The Lakeside Company:

Auditing Cases
SOLUTIONS MANUAL 12e
Table of Contents

John M. Trussel and J. Douglas Frazer

A Note on Ethics, Fraud and SOX Questions

2

A Note on Research Assignments

3

Introductory Case
5

Case 1 14

Case 2 22

Case 3 33

Case 4 44

Case 5 58

Case 6 74

Case 7 82

Case 8 92

Case 9 101

Case 10 110

Case 11 116

Case 12 125

Case 13 136

1
 A NOTE ON ETHICS, FRAUD, AND SOX QUESTIONS

The Lakeside Company: Auditing Cases, 12th edition, has been updated
in light of the accounting scandals of the early 2000s, the passage of the
Sarbanes-Oxley Act of 2002, and the renewed interest in ethics within
the accounting and auditing profession.

Sarbanes-Oxley issues have been incorporated in two ways. First, case

content has been altered to include Lakesides consideration of financing
expansion through an initial public offering, and the resulting impact
such a decision would have on Lakeside and on Abernathy and
Chapman, CPAs. Second, the discussion questions and exercises have
been expanded to include consideration of Sarbanes-Oxley and new
auditing and independence standards, both by adding a section in the
end-of-chapter material and by reference in the other questions where
appropriate.

Ethics questions are now specifically identified with an ethics logo. The
ethics questions are often open ended, and this solutions manual does
not try to give exact answers to these questions. Rather, we intend to
give some ideas for classroom discussion, and to help with student
research on these questions.

Fraud questions are now specifically identified with a fraud triangle.

Fra
Fra
ud
ud

2
 A NOTE ON RESEARCH ASSIGNMENTS

The "Apply Your Research" and "Consulting Partner Review" assignments

included at the end of several cases do not lend themselves to definitive
solutions that could be included in an instructor's manual. The assignments are
simply not intended to be exercises in arriving at a predetermined answer.
Rather, the applications of the suggested readings have the following objectives:

- 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.

- To introduce students to accounting and business journals as well as other

important publications. After college, students must be able to "keep
current" or their effectiveness will quickly decline. In most cases, this
continuation of their education is provided by the regular reading of
publications such as The Wall Street Journal, Journal of Accountancy,
CPA Journal, and Forbes. These assignments require the students to
begin reading these journals prior to graduation. The students should
become comfortable with their ability to understand and use the materials
in professional publications. In addition, real-world aspects of many
accounting issues are presented through these various readings.

- To develop the students' ability to derive viable solutions to auditing

problems. Unfortunately, students in college often come to the belief that
all auditing issues can be resolved simply by applying the
pronouncements of various authoritative bodies. Textbooks too often
present problems that have one ultimate answer. However, in many real
cases, no definitive solutions actually exist. Thus, when faced with such
problems, students must be capable of reviewing the available literature
and then using that information as a basis for arriving at a workable

3
 decision.

- To promote auditing research. In most of these library assignments,

students are provided with one or more resources as starting points for their
research. However, the instructor should always push the students to look
for more and different types of information. The ultimate purpose of these
assignments is to force the students into the library and online sources to do
the searching for themselves. One excellent method of introducing the
assignments is to use some class time to illustrate the various methods of
research that are available to them, including electronic resources, such as
the following:
o http://www.sec.gov
o http://www.PCAOBUS.org
o http://www.AICPA.org
o http://www.FASB.org
o Your state society of CPAs also operates sites.

If possible, a business librarian or a research librarian may be enlisted to

discuss the various search techniques that can be used at the school's
library for research purposes. Developing the ability to find information is
one of the most important skills that can be achieved by an accounting
major.

4
 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 the 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

5
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:

- Although only a regional firm, Abernethy and Chapman apparently has a

client base that includes a number of large clients in several different
industries. By acquiring the local firm, the larger organization will
frequently be able to retain these customers, thus increasing its own client
list.

- 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:

6
- Frequently, the purchase price will be a considerable amount of money
because of the goodwill inherent in an established accounting firm. The
offer to sell may be especially tempting if the partners are nearing
retirement age and the future of the firm appears uncertain.

- 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.

- PCAOB registration and SEC practice presents hurdles that might be

overcome through a merger with a larger firm.

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

7
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.

To: DeAnna Malott

From:
Date:
Re: Quality Control Standards at Abernethy and Chapman

Overview: I was employed by the firm of Abernethy and Chapman to review the
quality control standards within the firm. The following represents my evaluation of
these standards according to the six elements required by the AICPA.

Evaluation:
Standard Existing Recommendations Additional
Procedures Information
Needed
Leadership The case does The firm should have What specific
responsibilities not explicitly policies in place that policies does the
address this establish the tone at firm have to
standard. the top for quality demonstrate
However, the firm within the firm. leadership
has some items responsibilities for
in place, such as quality within the
a partner firm?
dedicated to
monitoring the
system.
Relevant Firm requires its The AICPA's Code of The case does
ethical employees to Professional not mention
requirements sever all Conduct does not spouses or
financial ties to require all dependents of
audit clients. employees to sever the employees.
ties with all audit Spouses and
clients. For dependents must
example, staff also be
auditors not working independent, as
on a particular defined by

8
 engagement need Section 100--
not sever ties. In this Rule 101 of the
case, the firm Code. In this
exceeds the case, the firm
minimum level of should
conduct for strengthen its
independence. requirements.
The case does not How does the
address other ethical firm meet other
requirements. ethical
requirements?
Acceptance This case does It is important to
and not address this have many controls
continuation of control standard. when considering a
clients It does note that potential client, so
the firm is that the potential
attempting to risks of legal
gain more clients exposure are not too
through an great. (Note: This
extensive topic is addressed in
marketing Case 2.)
program.

The firm This appears to be a

Human considers reasonable quality
resources experience and control.
technical
competence in
assigning
personnel to
audit
engagements.
The firm hires This seems to be a
only college more than adequate
graduates with a quality control
major in procedure. In fact,
accounting and many firms hire
requires that professionals, such
each as computer experts,
professional sit who were not
for the CPA accounting majors.
exam within one
year of
employment.
The firm requires Many states require

9
 40 hours of that a minimum
continuing number of continuing
education per professional
year; however, education hours be
the case does in accounting- and
not address the auditing-related
issue of the type courses.
of education
(e.g., accounting
and auditing
versus other
courses).
The firm The case does
promotion not address the
procedures issue of
consider assessment of
seniority and technical
technical competence.
competence, Many firms
which seems to require a written
be an adequate assessment of
control. performance
after each
engagement.

Engagement The firm requires The firm should have It is not clear from
performance that a consulting a mechanism for the case how the
partner be consultation with team documents
assigned to each authoritative the work
audit literature and other performed on an
engagement. sources, including audit
The consulting outside experts, if its engagement. An
partner assures professional staff evaluation of
that the work lacks expertise in a audit
performed by the particular area. documentation is
engagement necessary for
team meets complete
applicable evaluation of the
professional quality controls.
standards and
regulatory
requirements.
This helps to
ensure
objectivity, as the
consulting

10
 auditor is not a
direct part of the
engagement.
The firm seems
to have a clear
chain of
command and
adequate
supervision on
the audit. The
staff auditors
report to the
senior auditor,
who in turn
reports to the
manager. The
partner-in-
charge has an
overall
supervisory
position.

The firm has a A comprehensive The case does

Monitoring partner, DeAnna system of not mention what
Malott, assigned documentation of the types of
to monitor the quality controls documents are
quality control should be developed. required to
standards. support these
controls, but
documentation is
extremely
important. For
example, many
firms require
employees to
submit a listing of
all financial ties
to companies so
that the firm can
monitor its
independence.

Conclusion: The firm has many policies related to quality control standards.
However, the firm has room for improvement in many of the areas, particularly in
the acceptance and continuation of clients.

11
 SUGGESTED ANSWERS TO SARBANES-OXLEY QUESTIONS

(1)

Students should be encouraged to visit the PCAOB website

(http://www.pcaobus.org) when answering this question:

- Registration CPA firms must be registered to be associated with public

companies. The application for registration is an online process. There is a fee, it
is small relative to other costs of maintaining the registered status and changing
the nature of the firm to comply with PCAOB rules. Here is the fee structure from
their website:

- Inspection - The PCAOB operates a system of inspections and publicizes

the results, per its authority under the SOX Act:

- The Act provides that an inspection shall include at least the

following three general components:
An inspection and review of selected audit and review
engagements of the firm, performed at various offices and by
various associated persons of the firm;
An evaluation of the sufficiency of the quality control system of
the firm, and the manner of the documentation and
communication of that system by the firm; and
Performance of such other testing of the audit, supervisory,
and
quality control procedures of the firm as are necessary or
appropriate in light of the purpose of the inspection and the
responsibilities of the Board.

- Regular inspections are on a three-year cycle, although smaller

firms may be less frequent. Special inspections can be required by the
PCAOB.

- Maintenance of independence under PCAOB rules and SOX-

12
proscribed activities:

Proscribed activities under SOX (section 201):

Section 201: Services Outside The Scope Of Practice Of Auditors; Prohibited
Activities.

It shall be "unlawful" for a registered public accounting firm to provide any non-
audit service to an issuer contemporaneously with the audit, including: (1)
bookkeeping or other services related to the accounting records or financial
statements of the audit client; (2) financial information systems design and
implementation; (3) appraisal or valuation services, fairness opinions, or
contribution-in-kind reports; (4) actuarial services; (5) internal audit outsourcing
services; (6) management functions or human resources; (7) broker or dealer,
investment adviser, or investment banking services; (8) legal services and expert
services unrelated to the audit; (9) any other service that the Board determines,
by regulation, is impermissible. The Board may, on a case-by-case basis, exempt
from these prohibitions any person, issuer, public accounting firm, or transaction,
subject to review by the Commission.

It will not be unlawful to provide other non-audit services if they are pre-approved
by the audit committee in the following manner. The bill allows an accounting firm
to "engage in any non-audit service, including tax services," that is not listed
above, only if the activity is pre-approved by the audit committee of the issuer.
The audit committee will disclose to investors in periodic reports its decision to
pre-approve non-audit services. Statutory insurance company regulatory audits
are treated as an audit service, and thus do not require pre-approval.

The pre-approval requirement is waived with respect to the provision of non-audit

services for an issuer if the aggregate amount of all such non-audit services
provided to the issuer constitutes less than 5% of the total amount of revenues
paid by the issuer to its auditor (calculated on the basis of revenues paid by the
issuer during the fiscal year when the non-audit services are performed), such
services were not recognized by the issuer at the time of the engagement to be
non-audit services; and such services are promptly brought to the attention of the
audit committee and approved prior to completion of the audit.

The authority to pre-approve services can be delegated to 1 or more members of

the audit committee, but any decision by the delegate must be presented to the
full audit committee.

- Partner rotation - The rotation of the lead partner and the reviewing partners
are required by the SOX Act.

- Quality Control Standards Registered firms must maintain the SEC

practice requirements:

13
- AICPA Quality Control Standards for public company audits are summarized
at: http://cpcaf.aicpa.org/Resources/

14
 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

15
different industry.

Auditing standards require that auditor to 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, and are not for carrying out management decisions. The firm
cannot make decisions for the client.

16
Sarbanes-Oxley specifically proscribes various activities that have traditionally
been part of the CPAs repertoire. Design of accounting systems is prohibited,
although helping a client with selection and implementation of off-the-shelf
packages would be acceptable. So, in this case, it depends on what the client
means by developing. In the event that Lakeside goes forward with its public
offering Abernathy and Chapman will need to decide whether to remain
independent so they can continue as Lakesides auditor, or sacrifice
independence to do systems consulting. Sarbanes-Oxley prevents trying to do
both.

(5)

In his article "The Initial Audit Engagement Conference" in the Journal of

Accountancy for September 1976, Bernard Valek lists a number of steps that can
be performed in a plant tour to avoid later "surprises" as well as to assist the firm
in establishing an appropriate audit fee. The first three are typical of a plant tour.
The others go beyond the typical tour. Students should not be expected to
anticipate each of these procedures but the question can be used to emphasize
the importance of the auditor's complete understanding of the audit client. These
steps include:

* Inspect inventory for possible obsolescence and an indication of the major

product lines of the company.

* Verify the presence or absence of a perpetual inventory system.

* Review manufacturing facilities for indication of level of activity as well as

any idle machinery.

* Review journals for careful preparation.

* Review general ledger activity for unusual entries.

* Review monthly financial statements for unusual variations.

* Review bank reconciliations, and compare to general ledger.

* Examine accounts receivable reconciliation to general ledger balance.

* Review client physical inventory method.

* Discuss with client the policy for valuing inventory and identifying obsolete
inventory items.

* Discuss with client the procedures for obtaining a proper year-end cutoff.

17
* Review depreciation schedules, and recalculate a sample of the
depreciation expense figures.

* Review income tax returns.

* Examine information relating to any capital stock or retained earnings

transactions for the past year.

* Review minutes of board of directors' meetings and stockholders'

meetings for unusual or material matters.

* Read lease agreements.

* Review past audit reports.

(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 of 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. Additional fraud risk factors may also be
identified by the students.

Fraud Risk Factors Auditor Follow Up

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
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

18
Fraud Risk Factors
states.
Uncertainty Involved with the Sixth
Store - A qualified opinion was issued
by the predecessor auditor in
connection with this store.
Inventory - The mere size of the
inventory of a business like Lakeside
would make this account a critical audit
area.
Distributorship Sales - The case
indicates that these sales have risen
dramatically during the past two years.
Bonus System - This system has been
recently installed by Lakeside, so very
little is known about its effects upon the
financial results of the company.
Related Party Transactions - The case
indicates that Lakeside has begun to
have financial dealings with the
president of the company.
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.
Accounts Receivable - All
distributorship sales are made on
credit.
Loan Agreements - Lakeside has a
number of loans outstanding.
Inventory Returns - For distributorship
sales, up to 20% of the inventory items
19
Auditor Follow Up
may require the extensive gathering of
evidence, or even preclude an opinion.
Abernethy and Chapman must face the
question as to whether this issue can
be resolved during 2009.
The auditor will face the problem of
verifying the existence, cost, value,
presentation, and ownership of the
electronic equipment.
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.
This factor alone can cause difficulty in
the auditor's examination. In addition,
any bonus system will provide an
incentive for the employees to falsify
the company's financial records. The
auditor must be aware that employees
can benefit from producing falsely
inflated income figures.
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.
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.
The size of the receivable account and
the problem of determining collectibility
will be a critical audit area for the
auditor.
The auditor will need to study each
loan agreement to ascertain that the
company is not violating any of the loan
covenants.
Not only is the potential size of this
liability a problem, but the auditor's
Fraud Risk Factors
can be returned within four months. As
of the end of the year, Lakeside will
have a large contingent liability
associated with the inventory items
sold during the last four months.
Possible public offering of stock
20
Auditor Follow Up
ability to estimate the amount must be
a concern.
A public offering raises risk for
manipulation of the financial statements
in order to attract capital. In addition,
the number of potential readers of
financial statements has changed
dramatically, making the risk
associated with this audit much higher.
(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, 2011, 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 2010, the Lakeside Company made a large 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. Management of the company has refused to recognize this
impairment loss.

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, 2011, 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)

21
 SUGGESTED ANSWERS TO SARBANES-OXLEY QUESTIONS

(1)

The issuance of stock is regulated by the Securities and Exchange Commission

and the accounting, auditing and reporting is regulated by the PCAOB since
2002. A summary of the regulations follows:

Issuance of stocks are regulated primarily under the SEC acts of 1933 and 1934.
Registration with the SEC is required, which includes financial reporting. The
laws are summarized at: http://www.sec.gov/about/laws.shtml.

The financial reporting and auditing for public companies has been regulated by
the PCAOB since 2002. The PCAOB registers, inspects and disciplines the
auditors of public companies. Its effect on the public companies is indirect,
through the regulation of the auditors.

