CHAPTER 3: AUDIT REPORTS

1).Explain why auditors' reports are important to users of financial statements and why
it is desirable to have standard wording.

Answer:

Auditors' reports are important to users of financial statements because they inform users of
the auditor's opinion as to whether or not the financial statements are fairly stated or whether
no conclusion can be made with regard to the fairness of their presentation. Users especially
look for any deviation from the wording of the standard unmodified report and the reasons
and implications of such deviations. Having standard wording improves communications for
the benefit of users of the auditor's report. When there are departures from the standard
wording, users are more likely to recognize and consider situations requiring a modification
or qualification to the auditor's report or opinion.

2) List the seven parts of a standard unqualified audit report andexplain the meaning

of each part. How do the parts compare with those found in qualified report?

Answer:

The unqualified audit report consists of:

 Report title:

Auditing standards require that the report be titled and that the title includes the word
independent.

 Audit report address:

The report is usually addressed to the company, its stockholders, or the board of directors.

 Introductory paragraph:

The first paragraph of the report does three things: first, it makes the simple statement
that the CPA firm has done an audit. Second, it lists the financial statements that were
audited, including the balance sheet dates and the accounting periods for the income
statement and statement of cash flows. Third, it states that the statements are the

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responsibility of management and that the auditor's responsibility is to express an opinion on
the statements based on an audit.

 Scope paragraph:

The scope paragraph is a factual statement about what the auditor did in the audit. The
remainder briefly describes important aspects of an audit.

 Opinion paragraph:

The final paragraph in the standard report states the auditor's conclusions based on the results
of the audit.

 Name of CPA firm:

The name identifies the CPA firm or practitioner who performed the audit.

 Audit report date:

The appropriate date for the report is the one on which the auditor has completed the most
important auditing procedures in the field. 

The same seven parts are found in a qualified report as in an unqualified report. There are
also often one or more additional paragraphs explaining reasons for the qualifications.

3).What are the purposes of the scope paragraph under the auditor's responsibility in
the auditor's report? Identify the most important information included in the scope
paragraph.

Answer:

The purpose of the scope paragraph under the auditor's responsibility is to inform the
financial statement users of the nature of the audit procedures performed. The information in
the scope paragraph includes:

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1. Procedures used to obtain audit evidence about the amounts and disclosures in the financial
statements.

2. The audit procedures selected depend on the auditor's judgment, and consider the auditor's
assessment of the risks of material misstatement, whether due to fraud or error.

3. As part of this risk assessment, the auditor considers internal control over financial
reporting in the design of the audit procedures.

4. An audit includes evaluating the appropriateness of the accounting policies used, the
reasonableness of significant estimates, and the overall presentation of the financial
statements.

6).What five circumstances are required for a standard unqualified audit report to be
issued?

Answer:

A standard unqualified audit report may be issued under the

following circumstances:

1. All statements-balance sheet, income statement, statement of retained earnings, and

statement of cash flows-are included in the financial statements.

2. Sufficient appropriate evidence has been accumulated and the auditor has conducted the
engagement in a manner that enables him or her to conclude that the audit was performed in
accordance with auditing standards.

3. The financial statements are presented in accordance with appropriate accounting standards
such as U.S. generally accepted accounting principles or IFRS. This also means that adequate
disclosures have been included in the footnotes and other parts of the financial statements.

4. There are no circumstances requiring the addition of an explanatory paragraph or

modification of the wording of the report.

5. The three general standards have been followed in all respects on the engagement.

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7).What type of opinion should an auditor issue when the financial statements are not in
accordance with GAAP because such adherence would result in misleading statements?

Answer:

When adherence to GAAP would result in misleading financial statements there should be a
complete explanation in a separate paragraph. The separate paragraph should fully explain
the departure and the reason why GAAP would have resulted in misleading statements. The
opinion should be unqualified, but it should refer to separate paragraph during the portion of
the opinion in which GAAP are mentioned.

9). Describe what is meant by reports involving the use of other auditors. What are the
three options available to the primary auditor responsible for the opinion, and when
should each be used?

Answer:

When another CPA has performed part of the audit, the primary auditor
issues one of the following types of reports based on the circumstances.

1. No reference is made to the other auditor. This will occur if the other auditor audited an
immaterial portion of the financial statements, the other auditor is known or closely
supervised, or if the principal auditor has thoroughly reviewed the other auditor's work.

2. Issue a shared opinion in which reference is made to the other auditor. This type of report
is issued when it is impractical to review the work of the other auditor or when a portion of
the financial statements audited by the other CPA is material in relation to the total.

3. The report may be qualified if the principal auditor is not willing to assume any
responsibility for the work of the other auditor. A disclaimer may be issued if the segment
audited by the other CPA is highly material.

10).The client has restated the prior-year statements because of a change from LIFO to
FIFO. How should this be reflected in the auditor’s report?

Answer:

Even though this change has been reflected in the financial statements, a separate explanatory
paragraph is required to explain the change in generally accepted accounting principles in the
first year in which the change took place.

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11). Distinguish between changes that affect consistency and those that may affect
comparability but not consistency. Give an example of each.

Answer:

Changes that affect the consistency of the financial statements may

involve any of the following:

1. Change in accounting principle

2. Change in reporting entity
3. Corrections of errors involving accounting principles.

12).List the three conditions that require a departure from an unqualified opinion and
give one specific example of each of those conditions.

