CASE 3

SUGGESTED ANSWERS TO DISCUSSION QUESTIONS

(1)
Although this question can be answered by a simple reading of Exhibit 3-1, it
does force the student to consider the contractual obligations being assumed by
both parties. One portion of this letter that might warrant discussion is the CPA
firm's declaration that absolute assurance is not being given in regard to major
misstatements. The students can be queried as to the reasons for including this
statement. In addition, the students can be asked to discuss the method by
which the client company can draw the distinction between reasonable
assurance and absolute assurance. As a different line of questioning, the
students can discuss other responsibilities that could have been accepted by
either party.
The engagement letter is required. Responsibilities of the CPA firm found in the
engagement letter:
*

To perform an audit in order to express an opinion on the client's financial

statements,

To make a search for material misstatements,

To report any internal control weaknesses,

To report any potential fee changes,

To provide the final audit report by February 22, 2010.

Responsibilities of the client:

*

To pay the audit fee,

To provide a year-end trial balance by January 17, 2010, and an interim

trial balance by October 17, 2009,

To provide audit documents to the CPA firm as specified.

(2)
In performing analytical procedures, auditor expectations should be derived from
a wide variety of sources. For cost of goods sold, Abernethy and Chapman

should consider each of the following in arriving at an anticipated total:

-

Past figures. If cost of goods sold has always been a certain percentage
of Lakeside's sales, that same relationship would be expected to continue
unless other factors have changed. Had Lakeside, for example, switched
from cheaper products to more expensive ones, the relationship between
cost of goods sold and sales would possibly be affected. Or, if Lakeside
has dropped the Cypress line in order to sell the products of some other
manufacturer, a similar change might have been anticipated. However,
without an adjustment of this type, cost of goods sold as a percentage of
sales would be expected to remain stable.
Industry averages.
By studying trade publications, Abernethy and
Chapman can determine an industry average for cost of goods sold as a
percentage of sales. Although Lakeside's results could not be expected to
be exactly the same as this average, the auditors should not anticipate a
significant variation to occur without some adequate explanation.
Competitors.
If available, the financial statements of competing
companies can be used to determine the normal relationship of cost of
goods sold to sales. Although no two companies are ever alike, important
comparisons such as this one should be made between similar
companies.
Budgeted figures. If Lakeside has an annual budget, the numbers
estimated by the company at the beginning of the period can be used by
the auditor in establishing an expected cost of goods sold.

(3)
-

Lakeside holds an inventory of high technology items: consumer electronic

equipment. Obsolescence of a portion of this merchandise is an everpresent danger because of new innovations. The inventory can also be
easily damaged, a problem that is not always visually obvious.

Lakeside distributes merchandise to retail stores. A generous return policy

is provided; thus, an estimate must be made of the sales returns that will
be received by the company after the audit is concluded.

Lakeside sells on credit throughout two states.

collections from accounts receivable may be difficult.

Lakeside rents a number of its stores. The auditor must determine

whether capitalization of these leases is required.

Lakeside has a large amount of debt. The auditor has to ensure that all
debt is being properly reported and disclosed. The interest expense
associated with these liabilities must also be correctly calculated and
recognized. In addition, the auditors need to verify that all loan covenants

Hence, estimating

are being met.

-

Lakeside is considering going public. A company attempting to raise

significant capital may be tempted to over-estimate assets and revenues.
The auditor needs to be particularly careful on accounts that lend
themselves to significant estimate.

(4)
The auditor must be satisfied that sufficient, competent evidence has been
obtained to substantiate an opinion concerning the fair presentation of the client's
financial statements. The decision as to the sufficiency of this evidence is left
solely to the judgment of the auditor. Only through years of experience can the
auditor develop the ability to make this determination. Although specific
guidelines for this decision are not available, all significant problems must be
resolved and all suspicious occurrences should be investigated. Evidence needs
to be accumulated for each significant area of the financial statements to
substantiate the assertions made by the client about its reported balances.
Where inherent risk and control risk are judged to be high, the auditor must take
steps to reduce detection risk to an acceptable level. In such cases, several
steps are possible: performing additional substantive testing, using more
experienced staff personnel, performing testing procedures closer to the balance
sheet date, or relying on more effective testing procedures.
Another factor that influences the auditor's decision is the quality of evidence
being accumulated. Some information may come directly to the auditors from
outside parties, data that is usually considered to be of a higher quality than
evidence prepared by the client company. Less evidence is required if it is
judged by the auditor to be of a high quality.
Although each of these factors is considered, the ultimate decision still must rest
with the auditor's judgment. This individual is taking responsibility for the audit
opinion as well as accepting the risks involved in circulating this report. Thus, the
auditor must be satisfied that, based upon the wisdom gained through years of
audit experience, sufficient evidence has been obtained.
(5)
Any discussion as to the "quality" of evidence being gathered by analytical
procedures must be based on the objective of the testing. Analytical procedures
performed in the planning stage are not primarily designed for the purpose of
indicating the fair presentation of financial information. Instead, they are used in
the assessment of risk, to alert the auditor to potential problem areas that may
require additional substantive testing. In that respect, analytical procedures
serve a vital audit purpose. Students should always be reminded, though, that
this testing is only one component of the overall substantive testing being

