the PICPA.
6-2 Solutions Manual – Public Accountancy Profession
4. A network of accounting firms is a body to which individual CPA firms come
together to pursue common interests. The services generally provided by the
network include:
• centralized staff that provides accounting and auditing expertise to its
members on a world-wide basis,
• a referral service for audit firms that have clients in different parts of the
country or world,
• a referral service for a firm to utilize when clients desire expertise or
consulting services that the audit firm does not provide.
• standard audit programs and/or procedure’s manuals for the member audit
firms.
In some cases, the network can be a network of firms that are not otherwise
affiliated. In other cases, the network firms all operate under one common name,
e.g. Grant Thornton International.
e. For departures from PFRS, the choice among opinions would be between a
qualified opinion (for less material departures) and an adverse opinion (for
more material departures).
f. While the concept of materiality does consider dollar amounts and their
effects on users’ decisions, qualitative factors also need to be considered when
assessing materiality. For example, a small dollar amount (in absolute terms)
may influence a company’s ability to meet its earnings expectations or report
higher earnings than in previous years. Situations such as this need to be
considered as well as the absolute dollar amount of an item in assessing
materiality.
Cases
1. (1) Auditing does not involve the creation of goods. However, it does serve a
worthwhile purpose in our society because it enhances the flow of reliable
financial information needed to conduct commerce in our economy. It also
assists in the conduct of government by providing reliable information for
tax purposes and regulatory purposes. Audits have been legally mandated to
ensure objective information. However, research has indicated that audits
would be required even if not mandated. The initial audits performed in
conjunction with the settlement of the new world arose because of owners'
need to have an independent assessment of the returns earned by their
managers.
(2) The accounting profession did provide early warning signals of the potential
problems within many industries. However, it clearly failed in other areas.
Some of the problems were related to the impreciseness of accounting
principles (e.g. Enron) while others were more closely related to regulatory
failures (e.g. Savings & Loan Industry). However, many of the failures were
due to systematic problems in the accounting profession that has been
addressed by Sarbanes-Oxley.
(3) Finding fraud may be important. However, many misstatements that are
made in conjunction with an organization's financial statements are not
intentional but are simply the result of errors. The audit function is designed
to detect material misstatements -- whether they are due to errors or fraud.
Thus, the audit function is actually broader than the colleague had desired.
Ensuring that a financial statement contains no material misstatements also
ensures that the auditor addresses the likelihood that material fraud may
also have occurred.
(4) There is a potential problem with the auditors being hired by management.
The Sarbanes-Oxley Act requires companies that are publicly traded to have
an audit committee composed of independent directors (nonmembers of
management) that have the responsibility for evaluating the performance of
the auditors. The audit committee should exist to present the views and
interests of outside owners of the organization and provide effective insulation
against undue pressure by management on the audit function. The SEC is very
cognizant of independence issues and periodically addresses actions or
relationships that they believe may impair the auditor’s independence.
(5) PFRS represents rules and conventions that are acceptable at one point in
time. Much of the diversity in accounting principles is necessary to reflect real
economic differences between organizations and the types of transactions in
which the organization is engaged. Beyond this argument, differences such as
Weighted Average / FIFO accounting have evolved over the years. The
profession attempts to mitigate the potential problems associated with the
diversity by providing disclosure of the differences and by developing other
procedures to make it difficult for firms to change accounting principles.
Thus, the financial statements of a company should be comparable over a
period of time.
(6) It seems that this individual really wants to have a career in auditing. External
auditing has changed; in today's environment, the auditor must thoroughly
understand a company's business in order to audit it. A key function of
internal auditors is to add value through their recommendations.
(8) Auditors operate in an environment in which they must have a sense of trust
with management – at least to the extent that confidential or proprietary
information is not made public. Thus, if all recommendations made to
management were to be made public, management might simply ask that
recommendations no longer be made. Further, it must be recognized that
many of the recommendations made to improve operations are informal in
nature and might not be based on thorough study of a particular area.
Auditors may justifiably fear litigation from recommendations made public
that were made only on informal observations.
(c) This question and should encourage a widely ranging discussion by users.
Topics that might be addressed include these:
1. The potential deficiencies in PFRS.
2. The ability to detect fraud when management has attempted to cover
it up.
3. The responsibilities of users to perform their own work and to not
expect someone else to make decisions for them.
4. The overall responsibility of management for the integrity of the
financial statements.
5. The value of reports on internal control.
6. The difficulty of measuring the economics of complex transactions.
CHAPTER 7
Questions
4. a. Consultation
b. To ensure that personnel have access to persons with more experience in
dealing with problems they have encountered.
c. For each industry for which the office has a client, a specialist will be
identified.
5. a. Independence
b. To ensure that personnel meet PICPA guidelines for independence.
c. Firm personnel must list their investments. Personnel must report any stock
acquisitions.
6. a. Supervision
b. To ensure that work performed meets the firm’s standard of quality.
c. Staff personnel are to follow firm guidelines for working paper development.
7. a. Inspection / Review
b. To verify that quality control procedures are being followed.
c. Inspect the audit programs for all engagements.
2. Auditing standards indicate that auditors should report major issues discussed with the
entity’s management prior to being retained as auditor, including discussions regarding
the application of accounting principles and auditing standards. Discussion of such
matters may place pressure on the auditor to yield to management’s view. Making the
audit committee members aware of such matters should enable them to better monitor
the auditor’s independence. Standards do not preclude clients from making suggestions
about audit staff. Clients frequently make requests to have persons on the audit who
have experience in the industry. If a client requests that minority persons not be
assigned to an audit, however, the auditor must carefully consider the ethical
implications of that request.
CHAPTER 8
Questions
1. Foreign public accounting firms have found that to retain their multinational
clients, they have had to develop the capacity to provide services worldwide.
Although the roots of at least two of the big firms in the United States are
traceable to European ancestry, public accounting firm involvement in
international activities has paralleled the gradual involvement of businesses in
international activities. In the early 1900s, some public accounting firms
established representative offices in foreign countries. As business activity
expanded, the firms opened offices in foreign cities. During the 1970s, some
countries forced these firms to close their offices. To be able to serve their clients,
the firms established correspondent relationships with locally owned accounting
firms; in these relationships, local partners remain separate, local, autonomous
organizations. Because domestic and foreign partners in a correspondent
relationship agree to follow a common code of ethics and practice guidelines, each
is able to rely on the work the other performs. A big firm auditing a U.S. business
with significant activities in France, for example, would rely on its Paris office to
audit the activities of the business in France.
Cases
1. The PICPA currently develops independence and ethical standards, quality control
standards, and auditing and attestation standards that apply to its members.
However, PICPA standards are applicable to the audits and auditors of nonpublic
clients based on general acceptance by the courts, and adoption by state boards of
accountancy and other regulatory bodies. The AICPA also has a voluntary peer
review program, and enforces its standards on its members.
The PCAOB was given the legal authority to develop independence and ethical
standards, quality control standards, and auditing and attestation standards that
apply to public company auditors and integrated audits. The PCAOB also is
charged with performing inspections of registered audit firms, and may sanction
the firms for noncompliance with its standards and the provisions of Sarbanes-
Oxley Act.
The state boards of accountancy regulate CPA firms and CPAs in the various states
and jurisdictions. They have the authority to establish their own standards, but
have generally adopted the standards of other bodies such as the PICPA and the
PCAOB. A state board enforces its standards in its state or jurisdiction and has the
authority to revoke a CPA firm or individual CPA’s right to practice in the state.
• It was inappropriate for Arnold to hire the two students to conduct the
audit. The audit must be conducted by persons with proper education and
experience in the field of auditing. Although a junior assistant has not
completed his formal education, he or she may help in the conduct of
the audit as long as there is proper supervision and review.
• Because of the financial interest in whether the bank loan is granted,
Arnold is not independent.
• Arnold did not review the work or the judgments of the assistants and
clearly failed to adhere to this standard.
• Arnold accepted the engagement without considering the availability of
competent staff. Arnold failed to supervise the assistants and did not
adequately plan the work.
• Arnold and the assistants did not obtain the require understanding of
the entity and its environment, including internal control.
• Arnold acquired no evidence that would support the financial
statements. Merely checking the mathematical accuracy of the records
and summarizing the accounts is inadequate.
• Arnold's report makes no reference to applicable reporting framework.
Because Arnold did not conduct a proper audit, the report should state
that no opinion can be expressed.
• In this case both the statements and the auditor's report lack adequate
disclosures.
3. (a) When the auditors discover illegal acts by a public client, they should
consider three major factors. First, the auditors should consider the effect
of the acts on the client's financial statements, including the possibility of
fines and loss of business. To comply with the applicable reporting
framework, the financial statements must reflect the material effects of
illegal acts.
Second, the illegal acts may affect the auditors' assessment of the integrity
of management. In deciding whether to continue to serve the client, the
auditors should consider the nature of the illegal acts and management's
response to the acts after they are uncovered.
Third, the auditors should consider whether the occurrence of the illegal act
indicates that there is a material weakness in the company’s internal control
over financial reporting.
(b) The following courses of action are available to the auditors:
(1) The auditors could issue an unqualified opinion and take no further
steps regarding the illegal activities. This course of action could be
argued on the basis that the effect of the acts on the financial
statements is not material. If the auditors take this course of
action, they should also consider whether the illegal act and related
actions by management and the board indicate a material weakness
exists that would affect their report on internal control over
financial reporting.
(2) The auditors could issue a qualified opinion because the financial
statements depart from the applicable reporting framework, in that
they fail to disclose the illegal acts. This course of action could be
argued on the basis that any illegal activities by the client are
material, especially when management fails to take any steps to
prevent the acts. If the auditors take this course of action, they
should also consider whether the illegal act and related actions by
management and the board indicate a material weakness exists that
would affect their report on internal control over financial
reporting.
(3) The auditors could withdraw from the engagement, because the cli-
ent's failure to take actions to prevent such activities indicates that
Generic's management lacks sufficient integrity.
(c) We believe that the auditors should consider withdrawing from the
engagement. Generic's top management seems far too complacent
regarding these activities. Their refusal to take any action to prevent the
acts in the future provides a signal to lower level management that top
management approves of illegal acts. The auditors clearly should question
the integrity of management in this situation.
Dear Jenny:
As much as I support your strenuous efforts to minimize air and water
pollution from the manufacturing operations of your company, there are specific
reasons which make it impossible for me as a CPA to attest to the extent of your
accomplishments in this area along the lines you have suggested. When we
perform the attest function with respect to your financial statements each year,
we are expressing our professional opinion that your financial statements are
prepared in conformity with certain standards, or applicable reporting framework.
In order for us to attest to the effectiveness of your pollution control
program, recognized standards would have to be established in this field. No
such standards presently exist for a factory to the best of my knowledge. Of
course the national government has set standards for exhaust emissions on
automobile engines and we could, by retaining independent consulting
engineers, obtain a basis for attesting to the compliance of a given automobile
engine to those standards.
We are quite willing to extend the attest function in various directions if
we can find a basis for objective comparison of a given operation with a clearly
defined standard. Perhaps your engineering department can develop some
specific quantitative data on the industrial waste from your operations. We
might then be able to perform the necessary examination of such data to enable us
to attest to the validity of your representations as to your operations. Of course,
this would not be the same thing as providing your relative position in the
industry. After reviewing this possibility with your engineering staff, if you
would like to discuss the matter further with us, we will be glad to meet with
you.
Sincerely,
Alice Borromeo
CHAPTER 9
OVERVIEW OF RISK-BASED
AUDIT PROCESS
Questions
2. An engagement letter is sent to the client by the auditors to make clear the
nature of the engagement, any limitations on the scope of the audit, work to be
performed by the client's staff, and the basis for computing the auditors' fee.
The engagement letter represents the written contract for the engagement, and its
primary objective is to prevent possible misunderstandings between the client
and the auditors. It constitutes an executory contract between the auditors and
the client.
5. The two types of misstatements due to fraud are (1) misstatements arising from
fraudulent financial reporting, and (2) misstatements arising from
misappropriation of assets (sometimes referred to as defalcation). Fraudulent
financial reporting is of more concern to the auditors because it typically results
in effects that are much more material to the financial statements. Defalcations
often are not material to the financial statements.
11. Factors which may cause an audit engagement to exceed the original time
estimate include the following:
(1) Accounting records may not be up to date and complete.
(2) Inadequacies in internal control may be discovered necessitating a more
detailed audit than anticipated.
(3) A significant risk, such as a fraud risk, may be discovered requiring an
extension of audit procedures.
(4) Fraud may be discovered, and an extended investigation may be
authorized by the client to clarify the situation.
(5) Inadequate supervision of audit staff may permit unnecessary or mis-
directed work to be performed.
(6) Findings during the course of the audit may cause the client to request
extension of the scope of the work.
In some engagements, clients are charged at agreed daily or hourly rates for the
time used to perform the audit. The difficulty of forecasting time requirements
is a principal reason for the use of per diem rates rather than quoting a fee for
the entire engagement. For many engagements, a maximum fee is agreed upon;
this plan may, of course, force the auditing firm to absorb part of the cost of
unexpected amounts of work. A decision as to charging the client for unusual
amounts of time will involve consideration of all aspects of the engagement and
prior relations with the client. Generally, however, the client should not be billed
for excessive time attributed to audit inefficiencies (e.g. item (5) above).
12. Underreporting of time results in the CPA firm not billing the client for all of the
time actually involved in rendering the professional services. Thus, the firm's
revenue is being restricted. In addition, the underreporting will cause the firm to
underestimate the amount of time required for future engagements. Thus, auditors
on future engagements will be expected to perform audit procedures in an
unrealistically short period of time. This interferes with the performance of an
effective audit as well as the realistic evaluation of firm personnel.
Cases
b. The form and content of engagement letters may vary, but they would
generally contain information regarding:
• The objective of the audit.
• The estimated completion date.
• Management’s responsibility for the financial statements.
• The scope of the audit.
• Other communication of the results of the engagement.
