Professional Documents
Culture Documents
Kumpulan Jawaban Case Lakeside
Kumpulan Jawaban Case Lakeside
Auditing Cases
SOLUTIONS MANUAL 11e
Table of Contents
John M. Trussel and J. Douglas Frazer
A Not on Ethics, Fraud and Sox Questions
2
A Note on Research Assignments
4
Introductory Case
6
Case 1
13
Case 2
21
Case 3
29
Case 4
39
Case 5
51
Case 6
67
Case 7
74
Case 8
83
Case 9
92
Case 10
100
Case 11
105
Case 12
115
Case 13
127
1
(7-1) The case assumes that tests of controls have been completed and
substantive testing in the payroll area has commenced. During the
internal control evaluation and testing what options are available to the
CPA to document problems and communicate their effect? Write a sample
of a material weakness in the area of payroll internal control that would
be included in the auditor's report. Objective Material weakness
example.
(9-1) The Sarbanes-Oxley legislation raised the expectations on the
oversight provided by the board of directors and established the
role of the financial expert.
How would these expanded
responsibilities affect the financial accounting questions that
played a significant part in Case 9? Objective The role of the
audit committee and the financial expert.
(9-2) Under Sarbanes-Oxley, management can no longer claim to be
unaware of its financial reporting system. In this case, how do the
answers provided by Rogers relate to his anticipated plan to take
his company public? Objective Management responsibility, and
section 404.
(13-1)
According to Case 1, the Lakeside Company is considering a
public offering of stock to finance its growth. At present, Abernethy
and Chapman do not presently have any audit clients that are
public companies. Write a report discussing how the SarbannesOxley Act impacts the firm's independence regarding the provision
of audit and non-audit services? Objective The impact of the
proscribe non-audit services in general and in Abernathy and
Chapman case.
To provide a means for improving the writing skills of students. From all
reports, accounting majors too often leave college lacking in the basic
ability to compose and construct sentences and paragraphs. Accounting
and auditing (especially as one moves up in an organization) obviously
require skills other than the purely quantitative.
Memos, reports,
footnotes, audit and accounting guides, etc., all require accountants and
auditors to be effective communicators of the written word. Indeed, the
instructor may want to team up with a member of the school's English or
communications department to enhance the effectiveness of these
assignments. The auditing instructor can then evaluate the technical and
research portions of the assignment, while the English instructor would
make suggestions as to grammar, syntax, construction of sentences and
paragraphs, logic of the thought process, etc. As a preliminary step, the
instructor may want to assign articles such as "Word Crunching: A Primer
for Accountants" from the March 1990 issue of the Journal of
Accountancy.
decision.
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INTRODUCTORY CASE
SUGGESTED ANSWERS TO DISCUSSION QUESTIONS
(1)
The staff auditor performs many of the detailed audit procedures, such as
preparing and controlling accounts receivable confirmations. In general the work
of the staff auditor is controlled by audit program and supervised by the senior
auditor
The senior auditor coordinates the audit at the client's location and performs
many of the more difficult audit procedures, such as analytical review
procedures. Usually the detailed work performed by the audit senior is more
sophisticated and requires the experience gained by someone holding that rank.
The audit senior is supervised by the manager.
The manager and the partner have supervisory roles. Managers and partners
often have more than one audit team under supervision at any given time.
The partner is the person who has responsibility for determining whether the
firms signature can be attached to audit report.
(2)
The partner-in-charge of an audit is the definitive decision-making position on the
audit team. Although the manager and senior auditor make several decisions,
they must get ultimate approval from the partner-in-charge of the audit. The
consulting partner's role is to add a further degree of objectivity to the audit. The
consulting partner reviews and critiques certain crucial decisions made by the
audit team, such as the final audit report. The partners should be rotated to
assure independence.
Sarbanes-Oxley (SOX-S203) requires the identification of a Leading Partner and
a Reviewing Partner. Both partners must be rotated every five years.
(3)
An accounting firm is a business like any other, and its management must
recognize that a marketing strategy is probably necessary to generate a
continual flow of sufficient operating revenues. However, in the accounting
profession, disagreement exists as to the extent that such marketing should take.
In the past, overt marketing was not permitted since it was considered to be
unprofessional. This position was supported based on the reasoning that a firm
should be selected based solely on the quality of its service. No reliable system
existed, though, for conveying such information to potential clients. Hence, firms
with many clients tended to remain large, while smaller firms often found growth
to be nearly impossible. In the free market system espoused by the United
States, restrictions on such practices as advertising and solicitation were
inevitably overturned. Over the past three decades, attitudes toward marketing
have changed dramatically as competition has become much more intense.
Advertisements by CPA firms in newspapers and magazines are now common.
Newsletters such as that distributed by Abernethy and Chapman are also
frequently used to increase a firm's name recognition in the business community.
In the current world of business, some type of marketing strategy seems
imperative if an accounting firm is to compete. Whether that marketing should
extend to formal advertising is often a question of firm policy. Most importantly,
the firm must ensure that potential clients know of its presence and the services
that it offers. A client will probably not select a CPA firm based on advertising.
However, the client may initially become aware of the firm only through some
type of marketing.
Interestingly, some members of the accounting profession view marketing as
having had a negative impact on the profession as a whole. Price competition for
new clients is often associated with the marketing of a firm. These critics assert
that lowered fees result in sloppy and hurried audit work that can decrease the
overall reputation of the profession. [Additional resources discussing this issue
can be found in the "Suggested Readings" at the end of this case.]
(4)
A national or international CPA firm might consider acquiring Abernethy and
Chapman for several reasons:
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The larger firm may be interested in moving into this geographical region,
and buying the local firm will provide an instant base on which to build a
practice in the area.
The larger firm may already have an office in this location and feels that
combining the practices will reduce expenses.
Abernethy and Chapman might have several reasons for viewing an acquisition
in a favorable light:
The smaller firm may have trouble dealing with increased competition from
bigger firms. Often clients may decide that a change to a nationally known
CPA firm should be made to add extra stature to the audit report. If a local
organization has only a few large clients, it cannot economically afford to
lose a significant amount of revenue in this way. A merger may help the
firm to keep its clients.
-
The regional firm may also desire the additional backup services offered by
large organizations. National CPA firms usually have experts in many
industries as well as in specific audit areas who are available for
consultation. In a smaller firm, this degree of assistance is not always
available when a difficult accounting or auditing problem is encountered.
Many mergers have occurred in the auditing profession during recent years.
Critics assert that this trend has reduced competition and will inevitably lead to a
decrease in audit quality. Proponents counter by stating that mergers lead to
more efficient operations and, thus, improve audit quality. Obviously, mergers
will create a drastic change in the profession as more of the smaller firms
disappear. Audit work in this country may possibly become concentrated within
the largest CPA firms. Whether this result is good for the auditing profession may
be merely a question of perspective. To the smaller firms struggling to survive
and grow, the mergers are usually considered a threat as the bigger firms
become more competitive. To the larger firms, the chance for continued growth
and more efficient operations is always an important objective.
See the Sarbanes-Oxley section below for a follow up question related to the
impact of SOX on the auditing profession.
(5)
Moving staff from one area of a CPA firm to another can cause the perception of
an independence problem. For example, the appearance of independence may
be in question if a member of the consulting staff helps to install a new
accounting system for a client and then she moves to the audit staff to audit this
same client.
See the Sarbanes-Oxley section below for a follow up question/answer related to
the impact of SOX, in particular the list of proscribed activities for registered CPA
firms.
SUGGESTED ANSWERS TO EXERCISE
(1)
The question requires students to address all the elements of a quality control
system, as included in Statement on Quality Control Standards No. 2. In some
cases, students should recognize the need for additional information.
-Independence, Integrity, and Objectivity: Abernethy and Chapman requires its
employees to sever all financial ties to audit clients. The AICPA's Code of
Professional Conduct does not require all employees to sever ties with all audit
clients. For example, staff auditors not working on a particular engagement need
not sever ties. In this case, the firm exceeds the minimum level of conduct for
independence. However, the case does not mention spouses or dependents of
the employees. Spouses and dependents must also be independent, as defined
by Section 100--Rule 101 of the Code. In this case, the firm should strengthen
its requirements.
-Personnel Management: The firm considers experience and technical
competence in assigning personnel to audit engagements. This appears to be a
reasonable quality control.
The firm hires only college graduates with a major in accounting and requires
that each professional sit for the CPA exam with one year of employment. This
seems to be a more than adequate quality control procedure. In fact, many firms
hire professionals, such as computer experts, who were not accounting majors.
The firm requires 40 hours of continuing education per year; however, the case
does not address the issue of the type of education (e.g., accounting and
auditing versus other courses). Many states require that a minimum number of
continuing professional education hours be in accounting- and auditing-related
courses.
The firm promotion procedures consider seniority and technical competence,
which seems to be an adequate control. However, the case does not address
the issue of assessment of technical competence. Many firms require a written
assessment of performance after each engagement.
-Engagement Performance: The firm requires that a consulting partner be
assigned to each audit engagement. The consulting partner assures that the
work performed by the engagement team meets applicable professional
PCAOB
website
10
Quality Control Standars registered firms must maintain the SEC practice
requirements:
-
12
CASE 1
SUGGESTED ANSWERS TO DISCUSSION QUESTIONS
(1)
Financial statements are frequently relied on by outside parties such as
stockholders and banks when making decisions about an enterprise. Should
equity securities be bought or sold? Should a long-term loan be given?
However, financial statements are the representations of the management of the
company. As such, these statements will not necessarily be fairly presented.
Material misstatements may exist in the form of errors, irregularities, or illegal
acts. The management might, for example, have an insufficient knowledge of
generally accepted accounting principles to produce appropriate statements.
Human error or bias is also possible in the gathering and reporting of financial
information. In addition, the management may have fraudulently manipulated the
data in hopes of achieving some objective.
Outside parties are aware that the financial information produced by a company
and its management may not always be reliable. Hence, to add credibility to this
reporting process, independent experts are retained to audit the financial
statements and test the underlying accounting records. These auditors then
issue an opinion for the benefit of outside parties as to the fair presentation of the
financial statements in conformity with generally accepted accounting principles.
This added degree of assuredness allows decision-makers to rely on reported
financial information.
(2)
A CPA firm could not be expected to maintain expertise in every potential industry
that it might audit. In reviewing a potential client, the firm should evaluate its
ability to gain the necessary industry expertise prior to the actual audit, but no
requirement exists that this knowledge must be possessed prior to accepting the
engagement.
Each industry may have its own specific accounting practices. In addition,
certain industries frequently offer unique auditing problems. Thus, without a
thorough investigation, the auditor cannot ascertain the knowledge that will be
needed in examining a potential client. In the consumer electronics business, for
example, the methods of distribution as well as credit policies would be
significantly different from those found in a car dealership. Damaged or obsolete
inventory are other problems that might be more important in this specific
industry. Hence, a knowledge of one type of operation does not necessarily
mean that the auditor has the expertise needed to examine a client operating in a
13
different industry.
Auditing standards require that auditor have the expertise by the completion of
the audit, but this expertise need not be in place at the beginning. It would be
unethical to misrepresent a firms experience, but it need not be volunteered.
(3)
A profit-sharing bonus plan gives employees an added incentive to seek
increases in company income; a larger profit figure will lead to a larger bonus at
the end of the year. Consequently, employees may be tempted to inflate income
artificially by creating false sales or deferring the recording of expenses. An
auditor must always be alert for situations that can promote the possibility of such
irregularities. A profit-sharing bonus plan may well have only positive effects on
company employees. However, the auditor should not be so naive as to fail to
recognize that some individuals may take advantage of such plans by
manipulating the financial records.
This problem may be especially significant in the Lakeside Company because
the bonus plan is new and the stores are geographically located at a distance
from the home office. New plans require adaptation by company controls and
such separation always increases potential control concerns. In addition, Rogers
has already mentioned that some of the internal control systems are no longer
adequate. Thus, the possibility of inflated income figures is even more of a
possibility.
(4)
Critics of the auditing profession have argued vehemently for a number of years
that advisory services such as those discussed in this question taint the
appearance (and possibly the reality) of independence. These services may
appear to the public to give the audit firm a financial interest in the success of the
company. This argument holds that the firm will now want the client to succeed
as proof of the quality of the advice that was given. In addition, the audit team
may be less judicious in investigating these systems since they are aware that
members of their own firm designed and installed them.
Audit firms counter by stating that adequate safeguards have been put into place
to ensure continued independence.
For example, advisory services are
frequently rendered by a separate division of the firm so that no proximity exists
between this function and the audit staff. In addition, firms are not allowed to
give many types of advice that might jeopardize their independence. Finally,
audit firms must make certain that their services are limited to making
recommendations, not carrying out management decisions. The firm cannot
make decisions for the client.
14
Discuss with client the policy for valuing inventory and identifying obsolete
inventory items.
Discuss with client the procedures for obtaining a proper year-end cut-off.
15
(6)
A company may not want its CPAs to audit a client's records because the
auditors gain a substantial amount of competitive information during an
audit. However, CPAs are bound by confidentiality under the AICPA's
Code of Professional Conduct. Also, a CPA's knowledge of the industry
gained from having several clients in the same industry provides him or
her with insights he/she may not have otherwise had.
SUGGESTED ANSWERS TO EXERCISES
(1)
(a) and (b) The independent auditor must be able to review massive quantities of
information and identify the fraud risk factors that may affect the amount of
evidence to be gathered or the opinion to be rendered. This question calls upon
the judgment abilities of the students. The format used by students for this
memo is not important as long as it is clear and understandable. SAS 99 requires
use a brainstorming session in the planning stage to be sure that everyone
associated with the audit understands the nature of the business and the
potential risk of fraud. These sessions can also occur during the audit if
additional evidence presents itself. Potential problems that students would be
expected to identify are as follows:
*
Internal Control - The president of the company admits that the company's
internal control is antiquated. Control problems may be heightened in that
operations extend throughout two states. Since understanding the internal
control is one of the prerequisites for ultimately determining the amount of
substantive testing that will be required, the weakness of the various
controls may require the extensive gathering of evidence, or even
preclude an opinion.