performed by the independent auditor. Furthermore, analytical procedures

provide circumstantial evidence which, taken alone, is not a high quality type of
evidence.
(6)
Knowledge of the consumer electronics business is just one aspect of Cline's
expertise that will allow him to evaluate the fair presentation of Lakeside's
financial statements. Overall knowledge of the client company and the industry in
which it operates should also allow the auditor to
-

identify areas that may need special consideration;

assess conditions under which accounting data are produced, processed,
reviewed, and accumulated within the organization;
evaluate the reasonableness of estimates;
evaluate the accuracy of management representations;
make judgments about the appropriateness of the accounting principles
applied and the adequacy of disclosures.

Knowledge of a business and the industry in which it operates may be obtained

from examining the client company's accounting records and inquiry of the client
personnel. This information can be supplemented through review of the prior
years' audit documents, AICPA Accounting and Audit Guides, industry
publications, financial statements from other companies in the same industry,
college textbooks, magazines, and other trade periodicals.
Since the students may not be familiar with the AICPA Industry Audit Guides, the
instructor may want to bring an example or two to class for this discussion.
Examples of the industries covered by these audit guides include:
-

Airlines
Finance Companies
Investment Companies
Providers of Health Care Services

(7)
A number of the current concerns faced by auditing firms as well as the auditing
profession as a whole relate either directly or indirectly to increased price
competition. Through class discussion of this particular question, students should
be able to ascertain at least three of these problems:
*

Price competition forces narrow time constraints on the work of the

independent auditor. In order to finish an audit engagement in a short
enough time so that a reasonable profit can be made, a danger exists that

the auditor will 1) accept less than sufficient evidence, 2) fail to recognize
critical audit areas, or 3) not be able to acquire the depth of knowledge
necessary for essential audit judgments. Thus, the argument is frequently
raised that price competition leads to a decrease in overall audit quality.
*

Because the initial year of an audit will often require significantly more time
than examinations of subsequent years, price competition can lead a firm
to actually lose money in the first year of an engagement. Therefore, the
CPA firm must work to keep a client for several years to offset this initial
loss and produce a reasonable profit. The necessity of retaining an
engagement for a number of years may force the firm to be subservient to
management's demands to avoid being fired. This argument has lost much
of its impact over the last few years as client companies have established
audit committees comprised of outside members of the board of directors
to ensure the independence of the auditing firm.

Many auditors also feel that price competition is generally detrimental to the
public accounting profession. The main thrust of this argument is that price
competition encourages companies to select their independent auditors
based primarily on cost rather than on the quality of audit work. This type
of selection process would favor firms offering cheap rates over auditing
firms offering quality services.

After the students have been allowed to discuss the problems associated with
price competition, the instructor may want to ask whether these problems
outweigh the advantages of having the auditing profession participate in the free
market system. Since most business students in the United States appear to
advocate free markets within the country, some interesting discussion can be
stimulated as to whether the auditing profession should be exempt from price
competition.
(8)
According to the audit risk model, planned detection risk (PDR) equals
acceptable audit risk (AAR) divided by the product of inherent risk (IR) and
control risk (CR). Holding inherent risk and acceptable audit risk constant, there
is an inverse relationship between control risk and planned detection risk. Thus,
an increase (decrease) in control risk leads to a decrease (increase) in planned
detection risk. Also, as planned detection risk decreases (increases), the amount
of substantive tests and other audit procedures increases (decreases). That is, if
the auditor determines the level of detection risk to be low, he or she wants the
chance of not detecting an error too small. In order to have a small chance of not
detecting an error, the auditor must do more testing. For example, given
AAR=10% and IR=80%, and assuming an 80% CR (high), then using the audit
risk model, planned detection risk is a relatively low 15.6% [.10/(.80x.80)], but
assuming a 20% CR (low), then planned detection risk is a relatively high 62.5%