• The fact that because of the test nature and other inherent
limitations of any system of internal control, there is an
unavoidable risk that even some material misstatement may remain
undiscovered.
• Access to whatever records, documentation, and other information
may be requested in connection with the audit.
• Arrangements with respect to client assistance in the performance
of the audit engagement.
• Expectation of receiving from management written confirmation
concerning representations made in connection with the audit.
• Notification of any changes in the original arrangements that might
be necessitated by unknown or unforeseen factors.
• Request for the client to confirm the terms of the engagement by
acknowledging receipt of the engagement letter.
• The basis on which fees are computed and any billing
arrangements.
4. a. A CPA can use the following sources of information to help decide whether to
accept a new audit client.
Analysis:
Special or unusual risk related to the prospect
Need for special skills (e.g., computer or industry expertise)
b. Students can decide this acceptance question either way, although the brief
facts prejudice the conclusion toward nonacceptance. The CPA’s own firm
decided to resign only 10 years ago, presumably over matters of owner-
manager integrity. Yet, Mr. Sello appears to be a respected member of his new
community. Maybe his “fast and loose” accounting past is behind him. Maybe
not.
5. Benefits of engagement letters are:
• Helps establish an understanding between client and auditor of the terms of
the engagement and the nature of the work.
• Helps avoid quarrels and misunderstandings between client and auditor.
• Helps avoid disputes over the audit fee.
• Helps avoid legal liability assertions based on failure to do work that the CPA
may not have contemplated or agreed to do.
CHAPTER 10
Questions
3. The purpose of the team meeting on fraud risk is designed to allow the more
experienced team members to share insights and exchange ideas about how and
where the entity’s financial statements might be susceptible to material
misstatement due to fraud, to discuss how to design appropriate tests to detect
the misstatements, and to emphasize the importance of maintaining the proper
degree of professional skepticism regarding the possibility of fraud.
4. During the planning process, the auditors make preliminary estimates of both
risk and materiality for the engagement. The auditors must plan their engagements
to reduce the audit risk of issuing an unqualified opinion on materially misstated
financial statements to a relatively low level. At the account balance level, audit
risk actually has three components: (1) inherent risk, (2) control risk, and (3)
detection risk. On audits where the risk of
10-2 Solutions Manual – Public Accountancy Profession
misstatement is relatively high, the auditors must compensate by increasing the
effectiveness of their audit procedures. They may design more effective
procedures, increase the number of items selected for testing, or perform more
procedures at the balance sheet date rather than at an interim date. They may also
add an element of unpredictability to the procedures.
The auditors' preliminary estimates of levels of materiality also affect the nature,
timing, and extent of their planned procedures. Materiality levels determine
which accounts are significant enough to require audit, affect the size of the test
samples, and determine the dollar amount of individual items that warrant
examination.
5. (a) Auditors must obtain an understanding of the client and its environment in
order to determine whether the client should be accepted and to plan the
audit. This understanding encompasses the following:
(1) The nature of the client, including the client’s application of accounting
policies—The auditors’ understanding of this area will include the
client’s competitive position, organizational structure, accounting policies
and procedures, ownership, capital structure, and product lines. The
understanding will also encompass an understanding of the client’s
business model and its major business processes.
(2) The industry, regulatory, and other external factors—The factors included
here are industry conditions, such as the competitive environment,
supplier and customer relationships, and technological developments.
They also include the regulatory, legal, and political environment, and
general economic conditions.
(c) Knowledge of the client and its environment helps the auditors in:
6. During the tour of the client's plant facilities, Sison inspects all inventory areas
and makes note of the location, types, security, "housekeeping," and general
condition of the inventories. He also visits the receiving and shipping
departments and reviews the types of documents maintained. His observations
in these areas enable him to form a preliminary impression of the adequacy of
internal controls for inventories, and possible problems with respect to obsolete
or slow-moving inventories. He also can begin formulating plans for staffing
and carrying out the physical inventory observation.
Sison’s observation of the productive processes will acquaint him with the
client's physical plant facilities and layout, the nature of the products and
computer applications employed in the production process. He may also obtain
information on the client's documentation such as for production orders, raw
materials requisitioned to production, direct and indirect labor, and inspection
and testing of finished products. He meets the supervisory personnel, engineers,
and other key personnel responsible for production, and through inquiries and
conversations learns of any unique production problems, including excessive
spoilage and scrap. As a result, he will be in a position to evaluate the client's cost
accounting system during the course of the audit. He will also inquire about the
details of the client’s business processes.
Throughout the tour, Sison will add to his impression of the client's business
processes, control procedures and accounting records. He will notice, for
example, what personnel have access to computer terminals and accounting
records, whether plant assets have identification tags, and whether documents
such as production orders and receiving reports are serially numbered or controlled
by the computer.
(b) The three conditions necessary for the commission of fraud include: (1)
some type of incentive or pressure, (2) an opportunity to commit the fraud,
and (3) an attitude that allows the individual to rationalize the act. In a case of
fraudulent financial reporting, members of top management may have an
incentive to commit the act relating to maintaining the value of their stock
options. They may have an opportunity based on weaknesses in the
corporate governance of the organization. Finally, they may be able to
rationalize the act by assuming that the company will make enough income
next period to allow them to correct the misstatement.
(c) The auditors may respond to fraud risks by (1) a modification in the
approach having an overall effect on how the audit is conducted, (2) an
alteration in the nature, timing, and extent of the procedures performed, and
(3) performance of procedures to further address the risk of management
override of internal control.
8. (a) Shin may respond to fraud risks in the following three ways:
(1) A modification in the overall approach to the audit which might involve:
(a) Applying increased professional skepticism and designing
procedures that provide more reliable evidence.
1. d 6. d
2. a 7. d
3. d 8. d
4. d 9. d
5. d 10. d
Cases
(b) The auditors would likely respond by utilizing more experienced audit
team members. Specifically, audit staff that had experience with
complex revenue contracts in the telecommunications industry. They
would also likely increase the extent of the substantive tests of revenue.
(3) (a) There is an increased risk that the futures traders will fraudulent
overstate the value of the contracts to increase their compensation.
Our recent tour of Palace's plant was a most pleasant and interesting
experience. The information obtained on this tour and during the discussion of
your financial statements and accounting records has enabled us to plan the
scope of an audit especially suited to your needs.
Our fees are based on the time spent on the engagement by various
members of our audit staff, and will be billed at our established rates. The total
time required for an initial engagement is usually somewhat greater than in
repeat examinations, since the latter do not require analysis of past years'
transactions. Considerable savings in the cost of the audit may be made by
utilizing the services of your accounting staff to help us in certain phases of the
work. We can arrange for your employees to prepare for us a number of working
papers. If you approve, we shall indicate to your chief accountant the exact nature
of the working papers to be prepared.
We would like an opportunity during the next few days to discuss with you
and your chief accountant the nature of the preliminary work to be done by your
staff. We shall also be pleased to answer any further questions which you may
have concerning the determination of audit fees.
Questions
3. Advantages of flowchart:
Graphic presentation of systems.
Shows the steps required and the flow of forms and documents.
Easy to read and analyze.
Easy to update in subsequent years.
Disadvantages:
Takes some time to draw neatly.
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 client’s
internal financial controls beyond obtaining an initial understanding:
a. Controls may already have been evaluated as ineffective;
b. Further testing is not cost effective (i.e., the cost of further testing is
greater than the cost savings resulting from reduced substantive testing)
12. Some combination of the following means is typically utilized by the auditor in
testing a client’s internal financial controls:
a. Reprocessing transactions through the client’s system;
b. Observation of controls; and
c. Document examination and testing.
14. The following are some examples of internal control weaknesses and suggested
expanded substantive testing, given the weaknesses:
a. Perpetual inventory records not maintained: Expand test counts during
inventory observation
b. Bank accounts not reconciled: Expand year-end audit of cash accounts
c. Customer exceptions to monthly statements not investigated and
cleared: Expand accounts receivable confirmation at year-end.
15. Reportable conditions are matters coming to the auditor’s attention, as a result of
his/her study and evaluation of the client’s internal financial controls, relating to
significant deficiencies in the design or operation or of the internal controls that
could adversely affect the organization’s ability to record, process, summarize, and
report financial data consistent with the assertions of management in the financial
statements. The purpose of the reportable conditions letter is to inform the audit
committee, or similar body within the organization, of weaknesses for which they
may not be aware. Such communication increases the likelihood that the
weaknesses will be corrected on a timely basis.
11-4 Solutions Manual – Public Accountancy Profession
16. Use of any one of the approaches to studying and documenting a client’s
internal financial controls, by itself, is inadequate. Each approach adds a needed
dimension to the analysis. The memorandum requires depth of analysis not
found in the flowchart. The flowchart, on the other hand, promotes ease of
understanding and ready identification of strengths and weaknesses in controls.
The questionnaires and checklists add the dimension of completeness of
coverage. By using the three tools in combination, the auditor is able to gain a
deeper and clearer understanding of each of the subsets of the transaction cycles,
including major control strengths and weaknesses, thereby permitting more
accurate control risk assessments and more useful substantive audit programs
based on such assessments.
1. b 8. a 15. d 22. a
2. a 9. b 16. c 23. a
3. b 10. c 17. b 24. d
4. d 11. b 18 b 25. b
5. b 12. a 19. a 26. d
6. b 13. b 20. d 27. b
7. b 14. b 21. a 28. d
Cases
b. If, based on the initial understanding, controls are thought to be adequate, the
auditor should consider the following alternatives:
1. Document the understanding, assess control risk below maximum,
as considered appropriate, and document the basis for conclusions;
or
2. Document the understanding and test controls as a means for
further reduction in the assessed level of control risk. This
alternative would be chosen if the following conditions exist:
a. Controls are thought to be effective; and
b. Cost reductions through reduced substantive testing
exceed cost of further testing of controls.
c. 1. Auditors must study and evaluate internal control each year because the
environment within which the client operates is subject to constant
change; and controls must adapt to these changes if the system is to
remain effective. The auditor must identify the environmental changes
and determine that the relevant control points remain covered after the
changes.
-Question Yes No
Are customers who pay by check identified via store I.D. card or
other means?
Does company policy prohibit accepting checks for anything
except merchandise sales plus a nominal cash amount?
Is a receipt produced by the cash register given to each
customer?
Is the reading of each cash register taken periodically by an
employee who is independent of the handling of cash
receipts?
Are cash counts made on a surprise basis by an individual who is
independent of the handling of cash receipts?
Is the reading of each cash register compared regularly to the
cash received?
Is a summary listing of cash register readings prepared by an
employee who is independent of physically handling cash
receipts?
Are receipts forwarded to an independent employee who makes
the bank deposits?
Are each day’s receipts deposited intact daily?
Is the summary listing of cash register receipts reconciled to the
duplicate deposit slips authenticated by the bank?
Are entries to the cash receipts journal prepared from duplicate
deposit slips or the summary listing of cash register
readings?
Are the entries to the cash receipts journal compared to the
deposits per bank statement?
Are areas involving the physical handling of cash reasonably
safeguarded?
Are employees who handle receipts bonded?
Are charged back items (NSF checks, etc.) directed to an
employee who does not physically handle receipts or have
access to the books?
CHAPTER 12
Questions
2. Errors and irregularities: Auditors are required to plan the audit to detect errors
and irregularities that would have a material effect on the financial statements.
Clients’ illegal acts: Auditors are not required to search for illegal acts, but they
are warned to be alert to any that might be detected in the ordinary course of an
audit.
a. Existence assertion:
The practical objective is to establish with evidence that assets, liabilities
and equities actually exist and that sales and expense transactions actually
occurred. Cut-off can be considered an aspect of the existence assertion.
b. Occurrence assertion:
The practical objective is to establish with evidence that recorded
transactions or events that occurred during a given accounting period
pertained to the entity.
c. Completeness assertion:
The practical objective is to establish with evidence that all transactions of
the period are in the financial statements and all transactions that properly
belong in the preceding or following accounting periods are excluded.
Another term for these aspects of completeness is cut-off.
e. Measurement assertion:
The practical objective is to establish with evidence that a transaction or
event is recorded at the proper amount and revenue or expense is allocated
to the proper period.
f. Valuation assertion:
The practical objective is to establish with evidence that proper values have
been assigned to things (assets, liabilities, equities and related disclosures)
and events (revenues, expenses and related disclosures). Auditing Standards
refer to the practical objective of obtaining evidence about “valuations”
achieved by cost allocations such as depreciation and inventory costing
methods.
Control risk and inherent risk are also directly related to the setting of
materiality thresholds. If, for example, application of analytical procedures
(inherent risk analysis) leads the auditor to suspect earnings inflation, individual
item materiality thresholds should be reduced accordingly (i.e., either the
materiality percentage or the amount of unaudited income should be decreased.)
Similarly, if control risk analysis leads the auditor to suspect numerous errors,
aggregate materiality thresholds need to be lowered accordingly.
7. An auditor’s reaction to an immaterial error may differ from his or her reaction
to an immaterial irregularity. Auditors generally accumulate the amount of
individual immaterial errors to be sure that the aggregate of all errors is not
material. In addition, the auditor is concerned about whether an error came from
a misunderstanding or other cause that would have resulted in yet more errors
during the period. An auditor is expected to report all irregularities to the audit
committee or the board of directors and senior management.
11. The factors that should be considered are the peso amount of the account, the
likelihood of error, and the cost of auditing the account.
12. The auditor deals with both inherent risk and control risk during the planning
phase of the audit. Inquiry of client personnel, study of the business and industry,
application of analytical procedures, and documentation of the auditor’s 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.
12-4 Solutions Manual – Public Accountancy Profession
Multiple Choice Questions
Cases
b. The problem does not describe the kind of related party transactions
discussed in PSA 550.
d. The problem description indicates that this element of the audit was
conducted in a negligent manner. There’s nothing wrong about auditing a
sample of the transactions, but Campos’ follow-up and explanation of the
missing receiving reports leaves much to be desired. At the very least he could
have reviewed the reports produced by Antonio at a later date, and he could
have traced the purchases to the inventory records and perhaps noticed an
over-stocking condition. The auditors had some evidence that an irregularity
might exist, but they failed to apply extended audit procedures properly.