16
Uncertainty Involved with the Sixth Store - A qualified opinion was issued
by the predecessor auditor in connection with this store. Abernethy and
Chapman must face the question as to whether this issue can be resolved
during 2006.
Distributorship Sales - The case indicates that these sales have risen
dramatically during the past two years. Any sudden change or fluctuation
in an account balance will always warrant the auditor's attention. In this
instance, the auditor will be especially interested in verifying the validity of
these sales figures.
Related Party Transactions - The case indicates that Lakeside has begun
to have financial dealings with the president of the company. Obviously,
nothing is wrong with this arrangement, but such related party transactions
are often difficult for the auditor to verify. In addition, they require clear
disclosure.
Rental Agreements - Five of the stores have been leased and, apparently,
Store Seven will be rented from Rogers. Rental agreements pose the
question as to the need for capitalizing the lease. Abernethy and
Chapman will have to read the various agreements to see if any of them
qualify as a capital lease under the criteria established by the Financial
Accounting Standards Board.
17
18
(2)
INDEPENDENT AUDITOR'S REPORT
To the Board of Directors:
We have audited the accompanying balance sheet of the Lakeside
Company as of December 31, 2008, and the related statements of income,
retained earnings, and cash flows for the year then ended. These financial
statements are the responsibility of the Company's management.
Our
responsibility is to express an opinion on these financial statements based on our
audit.
We conducted our audit in accordance with auditing standards generally
accepted in the United States of America. Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation.
We believe that our audit provides a
reasonable basis for our opinion.
During 2007, the company made a $186,000 investment in a retail store
located in the eastern sector of Richmond, Virginia. This store has failed to reach
a break-even sales point to date and total recovery of the Company's investment
is highly uncertain. In our opinion, the chances are reasonably possible that the
asset's value has been permanently impaired and should be reduced to the net
realizable value in conformity with generally accepted accounting principles.
In our opinion, except for the effects of not recording or disclosing the
impairment of value of the asset, as discussed in the preceding paragraph, the
aforementioned financial statements present fairly, in all material respects, the
financial position of the Lakeside Company at December 31, 2008, and the
results of its operations and its cash flows for the year then ended in conformity
with accounting principles generally accepted in the United States of America.
King and Company (signed), Certified Public Accountants
Date: (last day of audit fieldwork)
19
20
CASE 2
SUGGESTED ANSWERS TO DISCUSSION QUESTIONS
(1)
The question of materiality is certainly one of the most complex issues in all of
auditing. No clear-cut guidelines have ever been established to aid the auditor in
deciding whether a specific balance or transaction is "material." This lack of an
official standard provides the auditor with the freedom to base all final decisions
on professional judgment. Unfortunately, without a formal rule, the auditor has
little guidance in applying judgment to a particular situation.
Materiality has traditionally been held to be any factor that would influence the
decisions of those parties relying on the financial statements. Identifying a
proper basis of comparison is an important aspect in determining whether an
uncertainty is material. Net income is the most obvious standard of comparison,
although another consideration is which of the statements is affected (e.g.,
Balance Sheet, Income Statement, or both?). The situation questioned by King
and Company involves an investment in fixed assets. Comparing the potential
loss to total assets, investment in stores, and owners' equity would seem a
reasonable basis for judging materiality. Another possible basis is the effect of
the asset write-off on net income.
In the Lakeside case, each auditor would have to decide independently as to
whether Store Six represents a material contingency for this client. The potential
closing of Store Six is certainly an unusual occurrence and for that reason should
be evaluated against the client's $500,000 net worth and the $1.8 million in total
assets reported in the case. In making these comparisons, the auditor needs to
anticipate the potential loss. Although the total loss could amount to $186,000,
Rogers has suggested $136,000 as a maximum figure. Unfortunately, estimates
provided by the president of the client company are circumstantial evidence,
having little power to persuade.
In the view of the authors, this potential loss (of over $100,000) for a company
with a net worth of only $500,000 would certainly appear to be material. Other
comparisons based on total assets or income would give similar results.
(2)
The CPA firm must talk with the predecessor auditor before accepting the
engagement. The new auditors can learn about the integrity of the potential
client's management as well as about any accounting or auditing problems that
might be encountered. If Rogers prohibits this meeting, Abernethy should
21
carefully explain the necessity of the procedure. The client may not be fully
aware of audit practices and fail to understand that such discussions are a
normal part of investigating new clients. Should the client still insist that no
communication be made with the previous auditor, Abernethy would normally
have to reject the new engagement unless very unusual circumstances
surrounded the client's request.
(3)
The information given by the predecessor auditor as to the integrity of the client's
management must weigh heavily in the decision to seek a new client. Because
of the potential legal liability faced by independent auditors, the decision to
accept a client has become quite important. No auditor wants to perform an
engagement for a company with a management that cannot be trusted.
However, in evaluating the assertions of King and Company, Abernethy must
realize that this firm has just been fired from the Lakeside audit. Some potential
bitterness toward the client is certainly possible. Thus, auditors usually seek
references from other than just the predecessor auditor before deciding whether
to actively pursue a new audit client.
(4)
In a peer review, a team of outside auditors is hired by a CPA firm to review its
system of quality controls, the policies and procedures utilized by that
organization to ensure that its members are following all professional standards audit, accounting and review, ethics, etc. This review helps to ensure that the firm
is fulfilling its professional responsibilities. If the peer review team discovers
practices that are unprofessional or inadequate, the firm can make immediate
corrections to rectify the problems.
Peer reviews originated in the 1970s when litigation of CPA firms became
rampant, and congressional investigations of the profession indicated that drastic
improvements were needed. The peer review process was instigated to provide
firms with a means of getting outside consultation about their professional
practices. Rather than discovering problems only after losing a lawsuit, the firms
were periodically reviewed by these outside teams to catch problems before they
grew to be too large.
A peer review team looks at the means by which the public accountant ensures
quality control within its practice. For example, the acceptance of new clients
should be properly monitored by the firm. Adequate consultation needs to be
made available to all staff members so that audit problems can be properly
resolved. Hiring and promotion practices should be established and in place to
provide sufficient staffing for all engagements. The peer review team looks at all
areas of quality control to ascertain that problems do not exist that could lead to
substandard work. In addition, the team reviews the audit documents for a
22
23
24
Privately held
2.
The basic liability to the client is for losses occurring as a result of any firm
negligence. If Abernethy and Chapman performs the engagement as an
average, prudent auditor would, no problem exists. If not, the client may
sue for return of its audit fee as well as any other resulting losses. A
special problem area exists in the Lakeside case: the client's weak
internal control. Such weaknesses increase the likelihood of fraud or
embezzlement. The control problems also make discovery of such
defalcations more difficult. In addition, proving that the firm is innocent of
negligence is often difficult to do if the client loses money through
defalcations not discovered by the auditor.
3.
4.
5.
As a privately held business, this audit does not fall under federal security
laws. Thus, the auditor is bound by common law and is judged under such
precedents as the Ultramares case, the CIT Financial Corp. case, and the
Rusch Factors case. In the Lakeside audit, the CPA firm should have no
liability to third parties unless the audit is performed in a grossly negligent
manner or the firm is negligently responsible for careless financial
misrepresentations. In a few jurisdictions, they may be held liable to
foreseen or foreseeable beneficiaries for ordinary negligence.
25
2.
3.
Predecessor auditor stated that the firm was discharged over the wording
of the previous audit opinion.
4.
5.
6.
(2)
The auditor will perform a number of steps in reviewing the audit documents of
the predecessor auditor. The major objective is to examine the types of
information that would be available to an auditor in an ongoing engagement.
Through this review, the auditor can gain satisfaction as to the validity of
beginning account balances as well as accounting principles applied in the
previous audits. By relying on the work of the predecessor auditor, the extensive
review necessary in an initial audit can be held to a minimum.
The audit working paper review should include the following steps:
*
Review internal control evaluations for obvious weak areas and for
strengths.
26
(3)
This answer assumes that King and Company, the predecessor auditor, has no
reason to believe that their previous report is not still appropriate. Furthermore,
that firm has reviewed the current financial statements and obtained a
representation letter from Abernethy and Chapman, the successor auditor,
stating that the current year's audit has not revealed anything that would have a
material effect on the prior year's audit.
27
28
CASE 3
SUGGESTED ANSWERS TO DISCUSSION QUESTIONS
(1)
Although this question can be answered by a simple reading of Exhibit 3-1, it
does force the student to consider the contractual obligations being assumed by
both parties. One portion of this letter that might warrant discussion is the CPA
firm's declaration that absolute assurance is not being given in regard to major
misstatements. The students can be queried as to the reasons for including this
statement. In addition, the students can be asked to discuss the method by
which the client company can draw the distinction between reasonable
assurance and absolute assurance. As a different line of questioning, the
students can discuss other responsibilities that could have been accepted by
either party.
The engagement letter is required. Responsibilities of the CPA firm found in the
engagement letter:
*
(2)
In performing analytical procedures, auditor expectations should be derived from
a wide variety of sources. For cost of goods sold, Abernethy and Chapman
29
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 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
30
Hence, estimating
(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
31
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:
*
32
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%
33
[.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.
34
a)
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%
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.
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%
30 times
2.8 times
Profit Margin
2.93%
2.27%
Return on Assets
6.09%
6.73%
Days
hand
inventory
35
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.
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.
Nothing unusual
36
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.
37
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.
Procedure
Scan the trial balance
Results
The equipment account shows
an increase from the previous
year.
38
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.
39
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:
40
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:
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
42
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)
43
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.
44
45
(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.
46
(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 prenumbered.
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.
47
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 function appears to begin
immediately upon the receipt of the cash.
8. Transactions authorized -- all transactions seemed to be appropriately
authorized.
9. Other control procedures that might be mentioned by the students:
-
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 crossreferencing. In case of a later dispute, locating the invoice might be difficult.
48
(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:
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.
(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
49
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.
50
CASE 5
SUGGESTED ANSWERS TO DISCUSSION QUESTIONS
(1)
SAS 31, "Evidential Matter," states that: "The measure of the validity of
[evidential matter] for audit purposes lies in the judgment of the auditor...." (par. .
02) Thus, the quality of oral evidence is an evaluation made by the auditor that
would be influenced by a number of factors: the perception of management's
integrity, the rank of the individual providing the information, the ability to
corroborate the evidence by other sources, and the purpose for which evidence
is being gathered. However, in all cases, statements made by the employees of
a client are only circumstantial evidence. In a comparison with other forms of
evidence (such as observing physical existence and receiving confirmations
directly from third parties), it provides less assurance.
In this case, Mitchell is attempting to gather additional evidence concerning
Lakeside's systems, especially the design and operating efficiency of control
procedures and policies. Oral evidence serves an important role in such testing
but still has to be complemented by other testing: a review of completed internal
documents, flowcharts, organizational charts, job descriptions, systems manuals,
etc.
Conversely, oral information provides less evidence in the substantive testing of
account balances. Whereas company employees should be able to furnish
relevant information as to the functioning of control procedures within the various
accounting systems, the auditor must rely almost exclusively on other types of
testing to determine the fair presentation of the client's financial statements.
(2)
Accounts receivable generate a constant flow of cash into a company, offering a
temptation to any employee who might be inclined to steal. Over the years,
ingenious individuals have devised a multitude of plans for diverting this
monetary inflow to themselves. Some of the more common schemes include the
following:
51
Lapping can occur. One or more accounts receivable are collected by the
company but the money is stolen by an employee. However, since the
collection is not recorded, another invoice will eventually be sent to these
customers who would then alert the company to the earlier payment. To
prevent the processing of this second bill, subsequent cash collections from
other customers are applied to the balances of the original customers. This
series of events can be repeated indefinitely. Money is stolen on a daily or
weekly basis to cover each previous theft.
(3)
A company's net income can always be inflated by creating fictitious credit sales.
For example, an invoice is prepared for a fake customer with the amount being
recorded as an increase in both accounts receivable and sales. In the Lakeside
audit, the client company wants to grow. Bank loans or new equity investments
may be needed for this purpose. Increased income would make this type of
financing easier (and, perhaps, cheaper) to negotiate. False sales might also be
created for a different reason: the regional sales representatives are paid a
commission based on sales. Thus, to inflate their own income, they might
attempt to falsify sales records.
Students may also suggest that fictitious sales will inflate the profits of the
individual stores and, thus, increase the bonuses paid to the manager and
assistant manager. However, this case indicates (as does the balance sheet in
Case 3) that all credit sales are made by the distributorship side of the business.
The stores do not sell on credit so that fictitious sales cannot be created through
the recording of extra accounts receivable.
(4)
In talking with client personnel, an auditor must be constantly alert for any
indication of potential problems. "Red flags" are often encountered in these
discussions that need to be investigated to ensure that material misstatements
do not exist. During Mitchell's conversation with Miller, a number of comments
are made that should concern the auditors:
No justification seems to exist for using .7% of net sales as the estimation
of bad accounts. The auditor cannot corroborate a number that appears to
have been selected at random. A new attempt must be made to derive an
estimation that is a reasonable representation of the company's
uncollectible accounts.
The company waits until an account is 15 days old before a second invoice
is mailed. This delay is, perhaps, one of the reasons that the age of the
accounts has increased. Many customers may be waiting for the pressure
of the second bill before making payment.
Miller writes off accounts as uncollectible with no apparent company
control. Since bad accounts may indicate errors or irregularities, they
should always be reviewed and approved by some independent party
within the organization.
Miller produces and mails the final invoice for overdue accounts. Since
Miller has a great many responsibilities in this system, this last billing
should be made by some other individual. Therefore, if the account has
been paid (and stolen or incorrectly recorded), the information comes back
to this independent person.
Prices and extensions of invoices are sometimes checked after the invoice
has been mailed to the customers. This system is obviously inefficient.
Payments may be made incorrectly, and customers can become
aggravated by later adjustments being made.