[.10/(.80x.20)].
(9)
According to SAS 99 the assessment of the risk of fraud begins with a meeting of
the entire team for such purpose. This brainstorming session needs to
encourage the involvement of all team members and cannot be just a staff
training session. The objective is to solicit the ideas from all team members and
to sensitize the entire team to the particular problem areas that this client
presents. The process begins with such a session, but does not end there.
During the audit the entire team needs to consider how the information being
developed relates to the areas already identified, noting new areas that need
attention, or adjusting expectations on the areas already identified. The areas
identified by fraud risk are primarily in the areas of inherent risk and control risk.
Increased fraud risk represents an increase in inherent risk (the risk that errors
exist) or will also increase the control risk (the risk that the clients internal control
system will not detect the error or irregularity).
(10)
The registration process is not difficult. Maintaining the status of a registered CPA
firm is more difficult and requires that the firm be willing to adjust its operations
including independence and staffing quality control standards to meet the higher
expectations of the PCAOB. They may also be required to change the nature of
their practice, at least as far as publicly traded clients because of the list of
proscribed activities. Abernathy and Chapman have sufficient time to become
registered and therefore need only be concerned about accepting Lakeside as a
client if there is some obstacle to their registration. If Lakeside asks if they are
currently registered, then the answer has to be, no, but we are pursing
registration.
SUGGESTED ANSWERS TO EXERCISE
(1)
Performing analytical procedures is one aspect of an auditing course that
traditionally generates a lot of student interest and enthusiasm. One method of
approaching this question is to have the class list the potential problems that
were discovered and then discuss the relative severity of each. The students
can be asked to consider the appropriate response that should be made by the
audit team to each of the elements listed. By discussing the various possible
responses, students are better able to recognize the attest function as a fluid
process that must be flexible enough to adapt to a specific set of circumstances.
It should be noted to students that, in practice, several years (rather than two)
would be analyzed for trends.

a)

Ratio analysis from 2007 to 2008.

Ratio
Current
# Days inventory on
hand
Receivable collection
period (days)

2007
1.35
93

2008
1.36
101

21

25

Debt-to-total-assets

74.4%

74.5%

Times interest earned

3.6 times

2.8 times

Profit Margin
Return on Assets

2.79%
8.47%

2.27%
6.73%

Return on Equity

33.2%

26.4%

Significance
No significant change
Increase may indicate obsolete or
slow moving inventory on hand
Slight increase may indicate relaxing
of credit policies and/or possible
understatement of allowance
No significant change; however, the
high ratio indicates significant leverage
and potential solvency problems if
additional debt is needed
Decline indicates reduced ability to
meet interest payments through
operations
No significant change
Declining return results from a
combination of declining net income
and increasing total asset base.
Decline in return results from a
combination of declining net income
and increasing equity base.

Conclusion: Lakeside had no significant changes in its liquidity or solvency

levels; however, the company appears to be experiencing a decline in its
profitability level. The audit staff should pay particular attention to revenueenhancing or expense-reducing areas, such as fictitious sales or improper
capitalization of expenses to halt this downward trend.
b) Ratio analysis: comparison to industry.
Ratio
Current

Industry Ave.
1.73

Lakeside 2008
1.36

on

65

101

Receivables collection
period

11

25

Debt-to-total-assets

13%

74.5%

Times interest earned

30 times

2.8 times

Profit Margin

2.93%

2.27%

Return on Assets

6.09%

6.73%

Days
hand

inventory

Significance
Lakeside is below the industry
average. This may indicate short-term
solvency (liquidity) problems.
Lakeside is well above the industry
average. This may indicate short-term
solvency problems.
Lakeside is well above the industry
average. This may indicate short-term
solvency problems.
Lakeside is significantly above the
industry average; this may indicate
long-term solvency problems.
Lakeside is significantly below the
industry average; this may indicate
solvency problems.
Lakeside is only slightly below the
industry average.
Lakeside is only slightly above the
industry average.

Ratio
Return on Equity

Industry Ave.
13.27%

Lakeside 2008
26.4%

Significance
Lakeside is significantly above the
industry average.

Conclusion: Lakeside is well below the liquidity level of the industry, and the
company is in a significantly worse solvency level than the industry. Auditors
should be aware of methods to enhance the liquidity and solvency levels, such
as unrecorded liabilities. Lakeside profitability is about the same as the industry
average, except for return on equity, in which it is more than double that of the
industry (primarily due to the high level of leverage).
c.