Encourage students to visit the SEC EDGAR site to understand the nature of
electronic, public financial information.

(2)

CPA firms wishing to be associated with public companies must be registered

firms, accept the inspection process, and be subject to the discipline of the the
PCAOB. CPAs in public practice ofhave three choices. It is not only public vs.
private, because some CPA firms are choosing to give up the requirement for
independence and perform accounting, tax, and consulting services that are not
possible for registered CPA firms. Thus their clients have two CPA firms, one for
the non-independent services and one for the audit. In the case of Abernathy and
Chapman, they will need to choose the nature of their practice. This is a major
strategic choice. Most CPA firms do not perform public company audits. Large
international and national firms handle almost all of the companies on the
exchanges.

22
 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 $1,000,000 net worth and the $3.6 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 less than $100,000 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 at least $100,000) for a company
with a net worth of only $1,000,000 would certainly appear to be material. Other
comparisons based on total assets or income would give similar results. (The
issue of materiality is considered in more depth in exercise 3 below).

(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

23
might be encountered. If Rogers prohibits this meeting, Abernethy should
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

24
substandard work. In addition, the team reviews the audit documents for a
selected number of engagements to see if sufficient, competent evidence is
being gathered and properly documented.

(5)

Audit documents (or working papers) are intended to provide a record of the
auditor's examination and the evidence accumulated. Thus, all testing done in
each audit area should be documented and included within the working paper
file. In addition, the audit documents must verify that the examination was
planned and the auditing staff was properly supervised. Any auditing or
accounting problems encountered during the engagement have to be spelled out
in the audit documents along with an explanation of the resolution of each issue.

The permanent file will hold all data about the client that is not anticipated to
change dramatically from year to year. It can be reviewed by the auditor prior to
beginning the engagement to gain insight into the organization of the company.
A permanent file will normally include items such as the articles of incorporation,
organization chart, chart of accounts, contracts, other long-term legal
agreements, and a written description of the company as well as its organization
and history.

The annual working paper ("current") file contains documentation of the evidence
gathered during a specific audit. Thus, the results of confirmations, inquiry,
observations, inspection, calculations, and all other testing are placed within
these audit documents. The contents of this file must substantiate the audit
opinion and also that the auditor followed generally accepted auditing standards
on this particular engagement.

(6)

As a professional, the independent auditor has a responsibility to ensure that a

prospective client understands the function of an audit prior to accepting an
engagement. Not every member of the business community will have the
background knowledge to comprehend the purpose of the attest function and the
extensive testing procedures that it requires. In addition, many possible clients
do not require the degree of assurance provided by an audit but are not aware of
alternatives such as compilations and reviews. Since independent auditors have
knowledge of the attest function and are offering these services to the public,
responsibility for a full understanding by the client lies with the firm. In addition,
the firm is required to reach an understanding of the audit function with the firm
and the engagement letter is used to document this understanding.

(7)

The providing of adequate service to a client would always require that the CPA

25
firm suggest a review rather than an audit whenever it might meet the company's
intended objectives. The client must understand, though, that a review is
substantially less than an audit. Procedures are limited primarily to inquiries of
the client's management along with analytical procedures applied to the financial
statements. The report then states that the firm was not aware of any material
modifications to the financial statements that require adjustment to be in
conformity with generally accepted accounting principles (a limited or "negative"
assurance).

In a review, control risk is not assessed, tests of controls are not made, and
adequate substantive testing procedures are not performed on which to base an
opinion as to the fair presentation of the financial statements. Because these
procedures are omitted, a review is less expensive than an audit. However, the
banks and stockholders must be willing to accept the lesser degree of assurance
being provided by the independent auditor. The client should be made aware of
this option but also the potential problems of not having a complete examination.
Of course, if Lakeside pursues the public offering, a review will not be adequate.

(8)

Many students may want to reject this engagement based on the internal control
problems, the impairment of value issue, and Rogers' arguments with the
predecessor auditors, but such situations are not uncommon occurrences in
auditing. Public accounting is not a risk-free profession; no perfect audit client
ever exists. Thus, a firm must be able to assess the problems involved and
weigh them against potential rewards. Abernethy and Chapman has an
opportunity here to pick up a new client in a new industry. In addition, Lakeside
has demonstrated the possibility of significant growth in the future. However, the
auditing firm needs to seek some resolution for the uncertainty before becoming
involved. Since that problem is already obvious, an understanding should be
reached with Lakeside prior to beginning the engagement. If this issue can be
successfully resolved, the auditor should seek this new client.

26
 SUGGESTED ANSWERS TO EXERCISES

Case 2 - Exercise 1

Abernethy and Chapman

ANALYSIS OF POTENTIAL LEGAL LIABILITY

Potential Client: The Lakeside Company

Type of Engagement: Audit

Form Completed By:

Date:

(1) Is the potential client privately held or publicly held?

Privately held

(2) Evaluate the possible liability to the client that Abernethy and Chapman
might incur, if the engagement is accepted.

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) List the third parties that presently have a financial association with the
potential client and could be expected to see the financial statements. These
parties are also called primary and foreseen beneficiaries.

The current stockholders

Cypress Products
Two banks financing the inventory
National Insurance Company of Virginia (mortgage loans)
Possibly other creditors

27
(4) Discuss the possibility that other third parties will be brought into a position
where they would be expected to see the financial statements of the
potential client. These parties are also called foreseeable beneficiaries.

As Rogers has expressed considerable interest in expansion, the CPA firm

should anticipate that the financial statements could be presented to
potential stockholders or lenders.

(5) Evaluate the possible legal liability to third parties, both present and
potential, that Abernethy and Chapman might incur if the engagement is
accepted.

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.

Abernethy and Chapman

INFORMATION FROM PREDECESSOR AUDITOR

Potential Client: Lakeside Company

Form Completed By:

Predecessor Auditor: King & Company

Date of Interview:

(1) Discuss the predecessor auditor's evaluation of the integrity of the

management of the potential client.

Predecessor auditor indicated no problems with the integrity of the

Lakeside management.

(2) Did the predecessor auditor reveal any disagreements with management as
to accounting principles, auditing procedures, or other similarly significant
matters? If so, fully describe these disagreements.

28
 A major problem existed between Lakeside and the predecessor auditor
involving an explanatory paragraph included in the 2008 report. This
uncertainty issue revolved around the potential loss foreseen in the
possible closing of one of Lakeside's stores.

(3) What was the predecessor auditor's understanding as to the reasons for the
change in auditors?

Predecessor auditor stated that the firm was discharged over the wording
of the previous audit opinion.

(4) Did the predecessor auditor give any indication of other significant audit
problems associated with the potential client?

The predecessor auditor also mentioned weaknesses in Lakeside's

internal control and Rogers' unwillingness to improve these systems.

(5) Did the predecessor auditor indicate any problem in allowing Abernethy and
Chapman to review prior years' audit documentation for the potential client?
If "yes," explain.

Predecessor auditor stated that the audit audit documents could be

reviewed.

(6) Was the predecessor auditor's response limited in any way?

No limitation was indicated.

29
 Case 2 - Exercise 2

[Note: 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].

Abernethy and Chapman

Review of Predecessor Auditor's Documentation

Client: The Lakeside Company

Predecessor Auditor: King & Company
Prepared by:
Date:

Prepare a list of the specific contents of the predecessor auditor's documentation

that should be examined by Abernethy and Chapman. Indicate each area that
should be reviewed and the purpose of studying these particular areas of the audit
documentation. Use the following format.

Area that Should be Reviewed Purpose of Review

Proposed Adjusting Entries
Tests of beginning balances in
accounts including inventory, land,
buildings, equipment, paid-in-capital,
and retained earnings.
Ascertain the specific accounting
principles applied in the previous fiscal
year.
Review internal control evaluations.
Review the analysis of contingencies.
Any problem areas (such as slow
collection of accounts receivable) that
were singled out in the previous year.
To determine the type and materiality of
the proposed adjustments
To determine that satisfactory evidence
has been obtained to verify beginning-
of-year balances, since ending
balances are audited by successor
auditor.
To determine if client consistently
applies accounting principles in the
current year.
To determine if there were any internal
control weaknesses/deficiencies noted
or if there are any particularly strong
areas of control noted.
To determine if adjustments or
disclosures need to be made for
contingencies in the current year.
To determine if the problems continue
to exist in the current year.

30
(3)

Note: Student answers will vary greatly due to the nature of the assignment.
Consider asking several students for their materiality level to see the range of
answers. This should lead to a good discussion about auditor judgment.

Preliminary Judgment about Materiality

Client: Lakeside Company

Balance Sheet Date: December 31, 2012
Prepared by:

Determine the preliminary judgment about materiality for the client as a whole.
Express your answer as a dollar amount. Determine the appropriate level of
materiality based on all analyses completed for the client thus far. Fully support
and discuss the materiality level that you determine.

Quantitative Considerations: Because materiality is relative, it is necessary to

have bases for establishing whether misstatements are material. A base is a
critical item of which users tend to focus while making decisions. The base will
vary depending on the nature of the clients business. Typical bases may include
net income before taxes, net sales, total assets and stockholders equity.
Percentages typically range from 1%-10% depending on the base.

Base (from Dollar Amount Percentage Base x Percentage

previous year) of Base Range
Net income before $408,000 3%-6% $12,240-$24,480
taxes
Total assets $3,628,000 1%-3% $36,280-$108,840
Net sales $10,754,000 1%-3% $107,540-$322,620

Qualitative Considerations: Certain types of misstatements are likely to be more

important to users than others, even if the dollar amounts are the same. For
example, misstatements that involve fraud may be more important to users than
misstatements due to unintentional errors. Fraud reflects on the integrity of
management and other employees of the client.

Item to be Considered Impact on Materiality

Outdated accounting systems Reduce the level
New client Reduce the level
Previous year qualified opinion Reduce the level

Preliminary Judgment about Materiality: Combine the quantitative and qualitative

considerations into one overall materiality level.

Materiality level: $50,000

31
Discussion: Discuss how you arrived at this dollar amount for the preliminary
judgment about materiality. That is, how did you combine the qualitative and
quantitative considerations to arrive at this dollar amount?

The preliminary judgment about materiality is set at $50,000. Since there are
three qualitative considerations that reduce the level, we chose the lower of the
ranges of the quantitative considerations. The average of the lower ranges is
$52,020 [($12,240 + $36,280 + $107,540) / 3 = $52,020]. We rounded to a
conservative $50,000 for ease of application.

The bases were chosen based on the nature of the clients business. Typical
users of the financial statements of a company in consumer electronics industry
will likely focus on profits, net sales and total assets. The percentage ranges are
typical for the bases. Assets and net sales are typically the largest bases and
thus have smaller percentage ranges than does net income before taxes. (Some
students may have chosen total liabilities or total stockholders equity since
banks are a major user of the financial statements).

At a $50,000 materiality level, then a total impairment of the carrying value of

Store 6 ($186,000) would be material, as would an impairment of half the
carrying value. The firm should discuss with Rogers the strong possibility of a
write down of Store 6, should an impairment test warrant one. (Note: In Case 9,
the students are required to perform an impairment test for Store 6).

(4)

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.

32
 INDEPENDENT AUDITOR'S REPORT

To the Stockholders:

We have audited the accompanying balance sheet of the Lakeside

Company as of December 31, 2012, 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, 2011,
were audited by other auditors whose report dated [give date], on those
statements included a qualified opinion because of inadequate disclosure of an
impairment of value. The impairment of value concerned the Company's
investment in one of its 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 2012 financial statements referred to above present

fairly, in all material respects, the financial position of the Lakeside Company as
of December 31, 2012, 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

Date: (last day of audit fieldwork)

33
 CASE 3

SUGGESTED ANSWERS TO DISCUSSION QUESTIONS

(1)

Although this question can be answered by a simple reading of Exhibit 3-1, it

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

The engagement letter is required. Responsibilities of the CPA firm found in the
engagement letter:

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

statements,

* To make a search for material misstatements,

* To report any internal control weaknesses,

* To report any potential fee changes,

* To provide the final audit report by February 22, 2013.

Responsibilities of the client:

* To pay the audit fee,

* To provide a year-end trial balance by January 17, 2013, and an interim

trial balance by October 17, 2012,

* To provide audit documents to the CPA firm as specified.

(2)

In performing analytical procedures, auditor expectations should be derived from

a wide variety of sources. For cost of goods sold, Abernethy and Chapman

34
should consider each of the following in arriving at an anticipated total:

- Past figures. If cost of goods sold has always been a certain percentage
of Lakeside's sales, that same relationship would be expected to continue
unless other factors have changed. Had Lakeside, for example, switched
from cheaper products to more expensive ones, the relationship between
cost of goods sold and sales would possibly be affected. Or, if Lakeside
has dropped the Cypress line in order to sell the products of some other
manufacturer, a similar change might have been anticipated. However,
without an adjustment of this type, cost of goods sold as a percentage of
sales would be expected to remain stable.

- Industry averages. By studying trade publications, Abernethy and

Chapman can determine an industry average for cost of goods sold as a
percentage of sales. Although Lakeside's results could not be expected to
be exactly the same as this average, the auditors should not anticipate a
significant variation to occur without some adequate explanation.

- Competitors. If available, the financial statements of competing

companies can be used to determine the normal relationship of cost of
goods sold to sales. Although no two companies are ever alike, important
comparisons such as this one should be made between similar
companies.

- Budgeted figures. If Lakeside has an annual budget, the numbers

estimated by the company at the beginning of the period can be used by
the auditor in establishing an expected cost of goods sold.

(3)

- Lakeside holds an inventory of high-technology items: consumer

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

- Lakeside distributes merchandise to retail stores. A generous return policy

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

- Lakeside sells on credit throughout two states. Hence, estimating

collections from accounts receivable may be difficult.

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

whether capitalization of these leases is required.

- Lakeside has a large amount of debt. The auditor has to ensure that all

35
 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
are being met.

- Lakeside is considering going public. A company attempting to raise

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

(4)

The auditor must be satisfied that sufficient, competent evidence has been
obtained to substantiate an opinion concerning the fair presentation of the client's
financial statements. The decision as to the sufficiency of this evidence is left
solely to the judgment of the auditor. Only through years of experience can the
auditor develop the ability to make this determination. Although specific
guidelines for this decision are not available, all significant problems must be
resolved and all suspicious occurrences should be investigated. Evidence needs
to be accumulated for each significant area of the financial statements to
substantiate the assertions made by the client about its reported balances.
Where inherent risk and control risk are judged to be high, the auditor must take
steps to reduce detection risk to an acceptable level. In such cases, several
steps are possible: performing additional substantive testing, using more
experienced staff personnel, performing testing procedures closer to the balance
sheet date, or relying on more effective testing procedures.

Another factor that influences the auditor's decision is the quality of evidence
being accumulated. Some information may come directly to the auditors from
outside parties, data that is usually considered to be of a higher quality than
evidence prepared by the client company. Less evidence is required if it is
judged by the auditor to be of a high quality.

Although each of these factors is considered, the ultimate decision still must rest
with the auditor's judgment. This individual is taking responsibility for the audit
opinion as well as accepting the risks involved in circulating this report. Thus, the
auditor must be satisfied that, based upon the wisdom gained through years of
audit experience, sufficient evidence has been obtained.

(5)

Any discussion as to the "quality" of evidence being gathered by analytical

procedures must be based on the objective of the testing. Analytical procedures
performed in the planning stage are not primarily designed for the purpose of
indicating the fair presentation of financial information. Instead, they are used in
the assessment of risk, to alert the auditor to potential problem areas that may

36
require additional substantive testing. In that respect, analytical procedures
serve a vital audit purpose. Students should always be reminded, though, that
this testing is only one component of the overall substantive testing being
performed by the independent auditor. Furthermore, analytical procedures
provide circumstantial evidence which, taken alone, is not a high quality type of
evidence.
substantive procedures - analytical procedures and tests of detail

(6)

Knowledge of the consumer electronics business is just one aspect of Cline's

expertise that will allow him to evaluate the fair presentation of Lakeside's
financial statements. Overall knowledge of the client company and the industry in
which it operates should also allow the auditor to

- identify areas that may need special consideration;

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

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

from examining the client company's accounting records and inquiry of the client
personnel. This information can be supplemented through review of the prior
years' audit documents, AICPA Accounting and Audit Guides, industry
publications, financial statements from other companies in the same industry,
college textbooks, magazines, and other trade periodicals.