Answer:

The three conditions requiring a departure from an unqualified report are:

 The scope of the Audit has been restricted:

A scope restriction imposed by the client or by circumstances beyond the auditor’s or

client’s control which prevents the auditor from accumulating sufficient evidence to reach
a conclusion regarding whether financial statements are stated in accordance with GAAP.
In this condition, the auditor would issue either a qualified scope and opinion report, or a
disclaimer of opinion. An example of a restriction caused by circumstances is when the
auditor is not appointed until after the client’s year-end. It may not be possible to
physically observe inventories, confirm receivables, or perform other important
procedures after the balance sheet date

 The financial statements have not been prepared in according with GAAP:

In this condition, the auditor would issue a qualified opinion if the GAAP violation were
moderately material, or an adverse opinion if the GAAP violation were highly material. For
example, if the client insists on using replacement costs for fixed assets or values inventory at
selling price rather than historical cost as required by generally accepted accounting
principles, a departure from the unqualified report is required.

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  The auditor is not independent:

In this condition, the auditor must issue a disclaimer of opinion.

13). Distinguish between a qualified opinion, an adverse opinion, and a disclaimer of

opinion, and explain the circumstances under which each is appropriate.

Answer:

Qualified opinion: A qualified opinion states that there has been either a limitation on the
scope of the audit of material accounts, transactions, or disclosures or a material departure
from GAAP in the financial statements, but that the auditor believes that the overall financial
statements are fairly presented. This type of opinion may not be used if the auditor believes
the exceptions being reported upon are extremely material, in which case a disclaimer or
adverse opinion would be used.

Adverse opinion: An adverse opinion states that the auditor believes the overall financial
statements are so materially misstated or misleading that they do not present fairly in
accordance with GAAP the financial position, results of operations, or
cash flows.

Disclaimer of opinion: A disclaimer of opinion states that the auditor has been unable to
satisfy himself or herself as to whether or not the overall financial statements are fairly
presented because of a significant limitation of the scope of the audit, or a non- independent
relationship under the AICPA Code of Professional Conduct between the auditor and the
client.

15). Explain how materiality differs for failure to follow GAAP and for lack of
independence.

Answer:

Materiality for lack of independence in audit reporting is easiest to define. If the auditor lacks
independence as defined by the AICPA Code of Professional Conduct, it is always
considered highly material and therefore a disclaimer of opinion is always necessary. That is,
either the CPA is independent or not independent. For failure to follow GAAP, there are three
levels of materiality: immaterial, material, and highly material.

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20). When an auditor discovers more than one condition that requires departure from
or modification of the standard unmodified opinion audit report, what should the
auditor's report include?

Answer:

When the auditor discovers more than one condition that requires a departure from or a
modification of a standard opinion audit report, the report should be modified for each
condition. An exception is when one condition neutralizes the other condition. An example
would be when the auditor is not independent and there is also a scope limitation. In this
situation the lack of independence overshadows the scope limitation. Accordingly, the scope
limitation should not be mentioned.

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 Chapter-7
27) The following are examples of documentation typically obtained by

auditors:

1. Vendors’ invoices

2. General ledger files

3. Bank statements

4. Cancelled payroll checks

5. Payroll time records

6. Purchase requisitions

7. Receiving reports (documents prepared when merchandise is received)

8. Minutes of the board of directors

9. Remittance advices

10. Signed W-4s (Employee’s Withholding Exemption Certificates)

11. Signed lease agreements

12. Duplicate copies of bills of lading

13. Subsidiary accounts receivable records

14. Cancelled notes payable

15. Duplicate sales invoices

16. Articles of incorporation

17. Title insurance policies for real estate

18. Notes receivable

Answer:

A) Duplicate sales invoices Internal

2. Subsidiary accounts receivable records Internal

3. Vendors’ invoices External

4. General ledgers Internal

5. Title insurance policies for real estate External

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6. Notes receivable External

7. Bank statements External

8. Cancelled payroll checks External

9. Cancelled notes payable External

10. Payroll time cards Interna

11. Purchase requisitions Internal

12. Articles of incorporation External

13. Receiving reports (documents prepared when merchandise is received Internal

14. Minutes of the board of directors Internal

15. Signed W-4s (Employee’s Withholding Exemption Certificates) Internal

16. Remittance advices External

17. Signed lease agreements External

18. Duplicate copies of bills of lading External

B) External evidence is considered more reliable than internal evidence because external
evidence has been in the hands of both the client and another party, implying agreement about
the 7-28 (Objective 7-4) The following are examples of audit procedures:

1. Review the accounts receivable with the credit manager to evaluate their collecti -

bility.

2. Compare a duplicate sales invoice with the sales journal for customer name and

amount.

3. Add the sales journal entries to determine whether they were correctly totaled.

4. Count inventory items and record the amount in the audit files.

5. Obtain a letter from the client’s attorney addressed to the CPA firm stating that the

attorney is not aware of any existing lawsuits.

6. Extend the cost of inventory times the quantity on an inventory listing to test

whether it is accurate.

7. Obtain a letter from an insurance company to the CPA firm stating the amount of

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the fire insurance coverage on buildings and equipment.

8. Examine an insurance policy stating the amount of the fire insurance coverage on

buildings and equipment.

9. Calculate the ratio of cost of goods sold to sales as a test of overall reasonableness of

gross margin relative to the preceding year.

10. Obtain information about internal control by requesting the client to fill out a

questionnaire.

11. Trace the total in the cash disbursements journal to the general ledger.

12. Watch employees count inventory to determine whether company procedures are

being followed.

13. Examine a piece of equipment to make sure that a major acquisition was actually

received and is in operation.