Scan the financial statements and the trial balances.

Procedure
Scan the income statement
[Note: instructors may want to
suggest that students prepare a
common size income statement]

Results
The company's stores continue
to report an overall loss which is
increasing in amount.

Scan the balance sheet [Note:

instructors may want to suggest
that students prepare a common
size balance sheet]
Scan the cash flow statement

Nothing unusual

Scan the trial balance

Something appears to be wrong

with the information generated by
Store Three. The sales for that
store
have
increased
by
approximately 94% since the
previous year. At the same time,
the cost of the goods sold has
dropped from 58.5% of sales
(which is consistent with the
other stores) to only 50.3% of
sales. Also, the inventory held by
this store has risen by over 50%.
Sales Commissions for District D
in 2009 appear to be slightly out
of line.
All of the other
commissions are approximately
5.7% of sales, while this account
is nearly 7% of the applicable
sales figure.
Rent expense on vehicles and
equipment has decreased in
2009.

Scan the trial balance

Scan the trial balance

Cash flow from operations

declined significantly in 2008.

Significance
These losses suggest the
possibility that the stores will
eventually be discontinued by
Lakeside or drastically altered in
some manner.

The
cash
flow
problems,
combined with the solvency
problems may indicate a problem
with the company's ability to
continue as a going concern.
These fluctuations could indicate
recording errors or an employee
attempting to inflate the earnings
being reported for Store Three.
This problem is more germane
than might be encountered
normally because of the profitsharing bonus system that
rewards employees for reporting
high income figures.
Although not necessarily a
material figure, the potential error
should be investigated so that
Lakeside
can
make
the
appropriate
corrections
if
needed.
Such a decrease often serves to
indicate that the company has
acquired new property.

Procedure
Scan the trial balance

Results
The Repairs and Maintenance
account has increased by over
150% since 2008.

Scan the trial balance

The "Gain on Disposition of Fixed

Asset" balance of $14,000
warrants investigation.

Scan the trial balance

The Allowance for Doubtful

Accounts balance shows a debit
balance on September 30, 2009,
compared to a credit balance one
year earlier.

Scan the trial balance

The company's two bank credit

lines now have a total balance
that exceeds the $750,000
maximum that was indicated in
an earlier case.

Scan the trial balance

The long-term notes payable

have increased by $50,000. The
auditor would certainly be
interested in the application of
those funds as well as the loan
agreement
signed
by
the
company.
Sales returns have increased
significantly for both the company
stores and the distributorship.

Scan the trial balance

Significance
This significant increment may
indicate a posting error that will
require correction. Conversely,
actual repairs may have been
made by Lakeside.
In that
situation, the auditor needs to
verify that all capitalized costs
have been segregated and
properly accounted for within the
company records.
Often a company will fail to
remove the appropriate cost and
related accumulated depreciation
when a plant asset is sold. The
auditor should also ascertain that
the current year depreciation
expense has been properly
recognized. Finally, the sale of
an asset can lead to the
acquisition of a new asset as a
replacement. The independent
auditor should follow up on this
possibility to assure that any
replacement is appropriately
capitalized.
The auditor should determine if
the client has written off an
especially
large
group
of
accounts.
Perhaps bad debt
experience is changing and a
larger allowance is required.
The auditor should verify that no
loan covenants have been
broken. In addition, because of
disclosure requirements as well
as the effects on the interest
expense account, the auditors
will need to review any new
borrowing agreement.
The auditor should determine the
application of those funds as well
as the loan agreement signed by
the company.

The auditors need to ascertain

the reasons for such an increase.
Any change in the trend for sales
returns would lead the auditors to
reevaluate year-end accruals.

Procedure
Scan the trial balance

Results
The equipment account shows
an increase from the previous
year.

Scan the trial balance

The estimated bonus expense

has increased.

Significance
If the company has acquired
additional equipment during the
year, the auditor needs to verify
that
capitalization
and
depreciation were given proper
treatment.
That increase is probably due to
the profit-sharing plan having
been in effect for all nine months
of 2009, but the increase should
be investigated.