Since the students may not be familiar with the AICPA Industry Audit Guides, the
instructor may want to bring an example or two to class for this discussion.
Examples of the industries covered by these audit guides include:

- Airlines
- Finance Companies
- Investment Companies
- Providers of Health Care Services

(7)

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

37
* Price competition forces narrow time constraints on the work of the
independent auditor. In order to finish an audit engagement in a short
enough time so that a reasonable profit can be made, a danger exists that
the auditor will (1) accept less than sufficient evidence, (2) fail to recognize
critical audit areas, or (3) not be able to acquire the depth of knowledge
necessary for essential audit judgments. Thus, the argument is frequently
raised that price competition leads to a decrease in overall audit quality.

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

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

After the students have been allowed to discuss the problems associated with
price competition, the instructor may want to ask whether these problems
outweigh the advantages of having the auditing profession participate in the free
market system. Since most business students in the United States appear to
advocate free markets within the country, some interesting discussion can be
stimulated as to whether the auditing profession should be exempt from price
competition.

(8)

According to the audit risk model, planned detection risk (PDR) equals
acceptable audit risk (AAR) divided by the product of inherent risk (IR) and
control risk (CR). Holding inherent risk and acceptable audit risk constant, there
is an inverse relationship between control risk and planned detection risk. Thus,
an increase (decrease) in control risk leads to a decrease (increase) in planned
detection risk. Also, as planned detection risk decreases (increases), the amount
of substantive tests and other audit procedures increases (decreases). That is, if
the auditor determines the level of detection risk to be low, he or she wants the
chance of not detecting an error too small. In order to have a small chance of not

38
detecting an error, the auditor must do more testing. For example, given
AAR=10% and IR=80%, and assuming an 80% CR (high), then using the audit
risk model, planned detection risk is a relatively low 15.6% [.10/(.80x.80)], but
assuming a 20% CR (low), then planned detection risk is a relatively high 62.5%
[.10/(.80x.20)].

(9)

According to SAS 99, the assessment of the risk of fraud begins with a meeting
of the entire team for such purpose. This brainstorming session needs to
encourage the involvement of all team members and cannot be just a staff
training session. The objective is to solicit the ideas from all team members and
to sensitize the entire team to the particular problem areas that this client
presents. The process begins with such a session, but does not end there.
During the audit the entire team needs to consider how the information being
developed relates to the areas already identified, noting new areas that need
attention, or adjusting expectations on the areas already identified. The areas
identified by fraud risk are primarily in the areas of inherent risk and control risk .
Increased fraud risk represents an increase in inherent risk (the risk that errors
exist) or will also increase the control risk (the risk that the clients internal control
system will not detect the error or irregularity).

(10)

The registration process is not difficult. Maintaining the status of a registered CPA
firm is more difficult and requires that the firm be willing to adjust its operations
including independence and staffing quality control standards to meet the higher
expectations of the PCAOB. They may also be required to change the nature of
their practice, at least as far as publicly traded clients because of the list of
proscribed activities. Abernathy and Chapman have sufficient time to become
registered and therefore need only be concerned about accepting Lakeside as a
client if there is some obstacle to their registration. If Lakeside asks if they are
currently registered, then the answer has to be, no, but we are pursing
registration.

SUGGESTED ANSWERS TO EXERCISES

(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

39
process that must be flexible enough to adapt to a specific set of circumstances.
It should be noted to students that, in practice, several years (rather than two)
would be analyzed for trends.

a) Ratio analysis from 2010 to 2011.

Ratio 2010 2011 Significance

Current 1.35 1.35 No significant change
# Days inventory on 93 101 Increase may indicate obsolete or
hand slow-moving inventory on hand
Receivable collection 21 25 Slight increase may indicate relaxing
period (days) of credit policies and/or possible
understatement of allowance
Debt-to-total-assets 74.4% 74.5% No significant change; however, the
high ratio indicates significant leverage
and potential solvency problems if
additional debt is needed
Times interest earned 3.6 times 2.8 times Decline indicates reduced ability to
meet interest payments through
operations
Profit Margin 2.79% 2.27% No significant change
Return on Assets 8.47% 6.73% Declining return results from a
combination of declining net income
and increasing total asset base.
Return on Equity 33.2% 26.4% Decline in return results from a
combination of declining net income
and increasing equity base.

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

levels; however, the company appears to be experiencing a decline in its
profitability level. The audit staff should pay particular attention to revenue-
enhancing or expense-reducing areas, such as fictitious sales or improper
capitalization of expenses to halt this downward trend.

b) Ratio analysis: comparison to industry.

Ratio Industry Avg. Lakeside 2011 Significance

Current 2.16 1.35 Lakeside is below the industry
average. This may indicate short-term
solvency (liquidity) problems.
Days inventory on 69 101 Lakeside is well above the industry
hand average. This may indicate short-term
solvency problems.
Receivables collection 15 25 Lakeside is well above the industry
period average. This may indicate short-term
solvency problems.
Debt-to-total-assets 52% 74.5% Lakeside is significantly above the
industry average; this may indicate
long-term solvency problems.
Times interest earned 9.2 times 2.8 times Lakeside is significantly below the
industry average; this may indicate
solvency problems.

40
Ratio Industry Avg. Lakeside 2011 Significance
Profit Margin 4.2% 2.27% Lakeside is only slightly below the
industry average.
Return on Assets 8.1% 6.73% Lakeside is only slightly below the
industry average.
Return on Equity 19.3% 26.4% Lakeside is above the industry
average. Its large amount of debt is
leveraging up the return on equity.

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 well above the industry
(primarily due to the high level of leverage).

c. Scan the financial statements and the trial balances.

Procedure Results Significance

Scan the income statement
[Note: Instructors may want to
suggest that students prepare a
common size income statement.]
Scan the balance sheet [Note:
Instructors may want to suggest
that students prepare a common
size balance sheet.]
Scan the cash flow statement
Scan the trial balance
Scan the trial balance
Scan the trial balance
The company's stores continue
to report an overall loss, which is
increasing in amount.
Significant increases in short-
term borrowings.
Cash flow from operations
declined significantly in 2011.
Something appears to be wrong
with the information generated by
Store Three. The sales for that
store have increased by
approximately 94% since the
previous year. At the same time,
the cost of the goods sold has
dropped from 58.5% of sales
(which is consistent with the
other stores) to only 50.3% of
sales. Also, the inventory held by
this store has risen by over 50%.
Sales Commissions for District D
in 2012 appear to be slightly out
of line. All of the other
commissions are approximately
5.7% of sales, while this account
is nearly 7% of the applicable
sales figure.
Rent expense on vehicles and
These losses suggest the
possibility that the stores will
eventually be discontinued by
Lakeside or drastically altered in
some manner.
The short-term nature of the
borrowing could result in short-
term solvency and liquidity
problems.
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 profit-
sharing 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

41
Procedure Results
equipment has decreased in
2012.
Scan the trial balance The Repairs and Maintenance
account has increased by over
150% since 2011.
Scan the trial balance The "Gain on Disposition of Fixed
Asset" balance of $14,000
warrants investigation.
Scan the trial balance The Allowance for Doubtful
Accounts balance shows a debit
balance on September 30, 2012,
compared to a credit balance one
year earlier.
Scan the trial balance The company's two bank credit
lines now have a total balance
that exceeds the $750,000
maximum that was indicated in
an earlier case.
Scan the trial balance The long-term notes payable
have increased by $50,000. The
auditor would certainly be
interested in the application of
those funds as well as the loan
agreement signed by the
company.
Scan the trial balance Sales returns have increased
significantly for both the company
stores and the distributorship.
Scan the trial balance The equipment account shows
42
Significance
indicate that the company has
acquired new property.
This significant increment may
indicate a posting error that will
require correction. Conversely,
actual repairs may have been
made by Lakeside. In that
situation, the auditor needs to
verify that all capitalized costs
have been segregated and
properly accounted for within the
company records.
Often a company will fail to
remove the appropriate cost and
related accumulated depreciation
when a plant asset is sold. The
auditor should also ascertain that
the current year depreciation
expense has been properly
recognized. Finally, the sale of
an asset can lead to the
acquisition of a new asset as a
replacement. The independent
auditor should follow up on this
possibility to assure that any
replacement is appropriately
capitalized.
The auditor should determine if
the client has written off an
especially large group of
accounts. Perhaps bad debt
experience is changing and a
larger allowance is required.
The auditor should verify that no
loan covenants have been
broken. In addition, because of
disclosure requirements as well
as the effects on the interest
expense account, the auditors
will need to review any new
borrowing agreement.
The auditor should determine the
application of those funds as well
as the loan agreement signed by
the company.
The auditors need to ascertain
the reasons for such an increase.
Any change in the trend for sales
returns would lead the auditors to
reevaluate year-end accruals.
If the company has acquired
Procedure
Scan the trial balance
Results Significance
an increase from the previous additional equipment during the
year. year, the auditor needs to verify
that capitalization and
depreciation were given proper
treatment.
The estimated bonus expense That increase is probably due to
has increased. the profit-sharing plan having
been in effect for all nine months
of 2012, but the increase should
be investigated.

Exercise 3-2

Note: Refer the students to Case 1 and Case 2. Student answers will vary greatly
due to the nature of the assignment. Consider asking several students for their
inherent risk level to see the range of answers. This should lead to a good
discussion about auditor judgment.

Exercise 3-2
Overall Inherent Risk Level

Client: The Lakeside Company

Balance Sheet Date: December 31, 2012
Prepared by:

Inherent risk (IR) is a measure of the susceptibility of material

misstatement before considering the effectiveness of the internal
control. Determine the appropriate level of inherent risk for the audit
engagement as a whole, using qualitative terms (high, moderate or low
inherent risk). Complete the following table.

Factor Discussion Low Moderate High

Nature of clients Consumer electronics X
business industry is subject to swings
in the economy and is very
competitive.
Results of previous Qualified opinion rendered by X
audits predecessor auditor.
Initial versus repeat Initial engagement X
engagement
Quantity of related Many transactions with the X
party transactions owners separate business.
Quantity of non- Transactions are fairly X
routine transactions routine.
Quantity of estimates Bad debts require estimates. X
and judgment required Few other accounts do.
for accounts

43
Factor Discussion Low Moderate High
Potential for fraudulent Many risk factors for X
financial reporting fraudulent financial reporting
(fraud risk factors) were identified in case 1.
Potential for As noted in Case 1, X
misappropriation of accounting systems are
assets (fraud risk outdated, resulting in high
factors) potential for misappropriation
Other factors (list)
Other factors (list)
Conclusion: Overall Discussion for overall level is X
inherent risk level below.

Discussion: Discuss how you arrived at this overall level of inherent risk.

As noted in the table above, the client has many factors that lead to a high
evaluation of inherent risk, including the nature of the industry, the results from
previous audits, and others.

44
 CASE 4

SUGGESTED ANSWERS TO DISCUSSION QUESTIONS

(1)

Statement on Auditing Standards 78, "Consideration of Internal Control in a

Financial Statement Audit: An Amendment to SAS No. 55," identifies the five
elements of internal control as the Control Environment, Risk Assessment,
Control Activities, Information and Communication, and Monitoring. Cline's
questions appear to be designed to determine the degree of information that has
been established to date about each of these elements. Question (3) asks about
the information that the auditors could have looked at within the Lakeside
Company in order to respond adequately to these queries. Auditors must be able
to gather sufficient data in the early stages of an audit to assess the various risks
involved in the examination.

In studying the control environment of a company, SAS 78 recommends that a

number of factors should be assessed including those listed below. For several
of these factors, the types of information that the Abernethy and Chapman
auditors might use to make their evaluation is also discussed. A quick look at the
control environment will probably lead the auditors to the decision that Lakeside
has not established the environment needed for adequate internal control.

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

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

45
 the actual priority placed on internal control by the company. Documentation
of this should also be available for inspection. Rogers seems to understand
that better systems are needed but he has invested neither the time nor the
money to develop such policies and procedures. This lack of support may
indicate that the management is not serious about establishing adequate
control within the company. Because of the company's growth, improvements
in the future may be forthcoming, but at the present time the management
appears (from what has been said) to have let the company outgrow its
control policies and procedures.
Organizational structure. If Lakeside has a chart presenting the various
officials and their jobs, the auditors can assess whether control policies would
be easy to circumvent. Although Exhibit 3-2 shows the company divided into
clearly distinct areas, the Assistant to the President does seem to be in a
position to operate without proper control supervision. In addition, the
President seems to hold a significant amount of power in this company, with
very little control having been established.
Assignment of authority and responsibility. This factor includes how authority
and responsibility for operating activities are assigned and how reporting
relationships and authorization hierarchies are established. Since Lakeside is
not a huge organization, Rogers tends to intervene in many of the operating
activities. However, as Lakeside continues to grow, this may become a major
concern to the auditors.
Human resource policies and practices. These policies and practices relate
to hiring, orientation, training, evaluating, counseling, promoting,
compensating, and remedial actions. The auditors should inquire and
observe Lakeside's policies, including any standards for hiring the most
qualified individuals, training, and performance appraisals.

Risk assessment is the second component of internal control. The auditors will determine
and evaluate how Lakeside identifies, analyzes, and manages risks relevant to the
preparation of the financial statements. The auditors will want to pay particular attention
to several changes occurring at Lakeside and how the management deals with these
changes. These changes include the expansion of the company's stores, the concentration
on the Cypress product line, and the relatively new bonus system.

Next, the auditors will look at the actual control activities in place to see that
specific control objectives are being met. Within this testing, the auditors should
look at the following as goals of the company's internal control:

Performance reviews. Independent checks on both performance and proper

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

46
 documentation produced for a variety of transactions to ensure that each was
authorized by the appropriate individual within the company. Further, the
auditors will verify that Lakeside properly designs and uses adequate
documents. By walking through the various systems, the auditors can
determine if adequate documentation is required at each point and if those
documents are preprinted and prenumbered to ensure that the proper
information is gathered and retained.
Physical controls. By physical observation of the warehouse, the stores, and
other assets, the auditor can determine if Lakeside has adequate safeguards
over its assets.
Segregation of duties. By looking at the organization of a company, the
auditors can determine if the necessary separation of responsibilities is in
place to facilitate adequate control. For example, since Lakeside has a chart
showing the various officials and their jobs, the auditors can assess whether a
true system of checks and balances has been established. Although Exhibit
4-1 shows the company divided into clearly distinct areas, information in
Exhibits 4-3 and 4-4 indicates, for example, that the Assistant to the President
has a great many responsibilities, some of which raise the possibility of
control problems.

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

Identify and record all valid transactions.

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

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

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

47
(2)

An evaluation of the overall control environment is not possible from Exhibits 4-3
and 4-4. However, the auditors can see that responsibilities have been
developed and divided within the company. Each individual or department
seems to have a well-defined job within the two systems. Thus, some evidence
exists to indicate that management is aware of the importance of internal control.
Such systems simply cannot be created without adequate support by the
company's management.

In terms of risk assessment, Lakeside does not appear (from Cases 2 through 4)
to have a formal method of systematically assessing risks (Weakness). The
auditors should recommend a system of identifying risks, their significance, their
likelihood of occurrence, and how they might be managed. This is especially true
with Lakeside's growth of stores, concentration of suppliers (Cypress only), and
installation of a bonus system.