(5)
First, because of weaknesses found during the preliminary evaluation of the
internal control, control risk may be assessed at the maximum level. Since
maximum control risk is being assumed, the auditor has no reason to test the
operating efficiency of the control procedures.
Second, although potential strengths may be identified by the preliminary
evaluation of internal control, the auditors may still opt to assess control risk at
the maximum level. This decision would be justified if additional substantive tests
appear to be easier and cheaper to perform than the testing of the operating
efficiency of specific control policies and procedures. Thus, once again, the
testing of the control procedures becomes unnecessary.
In the new Sarbanes-Oxley environment, testing cannot be omitted for public
companies.
(6)
Inherent risk is the susceptibility of an account balance or class of transactions to
a material misstatement. A number of factors affect this assessment: the quantity
54
and size of transactions occurring over time, the past history of the company in
this area, the likelihood of theft, the necessity of performing complicated
calculations in order to generate reported figures, problems inherent to a
particular industry, the need for making estimations, the results of analytical
procedures, and the possibility of obsolescence. For example, in the Lakeside
audit, inventory would be an account that would probably have a high inherent
risk. The company has numerous transactions in both buying and selling
inventory. Computations of discounts and freight charges could be difficult, as
would be the application of a cost flow assumption. The possibility of theft,
breakage, returns, and obsolescence of inventory would all be high and require
periodic estimations.
The auditor's assessments of both inherent risk and control risk have a significant
impact on detection risk and, therefore, substantive testing procedures. If the
inherent risk and control risk are both determined to be low, detection risk need
not be kept low. Thus, less substantive testing (both in quantity and quality) is
needed. Conversely, if the inherent risk and the control risk are judged to be
high, the auditor must reduce detection risk. As discussed above, this risk can
be brought down to an acceptable level by such means as performing additional
substantive testing, using more experienced staff personnel, carrying out
procedures closer to the balance sheet date, or relying on more effective testing
procedures.
(7)
In positive confirmations, debtors are asked to respond in all cases whether or
not they are in agreement with the information given. When using the negative
form of request, debtors are asked to respond only if they disagree with the
information.
Since positive confirmations require a response in every case, they provide
better evidence than do negative confirmations. Hence, positive confirmations
are more appropriate when the internal control is weak, accounts are large or
old, or related parties are involved. Increased audit evidence is needed in each
of these cases. Negative confirmations are not as costly and are most often used
when less evidence is required.
(8)
The selection of a specific account for confirmation is an indication that the
auditor desires additional evidence or assurance about that particular balance. A
number of situations exist that would suggest the need for confirmation of a
specific account:
a)
55
b)
c)
The account is far overdue, indicating a possible bad debt to be written off
or that payment has not been properly recorded;
d)
The activity within the account has been unusual. For example, later
invoices were paid while earlier charges were ignored.
(9)
The debit entries made to Lakeside's Accounts Receivable control account
produce an audit trail made up of the following documents or records:
Sales Journal - indicates the original journal entry recorded for each sales
transaction. An auditor matches the debits in the general ledger account to
these journal entries to ascertain that no posting errors have been made.
Bill of Lading - records the quantity and description of the items being
shipped. The auditor compares it with the sales invoice to make certain that
the items ordered and billed are in agreement with the items that were
shipped.
Inventory Price List - used to price sales invoices. An auditor can use this
listing to verify correct pricing of the sales invoices.
57
Consistent with our answer in #11 above, Miller has not designed an effective
system. It is not unusual for a company to grow and what worked before can no
longer be relied on to handle the increased volume. Miller seems to exhibit a lax
attitude in several of his answers and therefore, since he is responsible for the
system, we must conclude that he has not made good decisions.
58
59
QUESTION (6)
Comments - The first three invoices are mailed by the sales division; any further
billing is made by Miller, who is in charge of the subsidiary ledger.
Significance - By having Miller send the last invoices, the opportunity for
manipulation is increased. In a small company such as Lakeside, this situation is
not unusual, but it should be accompanied by additional control and reconciliation
features.
Suggestion - Control can be established by allowing Miller to continue the billing,
but with the addition of the control procedures suggested in several of the other
questions.
QUESTION (7)
Comments - The responsibility for looking into complaints is vested in Miller.
Significance - Again, all of the responsibilities are in the hands of one person with
no independent control being applied. This lack of control reduces the possibility
that errors will be discovered. Basically, an opportunity to establish control over
Miller's work is being missed.
Suggestion - Lakeside should have complaints sent to an employee who can
then discuss the matter with both Miller and the customer to make certain that
the issue is properly resolved.
QUESTION (8)
Comments - According to the client, no formal change in the policy of granting
credit has been made. However, the increases in the size of the receivables, the
increase in the average age of the balances, and the apparent write-off of
additional uncollectible accounts indicate the possibility that some, perhaps
informal, modification has occurred. Because the credit policy has never been
formally established, the auditor may have trouble distinguishing an actual
change.
Significance - Any shift in credit policy requires auditor attention as to the effect
on the allowance account and bad debt expense. Abernethy and Chapman may
want to review the new customer accounts opened during the current year for
any indication of a change in credit policy. This issue may be especially
significant in the Lakeside audit since credit reports are filed by the sales
representatives who are paid on commission, thus benefiting from an increase in
sales.
Suggestions - Lakeside should adopt a policy to guide Rogers in his credit
60
61
Suggestion - All verifications should be made prior to mailing the invoice, ideally
by a different employee.
QUESTION (12)
The answers to Question (11), above, appear to pertain equally as well to this
question.
QUESTION (13)
Comments - Cash discounts are verified by the sales division.
Significance - System appears adequate. Financial information should be fairly
presented.
Suggestions - None
QUESTION (14)
Comments - Using prenumbered sales invoices and bills of lading along with the
periodic verification of all numbers is essential in assuring that all sales are
recorded. In an earlier case, the use of prenumbered forms is mentioned. Miller
suggests that the presence of all forms is tested periodically, but the auditor
should specifically ask about that procedure.
Significance - If the possibility exists that the company can make sales without
recording them, the auditor's ability to gain assurance as to completeness
assertion may be severely hampered.
Suggestions - Since the documents are already prenumbered, the auditor needs
to make certain that Lakeside has a policy for periodically verifying the presence
of all forms.
(2)
STEP (1-a)
Anticipated Results - The total listed on the sales invoice should agree with the
total on the sales invoice slip. In addition, evidence should be present to indicate
that a Lakeside employee has already made this same comparison.
Potential Problem - If the invoices do not agree, the possibility is raised that
fictitious or misstated sales are being recorded. Lack of tangible evidence (e.g.,
initials) that the matching procedure has been carried out would indicate that the
62
63
64
STEP (2-a):
Anticipated Results - Each debit entry should be corroborated by an appropriate
sales invoice agreeing as to amount and customer.
Potential Problems - This test has major significance in that it can alert the
auditor to any falsification of sales for the year. Fictitious sales could easily be
created by Lakeside since they prepare all sales invoices and other documents
internally.
STEP (2-b):
Anticipated Results - Each credit should agree with the cash remittance list as to
amount and possibly date of payment depending upon the method of posting.
Potential Problems - This tracing could denote errors in postings within the
system. Errors could indicate lapping by company employees.
STEP (2-c)
Anticipated Results - Each credit to a specific account should agree with the
listing of individual items on the bank deposit slips.
Potential Problems - Again, lapping or attempts by employees to cover cash
shortages may be uncovered through this test.
STEP (3)
Anticipated Results - For each of the customers, complete and updated credit
reports should be on file.
Potential Problems - The use of credit reports is an essential step in establishing
an appropriate credit-granting system. The presence of these reports would
indicate that the control procedure is operating efficiently. If the reports are
missing or incomplete, the auditor may want to seek additional evidence as to the
validity and collectibility of the receivables.
STEP (4)
Anticipated Results - Each list should be arithmetically correct. Its total ought to
agree in amount and date with the balance entered in the cash receipts journal.
Potential Problems - Cash shortages and cash thefts are often covered by
incorrectly footing a listing of cash transactions.
65
66
CASE 6
SUGGESTED ANSWERS TO DISCUSSSION QUESTIONS
(1)
In the brief description presented of Lakeside's inventory procurement system,
several specific control activities can be seen:
the case implies that the company uses preprinted forms so that adequate
information is captured whenever a document is prepared;
all invoices are matched with the appropriate purchase requisition and
receiving report before payment is approved;
(2)
Canceled checks are the last document in this system, while receiving reports
are one of the first. Whenever auditors select a final document such as a
canceled check and search for its documentation, they are seeking to
substantiate the validity of the balance being reported. All forms and documents
must be present to prove that the amount and the company's reporting were both
correct. Such testing also seeks to discover whether false transactions have
been entered into the system. For example, if a canceled check is found without
a corresponding receiving report or purchase requisition, the possibility exists
that money has been stolen from the company; a payment was made for
merchandise that was not ordered nor received.
Taking a beginning document such as a receiving report and tracing the impact of
the transaction through an entire system is intended to provide evidence of
completeness and that the system and its controls are working as designed.
67
Obviously, such testing will also provide evidence as to the validity of the account
balance, but this particular procedure is more often associated with the
completeness assertion and internal control evaluation.
(3)
How might Lakeside pay for goods that were received? The company could, as
an example, receive an invoice and not properly match it with the corresponding
receiving report. The receiving report might state that 10 items were actually
acquired while the invoice was for 20 or 100. The individual doing the review
may not notice the discrepancy and erroneously approve the invoice. As another
possibility, this individual might authorize an incorrect invoice in order to receive a
kickback from the vendor.
How might Lakeside fail to pay for goods that were not received? If either the
receiving report or the invoice is lost, the documents will not match and payment
cannot be made. Thus, the company may wait indefinitely for the other (lost)
form before approving the cash disbursement.
(4)
Audit documentation, also called a working paper, is designed to demonstrate
that the auditor has obtained sufficient, competent evidence on which to base an
opinion as to the fair presentation of the client's financial statements. Given that
overall objective, the working paper indicates the testing that was performed and
the evidence that was accumulated. The working paper should also specify any
problems that were encountered and their resolution. The working paper must
demonstrate that this portion of the examination was properly planned and that
all assistants were adequately supervised. In addition, the audit documents as a
whole must indicate that internal control was studied and evaluated. All audit
documents are the property of the auditor and are maintained by the auditor in
order to support the opinion rendered by the auditor.
(5)
A CPA firm must establish policies and procedures for the supervision of work at
all organizational levels to provide reasonable assurance that the examination
conforms to generally accepted auditing standards. Procedures for supervision
are necessary to ensure that appropriate judgments and conclusions have been
drawn from the work performed. Not every member of an audit team will have
the expertise necessary to evaluate the handling of each accounting and auditing
problem that arises. Furthermore, some of the audit staff may lack an in-depth
knowledge of the client or the client's industry, thus increasing the possibility of
incorrect judgments. Supervision by auditors having the necessary experience
and expertise provides reasonable assurance that sufficient evidence and proper
conclusions were obtained.
68
69
preferable to ensure that all audits are performed in a like fashion. However,
these standardized procedures should be supplemented with procedures
designed to meet the particular circumstances of each client.
SUGGESTED ANSWERS TO EXERCISES
(1)
Exhibit 6-1 may well be a student's first view of audit documentation. Therefore,
discussion of its clarity and completeness should force the student into a close
examination of the structure and function of the document. Students should be
encouraged to discuss the strengths of this particular working paper as well as its
weaknesses.
The audit procedures seem generally clear, although they do contain some
problems. For example, the fifth procedure states that the auditor "examined
canceled checks for amounts, dates, signatures, endorsements, and payee."
Obviously, the auditor is not just physically examining this information but is
confirming the data against some other document (the invoice).
This
reconciliation is not clearly stated. Also, in the seventh procedure, no indication
is given as to the purpose of verifying the account code.
Exception (A) is poorly written. The staff auditor does not indicate whether the
$200 and the $360 amounts are over or under the current list price. Additionally,
the explanation for the discrepancies is vague. Stating that "the difference
represents monthly purchases from Cypress at different prices than shown in
current price list" indicates nothing about the reason for the change. The major
problem, though, with this explanation (and the actual testing procedure) is that
Thomas' word is accepted as an adequate explanation for the discrepancy. The
auditor provides no information that any further testing has been carried out to
verify these amounts. The assumption has apparently been made through the
comment "Pass Further Work" that the differences are immaterial and, thus, do
not require additional testing. Since all of the supervisors have added their
initials, concurrence appears to exist with this evaluation. Students may want to
discuss whether these two discrepancies warrant further examination and, if so,
what testing could be performed.
Exception (B) is also vague and poorly written. Once again, Thomas' explanation
is apparently accepted without further question or testing. The comment does
not indicate the amount of the differences that are involved in this replacement.
Therefore, judging the materiality of the items will be quite difficult for the audit
supervisors.
Exception (C) seems relatively clear. An auditor would prefer to see this policy in
an official Lakeside manual rather than accepting oral evidence, but in a small
70
company such as Lakeside, that may not be possible. The auditor should adjust
the flowchart and memorandum for this system to include this discovery.
On the whole, other than comments A and B, this working paper appears to be
clear and comprehensive. By reviewing the steps of the audit program listed in
this case, students can see that Heyman has performed the audit procedures
designed by Mitchell.
(2)
Attached is one example of an audit document that could be produced by
carrying out the prescribed auditing procedures. A great amount of variety exists
in format, and students ought to be evaluated on the clarity and understandability
of their approach rather than on the development of a particular structure.
In reviewing this audit document with students, the instructor should be aware
that this question was developed with several educational objectives in mind:
(3)
If Art Heyman found inconsistencies in this part of the audit his
primary responsibility is to document the items. He should do only
enough work at this point to fully understand the nature of the
inconsistency, so that his documentation is adequate.
In
conversations with Mitchell further work may be developed.