2. a. Yes. Nicolas was a party to the issuance of false financial statements and as such
is a joint tortfeasor. The elements necessary to establish an action for common
law fraud are present. There was a material misstatement of fact, knowledge
of falsity (scienter), intent that the plaintiff bank rely on the false statement,
actual reliance and damage to the bank as a result thereof. If
action is based upon fraud there is no requirement that the bank establish
privity of contract with the CPA. Moreover, if the action by the bank is based
upon ordinary negligence, which does not require a showing of scienter, the
bank may recover as a third-party beneficiary (an exception to the strict
privity requirement). Thus, the bank will be able to recover its loss from
Nicolas under either theory.
b. No. The lessor was a party to the secret agreement. As such, the lessor
cannot claim reliance on the financial statements and cannot recover
uncollected rents. Even if he was damaged indirectly, his own fraudulent
actions led to his loss, and the equitable principle of “unclean hands”
precludes him from obtaining relief.
Questions
2. In the past decade, all parties failed to a certain extent. For detailed analysis, see
exhibit in the chapter and repeated here:
Board of Broad Role: the major representative of stockholders to • Inadequate oversight of management.
Directors ensure that the organization is run according to the • Approval of management compensation
organization charter and there is proper accountability. plans, particularly stock options that
Specific activities include: provided perverse incentives, including
• Selecting management. incentives to manage earnings.
• Reviewing management performance • Non-independent, often dominated
and determining compensation. by management.
• Declaring dividends • Did not spend sufficient time or
• Approving major changes, e.g. mergers have sufficient expertise to perform
• Approving corporate strategy duties.
• Overseeing accountability activities. • Continually re-priced stock options
when market price declined.
Management Broad Role: Operations and Accountability. Managing • Earnings management to meet
the organization effectively and provide accurate and analyst expectations.
13-2 Solutions Manual – Public Accountancy Profession
Overview of Corporate Governance Failures
Party Overview of Responsibilities
timely accountability to shareholders and other • Fraudulent financial reporting.
stakeholders. • Pushing accounting concepts to achieve
Specific activities include: reporting objective.
• Formulating strategy and risk appetite. • Viewed accounting as a tool, not a
• Implementing effective internal controls. framework for accurate reporting.
• Developing financial reports.
• Developing other reports to meet public,
stakeholder, and regulatory
requirements.
Audit Broad Role: Provide oversight of the internal and • Similar to Board members – did not
Committees of external audit function and the process of preparing the have expertise or time to provide
the Board of annual accuracy financial statements and public reports effective oversight of audit functions.
Directors on internal control. • Were not viewed by auditors as the ‘audit
Specific activities include: client’. Rather the power to hire and fire the
• Selecting the external audit firm. auditors often rested with management.
• Approving any non-audit work performed
by audit firm.
• Selecting and/or approving the appointment
of the Chief Audit Executive (Internal
Auditor),
• Reviewing and approving the scope
and budget of the internal audit
function.
• Discussing audit findings with internal
auditor and external auditor and advising the
Board (and management) on specific actions
that should be taken.
Self-Regulatory Broad Role: Setting accounting and auditing standards • AICPA: Peer reviews did not take a public
Organizations: dictating underlying financial reporting and auditing perspective; rather than looked at
AICPA, FASB concepts. Set the expectations of audit quality and standards that were developed and
accounting quality. reinforced internally.
Specific roles include: • AICPA: Leadership transposed the
• Establishing accounting principles organization for a public organization to a
• Establishing auditing standards “trade association” that looked for revenue
• Interpreting previously issued standards enhancement opportunities for its
• Implementing quality control processes members.
to ensure audit quality. • AICPA: Did not actively involve third
• Educating members on audit and parties in standard setting.
accounting requirements. • FASB: Became more rule-oriented in
response to (a) complex economic
transactions; and (b) an auditing
profession that was more oriented to
pushing the rules rather than enforcing
concepts.
• FASB: Pressure from Congress to develop
rules that enhanced economic growth, e.g.
allowing organizations to not expense
stock options.
Overview of Corporate Governance Failures
Party Overview of Responsibilities
Other Self- Broad Role: Ensuring the efficiency of the financial • Pushed for improvements for better
Regulatory markets including oversight of trading and oversight of corporate governance procedures by its
Organizations, companies that are allowed to trade on the exchange. members, but failed to implement those
e.g. NYSE, Specific activities include: same procedures for its governing board,
NASD • Establishing listing requirements – management, and trading specialists.
including accounting requirements,
governance requirements, etc.
• Overseeing trading activities,
Regulatory Broad Role: Ensure the accuracy, timeliness, and • Identified problems but was never
Agencies: the fairness of public reporting of financial and other granted sufficient resources by Congress
SEC information for public companies. Specific activities or the Administration to deal with the
include: issues.
• Reviewing all mandatory filings with the SEC,
• Interacting with the FASB in
setting accounting standards,
• Specifying independence standards required
of auditors that report on public financial
statements,
• Identify corporate frauds, investigate
causes, and suggest remedial actions.
External Broad Role: Performing audits of company financial • Pushed accounting concepts to the limit
Auditors statements to ensure that the statements are free of to help organizations achieve earnings
material misstatements including misstatements that objectives.
may be due to fraud. • Promoted personnel based on ability to
Specific activities include: sell “non-audit products”.
• Audits of public company • Replaced direct tests of accounting
financial statements, balances with a greater use of inquiries,
• Audits of non-public company risk analysis, and analytics.
financial statements, • Failed to uncover basic frauds in cases
• Other accounting related work such as tax such as WorldCom and HealthSouth
or consulting. because fundamental audit procedures
were not performed.
Internal Broad Role: Perform audits of companies for • Focused efforts on ‘operational audits’
Auditors compliance with company policies and laws, audits to and assumed that financial auditing was
evaluate the efficiency of operations, and audits to addressed sufficiently by the external
determine the accuracy of financial reporting processes. audit function.
Specific activities include: • Reported primarily to management with
• Reporting results and analyses to little effective reporting to the audit
management, (including operational committee.
management), and audit • In some instances (HealthSouth, WorldCom)
committees, did not have access to the corporate
• Evaluating internal controls. financial
accounts.
3. The board of directors is often at the top of the list when it comes to
responsibility for corporate governance failures. Some of the problems with the
board of directors included:
9. The external auditor should discuss any controversial accounting choices with
the audit committee and must communicate all significant adjustments made to
the financial statements during the course of the audit. In addition, the processes
used in making judgments and estimates as well as any disagreements with
management should be communicated. Other items that need to be
communicated include:
• All adjustments that were not made during the course of the audit,
• Difficulties in conducting the audit,
• The auditor’s assessment of the accounting principles used and overall
fairness of the financial presentation,
• The client’s consultation with other auditors,
• Any consultation with management before accepting the audit engagement,
• Significant deficiencies in internal control.
10. The auditor might utilize the following procedures in determining the actual
level of governance in an organization:
Cases
b. In the past decade especially, all parties failed to a certain extent. For
detailed analysis, see exhibit 2.2 in the chapter and reproduced below:
Management Broad Role: Operations and Accountability. • Earnings management to meet analyst
Managing the organization effectively and provide expectations.
accurate and timely accountability to shareholders • Fraudulent financial reporting.
and other stakeholders. • Pushing accounting concepts to achieve
Specific activities include: reporting objective.
• Formulating strategy and risk appetite. • Viewed accounting as a tool, not a
• Implementing effective internal controls. framework for accurate reporting.
• Developing financial reports.
• Developing other reports to meet public,
stakeholder, and regulatory requirements.
Overview of Corporate Governance
Party Overview of Responsibilities Failures
Audit Broad Role: Provide oversight of the internal and • Similar to Board members – did not
Committees of external audit function and the process of have expertise or time to provide
the Board of preparing the annual accuracy financial statements effective oversight of audit functions.
Directors and public reports on internal control. • Were not viewed by auditors as the
Specific activities include: ‘audit client’. Rather the power to hire
• Selecting the external audit firm. and fire the auditors often rested with
• Approving any non-audit work performed management.
by audit firm.
• Selecting and/or approving the
appointment of the Chief Audit Executive
(Internal Auditor),
• Reviewing and approving the scope and
budget of the internal audit function.
• Discussing audit findings with internal
auditor and external auditor and advising
the Board (and management) on specific
actions that should be taken.
Self- Broad Role: Setting accounting and auditing • AICPA: Peer reviews did not take a
Regulatory standards dictating underlying financial reporting public perspective; rather than looked at
Organizations: and auditing concepts. Set the expectations of standards that were developed and
AICPA, FASB audit quality and accounting quality. reinforced internally.
Specific roles include: • AICPA: Leadership transposed the
• Establishing accounting principles organization for a public organization to
• Establishing auditing standards a “trade association” that looked for
• Interpreting previously issued standards revenue enhancement opportunities for
• Implementing quality control processes to its members.
ensure audit quality. • AICPA: Did not actively involve third
• Educating members on audit and parties in standard setting.
accounting requirements. • FASB: Became more rule-oriented in
response to (a) complex economic
transactions; and (b) an auditing
profession that was more oriented to
pushing the rules rather than enforcing
concepts.
• FASB: Pressure from Congress to
develop rules that enhanced economic
growth, e.g. allowing organizations to
not expense stock options.
Other Self- Broad Role: Ensuring the efficiency of the • Pushed for improvements for better
Regulatory financial markets including oversight of trading corporate governance procedures by its
13-10 Solutions Manual – Public Accountancy Profession
Overview of Corporate Governance
Party Overview of Responsibilities Failures
Organizations, and oversight of companies that are allowed to members, but failed to implement those
e.g. NYSE, trade on the exchange. Specific activities include: same procedures for its governing
NASD • Establishing listing requirements – board, management, and trading
including accounting requirements, specialists.
governance requirements, etc.
• Overseeing trading activities,
Regulatory Broad Role: Ensure the accuracy, timeliness, and • Identified problems but was never
Agencies: the fairness of public reporting of financial and other granted sufficient resources by Congress
SEC information for public companies. Specific or the Administration to deal with the
activities include: issues.
• Reviewing all mandatory filings with the
SEC,
• Interacting with the FASB in setting
accounting standards,
• Specifying independence standards
required of auditors that report on public
financial statements,
• Identify corporate frauds, investigate
causes, and suggest remedial actions.
External Broad Role: Performing audits of company • Pushed accounting concepts to the limit
Auditors financial statements to ensure that the statements to help organizations achieve earnings
are free of material misstatements including objectives.
misstatements that may be due to fraud. • Promoted personnel based on ability to
Specific activities include: sell “non-audit products”.
• Audits of public company financial • Replaced direct tests of accounting
statements, balances with a greater use of inquiries,
• Audits of non-public company financial risk analysis, and analytics.
statements, • Failed to uncover basic frauds in cases
• Other accounting related work such as tax such as WorldCom and HealthSouth
or consulting. because fundamental audit procedures
were not performed.
Internal Broad Role: Perform audits of companies for • Focused efforts on ‘operational audits’
Auditors compliance with company policies and laws, and assumed that financial auditing was
audits to evaluate the efficiency of operations, and addressed sufficiently by the external
audits to determine the accuracy of financial audit function.
reporting processes. • Reported primarily to management with
Specific activities include: little effective reporting to the audit
• Reporting results and analyses to committee.
Overview of Corporate Governance
Party Overview of Responsibilities Failures
management, (including operational • In some instances (HealthSouth,
management), and audit committees, WorldCom) did not have access to the
• Evaluating internal controls. corporate financial accounts.
3.
Audit Activity to
Element of Poor Determine if Governance Risk Implication of Poor
Corporate Governance is actually Poor Governance
The company is in the This is not necessarily poor The lack of good risk
financial services sector governance. However, the management by the
and has a large number of auditor needs to determine organization increases the
consumer loans, the amount of risk that is risk that the financial
inherent in the current loan statements will be
including mortgages,
portfolio and whether the misstated because of the
outstanding. risk could have been difficulty of estimating the
managed through better risk allowance for loan losses.
management by the The auditor will have to
organization. focus increased efforts on
estimating loan losses,
including a comparison of
how the company is doing
in relation to the other
companies in the financial
sector.
The CEO and CFO’s This is a rather common In combination with other
compensation package and, things, the use of
Audit Activity to
Element of Poor Determine if Governance Risk Implication of Poor
Corporate Governance is actually Poor Governance
compensation is based on by itself, is not necessarily ‘significant stock options’
three components: (a) poor corporate governance. may create an incentive for
base salary, (b) bonus However, in combination management to potentially
based on growth in assets with other things, the use of manage reported earnings
‘significant stock options’ in order to boost the price
and profits, and (c)
may create an incentive for of the company’s stock.
significant stock options. management to potentially
manage reported earnings The auditor should
in order to boost the price carefully examine if the
of the company’s stock. company’s reported
The auditor can determine earnings and stock price
if it is poor corporate differs broadly from
governance by determining companies in the same
the extent that other sector. If that is the case,
safeguards are in place to there is a possibility of
protect the company. earnings manipulation and
the auditor should
investigate to see if such
manipulation is occurring.
The company has an The good news is that the The bad news is that a staff
internal auditor who organization has an internal of one isn’t necessarily as
reports directly to the audit activity. large or as diverse as it
CFO, and makes an needs to be to cover the
major risks of the
annual report to the audit
organization. The external
committee. auditor will be more
limited in determining the
extent that his or her work
can rely on the internal
auditor.