In addressing control activities, the auditors can see, as indicated in the answer
to Exercise (2), that the company seems to use adequate documents and
authorization procedures (Strength). In addition, although the Assistant to the
President has many different duties (Weakness), the company seems to have
made an attempt to segregate responsibilities in an appropriate manner.

Both of the information systems that are presented also seem well designed,
especially for a small but growing company. However, the company still uses
some manual systems that can be slow and offer the opportunity for many
human mistakes to be made (Weakness). The answer to Exercise (2) goes into
more detail concerning control strengths and weaknesses in this area.

The monitoring activities seem to be somewhat lax. However, with Lakeside still
being relatively small, Rogers' oversight somewhat compensates for the lack of
monitoring. With the growth of Lakeside, this is becoming less true.

(3)

After a preliminary assessment of control risk, the auditors have three possible
actions:

a) Because of potential strengths found within internal control, the auditor

may feel that control risk can be assessed at below the maximum level.
If so, the auditors must then be able to identify specific control
procedures that will likely prevent or detect material misstatements.
The auditors must perform tests of these controls to evaluate their
effectiveness to determine if a reduction in the assessment of control
risk is justified.

48
 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,
and/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 well-
devised 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)

49
This new information provides an increased risk on the motivation/incentive for
fraud to occur, and an increase in opportunity through collusion affecting
segregation of duties, in terms of the fraud triangle. It does not mean that fraud
has occurred, and does not have the rationalization necessary for fraud to occur .
The auditor faced with this information should document the discussion, and
make sure the audit team is aware of the conversation. It is not the job of the
staff auditor to initiate an investigation at this early point in the audit.

SUGGESTED ANSWERS TO EXERCISES

(1)

a)

The following page presents a flowchart for the revenue recognition system.
Numerous acceptable variations of this flowchart may be created. This problem
is not intended to suggest a rigid format for the flowchart but rather to give the
student experience in constructing and reading one. When evaluating a
student's work, several questions should be asked:

Does the flowchart truly mirror the system?

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

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

50
51
(1)

b)

Revenue and Cash Receipts Cycle

Distributorship Cash Receipts

Treasurers Office:

Checks arrive from customers along with a 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.

Assistant to the President:

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.

Sales Division:

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.

52
Controllers Office:

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.

Case 4 - Exercise 2a

INTERNAL CONTROL - PRELIMINARY ANALYSIS

CLIENT: The Lakeside Company

SYSTEM: Cash Receipts
DATE:
PREPARED BY:

List each document found in this system, the number of copies, and
whether it is prepared internally or externally.

*0 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.

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

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

*3 Sales Invoice (second copy) - prepared internally.

*4 Bill of Lading (only fourth copy is a part of this system) - prepared

internally, two copies sent to customer.

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

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

Answer each of the following questions. For each "No" answer,

comment on whether an internal control weakness is indicated.

53
 QUESTION YES NO COMMENT
(1) Is each X Exhibits 4-3 and 4-4 indicate that the sales
document within invoices (including the sales invoice slip)
this system pre- and the bills of lading are prenumbered.
numbered? None of the other documents shown in
this system would normally be pre-
numbered.
(2) Is the X Exhibit 4-4 indicates that all documents
authority for within this system are clearly assigned to
completing each a specific department.
document clearly
delineated?
(3) Are all X A number of the documents are reviewed
documents prior to the beginning of this system such
subsequently as the sales invoice and the bill of lading.
reviewed by an The validated bank deposit slips are
independent reviewed by the Assistant to the President
party within the while the cash remittance list is reviewed
company? by the Controller's Office. The bank
statement is reviewed by the Assistant to
the President. Finally, the bank
reconciliation is prepared by the Assistant
to the President but does not appear to be
reviewed. The failure to review this
document would constitute an internal
control weakness.
(4) Are X All instructions on the flowchart appear to
appropriate be reasonably complete, although any set
procedures clearly of written instructions could be put into
spelled out for more detail. One problem does exist:
completing and None of the instructions give guidance
reviewing each when discrepancies are found. For
document? 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) Is the record- X The Treasurer's Office, which serves the

54
 QUESTION YES NO COMMENT
keeping function custodial function for the cash funds, also
independent of records the initial receipt of cash. That
the custody type of organization is typical of small
function at all companies but does offer the opportunity
points throughout for theft or cash manipulation. In addition,
the system? 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) Are all X All computations are independently

mathematical verified except for the cash discounts.
computations The flowchart is unclear as to the
independently procedure to be applied when the sales
verified? division calculation does not agree with
the customer's payment.
(7) Does record- X The record-keeping function appears to
keeping begin at begin immediately upon receipt of the
the origin of the cash.
transaction?
(8) Are all X All transactions seemed to be
transactions appropriately authorized.
authorized?

(9) Indicate any other specific internal control features that have been
built into this system.

Other control procedures that might be mentioned by the students:

Checks are immediately stamped "For Deposit Only"

Spot checks made of cash remittance list totals to bank statement

deposits are made to counter potential "lapping" activities.

(10) Indicate any other specific internal control weaknesses that

appear to be present in this system.

Other control weaknesses that might be noted by the students: Invoice

slips and related documents are permanently filed by invoice number in

55
 the sales division rather than by customer name without any apparent
cross-referencing. In case of a later dispute, locating the invoice might
be difficult.

Case 4 Exercise 2 (b)

Abernethy and Chapman

INTERNAL CONTROL Control Risk Matrix Revenue Cycle

Client: Lakeside

Revenue Transaction-Related Audit

Objectives

Completeness:
Occurrence:

Accuracy:

Summarization:

Classification:

Timing:
Posting and
Internal Control
Sales orders recorded on C C
Controls

prenumbered forms
Credit is approved by Rogers C

Recorded sales are C

supported
By authorized shipping and
orders
Price list controls the prices C
and are checked
independently.

Statements are mailed C C C

monthly
Deficiencies

Miller has access to orders, D D D

billing and accounting

56
 No review by independent D D D
parties

Assessed Control Risk M H H L H L

C = control, D = deficiency
H = high risk, M = moderate risk, L= low risk

Note: each deficiency needs to be evaluated by identifying

compensating controls, potential misstatements, materiality and the
effect on audit evidence.

Case 4 - Exercise 3

The Lakeside Company

Internal Control Weaknesses - Revenue Recognition Procedures
December 31, 2012

Improvements that could be made in the revenue recognition system for the
distributorship sales division are listed below.

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:

*7 Establish a separate credit department to investigate new clients and set

credit limits based on this information.

*8 Prohibit Rogers or other company personnel from giving credit except

under specified conditions.

*9 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.

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

*11 Establish a separate accounts receivable department to monitor all

changes in each customer's individual account.

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

*13 When goods are shipped, a signed receipt should be received as proof of

57
 the transfer.

SUGGESTED ANSWERS TO SARBANES OXLEY QUESTIONS

(1)

The board of directors needs to be organized so that it can fulfill its purpose. The
primary improvement is to increase its independence and operation. The
President of the Corporation should be the Chairman of the Board of Directors,
and there should be sufficient independent board members to manage and
create a truly independent audit committee. Under Sarbanes-Oxley the audit
committee is the primary interface with the registered CPA firm.

Other structural changes may involve management and their duties. Unlike the
previous non-public audits, violations of segregation of duties, or lack of audit trail
might trigger a significant deficiency or material weakness notification.
Therefore, while in the past, expanded substantive testing was possible in the
event of internal control deficiencies, SAS 112 requires the communication of all
such problems in the context of the audit or the management report on the
internal control system.

(2)

The audit or internal control is still relevant in the determination of the audit risk
model and the determination of detection risk relative to the audit of the financial
statements; however, Sarbanes-Oxley requires that public company
management report separately on the internal control system over which they are
responsible. Further, the registered CPA firm must audit that management report.

The result is that Abernathy and Chapman must evaluate the effectiveness, and
test the effectiveness of the internal control system regardless of its impact on
the financial statement audit. In most cases this would involve increased auditing
and therefore higher fees.

58
 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...."
(para. .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:

*14 Money that comes to the company from a customer is stolen by an

employee with the balance then being written off the records as an
uncollectible account. This diversion of funds is especially likely when an
old account is collected, one that can be removed from the books without
arousing suspicion.

*15 Lapping can occur. One or more accounts receivable are collected by the
company but the money is stolen by an employee. However, since the

59
 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.

*16 A customer can pay the total amount of an invoice. An employee removes
cash equal to the 2% discount that is allowed when payment is made within
ten days. If the company does not have a specific policy for rebilling a
customer for incorrect discounts, the difference may simply be recorded as
a discount that has been taken.

(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:

*17 Access to the accounts receivable subsidiary ledger is available to all

employees within the company. Therefore, the possibility exists that an
individual could make an adjustment to a balance without Miller noticing.
The receivable of a friend or relative, for example, could be reduced.
*18 Aging of the receivables is performed only once a year. Although Miller

60
 claims that he can monitor the age of individual accounts, the company
needs to be aware of changes that occur over time. For example, the
increase in the age of the receivables during the current period seems to
have gone unnoticed. Consequently, the company's assets are tied up for a
longer period of time and the chance of accounts becoming uncollectible
increases. The company needs to be in a position to take corrective action
as soon as this type of problem begins to occur.
*19 Miller controls the accounts receivable subsidiary ledger with virtually no
company oversight or control. For example, no reconciliation with the
general ledger is made except for the auditor's testing once a year. Errors
and evidence of irregularities could exist and not be discovered for months.
*20 Complaints about billings are handled by Miller rather than by someone
independent of the system. The handling of complaints is an important
method of control, especially in an accounts receivable system, since
regular interaction with outside customers occurs. This control mechanism
is neutralized, however, if Miller is assigned to look into and resolve the
problems.
*21 No formal system exists for setting credit limits and granting credit. Rogers
appears to handle this aspect of the company based almost on intuition.
Thus, potentially excellent customers may have their credit limited while
risky customers are given excessive credit. A formalized system needs to
be developed with some oversight included.
*22 Credit is based solely on reports that are filed by the sales representatives.
These individuals have a direct interest in getting additional sales since
they are paid on commission. Thus, they have reason to want each report
to sound as if the customer is worthy of credit. Additional independent
information should be accumulated to help the company decide on the
granting of credit.
*23 The credit files are never updated. Therefore, the company learns that a
customer is no longer a good credit risk only by incurring a loss, the writing
off of a balance as a bad debt. Therefore, customers in financial difficulties
can run up large debts that will never be paid. The company needs to
establish a periodic review of credit information to ensure that each
customer is still worthy of credit. The age of the accounts receivable is up
significantly from the previous year without any good explanation. Miller
blames the change on Christmas, but the effects of that holiday would have
also been encountered in the preceding year. The possibility exists that bad
accounts or false accounts are now included within the receivable balance.
*24 Miller indicates that the company might have previously been holding
accounts rather than writing them off as bad on a timely basis. The auditor
must be concerned that this practice is still being followed. Companies will
often attempt to manipulate net income by varying the point at which
accounts are determined to be bad.
*25 No justification seems to exist for using 0.7% 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

61
 estimation that is a reasonable representation of the company's
uncollectible accounts.
*26 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.
*27 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.
*28 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.
*29 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
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

62
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) The balance appears to be with a related party;

b) The account is quite large in relation to other accounts receivable;

63
 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:

*30 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.

*31 Sales Invoice - serves within the Lakeside system as both an invoice
indicating the amount billed to the customer and a sales order. The auditor
can use the various copies of the sales invoice to verify that:

- credit was approved for the sale,

- quantities and types of items billed agree with the quantities and types
of items shipped to the customer,
- prices included on the invoice are appropriate,
- that the bill is mathematically correct.

*32 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.

*33 Accounts Receivable Subsidiary Ledger - indicates the receivable balance

from each individual customer. An auditor compares individual entries
made to this subsidiary ledger with entries in the control account in the
general ledger. Indicates proper functioning of system.

*34 Inventory Price List - used to price sales invoices. An auditor can use this
listing to verify correct pricing of the sales invoices.

*35 Inventory Sales Journal - records inventory sales as a basis for perpetual
inventory. An auditor verifies that the items recorded as being sold agree
with the sales invoice. Although this verification relates to the inventory
system rather than to receivables, the journal is mentioned in Exhibit 3-4
and does indicate an appropriate interface between the two systems.

Although the following documents are not part of the audit trail leading to the

64
recording of the Accounts Receivable debits, they are certainly relevant to any
testing made in connection with the fair presentation of those debits:

Invoice Slips, Cash Remittance Lists, Validated Bank Deposit Slips - some
or all of these documents can be used by the auditor to verify the actual
amount of cash received. The question of collectibility is best answered by
actual collection of the receivable. Thus, the auditor will compare the debit
entries in the receivable account to the subsequent cash collections.

This question also asks about the reliability of the evidence gathered from this
audit trail. Lakeside's audit trail is composed entirely of internally generated
documents. For example, even the original customer order is taken by telephone
and recorded by Lakeside employees. Thus, the reliability of the documents that
comprise this trail, such as bills of lading or sales invoices, would be closely tied
to the auditor's evaluation of internal control. If controls are perceived as strong,
the reliability of these documents is much higher than if controls are weak.
Because the audit trail is composed solely of Lakeside documents, the student
should be aware that testing this trail provides the auditor with only a portion of
the necessary evidence. Collection of the accounts receivable, for example, and
auditor confirmations would also provide evidence as to the fair presentation of
the accounts receivable.

(10)

Miller is uncertain how the 0.7% figure was determined. He says that the
previous auditors determined this figure several years ago, and that the company
has always used this figure. Obviously, this is not a reasonable method for
estimating bad debts. The figure should be evaluated by Lakeside's management
at least annually for its reasonableness. This evaluation should include a review
of the history of uncollectible accounts, the current credit policy, and the current
aging of accounts receivable.

(11)

Mitchell probably should not recommend that Accounts Receivable be confirmed

as of an interim date (November). The internal control for the revenues and
cash receipts cycle appear to be poor and cannot be relied upon to provide
reliable financial information for the month of December; thus, Accounts
Receivable should be confirmed at year-end.

(12)

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

65
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.

SUGGESTED ANSWERS TO EXERCISES

Note: Although no specific question relates to the following matter, students may
detect that a contradiction exists between a statement made by Miller in Case 5
and the system memorandum presented in Exhibit 4-3. Miller indicates that he
verifies the prices and extensions reported on sales invoices. Exhibit 4-3 states
that this control procedure is performed by the Controller's Office. Although this
discrepancy could mean that Miller's assertion is incorrect, it probably signifies
that the system has been altered subsequent to the development of the
memorandum. Discussion of this contradiction is a good lesson in the
importance of constantly updating the firm's knowledge of the client's systems
and internal control.

Case 5 - Exercise 1
Abernethy and Chapman
Internal Control Questionnaire - Accounts Receivable

Client: The Lakeside Company

Prepared by:
Date:

Questions Comments on Significance Suggestions

Current System
1 Does an independent The subsidiary During the year, On a periodic basis,
party on a regular ledger is reconciled virtually no control is a member of the
basis reconcile the annually by the maintained over administrative staff
subsidiary ledger? independent Miller's handling of should verify that the
auditors. the subsidiary subsidiary ledger for
ledger. The accounts receivable
possibility that errors agrees with the
or irregularities will general ledger
be discovered on a control account.
timely basis
becomes remote if
not impossible. In
addition, Miller has
the opportunity for
manipulating the
records to cover
thefts and other
defalcations.

2 Are appropriate, The criteria for For the auditor, a Establish a formal
established criteria in writing off accounts problem exists as to system for writing off

66
 Questions Comments on Significance Suggestions
Current System
place for writing off are nebulous and the consistency of bad accounts. This
doubtful accounts? seemingly based removing bad debts system need be no
solely on the from one year to the more than a list of
judgment of Miller. next. Once again, steps to be taken
no control appears prior to the decision
to exist over Miller's to remove an
judgment. account. Company
needs to ensure a
review of these
accounts.
3 Are accounts to be No independent The removal of bad Once a system has
written off properly party authorizes the accounts can be been established for
reviewed and write-off of bad used to cover cash the write-off
authorized by an accounts. thefts. Also, write- procedure (see
independent party? offs may be Question 2), an
approved without independent
sufficient attempts employee should be
being made at required to review
collecting the every account prior
receivables. to removal to make
certain that all proper
steps have been
followed.