71
Lakeside Company
Tests of Receiving Reports and Cash Disbursements
12/31/09
Audit Procedures
Date
t
t
t
t
t
t
t
t
t
t
t
t
8/20/09
Receiving
Report Number
3918
Invoice
Number
711
Number
3091
Check
8/21/09
3919
802
3121
GC
8/24/09
3920
991
3164
E F
8/27/09
3921
1261
3203
GBD
8/28/09
3922
1313
3251
9/2/09
3923
1406
3310
9/3/09
3924
1510
3345
9/7/09
3925
1616
3397
GB
9/7/09
3926
1691
3425
GC
9/14/09
3927
1812
3451
G E
9/16/09
3928
2072
3471
GC
9/21/09
3929
2149
3510
Audit Objective:
To verify that items received were properly ordered, received, and paid.
Scope:
Population: All receiving reports prepared during the period under audit.
Sample: Judgmentally selected 12 receiving reports from inventory department file. Pulled
reports sequentially, randomly starting with #3918.
Audit Procedures:
Compared receiving report with purchase invoice for quantity and description. All agreed except
B.
Compared receiving report to purchase requisition for quantity and description. All agreed except
B and C. All requisitions approved by Rogers or Miller.
Invoices reviewed for compliance to see if they were checked, extended, and footed by Lakeside
employees. All were except D.
Compared invoice prices with Cypress Master Price List. All agreed except E.
Inspected canceled checks and compared them to invoice amounts, recomputing 3% discount. All
agreed except E.
72
Lakeside Company
Tests of Receiving Reports and Cash Disbursement (cont.)
12/31/09
Comments
A Receiving report not in file. Client should be asked to find it or provide a reason for its absence.
Unless it is accounted for, the scope of testing may need to be expanded. AH
B On two invoices Cypress billed Lakeside for items different from those received. In both cases the bill
was for the items ordered, not those received. R.R. #3923 shows an item that is more expensive
than the one billed, while R.R. #3927 has an item that is less expensive than the one billed. The
purchase requisition for R.R. #2923 indicates Lakeside's acceptance of a replacement but no
indication in connection with R.R. #3927. Lakeside has paid for goods ordered, not goods received.
This reflects a serious problem with both the Lakeside and Cypress systems. AH
C Some receiving reports indicate receiving a different amount of goods than ordered. Requisitions
indicate that goods have been backordered in both cases. Lakeside, however, paid only for goods received.
System is functioning properly. AH
D No indication on this invoice that pricing, footing, or extensions were verified. Other invoices show
initials and tick marks. Failure to comply with the system in this one case. AH
E In a number of cases, invoice prices were less than the Master Price List. There seems to be a
discount on special items, but more evidence is needed. AH
F One invoice was reduced by a 4% discount, instead of 3%. Further inquiry required to determine
reason. AH
G In virtually all cases, checks were issued 2 or 3 days after the 20-day deadline for taking discounts, but
Lakeside took the discount in every case. Further inquiry is required to determine if Lakeside still
has a liability for these amounts. AH
73
CASE 7
SUGGESTED ANSWERS TO DISCUSSION QUESTIONS
(1)
A company profit-sharing arrangement is a matter of auditor concern because it
provides an incentive for employees to generate artificially high income figures.
These individuals can receive direct financial benefits from the manipulation of
reported earnings. This potential problem is even more of a concern in the
Lakeside engagement because controls are weak and each store is
geographically isolated from the oversight provided by the administrative offices.
(2)
This case describes the payroll system used by the Lakeside Company. Tests of
controls are designed by the auditor to verify that specific control features
identified as possible strengths are operating effectively. A sample of such tests
would include the following:
a.
b.
c.
d.
e.
f.
g.
h.
i.
Verify that each payroll record has been properly authorized by Mark
Hayes;
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j.
Compare the payroll transfer made from the general fund each period to
the total payment computed on the payroll record;
k.
Review canceled checks for proper signature, amount, payee, date, and
endorsement;
l.
Review payments made for withholdings and payroll taxes. Compare these
amounts to payroll records kept for each of these items.
(3)
Existence or Occurrence - For payroll expense, the auditor would want to
determine that all employees do, indeed, work for the company. If 48 employees
are paid each period, the auditor needs to ensure that 48 individuals are working
for Lakeside. The auditor should be concerned that one or more employees are
stealing money by receiving more than one check. A review of the payroll
records completed by the employees before they begin work provides some
evidence that the individuals do exist. In addition, the auditor can accompany the
paymaster (or whoever serves in this capacity) when paychecks are distributed.
This procedure allows the auditor to identify the person receiving each check to
ensure that the employee is the same as is listed on the check itself.
Completeness - Completeness is not usually a major problem in the area of
payroll expense where misstatements most often result from having extra
expense recorded (because of theft) rather than from having transactions
omitted. However, the auditor still wants to ascertain that the $1.1 million figure
to be reported contains all applicable payroll expenses. Thus, for example,
verifying that a year-end expense accrual has been made helps to prove that all
expenses were recorded. Furthermore, if payroll taxes and other costs are to be
reported within the payroll expense figure, the auditors should determine that all
such costs (Social Security, unemployment taxes, medical insurance premiums,
etc.) have been properly included in the final balance to be presented.
Rights and Obligations - For payroll expense, the auditor would want to ascertain
that work did occur during the period for which the company does have a legal
obligation to pay. The auditor would review the time tickets to make sure that
they seem proper and then recompute the amounts to be paid based on the
hours worked. These calculations provide evidence that the payments were,
indeed, the actual obligations of the client company.
Valuation or Allocation - Since an expense rather than an asset is involved, the
auditor is more interested in allocation than valuation. Verification should be
made that the proper expense is being allocated to the current year. Hence, the
auditor should recompute the cut-off made of the payroll calculation at both the
75
beginning and ending of the fiscal year. Determination needs to be made that
the figure being reported is for 2006 only.
Presentation and Disclosure - The auditor wants to make certain that the
financial statements fairly present the payroll expense figure. As shown in
Exhibit 3-1, a balance for "Salaries, Commissions, Bonuses" is reported for both
the stores and the distributorship. The auditor needs to determine that the
separation into these two classifications is properly performed. In addition, the
specific accounts included within this single category should be consistent from
year to year so that comparability is enhanced. Since the company does not
manufacture its inventory, no portion of the payroll expense should be assigned
to Cost of Goods Sold.
(4)
Types of evidence-gathering procedures that are used by an auditor during an
examination would include the following. (One method for approaching this
question is to ask the students to identify the accounts that could be tested
through each procedure.)
a) Observation of activities and conditions - usually a test of controls to
provide evidence of operating efficiency.
b) Physical examination and count - used to prove that an item physically
exists and agrees with the ledger balance.
c) Confirmation - proves existence of a balance by communication directly
with an outside party.
d) Inspection of documents - demonstrates that control procedures have been
performed or provides support for reported balances.
e) Recomputation
(including
footings,
cross-footings,
extensions,
recalculations, etc.) - demonstrates that control procedures have been
performed or provides support for reported balances.
f)
76
of operations.
i)
j)
Correlation with related information (including ratio and trend analysis) another analytical procedure to identify possible problem areas.
k)
l)
Obtaining a representation letter from the client's senior management management acknowledges responsibility for statements and provides
evidence in areas where other evidence may not be available.
This question also asks about the competence (significance and reliability) of
these procedures. Each test is potentially quite important and produces reliable
evidence but only if used in the appropriate circumstances. For example,
confirmation is one of the most important steps in auditing cash bank balances
but is rarely used in connection with an account such as land. Physical
examination is essential in auditing marketable securities where ownership and
value can often be ascertained visually. This same procedure is much less of a
factor in examining equipment. An audit procedure must match an account and
the type of evidence needed.
(5)
Maintaining a separate payroll bank account is a common control procedure
encountered by auditors. Having a separate payroll account:
Allows for easier application of control procedures such as limit tests, item
counts, and validity checks;
Allows for additional control over unclaimed checks, uncashed checks, etc.;
77
Facilitates the audit function in that the payroll balances are easier to verify;
(6)
Some of the more critical potential problems involving payroll include:
A.
B.
The working paper is not properly dated so that a reviewing auditor cannot
be certain that this testing applies to 2009.
The columns are not labeled. No method exists for identifying the
information that has been gathered.
In the first three columns, abbreviations such as "SM," "M-2," and "Salar."
are used without explanation, which makes possible the erroneous usage of
the information.
In the column that starts with $388, the seventh item and two items in the
next column do not have tickmarks, which may indicate that they have not
been tested. No indication is given as to the significance of these three
omissions.
According to the working paper, none of the items in the column that begins
with $39 has undergone any testing. That possibility seems unlikely, since
an exception has been found at point A.
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Comment A is vague and does not indicate any reason for the exception nor
does it discuss the significance of the problem. In addition, the note makes
no mention of potential testing that may be required because of the
exception.
Two canceled checks could not be found at point B, but no reason is given
nor is any suggestion included for further testing.
One tickmark (a caret) was used for two different tests. The reviewer has
no method of distinguishing the actual procedure performed.
Several of the auditing procedures listed at the bottom (on the left) use
vague terms such as "company records," "government records," and
"calculations" without any specific identification. Thus, determining the
procedures actually performed and the specific documents analyzed would
be virtually impossible.
The working paper does not contain objectives, scope, or conclusion (see
Exhibit 6-1). Therefore, it does not clearly spell out what was done or what
was found. No indication is presented as to the method of selecting the
employee names that have been used.
(2)
a A completed Exhibit 7 worksheet is shown on the following page.
b It appears that the 2008 bonus expense account is overstated (actual balance
= $6,000 v. estimated balance = $3,940); however, the amount of
overstatement ($1,060) does not seem material. The 2009 expense appears
to be overstated by $8,184 (= $19,500 recorded - $11,316 estimated). This
overstatement represents approximately 6% to 7% of net income and, thus, is
fairly significant; however, since it overstates an expense, it understates net
income. The auditor could either accept the balance or suggest that the client
make an adjustment.
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Exhibit 7
Lakeside Company
Account 585, Estimated Bonus Expense, for Nine Months ended
September 30, 2008 and 2009
2008 Bonus Plan
Sales
-Sales Returns
-Cost of Sales
-Dir. Sal. Exp.
-Rent
=Bonus Basis
x Bonus %
=Bonus
STORE
No.1
$273,000
7,900
162,600
45,200
9,600
48,200
2%
964
STORE
No.2
$397,800
25,190
239,300
59,200
28,400
45,710
2%
914
STORE
No.3
$236,100
11,950
138,200
39,300
12,000
34,650
2%
693
STORE
No.4
$242,300
14,050
137,200
38,600
13,200
39,250
2%
785
STORE
No.5
$373,000
30,010
229,000
54,800
30,000
29,190
2%
584
STORE
No.6
$110,800
11,300
68,100
32,300
12,000
(12,900)
2%
0
TOTAL
STORES
$1,633,500
100,400
974,400
269,400
105,200
184,100
2%
3,940
STORE
No.1
$319,900
12,200
185,300
51,200
10,500
60,700
4%
2,428
STORE
No.2
$398,900
29,900
228,400
59,300
33,000
48,300
4%
1,932
STORE
No.3
$458,800
49,500
231,100
40,400
13,200
124,700
4%
4,988
STORE
No.4
$265,400
19,850
152,400
41,200
14,000
37,950
4%
1,518
STORE
No.5
$364,600
48,250
218,000
55,100
32,000
11,250
4%
450
STORE
No.6
$121,200
13,700
73,800
32,300
12,200
(10,500)
4%
0
TOTAL
STORES
$1,928,800
173,400
1,088,900
279,400
114,700
272,400
4%
11,316
Sales
-Sales Returns
-Cost of Sales
-Dir. Sal. Exp.
-Rent
=Bonus Basis
x Bonus %
=Bonus
Notes: Lakeside makes an "imputed rent" charge to Store No. 6 for the purpose of determining this bonus. Sales (A/C
500); Sales Returns (Prepared by Client); Cost of Sales (A/C 550); Direct Salary Expense (A/C 580); Rent (Prepared by
Client).
adequate internal control over financial reporting and give its assessment of
whether or not internal control over financial reporting is effective. According to
the rules, management cannot state that internal control over financial reporting
is effective if even one material weakness exists at year-end.
Auditors report. The independent auditor will evaluate and report on the
fairness of managements assessment. The auditor also will perform an
independent audit of internal control over financial reporting and will issue an
opinion on whether internal control is operating effectively as of the assessment
date (i.e., the companys fiscal year-end). If one or more material weaknesses
exist at the companys fiscal year-end, the auditor cannot conclude that internal
control over financial reporting is effective.
Source: Internal Control over Financial Reporting: An Investor Resource,
December 2004 by: Deloitte & Touche LLP; Ernst & Young LLP; KPMG LLP;
PricewaterhouseCoopers LLP.
Documenting a significant deficiency could appear as in this example:
A material weakness is a control deficiency, or combination of control
deficiencies, that results in more than a remote likelihood that a material
misstatement of the annual or interim financial statements will not be prevented
or detected. The following material weakness has been identified and included in
managements assessment. The company has no effective human resource
function and personnel files are inadequate to assure approval of salaries and
wages. In addition, salaries are not approved by the board of directors. This
material weakness was considered in determining the nature, timing, and extent
of audit tests applied in our audit of the 200X financial statements, and this report
does not affect our report dated [same date as below] on those financial
statements.
Source: Perspectives on Internal Control Reporting A Resource for Financial
Market Participants, December 2004 by: Deloitte & Touche LLP; Ernst & Young
LLP; KPMG LLP; PricewaterhouseCoopers LLP. [Note: Payroll example was not
in the original quoted material].
82
CASE 8
SUGGESTED ANSWERS TO DISCUSSION QUESTIONS
(1)
A number of reasons could explain a difference between the physical inventory
count and a company's perpetual inventory records. When faced with any
discrepancy such as this, the auditor should consider all possible causes.
The cost flow assumption (FIFO, in this case) may have been improperly
applied in the perpetual records.
Goods in transit could have been incorrectly handled in either the perpetual
records or the physical inventory.