The Company has a loan The auditor should observe There are a couple of
committee. It meets the minutes of the loan elements in this statement
quarterly to approve, on committee to verify its that carries great risk to the
an ex-post basis all loans meetings. The auditor audit and to the
should also interview the organization. First, the
that are over $300 million
chairman of the loan loan committee only meets
(top 5% for this committee to understand quarterly. Economic
institution). both its policies and its conditions change more
attitude towards controls rapidly than once a quarter,
and risk. and thus the review is not
Audit Activity to
Element of Poor Determine if Governance Risk Implication of Poor
Corporate Governance is actually Poor Governance
timely. Second, the only
loans reviewed are (a) large
loans that (b) have already
been made. Thus, the loan
committee does not act as a
control or a check on
management or the
organization. The risk is
that many more loans than
would be expected could
be delinquent, and need to
be written down.
The previous auditor has The auditor should contact This is a very high risk
resigned because of a the previous auditor to indicator. The auditor
dispute regarding the obtain an understanding as would look extremely bad
accounting treatment and to the factors that led the if the previous auditor
previous auditor to either resigned over a valuation
fair value assessment of
resign or be fired. The issue and the new auditor
some of the loans. auditor is also concerned failed to adequately address
with who led the charge to the same issue.
get rid of the auditor.
Second, this is a risk factor
because the organization
shows that it is willing to
get rid of auditors with
whom they do not agree.
This is a problem of auditor
independence and
coincides with the above
identification of the
weakness of the audit
committee. This action
confirms a generally poor
quality of corporate
governance.
4. a&b. Cookie jar reserves are essentially funds that companies have “stashed
away” to use when times get tough. The rationale is that the reserves
are then used to “smooth” earnings in the years when earnings needs a
boost. “Smooth” earnings typically are looked upon more favorably by
the stock market. An example of a cookie jar reserve would be over-
estimating an allowance account, such as allowance for doubtful
accounts. The allowance account is then written down (and into the
income statement) in a bad year.
Auditors may have allowed cookie jar reserves because they are known
to smooth earnings, and smooth earnings are rewarded by the market. On
the flip side, fluctuating earnings are penalized, and present more risk to
the company of bankruptcy or other problems.
b. The main way that the audit committee can influence the independence
of the internal audit department is by choosing who is in charge of the
department. The “tone at the top” in the internal audit department will
go a long way. Further, the audit committee ought to approve the scope of
the internal audit charter, approve annual audit plans, as well as annual
budgets.
DESIGNING AN EFFECTIVE
RESPONSE TO ASSESSED
RISKS
Questions
4. Confirmations are usually considered more reliable because they are from
outside parties, while inquiries are made of client personnel.
5. When equivalent procedures are available to satisfy the need for evidence, an
auditor may consider cost in selecting among the alternatives.
1. c 3. c 5. c 7. a 9. d
2. d 4. a 6. c 8. d
14.2 Solutions Manual – Public Accountancy Profession
Cases
AUDIT EVIDENCE
Review Questions
9. Factual evidence is direct evidence, in that conclusions may be drawn from the
evidence without further corroboration. An example of factual audit evidence is
physical observation of inventory for existence. Inferential evidence is indirect, in
that direct conclusions cannot be drawn from the evidence. The auditor typically
examines other evidence to further corroborate the inferences drawn. An oral
statement by a product manager that one or more products are fully saleable and
not obsolete is an example of inferential evidence. The auditor may perform
inventory turnover tests and/or determine the date of last sale of the product to
further corroborate the product manager’s 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.
15. Evidence is persuasive if the auditor considers the evidence to be sufficient and
competent enough to afford a reasonable basis for an opinion.
1. d 4. c 7. d 10. d 13. b
2. d 5. a 8. b 11. a
3. c 6. d 9. d 12. b
Cases
2. 1. Types of evidence
2. 1. Mathematical (based on
c. Audit computation of expense unaudited data)
amounts
Review Questions
4. Audit conclusions can be made only about the population from which the
sample was drawn, and a conclusion can only be valid if the sample on which it
is based actually shows the characteristics of the population. Auditors can attempt
to achieve representativeness, but they cannot guarantee it. Sampling risk – the
probability that the sample does not adequately reflect the population
– always exists.
5. Refer to page 656, 2nd paragraph; page 657, 1st paragraph of the textbook.
9. Refer to page 663, 4th paragraph & page 664, 1st to 3rd paragraph of the textbook.
10. Sampling risk is the probability that the auditor’s conclusions concerning the
population will be in error. In terms of conclusions regarding internal control,
sampling risk consists of two subsets:
Alpha risk, the risk that the auditor will assess control risk too high and
perform more substantive testing than is necessary under the circumstances;
and
Beta risk, the risk that the auditor will assess control risk too low and perform
less substantive testing than is necessary.
For control testing purposes, the auditor is more concerned with beta risk than
alpha risk, because beta risk poses the threat of underauditing and is therefore
the basis for the audit opinion. The auditor controls this risk by setting beta risk
sufficiently low as to maintain overall audit risk at a level less than or equal to
10%.
16-2 Solutions Manual – Public Accountancy Profession
11. Refer to pages 675 of the textbook.
1. b 3. d 5. d 7. a 9. a
2. c 4. c 6. b 8. d 10. c
Comprehensive Cases
b. If the CPAs’ sample shows an unacceptable deviation rate, they may take
the following actions:
(1) They may enlarge their sample to increase the precision of their estimate.
Basic Audit Sampling Concepts 16-3
(2) They may isolate the type of deviation and expand examination as it
relates to the transactions that give rise to that type of misstatement.
(3) The auditors’ usual response to an unacceptably high deviation rate is
to increase their assessed level of control risk. Accordingly, the auditors
would increase the intensity of their substantive tests.
2. a. (1) Since the results of tests of controls typically play a significant role in
determining the nature, timing, and extent of other audit procedures, the
auditors usually specify a low level of risk of assessing control risk too
low. It is usually set at 5 or 10 percent.
Questions
Objective Example
1. Validity 1. Sale recorded without supporting shipping
orders.
2. Authorization 2. Lack of credit manager approval for a credit
sale.
3. Accuracy 3. Mathematical errors in sales invoice
calculations.
4. Classification 4. Sales classified in wrong product line revenue
account.
5. Proper Period 5. Sales recorded in month (quarter, year) before
the actual shipment.
6. Accounting 6. Sales charges fail to be posted to a customer’s
account.
7. Completeness 7. Shipments fail to be billed to customers and
recorded as sales and receivables.
2. Acceptable risk of
Inverse. The greater the acceptable risk,
assessing control risk
the smaller the sample.
too high
3. Tolerable deviation
Inverse. The higher the tolerable rate, the
rate
smaller the sample.
4. Expected population
Direct. The higher the expected rate, the
deviation rate (an larger the sample.
estimate rather than a
judgment)
The sample size is also directly related to the population size, although the
influence is generally minor. The larger the population, the larger the sample, but
not much.
4. The risk of assessing the control risk too low has the potential of affecting audit
effectiveness, thus damaging the quality of the audit for users. Professionally,
in light of responsibility to users, effectiveness is more important than efficiency,
which is affected by the risk of assessing the control risk too high.
= .2
TD = .048
1.0 x .4 x .6
6. The “connection” is a direct relationship between control risk and the tolerable
deviation rate. (1) When larger values are planned for control risk (say, 0.95, 0.90)
in an audit plan, more analytical procedure and test of detail work will be done.
Auditors will not rely very much on internal controls. Therefore, not much help
is expected from the controls anyway, so the tolerable deviation rate can be larger.
The direct relation is: The higher the control risk, the higher the tolerable deviation
rate can be. (2) When lower values are assigned to control risk (say, 0.10, 0.20)
in an audit plan, less analytical procedure and test of detail work will be done.
Auditors intend to rely on internal accounting controls. Therefore, effective
compliance with control policies and procedures is important, and the tolerable
deviation rate ought to be low. The direct relation is: The higher the planned
control risk, the higher the tolerable deviation rate can be.
7. Based on the specifications of risk of assessing control risk too low, tolerable
deviation rate and expected population deviation rate, sample sizes would be
determined independently for the two populations in the subdivision. If the
criteria are at least as stringent for each of the two as they would be for the
undivided population, the sum of the two sample sizes would be at least twice
the size of the sample figured for the single population (provided both
subdivided populations have 1,000 or more units).
8. Further reduction of the assessed level of control risk is justified only when the
upper occurrence limit is <= the tolerable occurrence rate. Recall that the
tolerable occurrence rate is that rate of error beyond which the auditor cannot
justify further reduction in the assessed level of control risk. A calculated rate
which exceeds the tolerable rate, therefore, would suggest a level of error which
precludes any lowering of assessed control risk.
The tolerable occurrence rate is the maximum error rate which the auditor
would accept while still lowering assessed control risk below maximum. The
auditor bases the tolerable rate on materiality of the attribute being tested. The
more critical an attribute to effective internal control, the lower the tolerable
occurrence rate. The tolerable occurrence rate has an inverse effect on sample
size.
10. Inherent risk is the risk that, in the absence of internal control, material errors or
irregularities will occur.
Control risk is the risk that internal financial control policies and procedures will
fail to prevent or detect material errors and irregularities.
Detection risk is the risk that material errors and irregularities, which are not
prevented or detected by internal financial control policies and procedures, will
not be detected by the independent audit.
Questions
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.
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).
18-2 Solutions Manual – Public Accountancy Profession
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.
10. Account balances also can be audited, at least in part, at an interim date. When
account balance audit work is done before the company’s 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.
12. Detection (or beta) risk affects sample size inversely for substantive testing
purposes. That is, the higher the acceptable detection risk, the smaller the
sample size; and the lower the acceptable detection risk, the larger the sample
size.
13. Precision is the range + – within which the true answer most likely falls. It is
set by the auditor as a function of materiality and those levels of beta and alpha
risk deemed acceptable. Reliability is the likelihood that the sample range
contains the true value. Also referred to as the confidence level, reliability is set
by the auditor on the basis of overall audit risk.
14. PPS sampling is restricted to populations for which the auditor suspects a few
errors of overstatement only.
15. Several statistical software packages are available to facilitate audit sampling
applications. In addition to calculating sample size and evaluating sample
results, these packages can also assist in the following sampling areas:
a. Stratify populations for sampling purposes;
b. Generate random numbers to facilitate sample selection;
c. Draw the sample, given computerized data bases.
1. b 5. c 9. d 13. a 17. d
2. a 6. b 10. a 14. a 18. b
3. c&d 7. b 11. a 15. c 19. c
4. b 8. d 12. c 16. d 20. d
Supporting Computations:
= 0.99 ;
Audited Value 47,520 490,000 x 0.99 = 485,100
3. c.
Book Value 48,000 490,000 – 485,100 = P4,900
= P4
d. P480
120
1,200 x P4 = P4,800
P 17,500 = 3.5%
7. P500,000
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 auditor’s opinion, alpha risk
is usually set equal to overall audit risk. Beta risk is set on the basis of the
auditor’s evaluation of inherent risk and control risk. The greater these risk
factors, as determined by the auditor during the audit planning stages, the
lower the beta risk set by the auditor. The lower the acceptable beta risk, the
larger the sample sizes for substantive testing purposes. Alpha and beta risk,
therefore, provide the necessary link between audit risk analysis and
substantive audit testing.
2. a. (1) Mean-per-unit estimates the total value of a population by (1) using the
sample mean as an estimate of the true population mean, and (2)
extending this estimated population mean by the number of items in the
population. The computations are as follows:
(2) Ratio estimation estimates total population value by (1) using the ratio
of the sample audited values to book values as an estimate of the ratio of
population audited value to book value, and (2) applying the estimated
ratio to the population book value. The computations are as follows:
(1) Estimated ratio of audited to book value =
(3) Difference estimation estimates total population values by (1) using the
average difference between the audited and book values of sample
items as an estimate of the average difference for all population items,
(2) extending the estimated average difference by the number of items
in the population, and (3) using the resulting estimate of the total
difference between audited and book value to compute the estimated
total value. The computations are as follows:
b. The sample contains an element of sampling error with respect to the average
peso value of production lots. The mean book value of the population is
P2,950 (P5,900,000 / 2,000 lots), while the mean book value in the sample
is P3,000 (P600,000 / 200 lots). Mean-per-unit estimation uses the mean
value of the sample as the basis for estimating total value. Thus, if the sample
contains a disproportionate number of higher (or lower) priced items, this
sampling error will affect the estimate of the total population value.
The estimate of total value developed in ratio estimation is based upon the
ratio of audited values to book values, rather than upon mean peso value. If
this ratio has no tendency to vary with the peso value of the lot, the estimate
of total value is not affected by the mean value of items in the sample.
However, sampling error may still be present if the sample lots are not
representative of the population with respect to the ratio of audited values
to book values.
3. The auditors would project the misstatement found in the sample to the population
using either the ratio or difference approach. The ratio approach would result in a
projected misstatement of P65,500. This may be computed by first calculating the
ratio of the audited to book value as 1.0131 [P23,100 / P22,800 (since there is a
net understatement of P300, the audited value is P23,100)] and estimating the
audited value of the population as:
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.
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:
= 69
P500,000 x 3
Sample size =
P25,000 – (P2,000 x 1.6)
Note: The reliability factor is from the zero misstatements row of the
PPS sampling table given in the case.
(2) The sampling interval is calculated simply by dividing the book value
of receivables by the sample size, as follows:
= P23,460
NOTES:
Projected misstatement
(a) Tainting percentages are calculated as the difference between book
and audited value divided by book value (e.g., (P50 – P47) / P50 =
6%).
(b) No tainting percentage is calculated for items in excess of the
sample interval and the actual misstatement is extended to
projected misstatement (as for the third error).
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.
= P300,000 / 60 = P5,000
c. Projected misstatement =
TESTS OF CONTROLS
Questions
1. Directly. Higher levels of control risk induce auditors to audit larger samples of
receivables, with confirmation date closer to the fiscal year end date. As for nature
of the procedures: higher levels of control risk induce auditors to use positive
confirmations instead of negative confirmations, and to consider vouching
subsequent payments by the customers.
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
19-2 Solutions Manual – Public Accountancy Profession
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.
8. If the credit limits are set and entered incorrectly, the credit approval process will
be systematically deficient.
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 vendor’s
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.