4 Is an appropriate Follow-up of bad If no follow-up is The receivable can

follow up made on debts is not made, the company be turned over to an
accounts that are addressed in the reduces the outside collection
written off? case; Mitchell does possibility of making agency or, as an
not ask this specific any future collection. alternative, a
question. Additionally, member of
attempting to collect Lakeside's staff can
an old account be assigned to look
receivable is a into the bad
control mechanism accounts
to ascertain that the periodically.
balance has not
actually been paid
and the money
stolen or the
collection recorded
incorrectly. Finally, if
no follow-up is
carried out, the
opportunity exists for
employees to steal
the money if it
should be received
at a later date.

5 Does the company No reevaluation of No proof exists that Client should

periodically re- the method for the bad debt schedule recent bad
evaluate the method estimating bad expense and the accounts to arrive at
in use for estimating accounts has been allowance for a new estimation of

67
 Questions Comments on Significance Suggestions
Current System
bad accounts? made by the client doubtful accounts is the bad debt
company. fairly presented. percentage.

6 Are customers billed The first three By having Miller Control can be
regularly by a party invoices are mailed send the last established by
separate from the by the sales division; invoices, the allowing Miller to
subsidiary ledger? any further billing is opportunity for continue the billing,
made by Miller, who manipulation is but with the addition
is in charge of the increased. In a of the control
subsidiary ledger. small company such procedures
as Lakeside, this suggested in several
situation is not of the other
unusual, but it questions.
should be accom-
panied by additional
control and
reconciliation
features.

7 Is an independent The responsibility for Again, all of the Lakeside should

verification made of looking into responsibilities are in have complaints sent
complaints from complaints is vested the hands of one to an employee who
customers in Miller. person with no can then discuss the
concerning their bills? independent control matter with both
being applied. This Miller and the
lack of control customer to make
reduces the certain that the issue
possibility that errors is properly resolved.
will be discovered.
Basically, an
opportunity to
establish control
over Miller's work is
being missed.

8 Was the companys According to the Any shift in credit Lakeside should
policy of granting client, no formal policy requires adopt a policy to
credit changed over change in the policy auditor attention as guide Rogers in his
the past year? of granting credit has to the effect on the credit decisions. In
been made. allowance account addition, outside
However, the and bad debt verification of credit
increases in the size expense. Abernethy ratings on a periodic
of the receivables, and Chapman may basis would help
the increase in the want to review the reduce the risk of
average age of the new customer high bad debt losses.
balances, and the accounts opened
apparent write-off of during the current
additional year for any
uncollectible indication of a
accounts indicate change in credit
the possibility that policy. This issue
some, perhaps may be especially
informal, significant in the

68
 Questions Comments on Significance Suggestions
Current System
modification has Lakeside audit since
occurred. Because credit reports are
the credit policy has filed by the sales
never been formally representatives who
established, the are paid on
auditor may have commission, thus
trouble benefiting from an
distinguishing an increase in sales.
actual change.

9 Can a credit sale No indication is To the auditor, the At the point in the
possibly be made given in the case as possibility of a sale accounting system at
without prior credit to whether sales being made without which the extensions
approval? invoices are verified credit approval casts and prices are
after the shipment to further doubts on the verified, the
ascertain reliability of the presence of credit
appropriate credit system of controls. approval should also
approval. The As a part of the tests be checked.
system is designed of controls, the
so that credit auditor will want to
approval is review a sample of
necessary before the sales invoices for
sale is made, but no proper credit
control mechanism approval.
is identified to
assure that the
system is working
properly.
10 Are credit files Credit files contain As indicated above, As a part of the
complete and only the sales the credit granting design of a
periodically representative's policy is informal and comprehensive
reviewed? credit reports and do based almost solely credit system,
not appear to be on Rogers' Lakeside should
reviewed judgment. Thus, the determine the
periodically. efficiency of the desired contents of a
system is unknown, credit file including
and review of the items such as
system by the outside credit
auditor is quite reports, financial
difficult. statements,
correspondence, etc.
Periodically, these
files need to be
reviewed by an
independent
Lakeside employee
to verify that all
information is
complete and up-to-
date. Each
customer's file is
also reevaluated at
regular time intervals
to judge whether

69
 Questions Comments on Significance Suggestions
Current System
credit should
continue to be
offered.

11 Are invoices verified Verification of goods Verifying extensions All verifications

as to agreement with and prices is made and prices after the should be made prior
goods shipped and by Lakeside invoice has been to mailing the
price of goods? employees. Miller sent to the customer invoice, ideally by a
implies that his is not a logical different employee.
checking of prices approach. Also,
and extensions are having Miller perform
not made on a timely this task adds
basis. In addition, nothing to the
this verification is efficiency of the
another organization.
responsibility
pertaining to
accounts receivable
concentrated in
Miller's hands.

12 Are extensions and See answers for

footing recalculated? question 11.

13 Are cash discounts Cash discounts are System appears None.

recomputed and verified by the sales adequate. Financial
verified as to actual division. information should
days? be fairly presented.

14 Can a sale possibly Using prenumbered If the possibility Since the documents
be made and goods sales invoices and exists that the are already
shipped without an bills of lading along company can make prenumbered, the
invoice being with the periodic sales without auditor needs to
recorded or mailed? verification of all recording them, the make certain that
numbers is essential auditor's ability to Lakeside has a
in assuring that all gain assurance as to policy for periodically
sales are recorded. completeness verifying the
In an earlier case, assertion may be presence of all
the use of severely hampered. forms.
prenumbered forms
is mentioned. Miller
suggests that the
presence of all forms
is tested periodically,
but the auditor
should specifically
ask about that
procedure.

70
(2)
Case 5 - Exercise 2

Abernethy and Chapman

Internal Control Evaluation

Client: The Lakeside Company

Prepared by:
Date:

Exhibit 5-2 is a portion of the audit program that Mitchell designed to test the
operating efficiency of controls in the revenue and cash receipts cycle. For each
individual test, indicate the anticipated results if the control procedure is working
properly. Also, if the control is not functioning properly, list the potential problems
that exist. Use the following format for your response:

Step Anticipated Results Potential Problem(s)

1-A 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.
1-B Anticipated Results - The
quantity and description of the
items sold should be the same
as the items shipped. Again,
Lakeside employees are
supposed to have previously
made this comparison and left
their initials or other proof of the
execution of this test.
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
employees are not complying with
the requirements of the system.
Potential Problem - Differences
warn the auditor that sales have
been both billed and recorded
incorrectly, or incorrect amounts
or types of inventory have been
shipped. Once again, a lack of
compliance by Lakeside's
employees may be shown if this
comparison has not been made.

1-C Anticipated Results - Cash Potential Problem - The cash

received as per the remittance may have been stolen, or
list should be consistent with the someone in the company may be
invoice and the invoice slip. engaged in lapping.
Customers should be
encouraged to include the
amount of payment on the
invoice slip as a further control
procedure. Because of the

71
Step Anticipated Results
discount, the auditor may want to
perform this step in connection
with the discount computation in
Step 1-D.
1-D Anticipated Results - Calculated
cash discounts should be
identical with the amounts
recorded by the client company.
In most cases, this calculated
discount figure will be equal to
the difference between the sales
invoice total and the cash
remittance.
1-E Anticipated Results - All prices
on the invoices should agree
with the prices being shown on
the approved price list.
1-F Anticipated Results - The
extensions and footings on the
invoice should be correct.
1-G Anticipated Results - The
amount received according to
the invoice slip should agree with
the listing of individual items
72
Potential Problem(s)
Potential Problem - Discounts
may be incorrectly recorded to
hide cash shortages or as a step
in stealing cash funds from the
company. Also, the company
may be allowing customers to
take discounts that have not
actually been earned. Allowing
these reductions would indicate
lack of efficiency in internal
control.
Potential Problems - Wrong
amounts may be paid by
customers. Improper pricing,
either intentionally or
unintentionally, also leads to
incorrect sales and receivables
figures on the financial
statements. If the invoice price
is too high, sales and income are
overstated; if too low, the figures
will be understated, and
company employees may be
receiving kickbacks from
customers.
Potential Problems - Wrong
amounts may be paid by
customers. Improper footings or
extensions, either intentionally or
unintentionally, also leads to
incorrect sales and receivables
figures on the financial
statements.
Potential Problems - A
discrepancy could indicate the
theft of the cash receipts. This
test also may alert the auditor to
Step Anticipated Results
being deposited. In addition, the
date of deposit should be the
same as the date on which the
payment is received.
1-H Anticipated Results - All cash
remittances should be recorded
promptly as credits to the
specific subsidiary ledger
accounts.
1-I Anticipated Results - Each
invoice should be initialed by
either Rogers or Miller to indicate
credit approval.
2-A Anticipated Results - Each debit
entry should be corroborated by
an appropriate sales invoice
agreeing as to amount and
customer.
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.
2-C Anticipated Results - Each credit
73
Potential Problem(s)
the possibility of lapping.
Potential Problems - Since the
subsidiary ledger is not well
controlled in the Lakeside
organization, this procedure may
be used to determine the
possibility of errors within the
ledger. This test also may
indicate lapping as well as other
manipulations of the accounts so
as to conceal cash shortages.
Potential Problems - Because
the credit system is not well
documented, the auditor will be
searching for evidence that sales
can be made without credit
approval. Such evidence would
have an effect on the auditor's
judgment as to the amount of
evidence needed in examining
the allowance account and bad
debt expense.
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.
Potential Problems - This tracing
could denote errors in postings
within the system. Errors could
indicate lapping by company
employees.
Potential Problems - Again,
Step Anticipated Results
to a specific account should
agree with the listing of individual
items on the bank deposit slips.
Potential Problem(s)
lapping or attempts by
employees to cover cash
shortages may be uncovered
through this test.

3 Anticipated Results - For each of Potential Problems - The use of

the customers, complete and
updated credit reports should be
on file.
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.

4 Anticipated Results - Each list Potential Problems - Cash

should be arithmetically correct.
Each total ought to agree in
amount and date with the
balance entered in the cash
receipts journal.
shortages and cash thefts are
often covered by incorrectly
footing a listing of cash
transactions.

SUGGESTED ANSWERS TO SARBANES-OXLEY QUESTION

(1)

This question is similar to the SOX question in Case 4. The emphasis is on the
difference between public and privately held companies. The difference involves
the testing of the controls. In the public company setting, controls are always
tested because of the separate disclosure by management of their evaluation
and testing of their system. In both public and privately held companies the
evaluation and possible testing of internal controls by the independent auditors is
related to the financial statement audit. The amount of substantive testing and
the determination of the detection risk is related to the internal control risk.

74
 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:

*36 The company maintains a perpetual inventory which provides significantly

greater control than does a periodic system;

*37 The case implies that the company uses preprinted forms so that adequate
information is captured whenever a document is prepared;

*38 All purchase requisitions are reviewed and authorized before merchandise
is ordered;

*39 Incoming inventory is inspected for damage upon receipt;

*40 All invoices are matched with the appropriate purchase requisition and
receiving report before payment is approved;

*41 Prices of every invoice are verified; and

*42 The mathematical accuracy of each invoice is checked prior to payment.

(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.
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

75
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.

Auditing literature places emphasis on the existence of appropriate supervisory

76
policies and anticipates that practices will be used by a firm in each audit
engagement to verify proper supervision. One such procedure is to have staff
members leave their initials to indicate the completion of a test or later review.
Thus, the working paper shown in Exhibit 6-1 was originally produced by Art
Heyman (AH) and subsequently reviewed by Carole Mitchell (CM), and Wallace
Andrews (WA). From the location of the initials, this auditing firm must require
acknowledgment at every point of audit judgment to indicate that the supervisors
concur with the actions taken. This policy enables the firm to monitor the degree
of supervision in each area of the audit as well as to ensure that no critical
problem will escape the attention of supervising auditors.

(6)

Because of the great volume of audit documentation accumulated during an

engagement, most firms use an indexing system to organize all materials.
Indexing allows the auditor easier access to the various documents and
expedites the review process. The "N-2" designation on this document is
apparently part of an indexing system, although no indication is given in the case
as to the actual derivation of the symbols. Abernethy and Chapman may be
using a code in which the letter N refers to the inventory account, and this
particular document presents the results of the second testing procedure
performed on that account.

(7)

One of the purposes of audit documentation is to serve as an historical record of

all audit testing performed by the CPA firm. This documentation provides a
guideline for future audits but, more importantly, serves as evidence should the
auditor's work ever come under question. To assure that the audit documents
clearly reflect the procedures that were carried out and the evidence gathered,
many auditing firms require that the objective, the scope, and the conclusions
reached be included in the documentation of each test. Furthermore, by having
to furnish this information, the staff auditor is more likely to understand the
purpose of the procedures being applied.

(8)

Audit procedures are the steps that are required to test a particular control,
transaction, or account. Some firms write procedures specifically designed for a
particular audit client. Also, some firms have standardized audit procedures for
use on all audits. For quality control standards, standardized procedures are
preferable to ensure that all audits are performed in a like fashion. However,
these standardized procedures should be supplemented with procedures

77
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.

Case 6 - Exercise 1

The Lakeside Company

Inventory Purchases and Cash Disbursements Transactions -
In-charge Review Comments
December 31, 2006

Prepared by:
Date:

Item on Working Paper Problem

The fifth procedure states that the
auditor "examined canceled checks for
amounts, dates, signatures,
endorsements, and payee."
The fifth procedure
Exception (A)
Exception (A)
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.
No indication is given as to the purpose
of verifying the account code.
Poorly written. The staff auditor does
not indicate whether the $200 and the
$360 amounts are over or under the
current list price.
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

78
Item on Working Paper Problem
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) 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
company such as Lakeside, that may
not be possible. The auditor should
adjust the flowchart and memorandum
for this system to include this discovery

Note: 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.

79
In reviewing this audit document with students, the instructor should be aware
that this question was developed with several educational objectives in mind:

*43 To introduce students to the types of testing procedures performed by

auditors in verifying the operating efficiency of a company's control policies
and procedures.

*44 To assist students in developing the ability to discover and evaluate control
problems. In this case, a number of problems exist; some are
meaningless, while some are quite significant. If this question is
approached, at least partially, as a discussion question, student ideas as to
the meaning and importance of each problem can be quite interesting.

*45 To aid students in developing audit document construction techniques. As

in a previous case, one or more of the students' efforts can be chosen and
presented to the class as a whole or in small groups for a technical critique.

(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.

80
 Case 6 - Exercise 2
Lakeside Company
Inventory Purchases and Cash Disbursements Transactions
December 31, 2012

Audit Doc. No.