The specific cost assigned to each inventory item might have been incorrect
in certain cases.
The final inventory listing (Exhibit 8-4) may have been extended or footed
erroneously.
errors contained in the counted figure. If Mitchell has appropriately observed the
taking of the physical count, the possibility of errors in the quantity of inventory
should be at a minimum. Additional testing, such as verifying the costing, the
extensions, and the footings will further reduce the risk of a material error in the
figure to be reported.
The presence of perpetual records adds another dimension to the inventory
verification. By comparing the ending figures from the physical count with the
perpetual records, the auditors can determine whether differences are connected
with the quantity or the unit cost for the individual inventory items. If the $6,000
is primarily created by quantity differences, the auditors should consider the need
for selected recounts. Conversely, if the difference is based on costing
variances, the auditors will concentrate on establishing the validity of those
particular figures.
A question may be raised by the students as to the reasonableness of a $6,000
difference between the physical count and the perpetual inventory records. For a
company having $3.5 million in cost of goods sold and a warehouse with over
$650,000 in inventory, this difference is not significant in size even with the use of
a perpetual system. A more important issue would be the composition of the
difference. If a great number of items are not in agreement with the records and
simply net to a $6,000 variance, the auditors have reason to be concerned.
Conversely, if only a few items display differences, verification is much easier.
(2)
An over-count of inventory leads to a decrease in cost of goods sold and, thus,
an increase in reported net income. In any situation in which the company
desires a high reported income (for example, to maintain high stock prices, in
anticipation of a loan or a bond issuance, to reach the level anticipated by a
financial forecast, etc.), over-counting of inventory must be of concern to the
auditors. This possibility is especially relevant to the Lakeside stores because of
the profit-sharing plan. The inventory is being counted by the manager and
assistant manager of each store, the same people who receive a bonus based
on that store's net income. Therefore, these employees can increase their bonus
for the current year simply by over-counting the inventory.
(3)
An undercount of ending inventory leads to an increase in cost of goods sold and
a decrease in reported net income for the current year. The most obvious reason
for a company to undercount ending inventory is to defer payment of income
taxes. A manipulation of this kind would be especially tempting to a company
experiencing cash flow problems. Other reasons for undercounting inventory
84
may be encountered but are less compelling than the motive to overcount. One
possible incentive is to push earnings from a very high performance year into the
next to smooth out a growth curve and avoid having to achieve that record again
in the following year. In a different vein, if the company must undergo union
contract negotiations in the near future, reporting less net income might prove to
be advantageous. However, little evidence exists in this case to indicate that
Lakeside's management would be tempted to reduce reported earnings except
possibly for the accompanying reduction in current taxes.
(4)
In the engagement letter prepared by Abernethy and Chapman (see Exhibit 3-1),
the firm stated that it expected "to obtain reasonable but not absolute assurance
that major misstatements do not exist." When a material misstatement goes
undetected and is reported in the client's financial statements, the question to be
raised concerns the difference between reasonable and absolute assurance. In
assessing responsibility in such cases, the public accounting firm is judged
against the work of the average prudent auditor. The firm must provide proof that
the examination was performed at least as well as would have been done by the
average prudent auditor. If a misstatement is missed that would have been
detected by the average prudent auditor, the firm is normally considered to be
guilty of negligence in the performance of the audit examination. In that case,
any losses incurred by the client company resulting from this mistake can be
recaptured from the firm. However, because Lakeside is privately owned, the
CPA firm will probably be liable to third parties for losses only if gross negligence
can be proven. Unfortunately, the distinction between negligence and gross
negligence is not clearly delineated by the courts.
(5)
A decision to observe less than 100% of the ending inventory always exposes
the auditor to some degree of risk. This risk is based on the possibility that a
material misstatement exists in the inventory not being observed. Three factors
would reduce that risk level in the audit of the Lakeside Company. First,
according to the September 30, 2009, trial balance, the inventory at the
warehouse makes up nearly 80% of the total inventory owned by Lakeside.
Thus, the possibility of a material problem in the inventory held at the stores is
limited. Second, the perpetual records enable the auditors to isolate variances at
all stores which can then be subjected to recounts or further testing if necessary.
Third, Lakeside appears to have an efficient system of taking the physical
inventory. Unless Mitchell and her staff spot weaknesses in the actual
procedures in use, the efficiency of this system offers assurance that the count in
each store has been accurate.
85
(6)
One method of manipulating net income is to record sales in one year with
recognition of any subsequent returns being delayed until the following period.
Normally, this problem is overcome by a year-end adjustment to establish an
estimation of all subsequent returns. As evidence of the validity of this
estimation, the auditor will review any sales returns received at the beginning of
the new year. The auditor should be aware that companies can alter reported
earnings significantly by shipping out large quantities of inventory at the end of a
year knowing that most of the items will be returned. If the shipments are
recorded immediately as sales, while the returns are estimated based on
historical data, the company can overstate current income.
(7)
As indicated in Question (2), above, over-counting of inventory is a potential
concern in any audit but especially so in the Lakeside engagement. Mitchell
records the last tag number as a preventive measure against the preparation of
falsified tags subsequent to her observation.
(8)
This question can generate debate among students who often expect the
auditors to perform extensive auditing procedures in regard to damaged and
obsolete merchandise. In reality, Mitchell's role is that of an observer; damaged
or obsolete inventory is the client's responsibility. The Lakeside memorandum
clearly indicates that company employees should separate these items prior to
the inventory count.
Mitchell will want to verify that all damaged or obsolete inventory items have
been segregated and correctly valued. If she is convinced that such inventory
has been isolated, she needs only to ascertain that the value has been
appropriately established by the company. If Mitchell is not satisfied by the
method used to value these items, especially if the total is material, she has the
option of calling upon an independent appraiser to assist her in substantiating the
valuation process.
A different problem arises if Mitchell discovers any damaged or obsolete
inventory that has not been separated from the rest of the merchandise. Unless
the client can provide a reasonable explanation, this discovery casts doubts on
the reliability of the counting process. Mitchell may then need to extend her
testing procedures to search for further evidence of such inventory.
86
(9)
Lakeside's procedures for taking its physical inventory seem well designed
especially since perpetual records are available for comparison purposes. By
following the process outlined in Exhibit 8-1, the company should be able to
arrive at an accurate ending inventory figure.
SUGGESTED ANSWERS TO EXERCISES
(1)
An audit program designed to verify the inventory listing and the reconciling items
would include steps such as the following:
a.
Trace the tags recorded by the auditor (Exhibit 8-3) to the physical inventory
listing (Exhibit 8-4), noting agreement as to description and quantity.
b.
Verify that no tags were added to the inventory listing beyond the last tag
recorded by the auditor.
c.
For each of the inventory items recorded by the auditor, compare the unit
cost indicated on the inventory listing with the cost per the master price list
(Exhibit 6-6). Note agreement as to description as well as unit cost. (Note:
Students may choose to select a new sample for this and the remaining
tests. The advantages to using the same sample throughout are that
recording on the working paper may be simplified and efficiency gained.)
d.
e.
f.
Using the master price list, compute a cost for the January 1-2, 2010,
receiving reports. Compare this total to the inventory listing for agreement.
g.
Using the master price list, compute a cost for the January 1-2, 2010, bills
of lading. Compare this total to the inventory listing for agreement.
h.
Review the inventory listing to ascertain that all tag numbers are included
with no duplications.
i.
87
case, this step will not be possible for the students to perform.)
j.
Agree the "total adjusted cost of inventory - 12/31/09" to the general ledger
at December 31, 2009.
(2)
One technique for approaching this case is to assign Question (1) for one class
period with the working paper to be prepared only after review of the students'
audit programs. This procedure helps to stress the connection between preparing
an audit program, evidence gathering, and developing a working paper. It
demonstrates a continuum from:
In reviewing the audit documents prepared by the students, the instructor should
insist that each specific audit procedure be spelled out along with the results of
that testing. As always, the working paper should be clear and complete, but it
must also indicate the fulfillment of each audit program step.
The attached working paper has been created as an example. It was produced
to correspond with the audit procedures outlined in Exercise (1). In completing
this assignment, procedure (i) has not been performed because the information
was not made available in the case. In addition, the working paper has been
prepared under the assumption that all goods are sold f.o.b. shipping point and
all purchases are acquired f.o.b. destination. These assumptions have been
made to simplify the audit testing, but the students may want to discuss the
additional procedures that would be required if other f.o.b. points had been
appropriate.
88
Lakeside Company
Tests of Inventory Listing--Warehouse
12/31/09
WP # F-3 p. 1
Prepared by: PR
1/12/10
Reviewed by:
Inventory Item
Tag No.
Serial Number
Quantity
Amplifiers
Component Systems
Beepers
Stereo Systems
Amplifiers
Speakers
Stereo Systems
CD Players
Receivers
Stereo Systems
VCRs
Speakers
Head Phones
CD Players
116
124
102
138
130
150
127
142
113
126
104
137
147
132
BC76-W
JB45-M
CB21-S
FU87-R
KZ54-T
YG28-Y
RA69-M
RW21-X
NB73-X
JH88-A
CZ55-H
BF23-G
PO88-Q
CD00-N
22
69
80
60
88
71
99
49
112
77
46
84
49
121
Audit
Procedures
Audit Objectives:
To verify that the physical count she observed agrees with the inventory
listing.
To verify that the inventory listing provides a fairly presented inventory cost
balance.
Scope: Items that were selected during the inventory observation. See WP F-1 and F-2.
Audit Procedures:
Traced items from inventory listing to master price list noting agreement as to
description and unit cost. No exceptions noted.
89
Lakeside Company
Tests of Inventory Counts--Warehouse
12/31/09
WP # F-3 p. 1
Prepared by: PR
1/12/09
Reviewed by:
Rec. Rep.
Qty.
Unit Cost
Total Cost
Audit Proc.
Jan. 1, 10 Televisions
JB45-H
3988
20
481.87
9,637.40
Jan. 2, 10 Headphones
KJ32-K
3989
40
32.00
1,280.00
RX04-L
3989
10
285.99
2,859.90
Total
13,777.30
XY76-R
Bill #
6015
Qty
20
Unit Cost
219.95
Total Cost
4,399.00
Audit Proc.
Jan. 1, 10
Jan. 1, 10
Televisions
BM09-H
6015
10
812.35
8,123.50
Jan. 2, 10
Stereo Systems
AB15-M
6016
20
256.98
5,139.60
Jan. 2, 10
Stereo Systems
JH88-A
6016
12
324.00
3,888.00
Jan. 2, 10
Receivers
CS33-P
6016
10
698.98
6,989.80
Jan. 2, 10
Televisions
AR65-C
6016
1,319.00
7,914.00
Jan. 2, 10
Speakers
BF23-G
6017
469.00
3,752.00
Total
42,205.90
Audit Objective:
To verify that the reconciling items to the inventory listing are valid and reasonable.
Scope:
All reconciling items to the inventory listing.
Audit Procedures:
Agreed quantity and description to WP F-1. No exceptions noted.
Agreed to master price list noting agreement as to description and unit cost. No exceptions
noted.
@ Agreed to inventory reconciliation.
Other Procedures:
Recomputed discounts on inventory reconciliation without exception.
Footed inventory reconciliation without exception.
Inventory adjustment of $6,156.78 is immaterial. Pass further work.
Audit Conclusion: Inventory reconciling items are valid and reasonable.
90
WP # F-1
Prepared by: PR
Date: 1/12/09
Lakeside Company
RECONCILIATION OF
PHYSICAL INVENTORY - WAREHOUSE
January 3, 2010
TOTAL COST OF INVENTORY - JANUARY 3,
2010 - WAREHOUSE
$664,950.33 @
Less: Inventory Received on January 1 and
January 2 (from Receiving Reports)
(13,777.30) F-3 p. 1
Add: Inventory Shipped Out on January 1 and
January 2 (from Bills of Lading)
40,205.90 F-3 p. 1
TOTAL COST OF INVENTORY - DECEMBER 31,
2009 - WAREHOUSE
$691,378.93 F
Less: Adjustments for Monthly Discounts
Given by Cypress
Tag 113 - Discount $30.00 x 85 Items Purchased
( 2,550.00) R
Tag 121 - Discount $ 8.25 x 40 Items Purchased
( 330.00) R
Tag 132 - Discount $12.60 x 60 Items Purchased
( 756.00) R
Tag 146 - Discount $11.50 x 80 Items Purchased
( 920.00) R
Tag 149 - Discount $ 6.50 x 35 Items Purchased
( 227.50) R
SUB-TOTAL
$686,595.43 F
Less: Adjustment for 3% Cash Discount Taken
on All Inventory Purchases
( 20,597.86)
TOTAL ADJUSTED COST OF INVENTORY - DECEMBER 31,
2009 - WAREHOUSE
$665,997.57 F L
INVENTORY IN WAREHOUSE PER PERPETUAL
INVENTORY RECORDS
(672,154.35)
INVENTORY ADJUSTMENT (REDUCTION)
$( 6,156.78) F A -6.1
Audit Objective:
To verify that the inventory balance is valid and reasonable.
Scope:
The listing to the inventory balance reconciliation.
Procedures:
@ Agreed to Inventory Listing
F Footed
R Recalculated
A Agrees to T/B
Audit Conclusion: The inventory balance is fairly stated.
91
CASE 9
SUGGESTED ANSWERS TO DISCUSSION QUESTIONS
(1)
Any company which does not maintain an extensive accounting staff will often
rely on the independent auditors for information concerning the application of
authoritative pronouncements. Most CPA firms assume some responsibility for
keeping client companies aware of important accounting standards and the
potential effects on financial reporting. Thus, Rogers' lack of knowledge about
Statement 34 is not unusual; a bigger surprise might be that the company's
auditors had not previously discussed the requirement with this client.
(2)
Where possible, expense accounting follows the matching principle which states
that expenses should be recognized in the period in which they assist in
generating revenues. An asset produces no revenues prior to being placed into
service. Therefore, any expense recognition (such as depreciation or interest)
would be inappropriate during construction. Only after the asset is in use
generating revenues, should any related expense be recorded.