14. Calculate the ratio of sales commission expense to sales as a test of sales commis -

sions.

15. Examine corporate minutes to determine the authorization of the issue of bonds.

16. Obtain a letter from management stating that there are no unrecorded liabilities.

17. Review the total of repairs and maintenance for each month to determine whether

any month’s total was unusually large.

18. Obtain a written statement from a bank stating that the client has $15,671 on deposit

and liabilities of $500,000 on a demand note.

Classify each of the preceding items according to the eight types of audit evidence:

(1) physical examination, (2) confirmation, (3) documentation, (4) analytical procedures,

(5) inquiries of the client, (6) recalculation, (7) reperformance, and (8) observation.
information and the conditions stated on the document

Answer:

1. Review the accounts receivable with the credit manager to evaluate their collectibility.-
Inquiry of Client

2. Compare a duplicate sales invoice with the sales journal for customer name and amount. –
Observation

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3. Add the sales journal entries to determine whether they were correctly totaled.-
Recalculation

4. Count inventory items and record the amount in the audit files. –PhysicalExamination

5. Obtain a letter from the client’s attorney addressed to the CPA firm stating that theattorney
is not aware of any existing lawsuits.-Confirmation

6. Extend the cost of inventory times the quantity on an inventory listing to test whether itis
accurate.-Recalculation

7. Obtain a letter from an insurance company to the CPA firm statingthe amount of the fire
insurance coverage on buildings andequipment.-Confirmation

8. Examine an insurance policy stating the amount of the fire insurancecoverage on buildings
and equipment.-Analytical Procedures

9. Calculate the ratio of cost of goods sold to sales as a test of overallreasonableness of gross
margin relative to the preceding year.-Analytical Procedures

10. Obtain information about internal control by requesting the clientto fill out a
questionnaire.-Inquiry of client

11. Trace the total in the cash disbursements journal to the generalledger. -Reperformance

12. Watch employees count inventory to determine whether companyprocedures are being
followed. –Observation

13. Examine a piece of equipment to make sure that a majoracquisition was actually received
and is in operation. –PhysicalExamination

14. Calculate the ratio of sales commission expense to sales as a testof sales commissions.-
Analytical Procedures

15. Examine corporate minutes to determine the authorization of theissue of bonds. –Physical
Examination

16. Obtain a letter from management stating that there are nounrecorded liabilities.-Inquiry of
Client

17. Review the total of repairs and maintenance for each month todetermine whether any
month’s total was unusually large. -AnalyticalProcedures

18. Obtain a written statement from a bank stating that the client has$15,671 on deposit and
liabilities of $500,000 on a demand note. –Confirmation

7-29- List two examples of audit evidence the auditor can use in support of

each of the following:

a. Recorded amount of entries in the acquisitions journal

b. Physical existence of inventory

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c. Accuracy of accounts receivable

d. Ownership of fixed assets

e. Liability for accounts payable

f . Obsolescence of inventory

g. Existence of petty cash

Answer:

A. Recorded amount of entries in the acquisitions journal- Inspection- Re-performanceb

B. Physical existence of inventory- Physical examination- Confirmation- Inspectionc.

C. Accuracy of accounts receivable- Re-performance- Confirmationd

D. Ownership of fixed assets- Physical examination- Confirmation- Inspectione.

E. Liability for accounts payable- Physical examination- Confirmation- Inspectionf.

F.Obsolescence of inventory- Physical examination- Inquiries of clientg.

G. Existence of petty cash- Physical examination

7-30- Eight different types of evidence were discussed. The following

questions concern the reliability of that evidence:

a. Explain why confirmations are normally more reliable evidence than inquiries of the

client.

b. Describe a situation in which confirmation will be considered highly reliable and

another in which it will not be reliable.

c. Under what circumstances is the physical observation of inventory considered

relatively unreliable evidence?

d. Explain why recalculation tests are highly reliable but of relatively limited use.

e. Give three examples of relatively reliable documentation and three examples of less

reliable documentation. What characteristics distinguish the two?

f . Give several examples in which the qualifications of the respondent or the quali -

fications of the auditor affect the reliability of the evidence.

g. Explain why analytical procedures are important evidence even though they are

relatively unreliable by themselves

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 A) Confirmations are normally more reliable evidence than inquiries of the client
because of the independence of the outside party confirming the information

B)Relatively reliable documentation examples include: vendor statements, bank

statements, and signed lease agreements. Relatively unreliable
documentation examples may be: copies of customer invoices, internal
memoranda and other communications, and a listing of fixed asset additions.

C) The difference between the reliable and unreliable

documentation examples noted above is whether they originate from outside or
inside the client’s organization. External information is considered more reliable than
internal documentation

Recalculation tests are highly reliable because the auditor is able to gain
100% assurance of the accuracy, but the tests only verify whether the
recorded amounts are accurately totaled. These tests do not uncover
omissions or fictitious amounts.
D) Analytical procedures are evidence of the likelihood of misstatementsin the
financial statements, but they are rarely sufficient by themselvesto conclude
that the statements are misstated. Other supportive evidence is needed
to determine whether apparent misstatements are actually material.
E) Confirmation of bank balances is considered highly reliable whereas
confirmation of a department store charge account is often not considered
reliable. Banks are accustomed to confirmations from auditors and
normally maintain excellent accounting records, whereas most
customers of department stores have neither characteristic.
f. If an auditor is not qualified to distinguish between valuable inventory (e.g., diamonds) and
worthless inventory (e.g., glass), the physical examination of inventory would not be considered to
be reliable evidence.