Prepared by: AH 12/2/12
Reviewed by:
Reviewed by:

Purchase Receiving
Requisition Report Number Invoice Check Check Audit
Date Vendor Number Number Number Amount Procedures
8/20/09 Cypress 6702 3918 711 3091 $2,413.95 1, 2, 3, 4, 5, 6
8/21/09 Cypress 6703 3919 802 3121 $523.80 1, 2, 3, 4, 5, 6, G
8/24/09 Cypress 6705 3920 991 3164 $1,810.28 1, 2, 3, 4, 5, 6, C
8/27/09 Cypress 6704 3921 1261 3203 $2,860.03 1, 2, 3, 4, 5, 6, E, F
8/28/09 Cypress 6706 3922 1313 3251 $6,030.04 1, 2, 3, 4, 5, 6, G, D
9/2/09 Cypress 6707 3923 1406 3310 $2,577.10 1, 2, 3, 4, 5, 6, B, G
9/3/09 Cypress 6708 3924 1510 3345 $3,745.60 1, 2, 3, 4, 5, 6, E
9/7/09 Cypress 6710 3925 1616 3397 $354.05 1, 2, 3, 4, 5, 6, A, G
9/7/09 Cypress 6709 3926 1691 3425 $1,507.77 1, 2, 3, 4, 5, 6, G, B
9/14/09 Cypress 6711 3927 1812 3451 $11,698.88 1, 2, 3, 4, 5, 6, G, C
9/16/09 Cypress 6712 3928 2072 3471 $2,941.36 1, 2, 3, 4, 5, 6, G, E
9/21/09 Cypress 6713 3929 2149 3510 $14,867.97 1, 2, 3, 4, 5, 6, G, C

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:
1. Review receiving reports. All complete and signed by inspectors, except A.
2. Compared receiving report with purchase invoice for quantity and description. All agreed except B.

81
 3. Compared receiving report to purchase requisition for quantity and description. All agreed except B and C. All requisitions approved by
Rogers or Miller.
4. Invoices reviewed for compliance to see if they were checked, extended, and footed by Lakeside employees. All were except D.
5. Compared invoice prices with Cypress master price list. All agreed except E.
6. Inspected canceled checks and compared them to invoice amounts, recomputing 3% discount. All agreed except E.

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. #3923 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

82
Audit Conclusion: Further testing necessary because of exceptions noted.

83
 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. Compare the payroll records produced by Sarah Sweet to time tickets

completed by hourly employees noting agreement as to hours
worked;

b. Verify that time tickets have been appropriately authorized;

c. Recalculate salaried employees' monthly pay and compare to the

payroll records;

d. Recalculate salesmen's commissions and compare to payroll records;

e. Recalculate payroll deductions based on government payroll tables

and the data listed on the W-4 form filed by each employee.
Compare these deductions to the company's payroll records;

f. Recompute Lakeside's payroll taxes and compare to total reported

balance;

g. Verify mathematical accuracy of net wage figures (salary less

deductions);

h. Foot the payroll record;

84
 i. Verify that each payroll record has been properly authorized by Mark
Hayes;

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

85
made that the proper expense is being allocated to the current year. Hence, the
auditor should recompute the cutoff made of the payroll calculation at both the
beginning and ending of the fiscal year. Determination needs to be made that
the figure being reported is for 2009 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) Retracing transactions from origination to final reporting - ensures that

accounting system is functioning properly so that balances will be correctly
reported.

g) Scanning accounting records - an analytical procedure designed to highlight

significant or unusual differences.

86
 h) Inquiry (including discussion, questioning, etc.) - helps auditors to learn
design of accounting systems and internal control and to evaluate efficiency
of operations.

i) Examination and corroboration of subsidiary records - serves as support for

reported balances.

j) Correlation with related information (including ratio and trend analysis) -

another analytical procedure to identify possible problem areas.

k) Review of subsequent events - provides support for year-end balances and

identifies happenings that require disclosure.

l) Reliance on outside experts - used for evidence-gathering purposes that go

beyond purely auditing and accounting skills such as inventory valuations
and engineering estimates.

m) Examination of legal letters and confirmations - helps to identify, assess,

and value significant events and contingencies.

n) 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;

Operates as a safety measure. By setting aside sufficient cash for payroll,

the company guards against spending money required for that purpose;

Allows for additional control over unclaimed checks, uncashed checks, etc.;

87
 Facilitates the audit function in that the payroll balances are easier to verify;

Limits the amount of money that would be subject to theft in a payroll

system;

Facilitates reconciliation of the bank account. Some organizations even

use 12 bank accounts - one for each month - to limit the problems
associated with the bank reconciliation process.

(6)

Some of the more critical potential problems involving payroll include:

A. Checks are issued to fictitious employees or to former employees who have

left Lakeside, with the checks being diverted and fraudulently cashed.

Substantive tests that may disclose this problem:

Observe distribution of payroll checks.

Review personnel files for a sample of employees to verify current status

is maintained.

Compare names in files to time tickets and verify authorization of time

tickets.

Review company's system for removing names of employees who no

longer work for the company.

Compare current number of employees to previous years for unusual

differences.

B. Payroll deductions are recorded or computed incorrectly, through error or as

part of a defalcation scheme.

Substantive tests that may disclose this problem:

Review W-4 forms, voluntary deduction forms, and employee contracts

for completeness.

Compare payroll register to W-4 forms recomputing appropriate

deductions.

88
 Mathematically verify payroll deductions (foot and cross-foot) and
compare payroll balance to canceled payroll checks.

Review payroll tax forms for agreement with computed balances and
with payroll register.

C. Year-end accrual may be ignored or incorrectly computed.

Substantive tests that may disclose this problem:

Review last payroll for the year to verify that recording was made in
proper period.

Recalculate accrual and verify against the first payroll of the subsequent
period.

SUGGESTED ANSWERS TO EXERCISES

(1)

This problem extends the students' introduction to working paper construction by

placing them in the role of supervisor. A number of errors exist in the example
presented in Exhibit 7-1, and the students should be able to identify most of
them.

The working paper is not properly dated so that a reviewing auditor cannot
be certain that this testing applies to 2012.

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

89
 an exception has been found at point A.

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. See Conclusion on the working paper below.

90
 Exhibit 7

Lakeside Company

Account 585, Estimated Bonus Expense, for Nine Months ended

September 30, 2011 and 2012

Doc. No.
Prepared by
Reviewed by

2011 Bonus Plan

STORE STORE STORE STORE STORE STORE TOTAL

No.1 No.2 No.3 No.4 No.5 No.6 STORES
Sales $547,000 $795,600 $472,200 $484,600 $746,000 $221,600 $3,267,000
-Sales Returns $15,800 $50,380 $23,900 $28,100 $60,020 $22,600 $200,800
-Cost of Sales $325,200 $478,600 $276,400 $274,400 $458,000 $136,200 $1,948,800
-Dir. Sal. Exp. $90,400 $118,400 $78,600 $77,200 $109,600 $64,600 $538,800
-Rent $19,200 $56,800 $24,000 $26,400 $60,000 $24,000 $210,400
=Bonus Basis $96,400 $91,420 $69,300 $78,500 $58,380 ($25,800) $368,200
x Bonus % 2% 2% 2% 2% 2% 2%
=Bonus $1,928 $1,828 $1,386 $1,570 $1,168 $0 $7,880

2012 Bonus Plan

STORE STORE STORE STORE STORE STORE TOTAL

No.1 No.2 No.3 No.4 No.5 No.6 STORES
Sales
$639,800 $797,800 $917,600 $530,800 $729,200 $242,400 $3,857,600
-Sales Returns
$24,400 $59,800 $99,000 $44,700 $96,500 $22,400 $346,800
-Cost of Sales
$370,600 $456,800 $462,000 $304,800 $436,000 $147,600 $2,177,800
-Dir. Sal. Exp.
$102,400 $118,600 $80,800 $82,400 $110,200 $64,400 $558,800
-Rent
$21,000 $66,000 $26,400 $28,000 $64,000 $24,000 $229,400
=Bonus Basis
$121,400 $96,600 $249,400 $70,900 $22,500 ($16,000) $544,800
x Bonus %
4% 4% 4% 4% 4% 4% 4%
=Bonus
$4,856 $3,864 $9,976 $2,836 $900 $0 $22,432

Audit Objective: To determine the appropriate balance is the estimated bonus

expense account (# 585).

Scope: The bonus calculations for all six stores.

Audit Procedures:

91
 Agreed all sales, cost of sales, and salary expense amounts to the
September 30, 2011 and 2012 trial balances.
Agreed all sales returns and rent amounts to client documentation (cannot
be performed by the students).
Agreed bonus percentages to bonus agreement approved by the board of
directors.
Footed and cross-footed each row and column.
Recomputed bonus amount.

Comments: Client 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).

Audit Conclusion:

The 2011 bonus expense account is overstated (actual balance = $12,000 v.

estimated balance = $7,880); however, the amount of overstatement ($4,120)
does not seem material. Pass further testing. The 2012 expense appears to be
overstated by $16,568 (= $39,000 recorded - $22,432 estimated). This
overstatement represents approximately 6% to 7% of net income and, thus, is
fairly significant. (It overstates an expense, it understates net income). We
suggest that the client make an adjustment as follows:

230-1 Estimated Bonus Liability $16,568

585-1 Estimated Bonus Expense $16,568

SUGGESTED ANSWERS TO SARBANES-OXLEY QUESTIONS

During the audit of the internal control system (Sect 404), the CPAs can conclude
that the management report on their evaluation and audit of the system is fairly
stated and that the system works as it was designed and the design is effective.
That is the best case situation. Problems create other reporting options based
on whether the management report identifies the problem, or the CPAs have
found a problem that is unreported by the management. It is possible to
conclude that the management report is fair and the system is ineffective and the
significant deficiencies have been identified both in the management report and
the CPA internal control audit.

Managements report. Management will state its responsibility for maintaining

adequate internal control over financial reporting and give its assessment of
whether or not internal control over financial reporting is effective. According to

92
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].

93
 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 perpetual records may be in error. A large volume of transactions are

processed during the course of a year, and some amount of human error is
to be expected in the recording.

The cost flow assumption (FIFO, in this case) may have been improperly
applied in the perpetual records.

The inventory may have been counted incorrectly by the company.

Merchandise on hand, for example, could have been overlooked.

Inventory might be out on consignment.

Inventory might have been stolen.

Damaged or obsolete inventory may have been disposed of by the

company without recording a reduction in the subsidiary ledger.

Goods in transit could have been incorrectly handled in either the perpetual
records or the physical inventory.

The rollback procedure used to arrive at the December 31 year-end figure

may have been incorrectly applied.

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.

The question as to whether the $6,000 difference warrants further attention is

subject to the auditor's judgment. Since the financial records are adjusted to
agree with the physical inventory, the auditor is primarily interested in potential

94
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 overcount 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.), overcounting 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 overcounting 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

95
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, 2012, 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.

96
(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, overcounting 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.

97
(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. For each of the inventory items recorded by the auditor, mathematically

verify the extensions on the physical inventory list.

e. Refoot the inventory listing.

f. Using the master price list, compute a cost for the January 1-2, 2013,
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, 2013, 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. By review of Cypress discount announcements, establish validity of monthly

discounts included in inventory listing. (With the information included in this

98
 case, this step will not be possible for the students to perform.)

j. Recompute the 3% discount taken by Lakeside and compare this amount

with the inventory listing noting agreement.

k Agree the "total adjusted cost of inventory - 12/31/09" to the general ledger
at December 31, 2012.

(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:

establishing the audit procedures to be performed, to

indicating the steps actually taken by the auditor, to

documenting the evidence collected.

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 FOB. 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.

99
 Lakeside Company WP # F-3 p. 1
Tests of Inventory ListingWarehouse Prepared by: PR 1/12/13
12/31/12 Reviewed by:

Inventory Item Tag No. Serial Number Quantity Audit

Procedures
Amplifiers 116 BC76-W 22
Component Systems 124 JB45-M 69
Beepers 102 CB21-S 80
Stereo Systems 138 FU87-R 60
Amplifiers 130 KZ54-T 88
Speakers 150 YG28-Y 71
Stereo Systems 127 RA69-M 99
CD Players 142 RW21-X 49
Receivers 113 NB73-X 112
Stereo Systems 126 JH88-A 77
VCRs 104 CZ55-H 46
Speakers 137 BF23-G 84
Head Phones 147 PO88-Q 49
CD Players 132 CD00-N 121

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 to inventory listing noting agreement as to description and quantity.
No exceptions noted.
Traced items from inventory listing to master price list noting agreement as to
description and unit cost. No exceptions noted.
Recomputed extensions on inventory listing. No exceptions noted.

Other Procedures:
Agreed last tag (#152) on inventory listing to WP F-1.
Footed inventory listing. No exceptions noted.
Accounted for sequence of tag numbers on inventory listing. No exceptions or
duplicates noted.

Audit Conclusion: The inventory listing is fairly stated.

100
 Lakeside Company WP # F-3 p. 2
Tests of Inventory Counts--Warehouse Prepared by: PR 1/12/13
12/31/12 Reviewed by:

Receiving Reports (January 1-2, 2013)

Date and Item Rec. Rep. Qty. Unit Cost Total Cost Audit Proc.

Jan. 1, 13 Televisions JB45-H 3988 22 481.87 10,601.14

Jan. 2, 13 Headphones KJ32-K 3989 32 9.95 318.40
Jan. 2, 13 Portable Media Players RX04-L 3989 10 285.99 2,859.90
Total 13,779.44 @

Bills of Lading (January 1-2, 2013)

Bill # Qty. Unit Cost Total Cost Audit Proc.
Jan. 1, 13 Amplifier XY76-R 6015 20 219.95 4,399.00
Jan. 1, 13 Televisions BM09-H 6015 10 812.35 8,123.50
Jan. 2, 13 Stereo Systems AB15-M 6016 20 256.98 5,139.60
Jan. 2, 13 Stereo Systems JH88-A 6016 12 324.00 3,888.00
Jan. 2, 13 Receivers CS33-P 6016 10 698.98 6,989.80
Jan. 2, 13 Televisions AR65-C 6016 6 1,318.87 7,913.22
Jan. 2, 13 Speakers BF23-G 6017 8 469.00 3,752.00
Total 42,205.12 @
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.

101
 WP # F-1, p. 3
Prepared by: PR 1/12/13
Reviewed by:

Lakeside Company
RECONCILIATION OF PHYSICAL INVENTORY - WAREHOUSE
December 31, 2012

Item Amount Procedures

TOTAL COST OF INVENTORY - 1/3/2013 - $1,434,101.69 @
WAREHOUSE
Less: Inventory Received on January 1 January 2 (13,779.44) x-ref. F-3 p. 1
(from Receiving Reports)
Add: Inventory Shipped Out on January 1 and 40,205.12 x-ref. F-3 p. 1
January 2 (from Bills of Lading)
TOTAL COST OF INVENTORY - 12/31/2012 - 1,460,527.37 F
WAREHOUSE
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) R
Tag 149 - Discount $ 6.50 x 35 Items Purchased (227.50) R
SUB-TOTAL 1,455,743.87
Less: Adjustment for 3% Cash Discount 43,672.32 R
TOTAL ADJUSTED COST OF INVENTORY - 1,412,071.55 F
12/31/20012 WAREHOUSE
INVENTORY IN WAREHOUSE PER PERPETUAL 1,425,896.25 A
INVENTORY RECORDS
INVENTORY ADJUSTMENT (REDUCTION) 13,824.66 *

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
* ImmaterialPass further testing. (Note: students may agree to adjust this amount).

Audit Conclusion: The inventory balance is fairly stated as of December 31, 2012.

102
 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

103
students in analyzing this case. Paragraph 29 of this pronouncement states:

"Insofar as the separate financial statements of the related parties are

concerned, the classification and accounting shall be the same as for
similar leases between unrelated parties except in cases where it is
clear that the terms of the transaction have been significantly affected
by the fact that the lessee and lessor are related. In such cases the
classification and/or accounting shall be modified as necessary to
recognize economic substance rather than legal form. The nature and
extent of leasing transactions with related parties shall be disclosed."

After reading FASB Statement 13, students may argue that the lease is actually
for a number of years (probably the life of the building) and that the proposed
series of one-year contracts is only a sham to create the appearance of an
operating lease. In reality, the lease (or so this argument would go) is for over
75% of the economic life of the property. However, if new lease payments are to
be negotiated each period (or if Lakeside intends to stay for only a short time in
that location), a legitimate economic reason may exist for this arrangement.
Unless Lakeside can show such a rationale for the one-year leases, the auditor
will probably use the "actual" life of the lease as justification for requiring
capitalization.