CASE 4
SUGGESTED ANSWERS TO DISCUSSION QUESTIONS
(1)
Statement on Auditing Standards 78, "Consideration of Internal Control in a
Financial Statement Audit: An Amendment to SAS No. 55," identifies the five
elements of internal control as the Control Environment, Risk Assessment,
Control Activities, Information and Communication, and Monitoring. Cline's
questions appear to be designed to determine the degree of information that has
been established to date about each of these elements. Question (3) asks about
the information that the auditors could have looked at within the Lakeside
Company in order to respond adequately to these queries. Auditors must be able
to gather sufficient data in the early stages of an audit to assess the various risks
involved in the examination.
In studying the control environment of a company, SAS 78 recommends that a
number of factors should be assessed including those listed below. For several
of these factors, the types of information that the Abernethy and Chapman
auditors might use to make their evaluation is also discussed. A quick look at the
control environment will probably lead the auditors to the decision that Lakeside
has not established the environment needed for adequate internal control.

Integrity and ethical values. The auditors should inquire as to policy

statements and a code of ethics. They should also be aware of any actions
by Lakeside's management to remove or reduce incentives and temptations
that might prompt its employees to engage in dishonest, illegal, or unethical
acts.
Commitment to competence. Lakeside should have a training program to
ensure that its employees have the knowledge and skills necessary to
accomplish tasks. The auditors should inquire as to any such programs.
Board of directors or audit committee participation. Abernethy and Chapman
will need to determine the oversight role (if any) played by the board of
directors. By looking at the minutes of the meetings, the auditors should be
able to determine whether the board is actually serving in a control capacity.
The case mentions that the board of directors had to approve of the hiring of
new independent auditors. Thus, a separate audit committee probably does
not exist. In addition, Rogers' assurance that the board would approve this
request would seem to imply that the board does not provide significant
control over the management of the company.
Management's philosophy and operating style. By talking with Rogers and
the other members of management, the auditors should be able to determine
the actual priority placed on internal control by the company. Documentation

of this should also be available for inspection. Rogers seems to understand

that better systems are needed but has invested neither the time nor the
money to develop such policies and procedures. This lack of support may
indicate that the management is not serious about establishing adequate
control within the company. Because of the company's growth, improvements
in the future may be forthcoming, but at the present time the management
appears (from what has been said) to have let the company outgrow its
control policies and procedures.
Organizational structure. If Lakeside has a chart presenting the various
officials and their jobs, the auditors can assess whether control policies would
be easy to circumvent. Although Exhibit 3-2 shows the company divided into
clearly distinct areas, the Assistant to the President does seem to be in a
position to operate without proper control supervision. In addition, the
President seems to hold a significant amount of power in this company, with
very little control having been established.
Assignment of authority and responsibility. This factor includes how authority
and responsibility for operating activities are assigned and how reporting
relationships and authorization hierarchies are established. Since Lakeside is
not a huge organization, Rogers tends to intervene in many of the operating
activities. However, as Lakeside continues to grow, this may become a major
concern to the auditors.
Human resource policies and practices. These policies and practices relate
to hiring, orientation, training, evaluating, counseling, promoting,
compensating, and remedial actions. The auditors should inquire and
observe Lakeside's policies, including any standards for hiring the most
qualified individuals, training, and performance appraisals.

Risk assessment is the second component of internal control. The auditors will
determine and evaluate how Lakeside identifies, analyzes, and manages risks
relevant to the preparation of the financial statements. The auditors will want to
pay particular attention to several changes occurring at Lakeside and how the
management deals with these changes. These changes include the expansion
of the company's stores, the concentration on the Cypress product line, and the
relatively new bonus system.
Next, the auditors will look at the actual control activities in place to see that
specific control objectives are being met. Within this testing, the auditors should
look at the following as goals of the company's internal control:

Performance reviews. Independent checks on both performance and proper

valuation of recorded amounts should be conducted. The auditors will want
to verify that reconciliations and other comparisons are made at important
junctures in the various systems.
Information processing. The auditors will want to verify that Lakeside has
both general controls and application controls. They will especially verify that
proper authorization of transactions exist. The auditors can examine the

documentation produced for a variety of transactions to ensure that each was

authorized by the appropriate individual within the company. Further, the
auditors will verify that Lakeside properly designs and uses adequate
documents. By walking through the various systems, the auditors can
determine if adequate documentation is required at each point and if those
documents are preprinted and prenumbered to ensure that the proper
information is gathered and retained.
Physical controls. By physical observation of the warehouse, the stores, and
other assets, the auditor can determine if Lakeside has adequate safeguards
over its assets.
Segregation of duties. By looking at the organization of a company, the
auditors can determine if the necessary separation of responsibilities is in
place to facilitate adequate control. For example, since Lakeside has a chart
showing the various officials and their jobs, the auditors can assess whether a
true system of checks and balances has been established. Although Exhibit
4-1 shows the company divided into clearly distinct areas, information in
Exhibits 4-3 and 4-4 indicates, for example, that the Assistant to the President
has a great many responsibilities, some of which raise the possibility of
control problems.