g. 1. Confirmation of accounts receivable - Corporation accustomedto

confirmations compared to a member of the general public.
2. Examination of the corporate minutes - Experienced partner
compared to a new assistant.
3. Physical observation of inventory - Auditor knowledgeable in the
client’s inventory compared to one who is not.
4. Attorney’s letter - General counsel compared to an attorney involved
only with patents

7-31 (Objective 7-4) As auditor of the Star Manufacturing Company, you have obtained
a. A trial balance taken from the books of Star one month before year-end:
Dr. (Cr. )
Cash in bank $ 87,000
Trade accounts receivable 345,000
Notes receivable 125,000
Inventories 317,000
Land 66,000
Buildings, net 350,000
Furniture, fixtures, and equipment, net 325,000
Trade accounts payable (235,000)

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 Mortgages payable (400,000)
Capital stock (300,000)
Retained earnings (510,000)
Sales (3,130,000)
Cost of sales 2,300,000
General and administrative expenses 622,000
Legal and professional fees 3,000
Interest expense 35,000
b. There are no inventories consigned either in or out.
c. All notes receivable are due from outsiders and held by Star.
Which accounts should be confirmed with outside sources? Briefly describe from whom
they should be confirmed and the information that should be confirmed. Organize your
answer in the following format:*
From Whom Information to Be

Answer:

ACCOUNT FROM WHOM INFORMATION

NAME CONFIRMED TO BE CONFIRMED

CASH IN BANK All banks in which Star  Name and address of the bank.
had deposits during the  The amount on deposit for each
year, including those account as of the balance sheet date
plus the name of each account, the
which may have had an
account number, whether or not the
account that was closed account is subject to withdrawal by
out during the year. check, and the interest rate if the
account is interest bearing.
 The amount for which Star was
directly liable to the bank for loans
as of the balance sheet date plus the
date of the loan, the due date, the
interest rate, the date to which interest
is paid, and description of the liability
and collateral.
 If internal controls over cash are
deficient, the auditor may wish to
request that the bank include a list
of authorized signatures with the
confirmation.

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 ACCOUNT FROM WHOM INFORMATION
NAME CONFIRMED TO BE CONFIRMED
TRADEACCOUN A representative sample The confirmation can be either a positive
TSRECEIVABL of debtors at a selected or negative form of request. The positive
E confirmation date which form requests the debtor to directly
may be either at the notify the auditor whether the
balance sheet or an information is correct and, if not correct,
interim date. which items are considered incorrect.
Confirmations should The negative form requests a reply only
also be requested for if the information is incorrect. In both
the following types of cases the information should include:
accounts:
 Name and address of the debtor.
 Accounts with large  Account number (if applicable).
balances;  The confirmation “as of” date.
 Past-due accounts;  The aged account balance or
 Accounts with zero individual invoices included in such
or credit balances; balance (with invoice date).
 Accounts written off
during the current
period;
 Accounts whose
collection is
considered
questionable;
 Other accounts of an
unusual nature.
NOTES A selected sample of  Name and address of the debtor.
RECEIVABLE notes receivable  Date of the note.
outstanding at the  Due date.
 Unpaid balance at balance sheet date.
balance sheet date.
 Payment arrangements.
If a note receivable was  Interest rate.
written off during the  Date of last interest payment.
year, the balance written  Collateral, if any, to secure the note.
off should be confirmed.
INVENTORIES Public warehouses or  Name and address of public
other outside custodians warehouse or other outside
(if any). custodian.
 The inventory date.
 Detailed lists of inventory stored.
Under auditing standards, direct
confirmation is acceptable provided
supplemental inquiries are made that
the inventory is the property of the
company, unless the amount is a
significant percent of current or total
assets.

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 ACCOUNT FROM WHOM INFORMATION
NAME CONFIRMED TO BE CONFIRMED
TRADE Suppliers from whom  Name and address of the supplier.
ACCOUNTS substantial purchases  The amount due and the amount of
PAYABLE have been made during any purchase commitments as of
the balance sheet date. When
the year, regardless of
internal controls are considered
the balances of their effective, the confirmation can be at
accounts at the balance an interim date; however, a
sheet date. thorough review must then be made
of changes in the major accounts
during the intervening period
between the confirmation date and
year-end. It should also be noted
that with interim confirmation, the
auditor loses a desirable audit
procedure for disclosing unrecorded
and contingent liabilities at the
balance sheet date.
As an alternative to confirmation letters,
it is a common practice to ask the
vendor to send, directly to the
independent auditor, a statement of the
vendor’s account with the client as of
the balance sheet date rather than send
an accounts payable confirmation.
MORTGAGES Mortgagee for each  Name and address of mortgagee.
PAYABLE mortgage that has a  Original amount.
balance at the balance  Date of note.
 Maturity date.
sheet date.
 Balance due at balance sheet date.
 Payment arrangements.
 Interest rate.
 Interest payment dates.
 Date of last interest payment.
 Nature of defaults and if any events
of default are known to mortgagee.
 Location of mortgaged property.

CAPITAL If Star uses an outside  Name and address of transfer agent

STOCK transfer agent and and registrar.
registrar, confirmations  Number of shares of common stock
authorized, issued, outstanding, and
should be sent to both.
held as treasury shares for the
company as of the balance sheet
date.