The auditors also need to verify that the $21,000 payment for the building has not
been "significantly affected" by the relationship between Lakeside and Rogers.
Abernethy and Chapman will want to learn how this figure was determined and,
perhaps, seek information about rental rates for similar property in the vicinity of
that store. Rogers states that "the price is quite reasonable for that store at that
location," but his opinion does not provide the auditors with much assurance.

Regardless of the accounting, as a related party transaction, the auditors must

ensure that the nature and extent of the lease has been fully disclosed within the
financial statements. Rogers has indicated that such reporting will be made.
Even if the lease were deemed to be an operating lease, the information included
within these notes could be used by readers to come to an understanding of the
nature of this transaction. This case indicates the importance of a complete
knowledge of accounting. A decision-maker need not be limited to working with
just the numbers presented in financial statements but should become capable of
using and understanding all of the information that is provided.

[Note: Another interesting issue is whether or not the Rogers Development

Company is a variable interest entity (VIE) that should be consolidated, as
defined in FASB Interpretation No. 46. See the "Apply Your Research" section
for this case].

104
(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.

Further inquiry of Rogers as to a justification for his favorable forecast

regarding this store. If these projections are based on tangible data or on
specific plans, the auditors will have much more assurance than if Rogers is
simply acting on intuition.

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

105
 electronics business which might (a) project a break-even point for a store
or (b) assess the risks involved in the failure of a single outlet.

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.

106
 LAKESIDE COMPANY Doc. No. I-3
Building-Warehouse/Office A/C 111-1
12/31/12 Prepared by:
AH
Date: 1/14/13

Description Amount Audit Procedures

Balance per books - Beg. of Year $327,000 1
Additions: Invoice No.
Grade land and pour foundation $21,800 3145 2
October - Warehouse Construction $16,900 3189 2
November - Warehouse Construction $25,300 3214 2
Roofing repair and warehouse construction $14,600 3228 2
Disposals: Cash Rec. No.
None None

Balance per books - End of Year 405,600

Proposed Adjustments: Adj. Entry
Reclassify to expense ($3,500) A
Excluded invoice $17,100 B
Partially excluded invoice $1,600 C
Capitalize interest $2,345 D
Subtotal of additions less disposals $96,145
Proposed reclassificationE ($96,145) E
Adjusted Total $327,000

Audit Objective: To verify the fair presentation of the "Building-Warehouse/Office" account.

Scope: All charges and potential charges to the account.

Audit Procedures:
Traced to 12/31/11 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.)
2. 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:

A $3,500 roof repair incorrectly classified in asset account.

AJE 1
640-1 Repairs and Maintenance 3500-
111-1 Building-Warehouse/Office 3500-

B Invoice #3316 for December work by Heilman Construction received after year-end.
AJE 2
111-1 Building-Warehouse/Office 17100-

107
210-2 Accounts Payable 17100-

C Invoice #3408 for work done 12/28/09-1/8/10 by Gaines Electrical Company received after year-
end. Accrue four days (4/12 x $4,800= $1,600).
AJE 3
111-1 Building-Warehouse/Office 1600-
210-2 Accounts Payable 1600-

D 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 2012 (3 months from October to December, per the invoices in
Exhibit 9-6). Thus, $93,800 x 0.10 x 3/12 = $2,345.

AJE 4
111-1 Building-Warehouse/Office 2345-
220-1 Accrued Interest Payable 2345-

E Warehouse expansion not in service at 12/31/09. Reclassify to new account.

AJE 5
New Construction in Progress-Warehouse 96145-
acct.
111-1 Building-Warehouse/Office 96145-

Audit Conclusion: Account is fairly stated, after adjustments, in accordance with GAAP.

108
 (2)

Lakeside Company
Impairment Test Store 6
December 31, 2012

Prepared by: AH
Date: 1/13/13

Instructions: Using the two-step approach, perform an impairment test given the
information available.

Step One: Recoverability Test

Source of Information Store profitability report/bonus calculation

Future Cash Flows $160,000 (audit procedure 1)

Book Value $186,000 (audit procedure 2).

Difference $(26,000)

Is impairment indicated? Yes, since the difference is negative.

Step Two: Measurement of Impairment

Source of Information Prior years work papers, appraisal

Market Value of Asset $150,000 (audit procedure 3)

Book Value of Asset $186,000 (above)

Impairment Amount $36,000

Audit Objective: To determine whether or not the value of Store 6 is impaired.

Scope: An estimate of future cash flows derived from Store 6 and the market
value of Store 6.

Audit Procedures: Used a two step approach as required by the FASB.

1. Future cash flows were computed from the bonus calculation for Store 6
(see Case 7) as follows. Note the store rent expense is not a cash outflow,
and is excluded from the calculation.

109
 Sales $242,400
-Sales Returns $22,400
-Cost of Sales $147,600
-Dir. Sal. Exp. $64,400
Net cash flows per year $8,000
x Estimated life 20 years
Total net cash flows for store 6 $160,000

2. Cost $256,800 Cost Accumulated Depreciation $70,800. Agreed to the

trial balance as of 9/30/12 (since 12/31/12 balances were not given).
3. The market value of the asset was estimated using the appraisal received
in 2011. The market has not changed dramatically in the past year; thus,
this is a reasonable estimate of the current market value.

Comments: There appears to be an impairment of approximately $36,000 based

on the results of the testing above.

Recommended Adjustment:

New Acct. Loss on Impairment $36,000

111-6 Building Store 6.. $36,000

Audit Conclusion: After the recommend adjustment, the carrying value of Store 6
is fairly stated.

Note for discussion: The students may decide that the amount is immaterial. Is
$36,000 material given that total assets are $3,638,000 (1%) in 2011, or total
income was $244,000 (15%)? The amount of recommended impairment depends
on the answers to that question. Students answers will likely vary greatly on this
exercise.

110
 SUGGESTED ANSWERS TO SARBANES-OXLEY QUESTIONS

(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.

111
 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
112
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 cutoff 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, 2009.
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

113
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 year-
end 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 ability 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.

114
 (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, 2012
Audit Area: Accrued Expenses
Date of Testing: February 4, 2013

(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
2012, and January 2013.

(3) Define the population:

All invoices received by the company during December 2012, and

January 2013.

(4) Define the sampling unit:

115
 Each individual invoice and the accrual established for it as of
December 31, 2012.

(5) Specify the acceptable risk of assessing control risk too low and discuss
any factors affecting this decision:

10%
(No information is presented in this case to indicate how this risk level
was derived. This is typically either 5% or 10%).

(6) Estimate the exception rate of the population, and discuss any factors
affecting this estimation:

3%
(Discussion Question 6 above examines the factors that should have
influenced this estimation.)

(7) Specify the tolerable exception rate and discuss any factors affecting this
decision:

6%
(Discussion Question 7 above examines the factors that should have
influenced this parameter.)

(8) Indicate the sample size and show the use of the finite correction factor if
applicable:

90
Exhibit 10-1 is appropriate for a 10% ARACR. The expected
population deviation rate of 3% is found in the left column with the
tolerable deviation rate of 6% found across the top. These two figures
intersect at a sample size of 132.

The finite correction factor presented in the case can be applied as

follows:
132
Appropriate Sample Size = 90
132
1
283

(9) Indicate the method used to draw a random sample:

Random number generator on the CPA firm's computer.

(10) Indicate the number of deviations discovered, the rate of deviations in the
sample, and the upper deviation rate in the population:

116
 Two errors were discovered;
the sample exception rate is 2.2% rounded (2/90); and
from Exhibit 10-2, two deviations found in a sample of 90 items indicates
a maximum rate of 5.8% (CUER) with a 10% ARACR.

(11) From a quantitative perspective, is the population reliable? (Include the

rationale for your answer):

With a 10% ARACR, the sample indicates that Luck's accrual of year-end
expenses has a CUER of 5.8%.

(12) Describe the types of deviations that were found:

The two errors are of relatively small amounts and appear to be caused
by mathematical mistakes.

(13) Recommendations:

Luck's analysis should be considered a fair representation of the year-

end accrual derived from these 283 invoices. However, the possibility
still exists that other invoices have been omitted either accidentally or to
manipulate net income. Thus, a search should be made for liabilities
which are unrecorded.

(1-b)

If three errors were found, then the results for questions (10) through (13) of
Exhibit 10-3 would be different. With three errors, the sample exception is 3.3%
rounded (3/90); and from Exhibit 10-2, three deviations found in a sample of 90
items indicates a CUER of 7.3% with a 10% ARACR. Since the tolerable rate was
6%, her work should not be considered reliable based on the number of errors it
contains.

117
 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

118
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.

Consequently, even in statistical sampling, a great number of decisions must be

made by the auditor. The legitimacy of the results that are eventually achieved is
related directly to the auditor's ability to make appropriate decisions in each of
these areas. In designing a sample, it is not unusual to obtain assistance from a
specialist, normally from within the firm.

(4)

In the competitive times that now preside over the public accounting profession,
the auditor cannot afford to rely on unnecessarily slow and time-consuming
techniques. More importantly, though, the auditor can never afford to do an
examination in less than a quality manner. Using judgmental sampling simply
because it may be faster is a shortsighted approach. Each audit must be
performed appropriately regardless of the amount of time involved.

Because of the time pressures present in modern auditing, each auditor needs to
possess a ready knowledge of statistical sampling techniques so that the
efficiency of their use can be increased substantially. Certainly, any procedure is

119
time-consuming if the auditor's understanding is limited. Through education and
the utilization of devices such as preprinted forms and computers, statistical
sampling plans can be carried out in a minimum of time. However, the auditor
should continue to be alert to situations where judgmental sampling can be
applied. Not every test warrants the use of statistical sampling, and the auditor
needs to be capable of drawing this distinction.

(5)

If the auditor is seeking to measure a rate of occurrence, sampling for attributes

is utilized. Consequently, this type of statistical sampling is often associated with
tests of controls where an error rate is being estimated. If, however, the auditor
is attempting to determine an amount, sampling for variables is appropriate. This
sampling technique is frequently used in substantive testing to evaluate the
reasonableness of a reported balance.

As is shown by Cases 10 and 11, the distinction between sampling for attributes
and sampling for variables is not always as clear-cut as the previous paragraph
implies. In Case 10, sampling for attributes was used to verify Luck's expense
accrual, whereas sampling for variables was utilized in Case 11 for this same
purpose. The auditor must always determine the objective of a specific test and
evaluate which type of testing will achieve that goal in the most efficient manner.

(6)

Given the risk parameters that have been established by the auditor, the actual
total of the differences in the client's population is estimated to lie between an
understatement of $8,960 ($3,760 + $5,200) and an overstatement of $1,440
($3,760 -$5,200). Since the auditor wants assurance that the client figure is
within $8,000 of the real total, the firm cannot accept the $46,311 as fairly
presented. The $8,960 estimation derived from the sample lies outside of the
acceptable boundary. The client total may still be appropriate, but this sample
indicates that too much risk exists to accept the balance without further testing.

120
 SUGGESTED ANSWERS TO EXERCISES

(1)-(A)

ABERNETHY AND CHAPMAN

DETERMINATION OF SAMPLE SIZE
SAMPLING FOR VARIABLES

Client: The Lakeside Company

Form Completed By: Carole Mitchell
Audit Area: Accrued Expenses
Date of Testing: 2/4/13 Year Ending: 12/31/12

(1) - Estimate the standard deviation of the population. Show the formula being
used and identify each element within this formula.

e n e
2 2

Estimated Standard Deviation =

n 1

e is the value of each unit sampled

is the average of each unit sampled
n is the number of units sampled

The initial 30 items selected in Exhibit 11-2 show 26 differences with a

zero balance and four with either positive or negative balances.

e (e)2
205 42,025
49 2,401
(110) 12,100
156 24,336
300 80,862 = 300/30 or 10

121
 80,862 3010
2

Estimated Standard Deviation = 52 rounded

30 1

(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 error for this population. Include any considerations that
were used in arriving at this parameter:

Tolerable error is $8,000, a figure apparently set judgmentally

by Dan Cline.

(5) - Specify a point estimate of the population error. Describe the method by
which this determination was made:

The initial sample of 30 items had an average error of $10 as computed

in (l) above. Since 283 items make up the entire population, the point
estimate of the population error is $2,830.

(6) - Calculate the appropriate sample size. Show the formula being used and
identify each element within this formula:
SD Z a Z r N
2

Sample size =
TM E

Where:
N is the population size
Za is the confidence coefficient for the acceptable risk of incorrect

122
 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

52 1.28 1.04 283

2

Sample size = 44 rounded

8,000 2,830

(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: 2/4/13 Year Ending: 12/31/12

(1) - State the objectives of the audit testing:

To determine the reasonableness of the client's year-end cutoff 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 2012 and January 2013.

(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.

123
(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 error 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:

e n e
2 2

Estimated Standard Deviation =

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 (e)2
205 42,025
49 2,401
(110) 12,100
156 24,336
(97) 9,409
(150) 22,500
47 2,209
100 114,980 = 100/50 or 2

124
 114,980 2 50
2

Estimated Standard Deviation = 48 rounded

50 1

(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):

SD N n
Precision Interval = N Za
n N

N is the population size

n is the total sample size
SD is the recomputed estimation of the standard deduction
Za is the confidence coefficient for the acceptable risk of incorrect
acceptance

48 283 50
Precision Interval = 283 1.28 $2,238
50 283

(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).

125
(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.

126
 CASE 12

SUGGESTED ANSWERS TO DISCUSSION QUESTIONS

(1)

The examination of a bank cutoff 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 cutoff 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 cutoff 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 cutoff made of cash disbursements.

* Verification of any unusually large check or any check of an odd nature

(such as to a related party) that cleared the bank during this subsequent
period. Such checks might have been issued at year-end to manipulate
cash or other account balances.

* 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 cutoff period as proof of
the "deposits-in-transit" figure on the year-end reconciliation.

* Identification of deposited (customer) checks returned by the bank because

of insufficient funds as well as any other bank charges reducing the cash
balance. This listing enables the auditor to determine the necessity of a
year-end adjustment.

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* Verification of the bank balance included in the year-end cash
reconciliation.

(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. Warehouse - The construction-in-progress on the warehouse addition must

be reported apart from the other land, buildings, and equipment on the
balance sheet since it is not yet used in the company's operations.
Because of the material nature of the expansion as well as the potential
effects on the company, Lakeside also needs to include an explanatory note
about the construction. This information would disclose the degree of
completion, the anticipated completion date, and an estimation of the final
expenditure total.

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 2010 fire loss will probably require disclosure in the 2009
financial statements.

Students may raise a question as to the materiality of the estimated loss

especially since it did not occur during 2012 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 non-
disclosure of this 2013 loss would require a qualification by the auditors in

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 2012.

c. Declaration of Cash Dividend - Unless the auditor views the declaration of

this cash dividend as an abnormal occurrence or an unusually large
amount, disclosure would not seem warranted. Little evidence exists to
indicate that this distribution will cause the 2012 financial statements to be
misleading if not disclosed.

(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. Cutoff 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
cutoff made either a few days before or a few days after the end of the period.

Cutoff 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 the 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:

* Failure to record liabilities improves a company's debt/equity ratio and,

where expenses are involved, would also produce an increased net income
for the current period. Therefore, a more favorable financial reporting is
possible simply by leaving some liabilities unrecorded until the beginning of
the following year.

* Often the incurrence of a liability will not generate a client-produced

document. For example, an obligation for utilities expenses might be
acknowledged by the client only at the receipt of an invoice. Thus, the
discovery of such liabilities is frequently dependent on the arrival of an
invoice which may not be for some weeks after the end of the year. For the
auditor, establishing complete assurance that all invoices have been
received and liabilities recorded in the proper time period can be difficult to
achieve.

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(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.

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(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 would 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.)