(3)
Theoretically, the management of the client company prepares all financial
figures which are then corroborated by the independent auditors. However,
Lakeside apparently has no one on its staff with the expertise to make this
particular calculation. In such cases, the auditor is frequently forced to generate
the data, and provide figures which are presented to the client as proposed
adjustments. Lakeside should be warned though that this task is outside the
realm of a normal audit and, if extensive, may require an additional fee.
(4)
This question offers another opportunity for interesting class discussion.
Students often view accounting as a discipline in which all questions can be
ultimately resolved by an adequate knowledge of accounting standards. In this
instance, they face a case of financial statement manipulation that is being
carried out by the client within the framework of accounting's own official
guidelines. A review of FASB Statement 13 can be assigned to assist the
92
93
(5)
The recording of accounting information is normally based on objective evidence
gathered by analyzing the impact of transactions that occur between the
reporting entity and outside parties. However, related party transactions do not
provide evidence with the same degree of objectivity. Sales prices or contracts,
for example, might not be negotiated as they would otherwise be with outsiders.
Figures may simply be fixed by management. Consequently, to inform the
financial statement readers of the impact of these dealings, the relationship must
be described along with the details of the transactions.
(6)
The potential impairment of value of Store Six has been an underlying problem
throughout the Lakeside audit. In discussing this issue, students frequently
concentrate on the wrong issues: client retention versus safety from litigation.
Audit opinions, however, should be based on the actual evidence accumulated
and the related reporting employed by the client, not on the avoidance of
problems. Such a limited approach fails to recognize the auditor's function: to
gather corroborative evidence on which to base an opinion as to the fair
presentation of the financial statements. Virtually no corroborative evidence is
presented in these cases in connection with Store Six and its potential
impairment of value; therefore, students have no basis for any specific course of
action. In practice, auditors first gather as much evidence as possible and only
then do they make a final determination when faced with this type problem.
Students can be asked to list the kinds of evidence Abernethy and Chapman
might seek in evaluating the possibility of a material impairment of value in
connection with Store Six. This exercise is a good technique for demonstrating
the necessity of creativity in the auditor's work. The auditor needs to consider all
possible ways to gain assurance about the future of this store. A few of the
evidence-gathering procedures that might be carried out would include:
Discussion with the owners and managers of the shopping center as to their
strategies for renting more space and improving customer traffic.
Talk to owners and managers of the stores located in the shopping center to
see whether their projections are similar to those of Rogers.
Search for any studies that have been prepared on the consumer
94
Hire a real estate appraiser to estimate the sales value of the building if it
should have to be sold. This valuation will enable the auditor to anticipate
the potential loss being faced by Lakeside.
One final point should be made in connection with this potential impairment of
value. The implication is made throughout these cases that the primary
responsibility for resolving this issue lies with the auditors. That is not correct.
The financial statements are representations of the management of the client
company. As such, management is responsible for justifying the financial
reporting. Unless Rogers makes a significant attempt to prove his present
position in this controversy, the auditors will have trouble rendering an unqualified
opinion.
(7)
Little doubt exists that Rogers has issued a subtle threat to the new audit firm.
One of the primary reasons for investigating the integrity of management prior to
accepting an engagement is to avoid the possibility of this type of blackmail. This
warning was issued in such a way by Rogers that Abernethy and Chapman will
probably not need to consider the possibility of resigning but, if a similar threat is
ever made in an overt manner, immediate resignation by the CPA firm should be
considered.
SUGGESTED ANSWERS TO EXERCISE
(1)
This assignment requires the students to analyze the client's Warehouse
account. In this case, for the first time, no audit program is available. The
students must determine which procedures to perform and then record the
actions taken as well as the evidence accumulated. The instructor may want to
discuss this requirement by simply asking the class what evidence-gathering
techniques should have been carried out by the auditor. An example of a
completed working paper for this assignment is attached.
95
LAKESIDE COMPANY
Building-Warehouse/Office A/C 111-1
W.P. I-3
2
Accountant: AH
Date: 1/14/10
12/31/09
163,500-
21,800
16,90025,300
14,600-
Proposed AdjustmentAJE#1
Proposed AdjustmentAJE#2
Proposed AdjustmentAJE#3
Subtotal (warehouse construction excluding interest)
Proposed Adjustment-interest
AJE#4
Subtotal (warehouse construction including interest)
Proposed reclassificationAJE#5
Adjusted Total
163,500-
Audit Procedures:
Traced to 12/31/08 audited balance per predecessor auditor's audit documents noting agreement.
(Note: Although necessary, this procedure cannot be performed with the information given in this
text.)
Traced to general ledger noting agreement. Also, traced to purchase invoice noting agreement as
to amount, and approval.
Other Audit Procedures:
Examined 9/1/09 minutes of Board of Directors' meeting noting approval for expansion.
Examined bank confirmation from Virginia Capital Security Bank indicating lien on warehouse in connection
with $100,000 loan.
Proposed Adjustments: See next page.
96
LAKESIDE COMPANY
Building - Warehouse/Office A/C 111-1
W.P. I-3
1
Accountant: AH
Date: 1/14/10
12/31/09
PROPOSED ADJUSTMENTS
A
640-1
111-1
B
111-1
210-2
3500-
C
Invoice for work done 12/28/09-1/8/10 by Gainer Electrical Company received after year-end.
Accrue four days (4/12 x $4,800= $1,600).
AJE 3
111-1 Building-Warehouse/Office
1600210-2
Accounts Payable
1600D
Capitalize interest on building loans. This figure is roughly estimated based on the expenditures
on construction (from "subtotal" on previous page) of $93,800, the interest rate charged on the direct loan,
10%, and the time of construction during 2009 (3 months from October to December, per the invoices in
Exhibit 9-6). Thus, $93,800 x .10 x 3/12 = $2,345.
111-1
220-1
AJE 4
Building-Warehouse/Office
Accrued Interest Payable
New
acct.
111-1
AJE 5
Construction in Progress-Warehouse
23452345-
96145-
Building-Warehouse/Office
96145-
Audit Conclusion: Account is fairly stated, after adjustments, in accordance with GAAP.
97
(1)
Quoting from the Act:
Section 301: Public Company Audit Committees.
Each member of the audit committee shall be a member of the board of directors of the
issuer, and shall otherwise be independent. "Independent" is defined as not receiving,
other than for service on the board, any consulting, advisory, or other compensatory fee
from the issuer, and as not being an affiliated person of the issuer, or any subsidiary
thereof.
The SEC may make exemptions for certain individuals on a case-by-case basis. The audit
committee of an issuer shall be directly responsible for the appointment, compensation,
and oversight of the work of any registered public accounting firm employed by that
issuer. The audit committee shall establish procedures for the "receipt, retention, and
treatment of complaints" received by the issuer regarding accounting, internal controls,
and auditing. Each audit committee shall have the authority to engage independent
counsel or other advisors, as it determines necessary to carry out its duties.
Each issuer shall provide appropriate funding to the audit committee.
(2)
Quoting from the act:
Section 302: Corporate Responsibility For Financial Reports.
The CEO and CFO of each issuer shall prepare a statement to accompany the audit report
to certify the "appropriateness of the financial statements and disclosures contained in the
periodic report, and that those financial statements and disclosures fairly present, in all
material respects, the operations and financial condition of the issuer." A violation of this
section must be knowing and intentional to give rise to liability.
98
CASE 10
SUGGESTED ANSWERS TO DISCUSSION QUESTIONS
(1)
The sheer quantity of transactions that are processed by most modern
corporations prohibits the auditor from attempting to evaluate more than a portion
of the total. Many large companies record millions of transactions per year, a
number that could not possibly be verified by an audit team at an acceptable
cost. Even if complete testing were possible, nonsampling risk would still exist
because of potentially unrecorded transactions, fraudulent transactions, and
auditor errors and oversights. Just as importantly, independent auditors are
employed to provide reasonable rather than absolute assurance as to the fair
presentation of a company's financial statements. The desired degree of
assurance can be achieved without examining every item.
Thus, some amount of risk is tolerated in the testing procedures being applied.
Statistical sampling allows certain aspects of that risk to be measured
mathematically. Auditors use statistics to determine the number of items that
should be examined to reduce sampling risk to a level that is considered justified.
(2)
Statistical sampling does not create additional work; rather, it guides the auditor
in performing the proper amount of work. In addition, although statistical
sampling may initially appear to be complex, the various procedures become
significantly easier with practice.
In any sampling plan (statistical or judgmental), a degree of uncertainty about the
final results must be accepted. Statistical sampling allows the auditor to set in
advance the amount of risk that is acceptable for a particular test. Mathematical
formulas and charts then enable the auditor to compute the size of the sample
that is necessary to reduce the risk involved to this tolerable level. Computer
programs make these calculations quick and easy. An auditor who appropriately
calculates a sample size of 89, for example, knows that the examination of this
number of items will provide results within predetermined parameters.
Statistical sampling also forces the auditor to consciously consider several
important aspects of the specific testing procedure. In this case, Mitchell has to
analyze the type of work being performed by the client and then set an
acceptable risk of assessing control risk too low (ARACR). She must also
evaluate the ability of the client personnel and estimate an expected population
exception rate. Finally, she has to arrive at a tolerable exception rate, the highest
99
rate at which reliance can be justified. All of these considerations are important
in applying this audit procedure. The statistical sampling plan being used by
Abernethy and Chapman requires the auditor to consider each of these limits
before testing can begin.
(3)
Sampling for attributes is utilized whenever an auditor wants to estimate the
occurrence rate of a specified characteristic. This procedure is frequently applied
in tests of controls where the auditor is seeking to measure the prevalence of
errors made by employees in following the control procedures built into a
particular accounting system. Thus, the auditor is attempting to determine a rate the percentage of errors committed. Although sampling for attributes has other
uses within an examination, it does enable the auditor to derive this specific
information being sought in a test of controls.
(4)
Mitchell is seeking to verify that a proper cut-off has been performed by the client
in recording its year-end accounts payable and accrued expenses. In this
process, a number of invoices are to be reviewed to ensure that Luck has
appropriately determined the amount owed by Lakeside on December 31, 2006.
At the same time, the auditor can also ascertain that a purchase requisition has
been prepared for each of these invoices. Mitchell may also elect to examine the
invoices to determine if physical evidence exists to indicate that each document
has been mathematically proven and properly authorized by company personnel.
Thus, several testing procedures can be carried out simultaneously by the audit
team.
(5)
Once again, as in question (1), the auditor is seeking only reasonable, not
absolute, assurance about the fair presentation of the client's financial
statements. Thus, the presence of some errors, especially if they are not
material, does not necessarily nullify the value of the information. In addition, the
auditor rarely relies exclusively on the work of one particular individual in making
an assessment. Luck's analysis will provide evidence about this expense
accrual, but other testing should be carried out before the audit team is satisfied
that the account balances are fairly presented.
Luck might commit mistakes for a number of reasons, most of which involve
human errors caused by carelessness, fatigue, misunderstanding, etc. She may,
for example, misread an invoice or miscalculate the amounts involved. She
100
could also omit an invoice entirely or include one a second time by accident. The
possibility also exists that Luck might have purposely misrepresented the yearend accrual as a way of manipulating the income figures to be reported by the
company.
(6)
In most examinations, previous experience with the client and its personnel will
assist the auditor in arriving at an estimation of an actual exception rate.
However, the firm of Abernethy and Chapman has not audited Lakeside in the
past; thus, Mitchell must rely more heavily on other techniques. To begin, she
should ascertain the difficulty of the task being performed. She will also have
had the opportunity to observe Luck's work throughout the engagement and
should hold some opinion as to the reliability of this employee. She may do a
pilot test, choosing a relatively small random sample to see what the sample
exception rate is. Finally, from experience with other clients, the auditor can
usually anticipate an exception rate for a particular task.
(7)
The 6% figure established by Mitchell in this case is a good example of the
importance of an auditor's being able to use judgment developed through
experience. The selection of this rate was undoubtedly influenced by a number
of factors such as the size of Lakeside's accrual, the adequacy of other testing
procedures, Mitchell's evaluation of Luck's ability, the risk involved in accepting
an incorrect accrual, experience with other audit clients, etc. However, after
assessing these and other possible variables, the ultimate decision as to the line
between reliance and non-reliance must always lie with the auditor.
(8)
According to Exhibit 10-2, a sample size of 40 (left column) with 2 errors (top
row) indicates a maximum error rate of 12.8% with a 10% ARACR. Since
Mitchell has specified a tolerable exception rate of only 6%, she cannot accept
the client's work as a fair representation of the amount of the year-end accrual.
The client's total accrual figure may, indeed, still be accurate, but the sample
indicates the possibility of too many errors for the accrual to be judged as
reliable. The error rate indicates that the risk level is too high for auditor
acceptance without additional testing.
101
(9)
In most cases, the auditor would now seek to apply other procedures to verify the
reported balance. The client might, for example, be requested to reconstruct the
accrual with the newly derived balance then being tested, again using sampling
for attributes. However, because of the small population size in this case,
Mitchell may simply resort to reviewing all 283 invoices to achieve adequate
assurance about the accrual. After analyzing the entire population, the auditor
can either accept the client's accrual or propose an adjustment.
SUGGESTED ANSWERS TO EXERCISES
(1-a)
ABERNETHY AND CHAPMAN
Sampling for Attributes
Client: The Lakeside Company
Year Ending: December 31, 2009
Audit Area: Accrued Expenses
Date of Testing: February 4, 2010
(1) State the objectives of the audit testing:
To verify the year-end accrual of expenses developed by the client.
(2) Define the attribute or attributes to be estimated:
The exception rate made by the client in determining the year-end
liability owed in connection with invoices received during December
2009, and January 2010.
(3) Define the population:
All invoices received by the company during December 2009, and
January 2010.