13. The point of this quotation is to generate discussion on the source of errors and
therefore the controls necessary when an accounting process is computerized.
Discussion items might include the following:
1. People have bad days and make mistakes; computers do not have bad days.
2. Murphy’s Law – If it is possible to make an error, someone will find a way
to do it.
3. People initiate the transactions and will make errors.
4. All controls should be considered together (manual and computer).
Excellent computer controls cannot be relied upon if the related manual
controls are weak.
5. In computer systems, it is extremely important to establish extensive input
validation controls to prevent people errors from getting into the processing
(GIGO – garbage in, garbage out).
6. People can prevent a good computer system from working well if they are
not convinced it is in their best interests.
7. People will rarely question computer printed output, even though it may not
be correct.
8. Most computer controls are to prevent, detect, or correct errors made by
people.
14. The purpose of the auditor’s search for unrecorded liabilities is to gather evidence
as to whether the liability assertion is true. The same concern exists in the internal
control objective “all valid transactions are recorded and none are omitted.” From
an evidence gathering perspective, it is much more difficult to gather evidence on
unrecorded transactions than to gather evidence that recorded transactions (and
account balances) are proper.
The search for unrecorded liabilities includes procedures in other audit areas
such as questions on bank and insurance confirmations and vouching the source
of funds for asset additions. Specific audit procedures in the search for
unrecorded liabilities include:
1. Obtain vendor’s invoices (or accounts payable vouchers) recorded for
several days after the balance sheet date to determine if the liability relates
to the balance sheet period under audit.
2. Scan cash disbursements for several days subsequent to year-end and vouch to
support to determine if cutoff was proper. Scan all cash disbursements until
the end of field work for unusual amounts and payees to determine if amounts
paid represent liabilities of the balance sheet period.
3. Examine BIR tax reports and correspondence and the audit reports of tax
authorities and trace additional tax assessments to the accounts.
4. Confirmation of accounts payable.
5. Use analytical procedures such as trend comparisons of accounts payable to
sales, sales taxes to sales, payroll taxes to gross payroll and interest expense
to average notes payable.
15. A “walk through” involves following a transaction from initiation through the
various steps until the transaction is recorded in the formal accounting records.
In the conversion cycle, the following would constitute a complete “walk
through:”
Step Documents Collected Controls Noted
Prepare production Production Order (P.O.) Support for P.O.
orders
Prepare bill of materials Bill of materials (B.M.) Separation planning
and manpower needs Manpower needs (M.N.) from production.
Assign job order and Note separation
foreman production supervisor
from foreman duties.
Job tickets and material Job tickets (JT) Production foreman
requisitions prepared Material requisition (MR) duties separated from
authorization.
Raw material records Issue slip (IS) Materials not issued
updated, issue slips without MR. IS
prepared prepared for all materials
released.
Observe time entered Approval by foreman of
and foreman approval on hours.
JT
Direct labor report Labor report (LR) Job tickets support L.R.
prepared
Observe timekeeping, Reconciliation hours per
compare job tickets to clock cards to hours per
clock cards J.T.
Material used report Material used report Issue slips and
prepared (MUR) requisitions support
MUR.
Observe matching issue Records from sources
slips and material used reconciled.
report
Observe matching job Records from separate
time tickets (or labor sources reconciled.
distribution) to labor
report
Enter costs in job cost Job cost sheets (JCS) Support for all entries in
sheets JCS.
Summary entry Summary entry form Job cost sheets support
prepared. summary entries.
Trace summary entry to Separation of duties; cost
General Ledger posting accounting and general
ledger.
Preparation of Report of units Independent report of
completion report completed (RUC) production completed.
Observe units compared Independent check of
to RUC, post finished RUC.
records
Products received report Products received report Independent records of
prepared (PRR) units put into finished
goods inventory.
Observe comparison Records from separate
RUC and PRR sources reconciled.
Job sheets closed out, Summary entry form Closed job sheets, RUC
summary entry prepared and PRR support
summary entries.
Trace summary entry to Separation of duties; cost
General Ledger posting accounting and general
ledger.
16. Weaknesses (lack of control where auditors believe one is necessary) are not
audited because auditors do not rely upon weaknesses to prevent, detect or
correct material errors. Auditors must consider the financial impact of
weaknesses on financial statements and plan substantive tests accordingly.
A control strength may be identified in interviews during the review phase (or in
preparing the flowcharts or questionnaires), but during test of controls auditing,
found to be nonexistent or operating ineffectively. For example, in the conversion
cycle the production management may state that foremen approve workers’ job
time tickets. However, when a sample of job time tickets are examined by auditors
for evidence of approval, none is found. Thus, a weakness is not found until the
control is tested. Therefore, control risk should not be assessed low until evidence
is gathered that the control is operating effectively.
17. The purpose of this review question is to foster discussion toward what
information an independent auditor needs to know. Items relevant to the
quotation might include:
1. Reference to the standard regarding “adequate technical training and
proficiency as an auditor.”
2. Reference to the standard regarding “due professional care.”
3. Obviously, the auditor must be knowledgeable about cost accounting to audit
a manufacturing company.
4. In a manufacturing company, the inventories most likely will be a major
asset which will require substantial audit work.
5. A proficient auditor must be knowledgeable in all phases of the business,
including production, marketing, finance as well as accounting data
processing.
18. The surprise observation enables the auditor to see how the distribution system
really works and increases his chances of detecting fraud. Such an observation
involves taking control of paychecks, then accompanying a client representative
as the distribution takes place. The auditor checks to see that each employee is
identified and that only one check is given to each individual. Unclaimed checks
are controlled and examined to detect any fictitious persons on the payroll.
19. A “walk through” of a personnel and payroll transaction would include discussions
with each person handling personnel and payroll records. The following illustrates
the steps and documents collected.
If the payroll is processed by computer, the clock cards and job time tickets
would be traced to batch control in the timekeeping and production departments,
to data preparation (keying to machine sensible form), to edit and validation
error reports and other computer output indicating control and finally to computer
prepared checks, labor distribution reports and summary general ledger entries.
1. c 5. a 9. d 13. b 17. d
2. c 6. c 10. b 14. a 18. d
3. b 7. c 11. a 15. c 19. c
4. c 8. b 12. a 16. d 20. b
Cases
2. The discussion could take several directions, including some or all of the
following:
1. Material Weakness. The facts seem to suggest “a condition in which specific
control features (few or none are described) or the degree of compliance with
them do not reduce to a relatively low level the risk that errors or irregularities
in amounts that could be material to the financial statements may occur and
not be detected within a timely period by employees in the normal course of
performing their assigned functions.” Castro has authority and influence over
too many interrelated activities. Nothing he does seems to be subject to
review or supervision. He even is able to exclude the internal auditor.
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.
Different people should: indicate the sales order source document (authorize),
prepare the computer program (authorize and record), operate the computer
(record), have custody of inventory and correct errors (reconciliation).
4. If the credit limits are set and entered incorrectly, the credit approval process will
be systematically deficient.
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5. Memorandum
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: Cash receipts are not promptly deposited. Cash should not be left undeposited
for a week.
Recommendation: Cash should be deposited at least once each day.
SUBSTANTIVE TESTS OF
TRANSACTIONS AND BALANCES
Questions
1. The cutoff bank statement is a bank statement sent by the bank directly to the
auditor, and it is usually for a fifteen or twenty day period following the
reconciliation date. The basic use of the statement by the auditor is to determine
whether outstanding checks were actually mailed before the reconciliation date.
2. All cash funds (and negotiable investment stock and bond certificates) should be
counted at the same time (simultaneously) so that money (or securities) cannot
be shifted from one location to another to conceal a shortage. If simultaneous
count cannot be made, as each fund (or each negotiable asset) is counted, it should
be locked and sealed until all are counted.
9. Auditors get in the most trouble by missing overstated assets and understated
liabilities. Therefore, they need to audit for the existence of assets and the
completeness of liabilities.
10. Notes payable audit evidence obtained from a standard bank confirmation used
in the audit cash. Sales tax liability derived partially from the audit of sales
revenue (also commissions payable and excise taxes payable). Income tax
liability is derived from the net income number (audit of all revenue and
expense accounts).
11. The types of fraud and material misstatement with respect to cash disbursements
include:
1. The sending of checks to a fictitious person or company to accomplices
outside (coupled with internal record alterations).
2. The increasing (altering) of amounts payable to outside accomplices.
3. The intercepting of payments to a bank (coupled with internal record
alterations).
4. The drawing of checks payable to cash or bearer for one’s own use.
12. The characteristics that the auditor is looking for in his review of the client’s
inventory-taking instructions include:
1. Names of client personnel responsible for the count.
2. Dates and times of inventory-taking.
3. Names of client personnel who will participate in the inventory-taking.
4. Detail instructions for recording accurate descriptions of inventory items,
for count and double-count, and for measuring or translating physical
quantities.
5. Detail instructions for making notes of obsolete or worn items.
6. Detail instructions for the use of tags, punched cards, count sheets, or other
media devices, and for their collection and control.
7. Plans for shutting down plant operations or for taking inventory after store
closing hours, and plans for having goods in proper places.
8. Plans for counting or controlling movement of goods in receiving and
shipping areas if those operations are not shut down during the count.
9. Detail instructions for compiling the count media (e.g., tags and punched
cards) into final inventory listings or summaries.
10. Detail instructions for pricing the inventory items.
11. Detail instructions for review and approval of the inventory count, notations
of obsolescence, or other matters by supervisory personnel.
13. As is true in other areas of a financial audit, verbal inquiry is a valuable tool for
obtaining preliminary evidence in the audit of inventory and cost of sales. For
example, the auditor can gain information such as the locations of inventory, dates
for the physical count, inventory held by consignees and public warehouses, the
cost-flow assumption used to price cost of goods sold and inventories, and the
pledging of inventory as collateral on loans.
15. The auditor can obtain preliminary evidence through physically observing plant
facilities and making verbal inquiries; for example, evidence can be obtained
regarding the quantity and size of assets, their location and apparent physical
condition, the activity surrounding them, and ownership of the facilities.
16. To obtain relevant audit data about investment securities, auditors’ procedures
include:
1. Inspecting the securities in the presence of a responsible client officer.
2. Personally examining the securities while other negotiable fund sources are
sealed off or are being examined simultaneously.
3. Obtaining a written statement from the client’s representative that the
securities were returned intact.
4. Obtaining the information by confirmation from an independent party (e.g.,
trustee) who holds the securities.
17. Investment cost can be vouched to brokers’ advices, monthly statements and
canceled checks. The auditors can similarly vouch the price of securities sold
and investment income to this documentary evidence and then trace amounts to
income, gain and loss, and cash accounts.
18. If investments are sold at substantial losses early in the period following year-
end, there is evidence that the securities were overvalued at the balance sheet
date. Accordingly, the auditor will consider whether such securities should be
written down in the financial statements of the period under audit.
19. The long-term liabilities (and fixed assets and owners’ equity) are characterized
by a few large transactions, unlike the current assets and liabilities which have
numerous small transactions. Except for the initial year of an audit, the entire
balance is not verified each year. Only the changes in the account that occurred in
the current period need to be audited. The results of the audit of prior year’s
changes are recorded in “carry-forward” working papers for these accounts.
22. The following matters are usually covered during the conference with the client
at audit completion:
a. Proposed audit adjustments;
b. Material internal financial control weaknesses;
c. Recommended footnote disclosures;
d. Type of audit report to be rendered.
1. b 5. c 9. b 13. c 17. d
2. b 6. c 10. c & d 14. d 18. a
3. d 7. c 11. b 15. d 19. a
4. d 8. b 12. b 16. c 20. c
Cases
1. a. The CPA’s test of the sales cutoff at June 30 should include the following
steps:
1. Determine what JETO’s cutoff policy is, review the policy for
reasonableness, and compare it to the prior year for consistency.
2. Select a sample of sales invoices (including the last serial invoice
number) from those recorded in the last few days of June and the first
few days of July.
3. Trace these sales invoices to shipping documents and determine that sales
have been recorded in the proper period in accordance with company
cutoff policy.
4. Determine that the cost of goods sold has been recorded in the period of
sale.
5. Select a sample of shipping documents for the same period and trace
these to the sales invoice. Determine that the sale and the cost of goods
sold have been recorded in the proper period.
6. Review the cutoff for sales returns and allowances, determine that it
has been based upon a consistent policy and that there have not been
abnormal sales returns and allowances in July; this might indicate
either an overstatement of sales during the audit period or the need for a
valuation account at June 30 to provide for future returns and
allowances.
b. (1) The CPA will use the July 10 cutoff bank statement in his review of the
June 30 bank reconciliation to determine whether:
(a) The opening balance on the cutoff bank statement agrees with the
“balance per bank” on the June 30 reconciliation.
(b) The June 30 bank reconciliation includes those canceled checks
that were returned with the cutoff bank statement and are dated or
bear bank endorsements prior to July 1.
(c) Deposits in transit cleared within a reasonable time.
(d) Interbank transfers have been considered properly in determining
the June 30 adjusted bank balance.
(e) Other reconciling items which had not cleared the bank at June 30
(such as bank errors) clear during the cutoff period.
3. a. Valid liabilities are recorded and none omitted (sound error checking
practices).
b. Observe client personnel making comparisons. Review correcting
journal entries that result from the comparison.
c. Purchases or other liabilities may fail to be recorded and the error not
detected by any other means.
4. a. The fact that the client made a journal entry to record vendors’ invoices which
were received late should simplify the CPA’s audit for unrecorded liabilities
and reduce the possibility of a need for a further adjustment, but the CPA’s
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
client’s 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.
d. In addition to the 2005 voucher register, the CPA should consider the
following sources for possible unrecorded liabilities:
1. Unentered vendors’ invoice file.
2. Status of tax returns for prior years still open.
3. Discussions with employees.
4. Representations from management.
5. Comparison of account balances with preceding year.
6. Examination of individual accounts during the year.
7. Existing contracts and agreements.
8. Minutes.
9. Attorney’s bills and letter of representation.
10. Status of renegotiable business.
11. Correspondence with principal suppliers.
12. Audit testing of cutoff date for reciprocal accounts, e.g., inventory and
fixed assets.