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(10) and (11)

In order to arrive at an estimation of the product warranty expense for 2009, the
auditors must certainly look at the past history of the company as mentioned in
this case. A schedule can be determined from the information given of the
expense incurred during the previous months. However, the auditors cannot be
satisfied with that evidence alone. Abernethy and Chapman should look for
factors that would cause the future repairs of the company to differ from the past.
For example, in scheduling the past repairs, the auditors need to watch for any
trends that are evident. Repair costs (such as labor or parts) might have begun
to climb recently or the incidence of product failure could be falling. Such trends
affect the calculation of the client's present liability.

The auditors should also look for other changes that are occurring that might
have an impact on this estimation. Some products, as an example, might be
more likely to break. If so, the auditors should determine if sales of those items
were growing or decreasing. A call to Cypress Products could provide valuable
data as to the repair rate for various items. This company, most likely, will
monitor closely the need for repairs. In addition, publications such as Consumer
Reports often provide statistics on the likelihood that products will fail. For
example, radios may break more often than stereo systems and, thus, require a
different percentage for estimation purposes.

Changes at Cypress Products can also impact the product warranty. If Cypress
has recently begun to stress quality in its production, repairs may be reduced;
whereas, if quality control is not emphasized, Lakeside's repairs can potentially
skyrocket. Abernethy and Chapman may want to talk with the management of the
local shops that do Lakeside's repairs to see if they have noted changes in the
quality of the items produced by Cypress. These individuals can also provide the
auditors with information on any changes in repair costs that have occurred
recently.

Finally, the auditors will want to review the repair costs incurred during the
approximately seven weeks following the end of the fiscal year. If repair costs
jump during the subsequent period, Abernethy and Chapman may need to raise
their estimation. However, if costs are being held at a minimum, the accrual
should be decreased.

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 SUGGESTED ANSWERS TO EXERCISES

(1)

A good introduction to this question is to ask the students to give their

estimations of the accrued repair expenses as of December 31, 2012. A number
of different responses will probably be volunteered. The instructor can then ask a
few individuals to explain the logic used to derive their figures. This exercise
serves as a lesson as to the nebulous nature of some accounting problems. The
students, who often believe that one absolutely correct answer can be derived for
every situation, should be quite interested in the number of legitimate answers
that are generated. Obviously, as long as the logic is sound, different estimated
amounts can be reasonable.

An additional factor in this case concerns the structuring of the data. Quite often,
the client will have accumulated information in a manner that is not relevant to
the needs of the auditor. Lakeside has classified its repair expense by the month
in which the item is returned while the auditors want to match the expense with
the month in which the item is sold. Therefore, a necessary step in establishing
the appropriate accrual is the restructuring of the data as is demonstrated in the
attached working paper. This worksheet presents one method of computing the
estimated repair accrual as of the end of 2012. The computation indicates that
Lakeside's accrued expenses are actually $24,675 too high; the adjustment will,
therefore, increase the company's net income by this amount.

A final point which may deserve some class discussion is the necessity of
verifying the client's data. To avoid making the case overly complex, the client's
figures have been used for this estimation without any testing. By now, the
students should realize that such immediate acceptance is inappropriate. The
auditor will have to ascertain the validity of this information before relying on it for
this computation.

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 LAKESIDE COMPANY W.P. No. M-4
Estimated Accrued Product Warranty Expense 2
12/31/12 Accountant: AH
Date: 2/2/13
A: Sales not under warranty
Historical Data 1/11 2/11 3/11 4/11 5/11 6/11 7/11 8/11 9/11 10/11 11/11 12/11
Sales for month 1064000 632000 718000 958000 972000 828000 742000 920000 884000 1066000 1172000 1600000
Repairs:
Month of Sales 386 274 354 444 294 122 512 568 420 584 938 1,010
1 month after 1,066 776 658 738 1,028 552 626 994 1,118 1,166 1,126 1,896
2 months after 1,674 638 962 960 1,250 858 1,138 924 1,258 1,332 1,314 1,770
3 months after 1,750 1,324 1,316 1,182 882 1,594 1,082 1,278 1,328 1,834 1,690 2,148
4 months after 686 640 912 1,404 2,058 1,470 1,024 1,208 1,188 1,250 1,596 2,402
5 months after 1,142 410 456 1,624 1,396 980 912 1,350 1,398 1,000 1,314 2,020
6 months after 914 502 404 1,034 440 544 398 782 280 1,166 1,408 1,390
Total repair expense 7,618 4,564 5,062 7,386 7,348 6,120 5,692 7,104 6,990 8,332 9,386 12,636
Repair expense as a
percentage of sales 0.72% 0.72% 0.71% 0.77% 0.76% 0.74% 0.77% 0.77% 0.79% 0.78% 0.80% 0.79%

B: Sales still under warranty

Historical Data Cont. 1/12 2/12 3/12 4/12 5/12 6/12 7/12 8/12 9/12 10/12 11/12 12/12
Sales for month 1221000 762000 692000 1114000 1180000 818000 844000 1100000 1022000 1205000 1284000 1748000
Repairs:
Month of Sales 646 672 468 670 842 736 1,198 502 554 440 846 1,008
1 month after 1,938 732 702 1,340 1,472 884 674 1,504 1,476 1,538 1,570
2 months after 1,722 794 820 1,532 1,368 1,032 750 2,406 1,660 1,868
3 months after 1,830 1,160 1,054 2,108 1,894 1,328 1,498 1,704 1,752
4 months after 2,046 1,098 584 1,436 1,788 1,254 1,648 1,204
5 months after 1,616 1,038 936 1,150 1,998 1,106 1,048
6 months after 970 610 1,288 1,340 1,158 1,032
Total repair expense 10,768 6,104 5,852 9,576 10,520 7,372 6,816 7,320 5,442 3,846 2,416 1,008
Repair expense as a
percentage of sales 0.88% 0.80% 0.85% 0.86% 0.89% 0.90%
26,848 returns to date for products still with warranty.

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Audit Objectives:
To estimate the accrued product warranty expense as of Dec. 31, 2012.

Scope:
All sales and returns for warranty claims for 2011 and 2012.

Audit Procedures:
Agreed Sales per Month to the general ledger. No exceptions noted.
Agreed Repairs per Month to the general ledger. No exceptions noted.

Comments:
A Historical data for the months from January 2011 to June 2012 (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 2012 to determine the year-end accrual.
During the 18-month test period, repair expenses showed a gradual increase from 0.72%
to 0.90% of sales. Because of this upward trend, it is recommended that Lakeside use
0.95% of sales for estimating repair expenses for the last six months of 2012.
B Sales during the last six months of 2012 are still under warranty. These sales total
$7,203,000 for an estimated repair expense of $68,428 based on 0.95% (see A above).
During the last six months of 2012, $26,848 in repairs were made in connection with these
sales. As of December 31, 2012, an estimated liability of $41,580 (= $68,428 - $26,848)
remains.
Lakeside's accrual of $90,930 should be adjusted ($90,930 recorded balance - 41,580
desired balance = $49,350 overstatement).

Proposed
Adjustment
220-1 Accrued Expenses Payable 49,350
680- Other Misc. Expenses 49,350

Conclusion
Accrued product warranty expense is fairly stated, after adjustment, in accordance with GAAP.

(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
2012 is not feasible. Presented below are two possible conclusions for this case.
The first is based on an unqualified opinion on the 2012 statements because
Abernethy and Chapman either believes the potential impairment of value on
Store 6 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
2011 statements. Since comparative statements are being published, Abernethy
and Chapman also have to provide information about this previous opinion.

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 UNQUALIFIED OPINION

INDEPENDENT AUDITOR'S REPORT

We have audited the accompanying balance sheet of the Lakeside

Company as of December 31, 2012, 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, 2011
were audited by other auditors whose report dated March 15, 2012, 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 2012 financial statements referred to above present

fairly, in all material respects, the financial position of the Lakeside Company as
of December 31, 2012, 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, 2013

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 QUALIFIED OPINION

INDEPENDENT AUDITOR'S REPORT

We have audited the accompanying balance sheet of the Lakeside

Company as of December 31, 2012, 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, 2011,
were audited by other auditors whose report dated March 15, 2012, 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 2010, 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, 2012, 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, 2013

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 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)
Management prefers to understand how the information is accumulated,
manipulated and reported. The old manual/paper systems provided an easy to
understand process. The computer takes the same information but does not let
the manager see the data manipulation. From the fraud perspective, the
computer makes it harder to alter records for most managers who do not have
the computer ability to do it within the system. On the other hand, a manager
who does have computer skills can conceivably alter the data from within.

(3)

Many individuals in business are skilled in one particular industry: audio

equipment, car sales, 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

138
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.

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.

(4)

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.

(5)

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

139
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
counts, or hash totals) to provide evidence of the accuracy of information
produced by the computer system. Periodically, the programs in use should be
rechecked for unauthorized alterations.

Control of a computerized system can also be enhanced by requiring a limited

amount of documentation for transactions. A physical receiving report, for
example, might be produced to back up the information that has been entered
directly into the computer. This document could be used for daily reconciliation of
transactions while also allowing for a periodic verification of the computer
records.

(5) and (6)

Public accounting firms have long held that a distinction is maintained between
consulting and audit services, a separation that protects them from any possibility
of a conflict of interest. In many organizations, the two services are offered
through relatively autonomous divisions. Furthermore, the client is free to
discuss possible improvements with any other business enterprise providing
these services. Many large companies, for example, use one firm for auditing
and a different organization for advisory services to avoid becoming too
dependent on any one group.

Although public accounting firms continue to assert that no problems are created
by their movement into consulting, many observers have expressed concern. In
the May 18, 1987, issue of Forbes magazine, this controversy was analyzed in
an article entitled "Blood on the Ledger." The following two quotations help to
explain the possible crisis that is created when CPA firms become involved in
consulting work:

"One of the issues attracting all this attention is the accounting

profession's steady move into consulting: designing computer systems,
engaging in strategic planning and providing financial counseling.
What's wrong with a bit of diversification? Simply this: An auditor is
supposed to be absolutely independent, and the lure of consulting
dollars could conflict with that. Even more significantly, an auditor who
is, in effect, overseeing the work of his partner, the consultant, might be
tempted to be less zealous in searching the client's books." (p. 202)

140
 "Happily, accounting remains for now at least one of the nation's most
admired professions, as shown by a recent Louis Harris poll of
shareholders and business leaders who believed accounting to have the
highest moral practices of any major profession - better than college
professors, lawyers, congressmen, journalists. Yet if something
happens to that credibility, there is more at risk than simply the fortunes
of the men and women in the green eyeshades. In theory, it is fine if
accounting firms want to pursue opportunities in related business fields
like strategic or financial consulting. There's even a strong contingent of
thought that such endeavors will help the firms better understand their
clients - and as a result do better audits for them. But the stakes
involved are huge. In the practical work of the marketplace, certified
public accountants are the only guarantors of financial integrity the
capitalist system has. The further the industry strays from its roots, the
bigger the chance of doing damage to its credibility with the public, and
that is something from which ultimately no one can profit." (p. 206)

The Enron Bankruptcy will have ramifications on auditor independence issues for
many years to come. For example, the Government Accounting Office (GAO)
issued new independence rules dealing with non-audit services performed by the
auditor in governmental audits. Also, the Sarbannes-Oxley Act required that
many of the consulting activities be eliminated for a firm's publicly-traded audit
clients.

SUGGESTED ANSWERS TO EXERCISES

(1)

The cases in this book have described several of the accounting systems in use
by the Lakeside Company. Because of the lack of complete computerization,
these various functions are mechanical in design, relying on the skills of the
company's employees. Therefore, Abernethy and Chapman can recommend to
Rogers a number of specific functions to be modernized through the installation
of a new accounting information system. Listed below are a few examples of the
types of suggestions that students may provide:

- Payroll

The names and pay rates for all employees are programmed into the
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

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 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.

- 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.

- Accounts Receivable Subsidiary Ledger

A listing of all customers is maintained within the database as well as the

current amounts owed by each and the age of the receivable. At the time
that a new sales order is approved and the merchandise shipped, the dollar
amount is entered into the computer so that the specific customer's balance
will be updated. When a collection is subsequently received, the payment is
also recorded by the computer as a reduction in the appropriate account
receivable balance. A daily list of overdue accounts is printed so that new
invoices can be mailed or other follow-up procedures instigated.

(2)

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In studying and evaluating the controls surrounding computerized systems, the
independent auditor anticipates finding certain procedures in use. Computer
controls are divided into "general" and "applications" controls.

General controls relate to all EDP activities and include:

A plan of organization and operation of the EDP function.
Procedures for documenting, reviewing, testing, and approving systems or
programs and changes in them.
Hardware and programmed controls built into the operating systems.
Access controls.
Other data and procedural controls (e.g., record reconstruction, backup
facilities, emergency procedures, etc.).

Applications controls relate to specific tasks performed by the EDP department,

such as preparing payroll. These controls are intended to provide assurance that
the recording, processing, and reporting of data are properly performed.
Applications controls can be further divided into "input," "processing," and
"output" controls.
Input controls ensure that input data is authorized, converted into machine-
sensible form, verified, and not lost, duplicated, or altered.
Processing controls provide assurance that transactions are processed, as
authorized, and that none were added or omitted.
Output controls ensure that output data are accurate and received only by
authorized personnel.

In Lakeside's situation, specific controls would include the following:

- All programs should be purchased from reputable software firms or written by

employees with an appropriate background in software development. The
company's entire accounting system often depends on the reliability of these
programs; thus, control must begin with their very creation. Programmers
should be segregated from computer operators and not permitted
unrestricted access to the hardware so that the programmers cannot
manipulate any of the programs.

- Proper documentation should be furnished with all programs to indicate the

controls that have been established within the various functions. This
documentation allows the client to verify that each program was developed in
an appropriate manner and has not been improperly modified since it was
put into operation. All program alterations and updates are to be
documented and reviewed by appropriate supervisory personnel prior to any
changes being made.

- 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

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 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.

- All programs should be tested periodically to verify that no unauthorized

changes have been made by company employees or any other parties.

- The computer system should be physically protected to prevent unauthorized

access as well as any physical damage that might occur because of fire,
smoke, heat, water damage, or other problems. In addition, backup files
need to be maintained in case current files are destroyed. For example, the
company should assure that its perpetual inventory records and its accounts
receivable subsidiary ledger can be reconstructed if damaged.

- Because an online, real-time system is being designed by Klontz in Exhibit

13-1, many of the employees of Lakeside will have direct access into the
memory of the computer. Access (or pass) codes should be used to limit any
one employee's ability to enter and change files that are not directly related
to an assigned function. These codes should be changed periodically.

- The computer may be programmed so as to prevent access into files except

during assigned times. Entry into a system after working hours, for example,
might be prohibited. Thus, employees would be prevented from returning to
work during the night to manipulate data.

- 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.

- Limit tests can be initiated so that transactions above or below specified

parameters will not be processed by the computer unless additional
authorization is entered. An order for merchandise of over $5,000 might, for
example, require further approval before the goods are shipped. Inventory
acquisitions for more than $20,000 might also necessitate a similar
authorization.

- Employees entering data might be required to complete documents for

verification purposes. Obviously, a computerized system can virtually reduce
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

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 subsequently be used by the company to check the data entered into the
computer.

SUGGESTED ANSWERS TO SARBANES-OXLEY QUESTION

(1) Sarbanes-Oxley established a list of proscribed services for a registered

auditing firms performing audits under the statute. The definition of these
proscribed activities was designed to increase or protect a firms
independence. This issue resulted from the scandals of the early 2000s,
where we observed auditors performing consulting and valuation activities,
among others, and consequently were unable to make professional
decisions.

The list of proscribed activities:

Bookkeeping and other accounting services

Financial information systems design and implementation
Appraisal or valuation services
Actuarial services
Internal audit outsourcing
Management or human resource functions
Broker or dealer or investment adviser or investment banking
Legal and expert services unrelated to audit
Any other service the PCAOB decides to add to the list.

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