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 ACCOUNT FROM WHOM INFORMATION
NAME CONFIRMED TO BE CONFIRMED
LEGAL FEES All of Star’s major The auditor should request a letter
attorneys. Letters from each attorney as to litigation
should also be sent to being handled as of and subsequent
attorneys that the to the balance sheet date. For each
independent auditor case, the attorney should give a
knows the client has description, report on its status as of
used extensively in prior the balance sheet date and as of the
years. date of the letter, and give his or her
opinion as to the ultimate liability. The
attorney should also state Star’s
indebtedness to him or her as of the
balance sheet date.
SALES AND Occasionally,  Name and address of outside
EXPENSE confirmation may be party.
ACCOUNTS requested from an  Other specific information would
depend on the nature of the item
outside party for
and the reason the auditor
individual transactions believes it is necessary to confirm
contributing to total the item.
expenses or sales. This
may be true where a
major item is based on a
formal contract and the
auditor wants
independent
confirmation of
agreement on the
significant term of the
contract and that these
terms have been
satisfactorily completed.

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 7-32-The following are various audit procedures performed to satisfy specific transaction-
related audit objectives as discussed in Chapter 6. The general transaction-related audit
objectives from Chapter 6 are also included. Audit Procedures 1. Trace from receiving reports
to vendors’ invoices and entries in the acquisitions journal. 2. Add the sales journal for the
month of July and trace amounts to the general ledger. 3. Examine expense voucher packages
and related vendors’ invoices for approval of expense account classification. 4. Observe
opening of cash receipts to determine that cash receipts are promptly deposited and recorded.
5. Ask the accounts payable clerk about procedures for verifying prices, quantities and
extensions on vendors’ invoices. 6. Vouch entries in sales journal to sales invoices and related
shipping documents. General Transaction-Related Audit Objectives Occurrence Posting and
summarization Completeness Classification Accuracy Timing –
a. Identify the type of audit evidence used for each audit procedure.
b. Identify the general transaction-related audit objective or objectives satisfied by each audit
procedure

Answer:

a. b.
TRANSACTION-
TYPE OF RELATED
AUDIT PROCEDURE AUDIT EVIDENCE AUDIT OBJECTIVE

1. Trace from receiving reports to Inspection Completeness

vendors’ invoices and entry in
the acquisitions journal.

2. Add the sales journal for the Recalculation Posting and

month of July and trace summarization
amounts to the general ledger.

3. Examine expense voucher Inspection Classification

packages and related vendors’
invoices for approval of expense
account classification.

4. Observe opening of cash Observation Timing and

receipts to determine that cash Completeness
receipts are promptly deposited
and recorded.

5. Ask the accounts payable clerk Inquiries of client Accuracy

about procedures for verifying
prices, quantities, and
extensions on vendors’ invoices.

6. Vouch entries in sales journal Inspection Occurrence

to sales invoices and related
shipping documents.

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7-33 - The following audit procedures were performed in the audit of inven - tory to satisfy specific
balance-related audit objectives as discussed in Chapter 6. The audit procedures assume that the
auditor has obtained the inventory count sheets that list the client’s inventory. The general balance-
related audit objectives from Chapter 6 are also included. Audit Procedures 1. Test extend unit
prices times quantity on the inventory list, test foot the list, and compare the total to the general
ledger. 2. Trace selected quantities from the inventory list to the physical inventory to make sure
that it exists and the quantities are the same. 3. Question operating personnel about the possibility
of obsolete or slow-moving inventory. 4. Select a sample of quantities of inventory in the factory
warehouse and trace each item to the inventory count sheets to determine if it has been included
and if the quantity and description are correct. 5. Compare the quantities on hand and unit prices on
this year’s inventory count sheets with those in the preceding year as a test for large differences. 6.
Examine sales invoices and contracts with customers to determine whether any goods are out on
consignment with customers. Similarly, examine vendors’ invoices and contracts with vendors to
determine whether any goods on the inventory listing are owned by vendors. 7. Send letters directly
to third parties who hold the client’s inventory and request that they respond directly to the
auditors. General Balance-Related Audit Objectives Existence Cutoff Completeness Detail tie-in
Accuracy Realizable value Classification Rights and obligations a. Identify the type of audit evidence
used for each audit procedure. b. Identify the general balance-related audit objective or objectives
satisfied by each

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Answer:

1. Trace selected quantities from Physical examination Existence and

the inventory list to the physical Accuracy
inventory to make sure that it
exists and the quantities are the
same.

2. Compare the quantities on hand Analytical procedures Accuracy

and unit prices on this year’s
inventory count sheets with
those in the preceding year as a
test for large differences.

3. Test extend unit prices times Recalculation Detail tie-in

quantity on the inventory list,
test foot the list, and compare
the total to the general ledger.

4. Question operating personnel Inquiries of the client Realizable value

about the possibility of obsolete
or slow-moving inventory.

5. Send letters directly to third Confirmation Existence,

parties who hold the client’s Completeness,
inventory, and request they and Accuracy
respond directly to the auditor.

6. Select a sample of quantities of Physical examination Completeness

inventory in the factory and Accuracy
warehouse and trace each item
to the inventory count sheets to
determine if it has been included
and if the quantity and
description are correct.

7. Examine sales invoices and Inspection Rights

contracts with customers to
determine whether any goods
are out on consignment with
customers. Examine vendors’
invoices and contracts with
vendors to determine if any
goods on the inventory listing
are owned by vendors.