AUDIT DOCUMENTATION
Questions
7. Client personnel may prepare working papers to reduce the time spent by the
auditor on the engagement. When client personnel prepare working papers, the
auditor should give the client personnel detailed instructions. Working papers
prepared by the client should be identified as PBC (prepared by client) and
should involve no decision making. The auditor should test completed working
papers against underlying documentation.
8. The lead schedule, especially on larger engagements, is designed to bridge the gap
between the working trial balance and the general ledger by listing all general
ledger accounts that are reported as one account in the financial statements.
Supporting schedules is a term for working papers that support the amounts
presented in the financial statements by providing support for a detailed account
on a lead schedule. Supporting schedules represent the bulk of working papers.
21-2 Solutions Manual – Public Accountancy Profession
9. In general, a properly prepared working paper should meet firm policy, have a
proper heading, clearly indicate the work performed, clearly meet the audit
objective for which it was designed, and clearly state the auditors’ conclusion.
10. The prior year’s 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 year’s working papers, the assistant
can see how the procedures were documented and is given a possible format for
organizing the current year’s working paper. In addition, exceptions noted in last
year’s working papers may alert the assistant to possible problems in the current
year. Finally, the prior year’s 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.
(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 client’s employees without specific
permission from the client.
1. d 9. b 17. d 25. b
2. d 10. b 18. c 26. d
3. c 11. a 19. c 27. d
4. a 12. d 20. d 28. c
5. d 13. d 21. b 29. d
6. c 14. b 22. d 30. c
7. c 15. d 23. a 31. d
8. d 16. d 24. b 32. d
Cases
1. a. (1) The functions of audit working papers are to aid the CPA in the
conduct of his work and to provide support for his opinion and his
compliance with auditing standards.
(2) Working papers are the CPA’s records of the procedures performed, and
conclusions reached in the audit.
b. The factors that affect the CPA’s judgment of the type and content of the
working papers for a particular engagement include:
1. The nature of the auditor’s report.
2. The nature of the client’s business.
3. The nature of the financial statements, schedules or other information
upon which the CPA is reporting and the materiality of the items included
therein.
4. The nature and condition of the client’s records and internal controls.
5. The needs for supervision and review of work performed by assistants.
d. The CPA should perform an adequate examination at minimum cost and effort
and the preceding year’s programs will aid in doing this. The preceding
year’s audit programs ordinarily contain information useful in the current
examination (such as descriptions of the unique features of a client’s
operations or records, a formalized sequence of audit steps in logical order,
and approximate time requirements to perform various phases of the work).
The auditor should decide whether to use the old program or prepare a new
one.
2. In general, the working paper is not set up in a logical manner to show what the
auditor wants to accomplish. The primary objective of the working paper is to
verify the ending balance in notes receivable and interest receivable. A
secondary objective is to account for all interest income, cash received and cash
disbursed for new notes, collateral as security, and other information about the
notes for disclosure purposes.
Specific deficiencies of the working paper presented in the question are:
a.
b.
DEFICIENCY
IMPROVEMENT
1. Tick mark explanation “tested” Should have separate tick marks
does not indicate specifically
meaning:
what was done. ▪ Agreed to confirmation
▪ Footed
▪ Traced to cash receipts journal
▪ Recomputed, etc.
2. Explanation of some tick marks is Explain all tick marks on the same
not given.
page of the working paper.
3. Classification of long-term
Recompute portions of notes which are
portion indicates no verification. long-term.
4. Paid-to-date row is confusing. Column should say “date paid to” and
this should be confirmed.
5. Due dates are missing for C.C. Include due dates on working paper
Co., P. Pablo and Tetra Co. for these notes.
c. SPREADSHEET SOLUTION
The purpose of using an Excel spreadsheet in this problem is to give the
student some experience in preparing a simple working paper using an
Excel spreadsheet. It should be explained to students that this type of
working paper may or may not be prepared in actual practice, and that often
templates are used to prepare more time-consuming working papers. Also,
whether or not tick marks are computerized is a matter to be decided. The
advantage is that the completed audit work can then be stored and reviewed
electronically, a direction many firms are going. On the other hand, it may be
more efficient to indicate audit work manually as it is performed, and a
contrast in the color of the tick marks through use of a colored pencil may
be desirable.
f f f f, cf f f f f, cf
tp wtb tb op wtb
Questions
6. Audit matters that should be communicated by the auditor to those charged with
governance are:
• Accounting policies
• Prior period communications
• Risks of material misstatement
• Material uncertainties
• Concerns
• Significant difficulties encountered
• Comments on entity management
• Audit adjustments
• Uncorrected misstatements
• The auditor’s report
• Agreed-upon matters
• Other matters
COMPLETING THE AUDIT AND
POST-AUDIT RESPONSIBILITIES
Questions
1. Many of the revenue and expense accounts are not material in relation to the
financial statements and may be combined with other accounts in the financial
statements. These accounts can be audited through analytical procedures. Such
procedures compare the account balance to related statement of financial
position accounts, to sales, to industry averages or to a multiple-year trend to
ascertain whether any unusual fluctuations are present. Unusual or unexpected
items would have to be investigated and material items vouched to supporting
documents.
3. In addition to the attorney’s letter, other procedures that are used to gather
evidence regarding contingencies include:
• Standard bank confirmation.
• Inquiry of client management.
• Reading of the minutes of the board of directors.
• Vouching to purchase and sales contracts.
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11. “Subsequent events” are material events that occur after the statement of
financial position date but before the end of field work (and thus, before the audit
report date) that require disclosure in the financial statements and related notes.
Auditors (and management) are responsible for gathering evidence on these
subsequent events and evaluating the proposed disclosure.
12. The actions the partner should take if the client consents to disclose the
information (which existed at the audit report date and materially impacts the
financial statements) is to determine the method and timing of disclosure.
The actions the partner should take if the client refuses to make disclosure are:
• Notify the client that the auditors’ report must no longer be associated with
the financial statements.
• Notify regulatory authorities that the auditors’ report should no longer be
relied upon.
• Notify users known to be relying on the financial statements that the auditors’
report should no longer be relied upon. Such notification may be to the SEC
and the stock exchanges.
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13. Once auditors have reported on audited financial statements, they have no
responsibility to carry out a retroactive review of their work. However, post-
issuance review may be made in connection with a firm’s internal quality
control monitoring program, peer review or otherwise, and the omission of an
auditing procedure may be discovered.
If an omitted procedure is found, the auditors should consult legal counsel and
take the following actions:
• Assess the importance of the omitted procedure to the present ability to
support the previously expressed opinion.
• Determine if there are persons currently relying or likely to rely on their
report.
• If the omitted procedure impairs present ability to support the previously
expressed opinion, the omitted procedure should be applied or alternative
procedures applied that would provide a satisfactory basis for the opinion.
• If, as a result of subsequent application of the omitted procedure or
alternative procedures, the auditors become aware of facts that existed at the
date of their report, they should refer to page 927 (Subsequent Discovery of
Facts Existing at the Date of the Auditor’s Report) for guidance.
14. In a “cold review,” a partner not otherwise associated with an engagement will
take the report (in draft copy) and all working papers and review the entire
engagement with a fresh start. The purpose of the review is to obtain the unbiased
view of a professional expert who is not committed to a particular engagement or
its problems. It is performed to aid in maintaining high standards of professional
practice.
15. A management letter is an extra audit service. Auditors write to the management
their recommendations about control, tax matters, operating efficiencies, and other
consulting subjects to impress on managers the benefits of audits in addition to
“just an audit.” The letter also serves to promote and sell CPAs’ consulting
services.
16. A good management letter can show the client some profit potential, and the CPA
may be hired to do the consulting work.
17. When the auditor learns of information existing at the date of a previously
issued audit report, that it, if known, would have altered the audit opinion, the
following steps are in order:
a. Determine whether the information is reliable and whether the facts existed at
the date of the audit report;
b. Request the client to make necessary disclosure to persons known to be
relying on the statements;
c. If the client refuses, the auditor has a duty to notify those known to be
relying on the audit report that such reliance is no longer justified (notifying
board of directors, SEC, and stock exchange usually satisfies this
requirement).
18. An auditor should investigate the new information as soon as practicable. When
an auditor determines that the information is reliable, that the facts existed at the
date of the report, and that the nature of the information and its effect on the
financial statements are such that the report would have been affected, the
auditor should consider whether persons are relying on the report. If the auditor
must take steps to prevent future reliance on the report, the preferred resolution
is for the client to issue revised financial statements and the auditor to issue a
revised report, unless the issuance of statements for a subsequent period is
imminent. When the effect on the financial statements of the subsequently
discovered information cannot be determined without a prolonged investigation,
the client should notify persons who are known to be relying on or who are
likely to rely on the financial statements and the related report. The client’s
notification should state that (1) the statements should not be relied on and (2)
revised financial statements and auditor’s report will be reissued on completion
of an investigation. If applicable, the client should discuss the matter with the
Securities and Exchange Commission, stock exchanges, and appropriate regulatory
agencies.
19. If the client refuses to disclose the newly discovered facts, the auditor should
consult with his or her attorney and notify each member of the board of directors
of such refusal and of the fact that, in the absence of such disclosure, the auditor
will take steps to prevent future reliance on the audit report. These steps may
include
• notifying the client that the audit report must no longer be associated with
the financial statements.
• notifying the appropriate regulatory agencies that the audit report
should no longer be relied on.
• notifying each person known to the auditor to be relying on the
financial statements that the audit report should no longer be relied on.
If such notification is impracticable, the auditor may request a
regulatory agency having jurisdiction over the client to take whatever
steps it deems appropriate.
1. c 12. b 23. a
2. b 13. c 24. c
3. a 14. a 25. a
4. c 15. b 26. a
5. d 16. b 27. b
6. b 17. b 28. a
7. d 18. c 29. a
8. d 19. a 30. c
9. d 20. b 31. d
10. c 21. d 32. c
11. d 22. a 33. a
Cases
(3) Preferably, the engagement letter should be sent at the beginning of the
engagement so that misunderstandings, if any, can be remedied.
(4) Obviously, the engagement letter will be most useful in clarifying
misunderstanding on a first engagement. But it is desirable that the letter
be renewed periodically. Client personnel or the nature of the engagement
may change, and the resubmission of the letter gives both parties an
opportunity to review the circumstances. Accordingly, for recurring
examinations of financial statements, it is appropriate to prepare an
engagement letter at the start of each examination. For other continuing
engagements, the engagement letter also should be updated periodically –
probably on a yearly basis.
(2) The client’s representation letter should be prepared by the auditors (to
ensure all items are included) and signed by members of management
whom the auditors believe are responsible for and knowledgeable about
matters covered by the representations. Normally, the chief executive
officer and chief financial officer should sign.
(3) The client’s representation letter should be obtained at the end of the
audit work and should be dated as of the date of the auditors’ report (the
date of the end of field work).
(2) The CPAs are not required to obtain a client’s representation letter when
performing engagements involving unaudited financial statements.
However, the CPAs may wish to obtain such a letter.
2. a. A subsequent event is an event or transaction that occurs subsequent to the
statement of financial position date but prior to the issuance of the financial
statements and auditor’s report that has a material effect on the financial
statements and therefore requires adjustment or disclosure in the financial
statements.
Some of these latter events, however, may be such that disclosure of them is
required to keep the financial statements from being misleading.
Occasionally such an event may be so significant that disclosure can best be
made by supplementing the historical financial statements with pro forma
financial data giving effect to the event as if it had occurred on the statement
of financial position date.
4. Other matters that J. Cee’s representation letter should specifically confirm include
whether or not –
a. Management acknowledges responsibility for the fair presentation in the
financial statements of financial position, results of operations, and cash
flows in conformity with financial reporting standards (or other
comprehensive basis of accounting).
b. All material transactions have been properly reflected in the financial
statements.
c. There are other material liabilities or gain or loss contingencies that are
required to be accrued or disclosed.
d. The company has satisfactory title to all owned assets, and whether there are
liens or encumbrances on such assets or any pledging of assets.
e. There are related party transactions or related amounts receivable or payable
that have not been properly disclosed in the financial statements.
f. The company has complied with all aspects of contractual agreements that
would have a material effect on the financial statements in the event of
noncompliance.
g. Events have occurred subsequent to the statement of financial position date
that would require adjustment to or disclosure in, the financial statements.
h. The accountant has been advised of all actions taken at meetings of
stockholders, board of directors, and committees of the board of directors
(or other similar bodies) that may affect the financial statements.
i. Management is aware of irregularities that could have a material effect on
the financial statements or that involve management or employees who
have significant roles in the system of internal control.
j. All financial records and data were made available.
k. Provision, when material, has been made to reduce excess or obsolete
inventories to their estimated net realizable value.
l. Provision has been made for any material loss to be sustained in the
fulfillment of, or from inability to fulfill, any sales commitments.
m. Provision has been made for any material loss to be sustained as a result of
purchase commitments for inventory quantities in excess of normal
requirements or at prices in excess of the prevailing market prices.
A Type I subsequent event (like the one described above) provides further
evidence of conditions that existed at the statement of financial position date,
and, if the related amounts are material, may require adjustment of the financial
statements. Type II subsequent events provide evidence of conditions which did
not exist at the statement of financial position date, and, therefore, do not require
adjustment, but may require footnote disclosure, if considered material.
6. (1) If an omitted procedure is found, the auditors should consult legal counsel
and take the following actions:
• Assess the importance of the omitted procedure to the present
ability to support the previously expressed opinion.
• Determine if there are persons currently relying or likely to rely on
their report.
• If the omitted procedure impairs present ability to support the
previously expressed opinion, the omitted procedure should be
applied or alternative procedures applied that would provide a
satisfactory basis for the opinion.