Next, the auditors will have to examine any information that helps to
ascertain the efficiency of the company's information and communication system.
In the case presented, little data is provided to evaluate the information system
except that Rogers feels the systems are outdated for a company of this size.
Therefore, the auditors should assess the design of the system and the people
who operate the accounting system. For example, the auditors might want to
select a number of transactions and trace them from the point of origination
through the accounting system to see that the recording process is performed
properly. This testing is designed to determine if the system is capable of
performing the following tasks in an effective manner:

Identify and record all valid transactions.

Describe on a timely basis the transactions in sufficient detail to permit
proper classification.
Measure the value of transactions.
Determine the time period in which transactions occurred.
Present the transactions appropriately in the financial statements.

The final component of internal control is monitoring. Monitoring is the process

that assesses the quality of internal control performance over time. Lakeside
does not appear to have an extensive monitoring system, such as an internal
audit function. Without an internal auditor, no independent party within the
company serves to monitor and oversee the company's internal controls. The
internal audit function can be extremely important in a company, especially where
stores and sales representatives operate at a geographic distance from the home
office.

(2)
An evaluation of the overall control environment is not possible from Exhibits 4-3
and 4-4. However, the auditors can see that responsibilities have been
developed and divided within the company. Each individual or department
seems to have a well-defined job within the two systems. Thus, some evidence
exists to indicate that management is aware of the importance of internal control.
Such systems simply cannot be created without adequate support by the
company's management.
In terms of risk assessment, Lakeside does not appear (from Cases 2 through 4)
to have a formal method of systematically assessing risks (Weakness). The
auditors should recommend a system of identifying risks, their significance, their
likelihood of occurrence, and how they might be managed. This is especially true
with Lakeside's growth of stores, concentration of suppliers (Cypress only), and
installation of a bonus system.
In addressing control activities, the auditors can see, as indicated in the answer
to Exercise (2), that the company seems to use adequate documents and
authorization procedures (Strength). In addition, although the Assistant to the
President has many different duties (Weakness), the company seems to have
made an attempt to segregate responsibilities in an appropriate manner.
Both of the information systems that are presented also seem well designed
especially for a small but growing company. However, the company still uses
some manual systems that can be slow and offer the opportunity for many
human mistakes to be made (Weakness). The answer to Exercise (2) goes into
more detail concerning control strengths and weaknesses in this area.
The monitoring activities seem to be somewhat lax. However, with Lakeside still
being relatively small, Rogers' oversight somewhat compensates for the lack of
monitoring. With the growth of Lakeside, this is becoming less true.
(3)
After a preliminary assessment of control risk, the auditors have three possible
actions:
a) Because of potential strengths found within internal control, the auditor
may feel that control risk can be assessed at below the maximum level.
If so, the auditors must then be able to identify specific control
procedures that will likely prevent or detect material misstatements.
The auditors must perform tests of these controls to evaluate their
effectiveness to determine if a reduction in the assessment of control
risk is justified.

b) Because of weaknesses found within internal control, the control risk

may have to be assessed at the maximum level. This evaluation will
probably force the auditor to reduce detection risk by such means as
performing additional substantive testing, using more experienced staff
personnel, carrying out procedures closer to the balance sheet data, or
relying on more effective testing procedures.
c) Although potential strengths may be identified within internal control,
the auditors may still opt to assess control risk at the maximum level.
This decision would be made if additional substantive tests appear to
be easier and cheaper to make than performing the necessary tests of
specific control policies and procedures.
Sarbanes Oxley requires expanded internal control auditing because the
Management Assessment of Internal Control needs to be separately audited by a
registered CPA firm, regardless of its effect on the audit of the financial
statements.
(4)
The auditor will normally begin verifying control policies and procedures by
making inquiries of the employees as to the performance of their duties. The
answers provided indicate to the auditor whether each individual understands the
duties that have been assigned as well as their purpose. A proper knowledge of
a job usually means that employees are more likely to comply with the system
and fulfill their responsibilities. In addition, the auditor is often able to observe
the work of these individuals during the audit fieldwork.
From these
observations, an evaluation can also be made as to the quality of the work being
performed.
Although inquiry and observation are important steps in testing control
procedures, the auditor needs to obtain more substantial evidence. A welldevised system of controls should require each employee to leave physical proof
whenever a task has been completed: a tickmark must be used, the person must
sign a form, a code number must be entered, etc. Thus, the auditor should be
able to trace this physical evidence through an entire system noting whether the
policies and procedures are operating efficiently. For important measures that
might reduce the assessment of control risk, the auditor may want to verify
effectiveness by examining a large number of documents.
Frequently, an
auditor evaluates control procedures within an entire system through a "test of
transactions." Transactions are traced through an accounting system to make
certain that the recording has been made properly and that each control
procedure is functioning as intended.
(5)