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 7-34- The following are nine situations, each containing two means of accumulating
evidence: 1. Confirm receivables with consumers versus confirming accounts receivable with
business organizations. Required Required Apago PDF Enhancer Chapter 7 / AUDIT
EVIDENCE 203 2. Physically examine 3-inch steel plates versus examining electronic parts. 3.
Examine duplicate sales invoices when several competent people are checking each other’s
work versus examining documents prepared by a competent person on a one-person staff.
4. Physically examine inventory of parts for the number of units on hand versus examining
them for the likelihood of inventory being obsolete. 5. Discuss the likelihood and amount of
loss in a lawsuit against the client with client’s in-house legal counsel versus discussion with
the CPA firm’s own legal counsel. 6. Confirm the oil and gas reserves with a geologist
specializing in oil and gas versus confirming a bank balance. 7. Confirm a bank balance versus
examining the client’s bank statements. 8. Physically count the client’s inventory held by an
independent party versus con - firming the count with an independent party. 9. Obtain a
physical inventory count from the company president versus physically counting the client’s
inventory. a. Identify the six factors that determine the reliability of evidence. b. For each of
the nine situations, state whether the first or second type of evidence is more reliable. c. For
each situation, state which of the six factors affected the reliability of the evidence.

Answer:

a. The six factors determining the reliability of evidence are:

1. Independence of provider
2. Effectiveness of client’s internal controls
3. Auditor’s direct knowledge
4. Qualifications of individuals providing the information
5. Degree of objectivity
6. Timeliness

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 b. c.
TYPE OF EVIDENCE FACTOR
SITUATION THATIS MORE RELIABLE AFFECTINGRELIABILITY
1 Confirmation with business Qualifications of provider
organizations

2 Physically examine three-inch Qualifications of provider

steel plates (in this case the auditor)

3 Examine documents when Effectiveness of internal controls

several competent people are
checking each other’s work

4 Examine inventory of parts for the Degree of objectivity

number of units on hand

5 Discuss potential lawsuits with Independence of provider

CPA firm’s legal counsel

Confirm a bank balance Degree of objectivity

6
Confirm a bank balance Independence of provider
7
Physically count the client’s Auditor’s direct knowledge
8
inventory

Physically count the inventory

9 Independence of provider and
auditor’s direct knowledge

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 7-35- Following are 10 audit procedures with words missing and a list of several terms
commonly used in audit procedures. Audit Procedures 1. _____ the unit selling price times
quantity on the duplicate sales invoice and compare the total to the amount on the duplicate
sales invoice. 2. _____ whether the accounts receivable bookkeeper is prohibited from
handling cash. 3. _____ the ratio of cost of goods sold to sales and compare the ratio to
previous years. 4. _____ the sales journal and _____ the total to the general ledger. 5. _____
the sales journal, looking for large and unusual transactions requiring investigation. 6. _____
of management whether all accounting employees are required to take annual vacations. 7.
_____ all marketable securities as of the balance sheet date to determine whether they equal
the total on the client’s list. 8. _____ the balance in the bank account directly with the East
State Bank. 9. _____ a sample of duplicate sales invoices to determine if the controller’s
approval is included and _____ each duplicate sales invoice to the sales journal for agreement
of name and amount. 10. _____ the agreement between Johnson Wholesale Company and the
client to determine whether the shipment is a sale or a consignment. Terms a. Examine e.
Recompute i . Count b. Scan f . Foot j. Observe c. Read g. Trace k. Inquire d. Compute h.
Compare l . Confirm a. For each of the 12 blanks in procedures 1 through 10, identify the
most appropriate term. No term can be used more than once. b. For each of the procedures 1
through 10, identify the type of evidence that is being used

Answer:

a. b.
PROCEDURE APPROPRIATE TERM TYPE OF EVIDENCE
1 Recompute (e) Recalculation

2 Observe (j) Observation

3 Compute (d) Analytical procedure

4 Foot (f), Trace (g) Recalculation and reperformance

5 Scan (b) Analytical procedure

6 Inquire (k) Inquiry of client

7 Count (i) Physical examination

8 Confirm (l) Confirmation

9 Examine (a), Compare (h) Inspection

10 Read (c) Inspection

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 7-36 ) Analytical procedures consist of evaluations of financial information
made by a study of plausible relationships among both financial and nonfinancial data.
They range from simple comparisons to the use of complex models involving many
relationships and elements of data. They involve comparisons of recorded amounts, or
ratios developed from recorded amounts, to expectations developed by the auditors.
a. Describe the broad purposes of analytical procedures. Required
Required
Required
A/C # 110—Notes Receivable Prepared by JD 1-21-12
12-31-11 Approved by PP 2-15-12
MARTINAPEX CO. AJAX, INC. J.J. CO. P. SMITH PETERSON TENT CO.
Date made 6/15/10 11/21/10 11/1/10 7/26/11 5/12/10 9/3/11
Date due 6/15/12 Demand $ 200/mo. $1,000/mo. Demand $400/mo.
Paid to date None Paid 12/31/11 9/30/11 Paid 11/30/11
Face amount $5,000 x $ 3,591 x $ 13,180 x $ 25,000 x $ 2,100 x $ 12,000 x
Interest rate 5% 5% 5% 5% 5% 6%
Value of security None None $ 24,000 $ 50,000 None $ 10,000
Note Receivable:
12/31/10 bal. $4,000 py $ 3,591 py $ 12,780 py $ 0 $ 2,100 py $ 0
Additions 25,000 12,000
Payments (1,000) x $(3,591) x (2,400) x (5,000) x (2,100) x (1,600) x
12/31/11 bal. $3,000 $ 0 $ 10,380 $ 20,000 $ 0 $ 10,400 TOTALS
Current $3,000 – $ 2,400 $ 12,000 – $ 4,800 $22,200 tb
Long-term – – 7,980 8,000 – 5,600 21,580 tb
Total end. bal. $3,000 @ $ 0 $ 10,380 @ $ 20,000 @ $ 0 $ 10,400 @ $43,780 tb
Interest Receivable:
12/31/10 bal. $ 104 py $ 0 py $ 24 py $ 0 $ 0 py $ 0 $ 128
Interest earned 175 x 102 x 577 x 468 x 105 x 162 x 1,589 #
Interest received 0 (102) x (601) x (200) x (105) x (108) x (1,116)
12/31/11 bal. $ 279 $ 0 $ 0 $ 268 $ 0 $ 54 $ 601 a/r
x = Tested
py = Agrees with prior year’s audit schedules.
tb = Agrees with working trial balance.
# = Agrees with miscellaneous income analysis in operations w/Apago PDF Enhancer
204 Part 2 / THE AUDIT PROCESS
b. When are analytical procedures required during an audit? Explain why auditors use
analytical procedures extensively in all parts of the audit.
c. Describe the factors that influence the extent to which an auditor will use the results of