• If as a result of subsequent application of the omitted procedure or
alternative procedures, the auditors become aware of facts that
existed at the date of their report, they should refer to page 927
(Subsequent Discovery of Facts Existing at the Date of the
Auditor’s Report) for guidance.
(2) If after reevaluating the scope of the examination and reviewing the
completed audit workpapers, procedures were found that tend to
compensate for the omitted procedure, the omitted procedure would not
have to be performed. The auditors should document their decision and
their support for this decision.
4. c. The audit engagement letter documents the contract between the client and
the auditor. This documentation also includes the basis of fees for services to
be provided.
5. c. The audit engagement letter documents the contract between the client
and the auditor. The letter should indicate the objective of the engagement.
6. d. Management’s assertions, as documented in the management
representation letter, often deny the existence of any irregularities, such as
those caused by employees, that may cause the financial statements to be
materially misstated.
7. b. The successor auditor should make specific and reasonable inquiries of
the predecessor auditor regarding matters that the successor believes will
assist him or her in determining whether to accept the engagement. The
inquiries should include specific questions regarding, among other things,
facts that might bear on the integrity of management.
8. a. The partner’s engagement review program is designed to confirm that
the audit was conducted in accordance with PSA. This review program is
also designed to identify any problems that may have arisen during the
audit, such as differences of opinion between an auditor and a specialist or
other consultant.
Questions
1. The entire audit process culminates in the preparation of the auditor’s report. The
auditor’s report is the primary product of the audit. The auditor should review
and assess the conclusions drawn from the audit evidence obtained as the basis for
the expression of an opinion on the financial statements. This review and
assessment involves considering whether the financial statements have been
prepared in accordance with an acceptable financial reporting framework. It may
also be necessary to consider whether the financial statements comply with
statutory requirements. The auditor’s report should contain a clear written
expression of opinion on the financial statements taken as a whole.
2. In order to form that opinion, the auditor shall conclude as to whether the
auditor has obtained reasonable assurance about whether the financial
statements as a whole are free from material misstatement, whether due to fraud
or error. That conclusion shall take into account:
(a) The auditor’s conclusion, in accordance with PSA 330 (Clarified),
whether sufficient appropriate audit evidence has been obtained;
(b) The auditor’s conclusion, in accordance with PSA 450 (Clarified),
whether uncorrected misstatements are material, individually or in
aggregate; and
(c) The evaluations required by paragraphs 12 to 15.
3. The auditor shall evaluate whether the financial statements are prepared, in all
material respects, in accordance with the requirements of the applicable
financial reporting framework. This evaluation shall include consideration of the
qualitative aspects of the entity’s accounting practices, including indicators of
possible bias in management’s judgments.
The auditor shall evaluate whether the financial statements adequately refer to or
describe the applicable financial reporting framework.
6. The auditor shall express an unmodified opinion when the auditor concludes that
the financial statements are prepared, in all material respects, in accordance with
the applicable financial reporting framework.
7. If the auditor:
(a) concludes that, based on the audit evidence obtained, the financial
statements as a whole are not free from material misstatement; or
(b) is unable to obtain sufficient appropriate audit evidence to conclude
that the financial statements as a whole are free from material
misstatement.
The auditor shall modify the opinion in the auditor’s report in accordance with
PSA 705 (Clarified).
11. The auditor’s report shall include a section with the heading “Auditor’s
Responsibility.”
The auditor’s report shall state that the responsibility of the auditor is to express
an opinion on the financial statements based on the audit.
The auditor’s report shall state that the audit was conducted in accordance with
PSAs. The auditor’s report shall also explain that those standards require that the
auditor comply with ethical requirements and that the auditor plan and perform
the audit to obtain reasonable assurance about whether the financial statements
are free from material misstatement.
12. The auditor’s report shall be dated no earlier than the date on which the auditor has
obtained sufficient appropriate audit evidence on which to base the auditor’s
opinion on the financial statements, including evidence that:
(a) All the statements that comprise the financial statements, including the
related notes, have been prepared; and
(b) Those with the recognized authority have asserted that they have taken
responsibility for those financial statements.
Multiple Choice Questions
1. B 6. C
2. A 7. B
3. D 8. D
4. D 9. B
5. C
Cases
1. You must determine whether an unqualified opinion satisfies the PSA reporting
standard, in particular:
a. Determine whether the financial statements are presented in conformity
with PFRS.
1. Read the footnote description of accounting policies.
2. Use a PFRS checklist.
3. Review the working papers for any indication of accounting policies
not described in the footnote or ones apparently not in conformity with
PFRS.
4. Determine if:
(i) The accounting principles are generally acceptable, having
authoritative support.
(ii) The accounting principles are appropriate in the circumstances.
(iii) The financial statements are informative.
(iv) The information is reasonably summarized.
(v) Material adjustments have not been waived without good reasons.
b. Determine whether any accounting changes have been made and whether
accounting principles have been applied consistently.
c. Determine whether the footnote disclosures are adequate to inform users of
any material information evident in the working papers.
2. 1. Title. The report needs a title referring to Rose as the independent auditor or
independent accountant.
2. Notice of audit. The report does not give the proper declaration of an audit of
the financial statements, especially the part about “in accordance with your
instructions,” which suggest that Rose surrendered some audit independence.
The reference to a “complete audit” is ill advised because it
suggests a 100% investigation, which is contradicted by the sentence about
“tests of the sales records.”
3. Responsibilities. The report says nothing about the auditor’s responsibility
for the audit report.
4. Opinion. The opinion sentence should not be modified with the phrase “with
the explanation given above.”
5. Opinion. The opinion sentence should not mention “minor errors we
consider immaterial,” but it should contain the phrase “presents fairly in all
material respects.”
6. Opinion/Identification of Financial Statements. The opinion should not
include reference to cash flows because the introductory paragraph did not
state that the cash flow statement was audited. This may be a deficiency in
the identification of the financial statements that were actually audited.
7. Opinion. The opinion paragraph refers improperly to ASC pronouncements.
It should refer to “generally accepted accounting principles.”
8. Date. The date accompanying Rose’s signature should be September 23 – the
day the field work was completed – not the company’s fiscal year-end date.
9. Other. The commentary on the economy and the strike are not generally
appropriate for an audit report. Even if the auditor wanted to draw attention
to these matters, their relevance for understanding the financial statements and
their manner of expression are both questionable.
10. Other. The negative assurance (concerning the recording of sales) is not
permitted in audit reports.
CHAPTER 25
MODIFICATIONS TO THE
INDEPENDENT AUDITOR’S REPORT
Questions
2. Students may identify more than one description of the “most important”
distinction between an opinion and a disclaimer. All the following are valid,
although (a) is intended to be the “Most Important:”
a. An opinion (unqualified, qualified or adverse) is an explicit statement of the
auditor’s conclusion(s), while a disclaimer is an (empty) assertion of “no
conclusion.”
b. An (unqualified) opinion is the highest level of assurance, while a
disclaimer is the lowest level (no assurance).
c. An opinion requires evidence as a basis, while a disclaimer results from lack
of evidence.
d. Auditors must be independent to give an opinion, while a disclaimer can
result from a CPA’s lack of independence.
3. A material scope restriction occurs when the auditor is unable to gather sufficient
competent evidence to support an unqualified opinion on the financial statements.
Scope restrictions may be client-imposed or they may result from other
circumstances, e.g., appointment of the auditor after the client’s physical inventory
has been taken. A material scope restriction need not result in a modification of the
auditor’s opinion provided the auditor can obtain satisfaction by alternate means.
25-2 Solutions Manual – Public Accountancy Profession
4. The principal auditor’s reference in his report to another auditor is not a
qualification in scope. The reference only shows the divided responsibility for
the audit work.
7. The audit opinion does not extend to the other information, and therefore, the
opinion is not affected by omission or inconsistency or incorrect supplemental
information.
1. C 11. D 21. C
2. D 12. C 22. D
3. C 13. A 23. D
4. D 14. A 24. A
5. A 15. C 25. D
6. B 16. C 26. B
7. C 17. B
8. C 18. B
9. C 19. C
10. A 20. B
Modifications to the Independent Auditor’s Report 25-3
Cases
1.
Independent Auditor’s Report
To the shareholders and board of directors of Various Fabrics, Inc.:
We have audited the accompanying statement of financial positions of Various Fabrics,
Inc. as of January 31, 2013 and 2012 and the related statements of income, retained
earnings, and cash flows for the years then ended. These financial statements are the
responsibility of the company’s management. Our responsibility is to express an opinion
on these financial statements based on our audits.
We conducted our audits in accordance with auditing standards. Those standards
require that we plan and perform the audit to obtain reasonable assurance about whether
the financial statements are free of material misstatement. An audit includes examining,
on a test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis for our
opinion.
In our opinion, the financial statements referred to above present fairly, in all material
respects, the financial position of Various Fabrics, Inc. as of January 31, 2013 and 2012
and the results of its operations and its cash flows for the years then ended in conformity
with generally accepted accounting principles.
2. 1. F, L 5. B, I
2. B, I 6. B, I
3. B, Q 7. E, J
4. A, J
3. A. 1, 7c.
B. 2, 7a.
C. 4.
D. 1.
E. 6.
F. 5.
G. 2 (Note: The change in principle should be described in the descriptive
paragraph following the scope paragraph.)
H. 3, 7c.
25-4 Solutions Manual – Public Accountancy Profession
I. 2, 7b.
J. 3, 7d.
K. 6. (given the materiality of property, plant, and equipment)
L. 1, 7e.
M. 1, 7b and 7e.
THE COMPUTER ENVIRONMENT
Questions
2. In a real-time system, much of the data are stored internally and documentation
is often not as extensive as in a batch system. Retrieval and audit of transaction
data, therefore, are often more difficult in a real-time system. Also, controls are
more likely to be programmed in real-time systems, and for this reason, are
more difficult to test.
4. In a batch system, files are stored off-line for the most part, and access control
assumes the form of safeguarding the programs, transaction files, and master
files by assigning responsibility for the files to a librarian and instituting a
formal checkout system. Only those persons authorized to process transactions
(computer operators) are permitted access to transaction and master files; and
programmers are permitted access to programs only for testing and “debugging”
purposes. In an on-line, real-time system, transactions and master files are
stored internally, often in a system of integrated data bases. Access control in
this type of data environment assumes the form of controlling access to data
bases and fixing of responsibility for the data base components. Assigning a
password to an individual who is responsible for the data base component
accessible by that password, canceling passwords of former employees, and
frequent changing of existing employees’ passwords are examples of access
controls in a real-time system.
26-2 Solutions Manual – Public Accountancy Profession
5. Recording forms and transaction logs assure consistency and completeness of data
inputs. The form or log should include codes describing such transaction
components as employee number, customer number, vendor number,
department number, stock number, purchased part number, or job number. The
form should also provide for quantities, prices, dates, and usually a short
narrative description of products, parts, materials, or services for purchase and
sales transactions.
6. A transaction file is the batch of entered data that has been converted into
machine-readable form. A transaction file may contain payroll information for a
specific period of time. It is similar to a journal in a manually prepared system. A
master file contains updated information through a particular time period. It is
similar to a ledger in a manual system.
1. d 5. c 9. c 13. c 17. c
2. c 6. c 10. c 14. d 18. a
3. a 7. c 11. d 15. a 19. b
4. a 8. b 12. c 16. a 20. a
Cases
An auditor should have the following concerns about the Box system:
• Does the system have any flaws or incompatibilities? (No one appears to
have tested the software or found out about others’ satisfaction with it.)
• The computer sits out in the open. (Anyone could have access to and damage
the hardware.)
• Anyone could come up with the password by guessing.
• The backup disks are not stored in a safe place.
• Was the conversion appropriately executed, with no data lost or added?
INTERNAL CONTROL IN THE
COMPUTER INFORMATION SYSTEM
Questions
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.
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.
9. Five things a person must have access to in order to facilitate computer fraud
are:
a. The computer itself.
b. Data files.
c. Computer programs.
d. System information (documentation).
e. Time and opportunity to convert assets to personal use.
10. Because many companies that operate in a network environment decentralize their
network servers across the organization, there is an increased risk for a lack of
security and lack of overall management of the network operations. The
decentralization may lead to a lack of standardized equipment and procedures.
27-4 Solutions Manual – Public Accountancy Profession
In many instances responsibility for purchasing equipment and software,
maintenance, administration, and physical security, often resides with key user
groups rather than with features, including segregation of duties, typically
available in traditionally centralized environments because of the ready access to
software and data by multiple users.
Cases
Are control totals established by the user prior to submitting data for
processing?
POSSIBLE ERRORS OR IRREGULARITIES – sales transactions may be lost in data
conversion or processing, or errors made in data conversion or processing.
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
auditor’s lack of understanding of the internal control, including the EDP
applications.
CHAPTER 28
Questions
3. The “audit trail” is the source documents, journal postings and ledger account
postings maintained by a client in order to keep books. These are a “trail” of the
bookkeeping (transaction data processing) that the auditor can follow forward
with a tracing procedure or back ward with a vouching procedure.
In a manual system this “trail” is usually visible to the eye with posting
references in the journal and ledger and hard-copy documents in files. But in a
computer system, the posting references may not exist, and the “records must be
read using the computer rather than the naked eye.” Most systems still have hard-
copy papers for basic documentation, but in some advanced systems even these
might be absent.
4. The audit trail (sometimes called “management trail” as it is used more in daily
operations than by auditors) is composed of all manual and computer records
that allow one to follow the sequence of processing on (or because of) a
transaction.
The audit trail in advanced systems may not be in a human-readable form and
may exist for only a fraction of a second.
The first control implication is that concern for an audit trail needs to be
recognized at the time a system is designed. Techniques such as integrated test
facility, audit files and extended records must be specified to the systems designer.
The second control implication is that if the audit trail exists only momentarily in
the form of transaction logs or master records before destructive update, the
external auditor must review and evaluate the transaction flow at various times
throughout the processing period. Alternatively, the external auditor can rely
more extensively on the internal auditor to monitor the audit trail.