This new information provides an increased risk on the motivation/incentive for

fraud to occur, in terms of the fraud triangle. It does not mean that fraud has
occurred and does not affect the opportunity or rationalization necessary for
fraud to occur. The auditor faced with this information should document the
discussion, and make sure the audit team is aware of the conversation. It is not
the job of the staff auditor to initiate an investigation at this early point in the
audit.
SUGGESTED ANSWERS TO EXERCISES
(1)
a)
The following page presents a flowchart for the revenue recognition system.
Numerous acceptable variations of this flowchart may be created. This problem
is not intended to suggest a rigid format for the flowchart but rather to give the
student experience in constructing and reading one. When evaluating a
student's work, several questions should be asked:

Does the flowchart truly mirror the system?

Is the flowchart understandable?
Is the flowchart overly complex, containing too many symbols and
explanations?

One technique that might be used with this assignment is to divide the class into
teams of three or four students each. Then select a flowchart at random from
each team and ask the team members to critique it. This process, which can be
done inside or outside of class, will compel the students to view the flowchart as
an instrument intended to communicate the design of a system.

(1)
b)
Revenue and Cash Receipts Cycle
Distributorship Cash Receipts
Checks arrive from customers along with the copy of the invoice slip. The checks are
received by the Treasurer's Office where each check is immediately stamped "For
Deposit Only." The checks are listed on a bank deposit slip and on a four-part cash
remittance list. This listing includes the customer, the amount paid, and the invoice
number.

The checks and the bank deposit slips are taken by the Treasurer's Office to the bank.
The second copy of the bank deposit slip is validated and returned to the Treasurer's
Office where it is placed in a permanent file by date along with the fourth copy of the
cash remittance list. The bank returns the first copy of the validated bank deposit slip
directly to the Assistant to the President where it is placed in a temporary file by date.
The invoice slips and the first three copies of the cash remittance list are sent by the
Treasurer's Office to the Sales Division. The second copy of the sales invoice and the
fourth copy of the bill of lading had originally been filed by that department when the
goods were shipped. Each invoice slip is matched with the corresponding sales invoice
and bill of lading. The appropriate discount is calculated and recorded on each copy of
the cash remittance list. Each invoice slip is then attached to the appropriate sales
invoice and bill of lading and placed in a permanent file by invoice number. The third
copy of the cash remittance list is placed in a permanent file by date.
The second copy of the cash remittance list is sent to the Controller's Office where the
cash receipts and the sales discounts are refooted. From this information, a daily
journal entry is made in the cash receipts journal. Subsequently, the second copy of the
cash remittance list is filed permanently by date.
The sales division sends the first copy of the cash remittance list to the Assistant to the
President. He compares the bank deposit slip that he has received from the bank
against the total of the cash remittance list for that same date with a spot check of
individual items. The list of collections is then used to update the Accounts Receivable
Subsidiary Ledger before being placed in a temporary file by date. Upon receipt of the
monthly bank statement, the cash remittance lists and the validated bank deposits are
removed and used to prepare the monthly bank reconciliation. The reconciliation, the
bank statement, the validated deposit slips, and the cash remittance lists are then
placed in a permanent file by date.
(2)
The student is asked to complete Exhibit 4-5, a preliminary analysis of the control
procedures in the cash receipts system.
Documents Found in This System:

Invoice Slips (one copy per payment) - prepared internally but returned
directly by outside party. It is the bottom portion of the number 4 copy of the
sales invoice.

Validated Bank Deposit Slips (two copies per day) - prepared internally but
validated by outside bank and mailed directly to the Assistant to the President.

Cash Remittance List (four copies per day) - prepared internally.

Sales Invoice (second copy) - prepared internally.

Bill of Lading (only fourth copy is a part of this system) - prepared internally,
two copies sent to customer.

Bank Statement (one copy per month) - prepared externally.

Bank Reconciliation (one copy per month) - prepared internally.