analytical procedures to reduce detailed tests in meeting audit objectives.*

24
a. The purposes of analytical procedures are:
1. Understanding the client’s business and industry.
2. Assessment of the entity’s ability to continue as a going concern.
3. Indication of the presence of possible misstatements in the financial statements.
4. Reduction of detailed audit tests.

b. Analytical procedures are required in the planning and completion phases of the audit
because of their importance in planning the audit, and as a final review for potential
misstatements. Auditors useanalytical procedures extensively because of their relatively low
cost and effectiveness in identifying potential misstatements.

c. The extent to which the auditor will use the results of analytical procedures to reduce
detailed tests depends on the effectiveness of the analytical procedure and whether it supports
the correctness of the recorded account balance. The effectiveness of the analytical procedure
is a function of the precision of the expectation developed by the auditor and whether it is
based on objective data

7-37) You are the in-charge on the audit of Vandervoort Company and
are to review the audit schedule shown above.

25
 a. List the deficiencies in the audit schedule.
b. For each deficiency, state how the audit schedule could be improved.
c. Prepare an improved audit schedule, using an electronic spreadsheet software program.
Include an indication of the audit work done as well as the analysis of the client data
(instructor’s option).

Answer:

In general, the audit schedule is not set up in a logical manner to showwhat the auditor wants
to accomplish. The primary objective of the audit schedule is to verify the ending balance in
notes receivable and interest receivable. A secondary objective is to account for all interest
income, cash received and cash disbursed for new notes, collateral as security, and other
information about the notes for disclosure purposes.
Specific deficiencies of the audit schedule presented in the question are included
below.A and B

a. b.
DEFICIENCY IMPROVEMENT
1. Tick mark explanation “tested” Should have separate tick marks meaning:
does not indicate specifically what
was done.  Agreed to confirmation
 Footed
 Traced to cash receipts journal
 Recomputed, etc.
2. Explanation of some tick marks is Explain all tick marks on the same page of
not given. the audit schedule.
3. Classification of long-term portion Recompute portions of notes that are long-
indicates no verification. term.
4. Paid-to-date row is confusing. Column should say “date paid to” and this
should be confirmed.
5. Due dates are missing for Include due dates on the audit schedule
J.J. Co., P. Smith, and Tent Co. for these notes.

26
c. Spreadsheet Solution

The purpose of using an Excel spreadsheet in this problem is to give the student some experience in
preparing a simple audit schedule using an Excel spreadsheet. It should be explained to students that
this type of audit schedule may or may not be prepared in actual practice, and that often templates are
used to prepare more time-consuming audit schedules. Also, whether or not tick marks
arecomputerized is a matter to be decided. The advantage is that thecompleted audit work can then be
stored and reviewed electronically. On the other hand, it may be more efficient to indicate audit work
manually as it is performed.

The following solution was prepared with Excel (FilenameP737.xls). The formulas used are
self-evident, so no listing isprovided, although it is available on the Companion Website. Two items
deserve comment:

1. An advantage of using a spreadsheet program for these types of analyses is that footing and
crossfooting are done automatically.

2. When auditor tick marks are done by computer, a problem arises as to how to place them on
the worksheet. One could use narrow columns inserted between the scheduled client data, or, as done
here, the tick marks are placed in blank rows beneath the related data.

VANDERVOORT COMPANY Schedule

A/C #110 - NOTES RECEIVABLE Prepared b
12/31/13 Approved b

Account #110 - Notes Receivable

Date Interest
Made/ Rate/Date Face Value of Balance Balance Receivable
Maker Due Paid to Amount Security 12/31/12 Additions Payments 12/31/13 12/31/12

Apex Co. c * 6/15/12/ 5% / 5000 None 4000 0 1000 3000 104

06/15/14 None pd. Tp r Tp
Ajax, Inc. c * 11/21/12 / 5% / 3591 None 3591 0 3591 0 0
Demand 12/31/13 Tp r Tp
J.J. Co. c * 11/1/12 / 5% / 13180 24000 12780 0 2400 10380 24
04/01/18 12/31/13 Tp r Tp
($200/Mo.)
P.Smith c * 7/26/13 / 5% / 25000 50000 0 25000 5000 20000 0
08/01/15 09/30/13 r r
($1000/Mo.)
Martin-Peterson c * 5/12/12 / 5% / 2100 None 2100 0 2100 0 0
Demand 12/31/13 Tp r Tp
Tent Co. c * 9/3/13 / 6% / 12000 10000 0 12000 1600 10400 0
02/01/16 11/30/13 r r
($400/Mo.)
22471 37000 15691 43780 128
f f f f, cf f
Tp wtb Tp