(4) Define the sampling unit:
102
132
90
132
1
283
103
104
CASE 11
SUGGESTED ANSWERS TO DISCUSSION QUESTIONS
(1)
Statistical sampling requires the auditor to establish risk parameters prior to the
start of a testing procedure. Thus, a desired level of assurance (and, conversely,
an acceptable level of risk) is always defined whenever statistical concepts and
mathematical formulas are to be utilized. The auditor is aware in advance of the
possibility of a mistaken conclusion. Such information is especially important if
the audit firm ever has to justify its examination and the opinion rendered.
However, application of statistical sampling does demand a specialized degree of
knowledge. The auditor must have an adequate understanding of statistical
methodology. In addition, developing a statistical sampling plan may require a
significant amount of audit time.
Judgmental sampling is many times easier and quicker to apply and is, thus,
especially appealing in audit areas where exact precision is not required. For the
auditor with sufficient experience, this type of sampling can frequently provide
satisfactory conclusions about much of the client's data. Unfortunately, since no
guidelines exist for key decisions such as acceptable risk levels, required sample
size, or the evaluation of final results, the auditor has no way of measuring the
potential for an incorrect assessment. In any test, not enough items may have
been examined to support a conclusion, or too much testing could occur creating
an inefficient audit. Furthermore, if the auditor must ever demonstrate in a peer
review or court case the basis for a particular decision, objective evidence to
substantiate the judgment is usually not available.
There is no correlation between sample size and choice of statistical versus
judgmental sampling methods.
(2)
As the partner-in-charge of the Lakeside examination, Cline must ensure that
sufficient, competent evidence has been obtained to satisfy himself that the
client's figures are fairly presented. Based on his years of audit experience, if
Cline is uncomfortable with the evidence accumulated to date, he is obligated to
seek additional assurance. No other individual has the responsibility; no one
else can specify the appropriate amount of evidence required in a particular
situation. Because the decision is a judgment, some auditors might agree with
Mitchell that the testing presented in Exhibit 11-2 is sufficient. However, Cline is
105
in charge of this audit, and he should never accept a client figure until personally
satisfied of its fair presentation.
(3)
Although based on mathematical concepts, statistical sampling relies heavily on
the auditor's professional judgment. Such judgments can be seen throughout the
sampling plans discussed by the Abernethy and Chapman audit team in Case 11:
The auditors had to decide whether to test the 283 invoices by sampling or
by examining the entire population.
The auditors had to choose between applying sampling for attributes to
evaluate the client's expense accrual or some type of sampling for variables
plan.
The auditors had to establish an acceptable risk of incorrect acceptance.
The auditors had to establish an acceptable risk of incorrect rejection.
The auditors had to set a tolerable misstatement, the amount of error the
firm was willing to accept in the reported balance.
The auditors had to decide which type of sampling for variables plan would
be used; both mean-per-unit and difference estimation were discussed in
this case. Monetary unit sampling and stratified mean-per-unit sampling
are just two of the other techniques used by auditors.
The auditors had to select a point estimation of the population error.
The auditors had to choose a method for randomly selecting the items to be
sampled.
106
107
n e
n 1
(e)2
42,025
2,401
12,100
24,336
80,862
e
205
49
(110)
156
300
108
= 300/30 or 10
80,862 3010
30 1
52 rounded
(2) - Specify the acceptable level of risk for incorrect acceptance. Identify the
confidence coefficient (Z value) for this percentage.
Include any
considerations that were used in arriving at this parameter:
The risk of incorrect acceptance was set at 10% but no information was
provided in this case to indicate the rationale for this decision. The Z
Value for a 10% risk of incorrect acceptance is 1.28 according to Exhibit
11-1.
(3) - Specify the acceptable level of risk for incorrect rejection. Identify the
confidence coefficient (Z value) for this percentage.
Include any
considerations that were used in arriving at this parameter:
The risk of incorrect rejection was set at 30% but no information was
provided in this case giving the rationale for this decision. The Z value
for a 30% risk of incorrect rejection is 1.04 according to Exhibit 11-1.
(4) - Specify a tolerable misstatement for this population.
considerations that were used in arriving at this parameter:
Include any
SD Z a Z r N
TM E
Where:
N is the population size
Za is the confidence coefficient for the acceptable risk of incorrect
109
acceptance
Zr is the confidence coefficient for the acceptable risk incorrect rejection
SD is the estimate of the standard deviation of the difference
TM is the tolerable misstatement of the population
E is the point estimate of the population misstatement
Sample size =
8,000 2,830
44 rounded
(1)-(B)
ABERNETHY AND CHAPMAN
SAMPLING FOR VARIABLES DIFFERENCE ESTIMATION
Client: The Lakeside Company
Form Completed By: Carole Mitchell
Audit Area: Accrued Expenses
Date of Testing: 2/4/10
Year Ending: 12/31/09
(1) - State the objectives of the audit testing:
To determine the reasonableness of the client's year-end cut-off to
arrive at accrued expenses.
(2) - Define the population:
All differences between the year-end accrual (as determined by the
client) and the audited balance. Accruals were computed using all
invoices received by the client in December 2009 and January 2010.
(3) - Define the sampling unit:
The difference between each year-end accrual determined by the client
and the proper balance as calculated by the independent auditors.
(4) - Specify the acceptable level of risk for incorrect acceptance and identify the
confidence coefficient (Z value) for this percentage:
Risk of incorrect acceptance is 10% with a confidence
coefficient of 1.28.
110
(5) - Specify the acceptable level of risk for incorrect rejection and identify the
confidence coefficient (Z value) for this percentage:
Risk of incorrect acceptance is 30% with a confidence
coefficient of 1.04.
(6) - Specify a tolerable misstatement for this population:
$8,000
(7) - Specify a point estimate of the population error:
$2,830
(8) - Calculate appropriate sample size (all computations should be attached):
50 (given in the problem)
(9) - Indicate the method used to draw a random sample:
Random number generator using computer
(10) - Recompute the standard deviation using the entire sample selected:
Estimated Standard Deviation =
n e
n 1
Where:
e is the value of each unit sampled
is the average of each unit sampled
n is the number of units sampled
All 50 items sampled in Exhibit 11-2 and 11-3 show 43 differences with
a zero balance and seven with either positive or negative balances.
e
205
49
(110)
156
(97)
(150)
47
100
(e)2
42,025
2,401
12,100
24,336
9,409
22,500
2,209
114,980
111
= 100/50 or 2
114,980 2 50
50 1
48 rounded
(11) - Calculate the average difference within the sample and extend this figure to
the entire population:
Average Difference of Sample = $100/50 = $2 difference per unit
(audited numbers are higher than client's balances)
Estimated Total Difference = 283 items x $2 = $566 (client figure is
understated)
(12) - Determine the precision interval. Show the formula being used and identify
each element within this formula (all computations should be attached):
Precision Interval =
N Za
SD
n
N n
N
283 1.28
48
50
283 50
$2,238
283
(13) - Identify the upper and lower confidence limits of the population based on
the precision interval and the average difference of the sample:
Actual population of difference is estimated to be between an
understatement of $2,804 ($566 + $2,238) and an overstatement of
$1,672 ($566 - $2,238).
112
(14) - Conclusions/Recommendations:
No portion of the computed range of total errors falls outside of the $8,000
tolerable error limit. The client's accrual should be accepted as a fair
representation of the year-end liability.
113
CASE 12
SUGGESTED ANSWERS TO DISCUSSION QUESTIONS
(1)
The examination of a bank cut-off statement is a common audit procedure that
serves to generate several types of corroborative evidence. In reviewing this
document, the auditor is seeking to verify the client's reported balance for cash
and related accounts. In addition, the auditor must always be aware of the
possibility of theft in connection with cash held by the client. Thus, the auditor is
especially attentive to any information from the cut-off statement (such as a
check that did not clear the bank in a reasonable time) suggesting the existence
of a defalcation problem.
Audit procedures that could be performed using the information obtained in a
bank cut-off statement would include:
*
Review of the checks clearing the bank during the first few days of the new
year. Clearance of these checks serves as evidence of the validity of the
"outstanding checks" total included in the client's year-end bank
reconciliation. Any check which is not returned by this time may have been
falsified to cover a cash shortage.
Review of the specific date on which each returned check cleared the bank.
This procedure serves as a means of ascertaining the appropriateness of
the year-end cut-off made of cash disbursements.
Identification of all inter-bank transfers made near the end of the year so
that they can be scheduled in assessing the possibility of check kiting.
Review of all deposits clearing the bank during this cut-off period as proof of
the "deposits-in-transit" figure on the year-end reconciliation.
114
(2)
Many thefts and other illegal acts are perpetrated through the use of bank
accounts that supposedly have been closed. For example, a dishonest
employee can utilize such an account to cash checks made out in the name of
the company. The check is first deposited in this account followed by a
subsequent withdrawal by the employee. In a different vein, the company itself
could use a "closed" account to hide illegal payments or other transactions from
the auditors. To gain evidence of the possibility of such actions, a confirmation
should be used to obtain final information about any bank account that has been
closed by the client during the current year.
(3)
a.
b.
Fire Damage - Although the fire occurred subsequent to the fiscal year,
Statement on Auditing Standards 1 specifies that some events happening
after the end of the period "may be of such a nature that disclosure of them
is required to keep the financial statements from being misleading." SAS 1
goes on to list a number of examples, including inventory destroyed by fire.
Thus, Lakeside's 2007 fire loss will probably require disclosure in the 2006
financial statements.
Students may raise a question as to the materiality of the estimated loss
especially since it did not occur during 2009 and only disclosure is at issue.
Certainly, if the loss is not judged to be material, disclosure will not be
required. Frequently, though, unless the amount is extremely small, the
auditors will propose reporting a loss simply to avoid any later recrimination,
an example of data being included for protection rather than for information.
However, if Lakeside objects to the inclusion, the auditor once again faces
the materiality issue that has been discussed at several points within these
cases. Now that the students are familiar with the information involved in
this audit, the question may be asked of them as to whether the nondisclosure of this 2010 loss would require a qualification by the auditors in
115
2009.
c.
(4)
For many companies, a number of transactions occur within two or three days of
the end of the fiscal year. In seeking evidence of the fair presentation of the
financial information, the auditor needs to ensure that the impact of these
transactions is recorded in the proper time period. Cut-off testing is designed to
accomplish this goal. Reporting problems are especially likely if the client's
accounting system is not able to adequately classify the sheer volume of
transactions that can occur at year's end. In addition, the auditor must be aware
that company management can manipulate reported net income by having the
cut-off made either a few days before or a few days after the end of the period.
Cut-off testing is especially important in connection with inventory and sales.
First, the daily quantity of transactions involving these accounts is usually quite
large. Second, if shipment of merchandise is required (either for goods being
bought or sold), the auditor must ascertain the point at which title legally transfers
as well as the physical location of inventory at the end of the year.
(5)
Determining the fair presentation of the liability accounts is a concern to the
auditor because of the possibility that obligations may have gone unrecorded by
the client company. At least two reasons exist for this potential problem:
*
116
(6)
Contingent losses such as those arising from law suits or the possible closing of
a store are frequently quite material in size. Thus, the auditor is usually faced
with a potential outcome that can have an enormous impact on reported financial
figures. Furthermore, the ability of the auditor (or anyone else) to foresee the
future resolution of such contingencies is largely speculation. In the audit of
Lakeside, for example, the loss from Store Six may never occur or it may amount
to as much as $186,000. The auditor is being forced to evaluate the reporting of
possible future outcomes, data that is not easily subjected to attestation. Finally,
contingent losses are not always easy to uncover. Unasserted claims, for
example, may generate little or no documentation by the client until a formal
claim is made. Therefore, the auditor must perform a thorough investigation in
hopes of revealing any contingencies that might otherwise go unreported. In
seeking evidence of these losses, the auditor will talk with the client
management, read the minutes of stockholders' meetings as well as the
meetings of the board of directors, check contracts and disputed transactions,
read correspondence with lawyers, and review all bank confirmations.
(7)
As with any confirmation, the letter of inquiry to the legal counsel must be
prepared and signed by the client but mailed by the audit firm. The confirmation
should direct the recipient to send all responses to the auditor who is attempting
to gain assurance about the existence, evaluation, and reporting of both asserted
and unasserted claims against the client company. The inquiry letter lists all
pending or threatened litigation identified by the client along with management's
evaluation of the current status of these actions. The list should be limited to
claims for which the law firm has devoted substantial attention so that a proper
evaluation can be made. The counsel is requested to furnish information as to
the nature of each matter, progress to date, likelihood of an unfavorable
outcome, and the range of potential losses. The legal firm is also asked to
identify any other asserted claims against the client that are known to exist.
This letter also includes a list and evaluation prepared by management of
unasserted claims against the company that are considered probable of
assertion with a reasonable possibility of unfavorable outcome. The law firm is
asked to indicate any disagreements with this client data. The inquiry letter also
seeks a confirmation that the client (not the auditor) will be advised of any other
unasserted claims that should be disclosed.
Finally, the letter requests the law firm to identify the nature and reason for any
limitations in the response to these inquiries.
117
(8)
The discovery and assessment of pending and threatened litigation has long
been an area of contention between the auditing and legal professions.
Traditionally, the independent auditor has looked to the client's attorney for
information to help evaluate these contingent losses. The legal profession has
often protested such inquiries for a number of reasons. One objection is that any
communication between the attorney and the auditor may be construed as a
breach of the confidentiality that exists between the attorney and the client.
Having broken the confidential nature of the relationship, attorneys risk not being
able to avail themselves of this privilege in the future. In addition, the question
has been raised as to whether the attorney could incur any liability if the
assessments provided to the auditor proved to be incorrect. Finally, attorneys
are cognizant of the effect upon client retention if they should reveal information
to the auditor which the client did not want disclosed.
Auditors search for all possible contingent losses which would then be evaluated
by the client. The client would describe these contingencies in a letter to the
company's legal counsel. The losses were to be split between "pending or
threatened litigation" and "unasserted claims and assessments." In response to
the first category, the attorney was to inform the auditor of any omissions or any
disagreements with the client's evaluations.