5. Major characteristics:
1. Staff and location of the computer – operated by small staff located within
the user department and without physical security.
2. Programs – supplied by computer manufacturers or software houses.
3. Processing mode – interactive data entry by users with most of the master file
accessible for inquiry and direct update.
Control Problems:
1. Lack of segregation of duties.
2. Lack of controls on the operating system and application programs.
3. Unlimited access to data files and programs.
4. No record of usage.
5. No backup of essential files.
6. No audit trail of processing.
7. No authorization or record of program changes.
6. Auditing through the computer refers to making use of the computer itself to test
the operative effectiveness of application controls in the program actually used
to process accounting data. Thus the term refers only to the proper study and
evaluation of internal control. Auditing with the computer refers both to the
study of internal control (the same as “auditing through”) and to the use of the
computer to perform audit tasks.
7. Both are audit procedures that use the computer to test controls that are included
in a computer program. The basic difference is that the test data procedure utilizes
the client’s 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 auditor’s
predetermined results to determine whether the controls work as described. In the
parallel simulation procedures the results from the auditor program are compared
to the results from the client program to determine whether the controls work as
described.
8. The test data technique utilizes simulated transactions created by the auditor,
processed by actual programs but at a time completely separate from the
processing of actual, live transactions. The integrated test facility technique is
an extension of the test data technique, but the simulated transactions are
intermingled with the real transactions and run on the actual programs
processing actual data.
14. With either data base or spreadsheet software packages, macros (sets of
instructions) can be developed for retrieving data from the working trial balance
and converting this data into classified financial statements. If one or more
subsidiaries are to be included, the consolidated process can also be automated by
the inclusion of special modules designed for that purpose. The standard audit
report, as well as recurring footnotes, can be included in the data base, and
modified to fit the circumstances of the current year’s audit results.
15. Relational data base packages have all the advantages of spreadsheets, and, in
addition, have the capacity to store and handle larger quantities of data. They are
especially useful in manipulating large data bases, such as customer accounts
receivable, plant assets, and inventories.
1. a 5. d 9. b 13. c 17. b
2. c 6. d 10. d 14. a 18. c
3. c 7. c 11. b 15. d 19. d
4. d 8. b 12. b 16. b
Cases
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.
c. (1) “Test data” is usually a set of data in the form of punched cards or
magnetic tape representing a full range of simulated transactions, some
of which may be erroneous, to test the effectiveness of the programmed
controls and to ascertain how transactions would be handled (accepted
or rejected) and if accepted, the effect they would have on the
accumulated accounting data.
(2) The auditor may use test data to gain a better understanding of what the
data processing system does, and to check its conformity to desired
objectives. Test data may be used to test the accuracy of programming by
comparing computer results with results predetermined manually. Test
data may also be used to determine whether errors can occur without
observation and thus test the system’s ability to detect noncompliance
with prescribed procedures and methods.
The CPA may also request, on a surprise basis, that the program be left in the
computer at the completion of processing data so that he can use the program
to process his test data. This procedure may reveal computer operation
intervention. If, so, ensures that a current version of the program is being
audited, an important procedure in computer installations newly installed and
undergoing many program changes. To gain further assurance about this
matter, the CPA should inquire into the client’s procedures and controls for
making program changes and erasing superseded program tapes, and should
examine log tapes where available.
2. a. Document retention
IMPACT ON THE INTERNAL CONTROL SYSTEM: In on-line real time
systems and EDI systems, the audit trail is frequently modified in the form
of reduced documentation. To compensate, internal controls should provide
for adequate input editing, as well as some form of transaction log as
documentation at the input stage.
IMPACT ON THE INDEPENDENT AUDIT: In examining internal control,
under these circumstances, the auditor must rely more on observation,
inquiry, and reprocessing of transactions for control testing purposes, and less
on document testing. If documents are retained for only a short period, the
auditor should also consider the feasibility of frequent visits for both
substantive and control testing purposes.
b. Uniformity of processing
IMPACT ON THE INTERNAL CONTROL SYSTEM: The impact of this
internal control characteristic is to generally strengthen control by
increasing the consistency of processing. Once the proper controls are
installed and tested, processing consistency increases the accuracy of
transaction processing over that which exists in manual systems.
IMPACT ON THE INDEPENDENT AUDIT: The auditor must emphasize
control study and testing at the point of transaction input and processing to
determine that the necessary controls exist and are functioning. Upon
determining that the necessary input and processing controls are in place
and functioning properly, the auditor may elect to perform little or no
document testing.
c. Concentration of functions
IMPACT ON THE INTERNAL CONTROL SYSTEM: In manual systems,
separation of functional responsibilities provides a double-check for the
purpose of enhancing processing accuracy. In EDP accounting systems,
consistency of processing removes the need for double-check.
IMPACT ON THE INDEPENDENT AUDIT: The auditor must determine that
the necessary input editing controls are in place and functioning to ensure
that transactions are accurately introduced into the processing stream.
Moreover, to ensure checks and balances within the electronic data processing
function, the auditor should study the organizational structure of the EDP
group to ascertain proper separation among the following functions:
Systems analysis and design
Program design, development, and testing
Computer operations involving data processing
Distribution of EDP output and reprocessing of errors
In batch systems, access to magnetic tape and disk files and programs
should be secured by assigning responsibility over these files to one or more
individuals designated as “librarians,” and instituting a formal “checkout”
system for releasing and reacquiring files and programs.
IMPACT ON THE INDEPENDENT AUDIT: The auditor should determine
that proper control over I.D. codes and passwords exists, that codes and
passwords are changed frequently and voided upon termination of
employment, and that responsibility for elements of data bases has been
appropriately fixed.
In batch systems, the auditors should determine that tape and disk files and
programs stored off-line are properly secured.
3. a. Test data approach: The auditor prepares simulated input data (both valid
and invalid transactions) that are processed, under the auditor’s control, by
the client’s processing system.
ITF approach: The auditor creates a fictitious entity within the client’s
actual data files, and processes simulated data during live processing by
client. The auditor then compares the results of processing with anticipated
results.
Advantage: The use of actual data eliminates the need for removing data from
the client’s 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
client’s programs, and compares them with auditor’s copy of authorized
versions.
In auditing through the computer, the auditor actually tests the programmed
controls used in processing specific applications. Such techniques as design
phase auditing, ITF, tagging and tracing, SCARF, test data, and surprise
audit are examples of auditing through the computer.
(c) The integrated test facility approach permits the introduction of auditor-
selected test data into a computer system with actual or “live” data and then
traces the flow of transactions through the various system processing
functions for comparison to predetermined actual results. An ITF involves the
creation or establishment of a “dummy” entity (e.g., a branch or division) to
receive the results of the test processing. Therefore, transactions are
processed against the test entity together with actual transactions. Test data
must be removed from the entity’s 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.
Auditing in a Computer Information Systems (CIS) Environment 28-11
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.
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.
Training and proficiency are very important for being able to obtain an
understanding of the internal control structure in a computer system. Client
personnel will expect audit personnel to be capable of working with a computer
system.
Questions
1. The report simply states: “The financial statements are not intended to be
presented in conformity with financial reporting standards.” The opinion
expression thereafter refers to a description of the comprehensive basis used.
2. The following are four comprehensive bases of accounting other than PFRS:
1. A basis of accounting to comply with the requirements of a governmental
regulatory agency (for example, insurance companies use a basis of
accounting pursuant to the rules of the insurance commission)
2. A basis of accounting used to file an income tax return
3. The cash receipts and disbursements basis of accounting (cash basis) and
modifications to the cash basis, such as recording depreciation on fixed
assets or accruing income tax.
4. A definite set of criteria having substantial support that is applied to all
material items in the financial statements, such as the price-level basis of
accounting.
Prior-year statements were unaudited: The auditor should label the prior-year
columns “Unaudited” and modify the report by adding a paragraph that
disclaims an opinion on the statements.
1. b 5. b 9. a 13. d 17. b
2. a 6. a 10. a 14. a 18. c
3. c 7. a 11. d 15. a 19. b
4. a 8. a 12. d 16. a 20. a
Cases
1.
To the Board of Directors of Neiny Ltd.:
We have reviewed the accompanying statement of financial position of Neiny Ltd. as of
December 31, 2014, and the related statements of income, retained earnings, and cash flows
for the year then ended, in accordance with standards established by the Auditing Standards
and Practices Council. All information included in these financial statements is the
representation of the management of Neiny Ltd.
A review consists principally of inquiries of company personnel and analytical procedures
applied to financial data. It is substantially less in scope than an examination in accordance
with auditing standards, the objective of which is the expression of an opinion regarding the
financial statements taken as a whole. Accordingly, we do not express such an opinion.
Based on our review, we are not aware of any material modifications that should be made to
the accompanying 2014 financial statements in order for them to be in conformity with
financial reporting standards.
The financial statements for the year ended December 31, 2013, were audited by us, and we
expressed an unqualified opinion on them in our report dated February 27, 2014, but we have
not performed any auditing procedures since that date.
2. a. The assertions that are incorrect and should otherwise be deleted are the
following:
1. Report should be addressed to Ms. Clean Corporation’s Board of
Directors.
2. Delete the entire paragraph describing the scope except for the
reference to cash in banks and accounts receivable.
3. Delete the opinion rendered on cash in banks and accounts receivable.
4. Delete the recommendation to acquire Ajacks.
b. The assertions that are missing and should be inserted are the following:
1. Date of the report.
2. Statement limiting the distribution of the report to Ms. Clean’s
management.
29-4 Solutions Manual – Public Accountancy Profession
3. Description of the procedures performed.
4. Statement that the agreed-upon procedures applied are not adequate to
constitute a PSA audit.
5. Description of the accountant’s findings.
6. Disclaimer of an opinion concerning cash in banks and accounts
receivable.
7. Statement limiting the report only to cash in banks and accounts
receivable and indicating that the report does not extend to the
financials taken as a whole.
3.
Independent Auditor’s Report
[Addressee]
We have audited the statement of assets, liabilities, and capital (income tax [cash] basis) of
Vanda & Corona, a partnership, as of December 31, 2014, and the related statements of
revenue and expenses (income tax [cash] basis) and statement of changes in partners’
capital accounts (income tax [cash] basis) for the year then ended. These financial
statements are the responsibility of the company’s management. Our responsibility is to
express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with auditing standards. Those standards require
that we plan and perform the audit to obtain reasonable assurance about whether the
financial statements are free of material misstatement. An audit includes examining, on a test
basis, evidence supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation. We believe
that our audits provide a reasonable basis for our opinion.
As described in Note X, the partnership’s policy is to prepare its financial statements on the
accounting basis used for income tax purposes; consequently, certain revenue and related
assets are recognized when received rather than when earned, and certain expenses are
recognized when paid rather than when the obligation is incurred. Accordingly, the
accompanying financial statements are not intended to present financial position and results
of operations in conformity with financial reporting standards.
In addition, the company is involved in continuing litigation relating to patent infringement.
The amount of damages resulting from this litigation, if any, cannot be determined at this time.
In our opinion, the financial statements referred to above present fairly the assets, liabilities,
and capital of the Vanda & Corona partnership as of December 31, 2014, and its revenue and
expenses and changes in its partners’ capital accounts for the year then ended, on the
income tax (cash) basis of accounting as described in Note X, which basis has been applied
in a manner consistent with that of the preceding year.
NONAUDIT ENGAGEMENTS:
PROCEDURES AND REPORTS
Questions
1. Examples of using “what has held true in the past will hold true in the future:”
(a) evaluating the collectibility of accounts receivable based on past collection
history,
(b) evaluating inventory obsolescence on the basis of past usage patterns,
(c) assessing the economic usefulness and useful lives of fixed assets based
upon experience with similar assets,
(d) relying on a control risk assessment for a period between the time of the
original assessment at interim and the fiscal year-end, and
(e) expecting to encounter classification and evaluation errors when
management has been known to have acted without sufficient decision
planning in the past.
2. Financial statements are unaudited if the CPA has not applied any auditing
procedures or has not applied procedures which produced sufficient evidence
upon which to base an opinion on the financial statements as a whole.
5. Both review service and compilation service engagements are less than an audit.
A comparison of the three amounts to a hierarchy of assurance:
1. Audit engagement Auditor obtains sufficient competent
evidence that serves as a basis for an
opinion on financial statements. The
auditor obtains reasonable assurance
within the inherent limitations of the audit
process.
2. Review engagement Accountant obtains limited assurance
through analytical procedures that there are
no material modifications that should be
made to financial statements.
3. Compilation engagement Accountant puts client information in
financial statement form without obtaining
any assurance (because no procedures are
performed) that material modification
should or should not be made to the
financial statements.
1. c 5. a 9. a 13. b 17. c
2. c 6. b 10. d 14. b 18. d
3. b 7. a 11. a 15. a 19. a
4. b 8. c 12. b 16. b 20. b
Comprehensive Cases
3. Nicky has no accounting staff and has little expertise in preparing financial
statements himself. However, he needs them occasionally, apparently for credit
purposes.
c. A review service is less than an audit, hence the report can be less than
positive assurance. Clients get what they paid (less) for.
5.
To the Board of Directors of Francisco Company
I have reviewed the accompanying statement of financial position of Francisco Company
as of December 31, 2014, and the related statements of income, retained earnings, and
changes in financial position for the year then ended, in accordance with standards
established by the Auditing Standards and Practices Council. All information included in
these financial statements is the representation of the management of Francisco
Company.
A review consists principally of inquiries of company personnel and analytical procedures
applied to financial data. It is substantially less in scope than an examination in
accordance with auditing standards, the objective of which is the expression of an
opinion regarding the financial statements taken as a whole. Accordingly, I do not express
such an opinion.
Based on my review, I am not aware of any material modifications that should be made
to the 2014 financial statements in order for them to be in conformity with financial
reporting standards.
The accompanying 2013 financial statements of Francisco Company were compiled by
other accountants whose report dated January 11, 2014, stated that they did not express
any opinion or any other form of assurance of those statements.
Jo Cee, CPA
January 15, 2015