Answers to Specific Questions on the Analysis Form, Exhibit 4-5:

1. Prenumbering of forms - Exhibits 4-3 and 4-4 indicate that the sales invoices
(including the sales invoice slip) and the bills of lading are prenumbered. None of the
other documents shown in this system would normally be pre-numbered.
2. Authority for completing each document - Exhibit 4-4 indicates that all documents
within this system are clearly assigned to a specific department.
3. Review of documents - a number of the documents are reviewed prior to the
beginning of this system such as the sales invoice and the bill of lading. The
validated bank deposit slips are reviewed by the Assistant to the President while the
cash remittance list is reviewed by the Controller's Office. The bank statement is
reviewed by the Assistant to the President. Finally, the bank reconciliation is
prepared by the Assistant to the President but does not appear to be reviewed. The
failure to review this document would constitute an internal control weakness.
4. Procedures for completing each document and for reviewing each document - all
instructions on the worksheet appear to be reasonably complete, although any set of
written instructions could be put into more detail. One problem does exist: none of
the instructions give guidance when discrepancies are found. For example,
according to the flowchart, a major problem exists in the sales division at point B.
According to the explanation, no instructions exist when the collection is less than
the amount of the invoice. Rather than rebilling the additional amount, the invoice
information is placed in a permanent file. Although this rebilling process may be
handled through the Assistant to the President or some other party, this procedure is
not indicated by the flowchart.
5. Separation of record-keeping function and custody function--the Treasurer's Office
which serves the custodial function for the cash funds also records the initial receipt
of cash. That type of organization is typical of small companies but does offer the
opportunity for theft or cash manipulation. In addition, the Assistant to the President
maintains the Accounts Receivable Subsidiary Ledger and reconciles the bank
statements. Although not specifically a control weakness because this individual
does not have access to the cash account, these combined responsibilities do offer
the opportunity for successful theft through collusion.

6. Verification of mathematical computations - all computations are independently

verified except for the cash discounts. The flowchart is unclear as to the procedure
to be applied when the sales division calculation does not agree with the customer's
payment.
7. Immediate record-keeping--the record-keeping
immediately upon the receipt of the cash.

function

appears

to

begin

8. Transactions authorized -- all transactions seemed to be appropriately authorized.

9. Other control procedures that might be mentioned by the students:
-

checks are immediately stamped "For Deposit Only"

spot checks made of cash remittance list totals to bank statement deposits are made
to counter potential "lapping" activities.

10. Other control weaknesses that might be noted by the students - invoice slips and
related documents are permanently filed by invoice number in the sales division
rather than by customer name without any apparent cross-referencing. In case of a
later dispute, locating the invoice might be difficult.
(3)
As a small organization, the controls that might actually be implemented are limited to
those procedures that would be cost effective. Listed below are several possible
improvements that could be considered:

Establish a separate credit department to investigate new clients and set credit
limits based on this information.

Prohibit Rogers or other company personnel from giving credit except under
specified conditions.

Use a sales order form that is different from the sales invoice. The two
documents serve different purposes and are most useful if designed to meet those
specific needs.

Have a separate shipping department to provide control over the inventory being
removed from the company.

Establish a separate accounts receivable department to monitor all changes in

each customer's individual account.

Establish a separate billing department to prepare the sales invoices and ensure
their accuracy.

When goods are shipped, a signed receipt should be received as proof of the
transfer.
SUGGESTED ANSWERS TO SARBANES OXLEY QUESTIONS

(1)
The board of directors needs to be organized so that it can fulfill its purpose. The
primary improvement is to increase its independence and operation. The President of
the Corporation should need be the Chairman of the Board of Directors and there
should be sufficient independent board members to manage create a truly independent
audit committee. Under Sarbanes-Oxley the audit committee is the primary interface
with the registered CPA firm.
Other structural changes may involve management and their duties. Unlike the
previous non-public audits, violations of segregation of duties, or lack of audit trail might
trigger a significant deficiency or material weakness notification. Therefore, while in
the past expanded substantive testing was possible in the event of internal control
deficiencies, SAS 112 requires the communication of all such problems in the context
of the audit or the management report on the internal control system.
(2)
The audit or internal control is still relevant in the determination of the audit risk model
and the determination of detection risk relative to the audit of the financial statements,
however Sarbanes-Oxley requires that public company management report separately
on the internal control system over which they are responsible. Further, the registered
CPA firm must audit that management report.
The result is that Abernathy and Chapman must evaluate the effectiveness, and test
the effectiveness of the internal control system regardless of its impact on the financial
statement audit. In most cases this would involve increased auditing and therefore
higher fees.