For unasserted claims and
assessments, the attorney was asked to inform the auditor only of disagreements
with the evaluations. If unasserted claims were omitted, the attorney would
advise the client of the necessity of making appropriate disclosure. If the client
then refused to report this information, the attorney was instructed to consider
withdrawal by resignation.
(9)
Related party transactions will always concern independent auditors because of
the difficulty in distinguishing the economic substance of the transaction from its
legal form. To obtain evidence that all related party transactions have been
disclosed, auditors send out inquiry letters to all related parties. The letter
questions the existence and extent of the dealings with the reporting entity, the
nature of the transactions, and the relationship between the parties. Once the
identity and terms of these transactions have been established, the auditor has to
use other means to verify their validity. Statement on Auditing Standards 45
suggests that the auditor may want to follow such steps as examining contracts,
verifying approval by the board of directors, evaluating any collateral, and
confirming information with intermediaries such as banks, attorneys, or agents to
determine the true economic substance of each transaction. (A complete listing
of "related parties" can be found in the glossary to FASB Statement No. 57,
Related Party Disclosures.)
118
119
120
LAKESIDE COMPANY
Estimated Accrued Product Warranty Expense
December 31, 2009
AH
Date: 2/2/10
Audit Objective:
To estimate the accrued product warranty expense as of Dec. 31, 2009.
Audit Procedures:
Comments:
A
Historical data for the months from January 2008 to June 2009 (18 months) are being used to develop
an estimate of monthly repairs expense. This estimate will be applied to the last six months sales of 2009
to determine the year end accrual. During the 18-month test period, repair expenses showed a gradual
increase from .72% to .90% of sales. Because of this upward trend, it is recommended that Lakeside use .
95% of sales for estimating repair expenses for the last six months of 2009.
B
Sales during the last six months of 2009 are still under warranty. These sales total $3,601,500 for an
estimated repair expense of $34,214 based on .95% (see A above). During the last six months of 2009,
$13,424 in repairs were made in connection with these sales. As of December 31, 2009, an estimated
liability of $20,790 (=$34,214-$13,424) remains. Lakeside's accrual of $45,465 should be adjusted
($45,465 recorded balance - 20,790 desired balance =$24,675 overstatement).
AJE #13- Proposed Adjustment
220-1
680-1
2467524675-
Audit Conclusion:
Accrued product warranty expense is fairly stated, after adjustment, in accordance with GAAP.
121
LAKESIDE COMPANY
Estimated Accrued Product Warranty Expense
12/31/09
A: Sales not under warranty
Historical Data
1/08
Sales for month
582000
Repairs:
Month of Sales
193
1 month after
533
2 months after
837
3 months after
875
4 months after
343
5 months after
571
6 months after
457
Total repair expense 3809
Repair expense as a .72%
percentage of sales
2/08
316000
3/08
359000
4/08
479000
5/08
486000
6/08
414000
7/08
371000
8/08
460000
9/08
442000
10/08
533000
11/08
586000
12/08
800000
137
388
319
662
320
205
251
2282
.72%
177
329
481
658
456
228
202
2531
.71%
222
369
480
591
702
812
517
3693
.77%
147
514
625
441
1029
698
220
3674
.76%
61
276
429
797
735
490
272
3060
.74%
256
313
569
541
512
456
199
2846
.77%
284
497
462
639
604
675
391
3552
.77%
210
559
629
664
594
699
140
3495
.79%
292
583
666
917
625
500
583
4166
.78%
469
563
657
845
798
657
704
4693
.80%
505
948
885
1074
1203
1030
695
6318
.79%
1/09
610500
2/09
381000
3/09
346000
4/09
557000
5/09
590000
6/09
409000
7/09
422000
8/09
550000
9/09
511000
10/09
602500
11/09
642000
12/09
874000
323
969
861
915
1028
808
485
5884
.88%
336
366
397
580
549
519
305
3052
.80%
234
351
410
527
292
468
644
2926
.85%
335
670
766
1054
718
575
670
4788
.86%
421
736
684
947
1894
999
579
5260
.89%
368
442
516
664
627
553
516
3686
.90%
599
337
375
749
824
524
251
752
1203
852
602
277
738
830
876
220
769
934
423
785
504
3408
3660
2721
1923
1208
504
122
(2)
This question has been included to emphasize the audit report as the end
product of the auditor's work. As this text has been an exploration of the attest
function rather than a full-scale audit, determination of an appropriate opinion for
2009 is not feasible. Presented below are two possible conclusions for this case.
The first is based on an unqualified opinion on the 2009 statements because
Abernethy and Chapman either believes the potential impairment of value on
Store Six is not material, or that its likelihood is only remote. The second
possible conclusion is that disclosure is needed in connection with the problems
encountered with Store Six, and that Rogers is unwilling to make this disclosure.
In both cases, the assumption is made that King and Company, the predecessor
auditor, continues to believe that a qualified opinion is still appropriate for the
2008 statements. Since comparative statements are being published, Abernethy
and Chapman also have to provide information about this previous opinion.
123
UNQUALIFIED OPINION
INDEPENDENT AUDITOR'S REPORT
We have audited the accompanying balance sheet of the Lakeside
Company as of December 31, 2009, and the related statements of income,
retained earnings, and cash flows for the year then ended. These financial
statements are the responsibility of the Company's management.
Our
responsibility is to express an opinion on these financial statements based on our
audit. The financial statements of Lakeside Company as of December 31, 2008
were audited by other auditors whose report dated March 15, 2009, on those
statements included a qualified opinion due to inadequate disclosure of a
potential impairment of value for one of Lakeside's stores.
We conducted our audit in accordance with auditing standards
generally accepted in the United States of America. Those standards require
that we plan and perform the audit to obtain reasonable assurance about
whether the financial statements are free of material misstatement. An audit
includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements. An audit also includes assessing the
accounting principles used and significant estimates made by management, as
well as evaluating the overall financial statement presentation. We believe that
our audit provides a reasonable basis for our opinion.
In our opinion, the 2009 financial statements referred to above present
fairly, in all material respects, the financial position of the Lakeside Company as
of December 31, 2009, and the results of its operations and its cash flows for the
year then ended, in conformity with accounting principles generally accepted in
the United States of America.
Abernethy and Chapman
Certified Public Accountants
Richmond, Virginia
February 15, 2010
124
QUALIFIED OPINION
INDEPENDENT AUDITOR'S REPORT
We have audited the accompanying balance sheet of the Lakeside
Company as of December 31, 2009, and the related statements of income,
retained earnings, and cash flows for the year then ended. These financial
statements are the responsibility of the Company's management.
Our
responsibility is to express an opinion on these financial statements based on our
audit. The financial statements of Lakeside Company as of December 31, 2008,
were audited by other auditors whose report dated March 15, 2009, on those
statements included a qualified opinion due to inadequate disclosure of a
potential impairment of value for one of Lakeside's stores.
We conducted our audit in accordance with auditing standards
generally accepted in the United States of America.. Those standards require
that we plan and perform the audit to obtain reasonable assurance about
whether the financial statements are free of material misstatement. An audit
includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements. An audit also includes assessing the
accounting principles used and significant estimates made by management, as
well as evaluating the overall financial statement presentation. We believe that
our audit provides a reasonable basis for our opinion.
During 2007, the company made a $186,000 investment in a retail store
located in the eastern sector of Richmond, Virginia. This store has failed to reach
a break-even sales point to date, and total recovery of the Company's investment
is highly uncertain. In our opinion, the chances are reasonably possible that the
asset's value has been permanently impaired and should be reduced to the net
realizable value in conformity with generally accepted accounting principles.
In our opinion, except for the effects of not recording or disclosing the
impairment of value of the asset, as discussed in the preceding paragraph, the
aforementioned financial statements present fairly, in all material respects, the
financial position of the Lakeside Company at December 31, 2009, and the
results of its operations and its cash flows for the year then ended in conformity
with accounting principles generally accepted in the United States of America.
Abernethy and Chapman
Certified Public Accountants
Richmond, Virginia
February 15, 2010
125
CASE 13
SUGGESTED ANSWERS TO DISCUSSION QUESTIONS
(1)
The authoritative auditing literature describes a material internal control
weakness as a condition where a company's systems fail to reduce to a relatively
low level the risk that a material error or irregularity will both occur and avoid
being detected within a timely period by employees in the normal course of
performing their assigned duties. If any such weakness does exist, the company
is exposed to the danger that an error or irregularity will occur, go undetected,
and then directly affect reported financial figures.
The auditor's role is to accumulate sufficient, competent evidence on which to
form an opinion as to the fair presentation of the client's financial statements.
However, during this investigation, one or more material control weaknesses may
be discovered. A description of these problems should be immediately
communicated to the client. In this way, management has the opportunity to
reduce the possibility that subsequent errors and irregularities will go undetected.
This report can also protect the auditor from legal responsibility if losses are
incurred by the client at a future point in time because of the weakness.
Consequently, if Abernethy and Chapman discovers a material weakness in
Lakeside's internal control, this information must be conveyed to the client as
soon as possible so that corrective actions can be taken. The description is to be
communicated either orally or in writing and should go to the senior management
of the company as well as the board of directors (or its audit committee).
(2)
Many individuals in business are skilled in one particular industry: audio
equipment, car dealerships, fashion design, etc. Others are trained in one
general aspect of business such as marketing, personnel, shipping, etc.
Although these people may be extremely efficient and productive, they are not
necessarily knowledgeable about computers and computer applications. In the
past, they may have focused their attention on a particular function and limited
their thinking to the methods that have historically proven successful. Any time
that a new approach is put forth, especially one with the complexity of modern
technology, human nature seems to resist the change. Rogers has built a large
company without a large computer component; he may be skeptical about
making significant alterations in a successful operation, especially changes that
he admittedly cannot visualize or fully comprehend.
126
Abernethy and Chapman has employed an appropriate system for educating the
client. Klontz is developing and will present a series of potential, clearly-defined,
functions that could be computerized. Thus, Rogers will be able to analyze the
possibilities that are offered by an automated system and judge for himself as to
which are worth the costs that are involved.
(3)
Public accounting firms come into contact with numerous business organizations,
their operations, and their accounting systems. Since the client's systems and
controls must be understood as a part of the attest function, the auditor has
always been in a position to note and propose improvements. Hence, the
opportunity and the expertise are both naturally in place to provide advisory work.
In recent years, such advice has become more formalized as firms have begun
to offer a wide range of services to clients as well as to other organizations.
During the last two decades, CPAs have come to recognize such work as a
lucrative offshoot of the public accounting profession.
(4)
A fully computerized accounting system has two major impacts on the work of the
independent auditor. First, the traditional audit trail is changed significantly. The
series of paper documents that could be followed from the inception of a
transaction to its final recording is often unnecessary in an automated system.
The information is entered into the computer so that no tangible record of
changes and events necessarily exists.
Second, computer processing does not utilize the same control procedures
commonly found in a manual system. For example, in manual systems, one
individual is frequently assigned to review and authorize the work of another
employee, a verification task not necessarily required by a computer.
Consequently, when an automated system is in use, the internal control must
take on new, sometimes creative, forms.
Because of the lack of an audit trail and the presence of different control
procedures, the audit firm must adapt its examination to new circumstances.
Increased emphasis is placed on developing tests of the computer controls to
ensure that all of the data being processed is reliable. The auditor would expect
the computer installation, for example, to have restricted access to limit the
possibility of unauthorized changes. Where direct input into the computer is
allowed, pass codes should be used for this same purpose. A control group also
needs to be created to monitor all computer processing and its output. In
addition, the client should require the use of control totals (batch totals, item
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Payroll
The names and pay rates for all employees are programmed into the
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computer. At the end of each pay period, the number of hours worked by
every hourly employee is also entered along with sales figures for individuals
being paid on commission. The computer automatically calculates the gross
pay for each employee. The amount to be paid to salaried workers is based
on individual contract rates while the salary for each hourly and commission
worker is determined from the information entered for the period. Federal
and state income tax withholding figures are also computed as well as Social
Security payments and any other payroll deductions. A net wage for each
individual is then derived with the computer printing out the actual
paychecks.
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Credit File
Information is accumulated about all of the customers to whom credit sales
are made. A review board is established by Lakeside to approve or reject the
continuation of credit to these customers as well as the extension of credit to
new customers. An approved customer list is then entered into the computer
and updated as needed. Whenever a sales order is received by the
company and processed, the computer scans this file to ensure that credit
should be given. The computer also reviews the amount and age of any
balances already owed by this same customer. If an excessive amount is
presently outstanding or if a balance is past due, credit approval can be
rescinded even if the customer is listed in this file.
Perpetual Inventory
All inventory balances are monitored by a computer program. At the time
merchandise is transferred to a customer, the identity of the specific items is
entered into the computer along with the quantity, perhaps using point-of-sale
technology. The computer is programmed to reduce the appropriate account
balances and automatically warns of any merchandise that is at an
unacceptably low level. Whenever goods are delivered to Lakeside, a
description of the newly acquired inventory is similarly entered. Again, the
computer updates the information stored in the perpetual records for each of
these particular items, thus providing ongoing data about the inventory on
hand.
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Testing of all programs should be performed before the client relies on them.
For a time, as an example, the company may want to run parallel processing
where all functions are carried out both manually as well as through the new
information system to ensure that the output is accurate. In addition,
Lakeside should process test (or erroneous) data using the various computer
systems to further verify the reliability of the output.
Where possible, validity checks could be installed within the various systems
so that data must be verified independently before being processed. A
customer name, as an example, has to be on an approved customer list
before a sale is authorized and merchandise shipped. Likewise, an
individual's identification number must be listed on a master employee file, or
a paycheck will not be produced.
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to zero the need for any type of written information. However, control may be
enhanced by having employees record a limited amount of data at the point
of a transaction solely for reconciliation purposes. As an illustration, a bill of
lading may be produced (manually or by the computer) and sent to the
customer as a verification of a shipment. A copy of this document can
subsequently be used by the company to check the data entered into the
computer.
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