Legend of Auditor’s Tick Marks

f Footed
cf Crossfooted

27
Tp Traced to prior year audit files
wtb Traced total to working trial balance
op Traced total to operations audit schedule - OP6
* Examined note for payee, made and due dates, interest rate, face amount,
andvalue of security. No exceptions noted.
c Received confirmation, including date interest paid to,interest rate, interest
paid during 2013, note balance, and security. No exceptions noted.
r Traced to cash receipts records
< Recomputed for the year

28
 CASES
7-38 Identify deficiencies in the sufficiency and appropriateness of the evidence gathered in
the audit of accounts payable of Grande Stores.

Answer:

The following are deficiencies in the sufficiency and appropriateness of the evidence in the
audit of accounts payable for Grande Stores:

McClure Advertising Credits – An insufficient number of confirmations (four)

were sent. The use of alternative procedures is probably acceptable. However,
one credit was confirmed by telephone, rather than by written confirmation.
Although the differences found were immaterial, the auditors should have
determined the reason for the differences, and any errors should have been
projected to the population.

Twenty additional credits were selected for testing. Whether this is a

sufficient number is a matter of judgment, and depends on several factors.
With a fairly small sample, it is critical that the items selected for testing
adequately represent the population. The testing relied on internal
documentation, which is insufficient to support the credits. The placing of the ad
is insufficient evidence without supporting evidence from the vendor supporting
the reduction in accounts payable.

Springbrook Credits – These credits were confirmed by telephone, andwere

not supported by a written confirmation. The staff auditor was suspicious of
the client’s unwillingness to allow written confirmation of the amounts, as well
as the client’s changing explanation of the nature of the credits, but did not
perform additional testing to resolve any doubts about the validity of the credits.

Ridolfi Credits – The auditor obtained an oral confirmation that these credits
were not valid. The client indicated that the auditor’s information was incorrect, but
would not allow the auditor to obtain written confirmation for these credits. In
addition, the credit memos had been altered, which should have further indicated
to the auditor that the credits were not valid.

29
 Accounts Payable Accrual – The auditors sent 50 accounts
payableconfirmations. Whether this is a sufficient number of confirmations is
amatter of auditor judgment. However, the adequacy of the confirmationsas
evidence is significantly undermined by the knowledge that the client told suppliers
how to respond. As a result, the auditor should have verified the confirmed balances
using alternative procedures. There is no discussionof the performance of alternative
procedures for nonresponses, or theresolution of the six responses that were not
reconciled to Grande’s records.

The auditors agreed to an adjustment of $260,000 when their cutoff

tests indicated a potential liability of $500,000. It would be appropriate for the
auditors to agree to a lower amount only if additional testing supported a
lower accrued liability.

7-39- The long-term debt schedule on page 207 (indexed K-1) was prepared by client
personnel and audited by AA, an audit assistant, during the calendar year 2011 audit of
American Widgets, Inc., a continuing audit client. The engagement supervisor is reviewing
the audit documentation thoroughly. Identify the deficiencies in the audit schedule that the
engagement supervisor should discover.*

Answer:

ACL Problem

a. There are 44 payroll transactions in the Payroll file. (This is determined by reading
the number at the bottom of the screen.)
b. The largest and smallest gross pay amounts for September are $4,395.83 and
$1,278.33, respectively. (Use Quick Sort.)
c. Total gross pay for September was $99,585.46. (Use the Total command.)
d. The report belowshows gross pay by department. (Use the Summarize command on
the Gross Pay column, save to a file, and print.)Note that this screenshot was produced using
the “Screen”option in the Output tab of the Summarize window. Students’ hardcopy printouts
will appear slightly different, but will contain the same departmental totals.

e. There are no exceptions in the calculation of net pay for September. (Use the
following Filter: Gross Pay – Taxes <> Net Pay.)

30
 f. There are no duplicate check numbers. (Use the Duplicates command on the
check [cheque] number column.) There are four missing checks (#12389- #12392). The audit
concern is that there may be unrecorded payroll transactions. (Use the Gaps command on the

check [cheque] number

31
32
 CHAPTER-8
8-28) The following are various activities an auditor does during audit planning. 1. Send an
engagement letter to the client. 2. Tour the client’s plant and offices. 3. Compare key ratios for the
company to industry competitors. 4. Review management’s risk management controls and
procedures. 5. Review accounting principles unique to the client’s industry. 6. Determine the likely
users of the financial statements. 7. Identify potential related parties that may require disclosure. 8.
Identify whether any specialists are required for the engagement. For each procedure, indicate
which of the first four parts of audit planning the procedure primarily relates to: (1) accept client and
perform initial audit planning; (2) understand the client’s business and industry; (3) assess client
business risk; (4) perform preliminary

planning
Audit Activities
1. Send an engagement letter to the
client.
2. Tour the client’s plant and offices.
3. Compare key ratios for the company
to industry competitors.
4. Review management’s controls and
procedures.
5. Review the accounting principles
unique to the client’s industry.
6. Determine the likely users of the
financial statements.
7. Identify potential related parties that
may require disclosure.
8. Identify whether any specialists are
required for the engagement.
Related Planning Procedure
(1) Accept client and perform initial audit
planning
(2) Understand the client’s business and
industry
(4) Perform preliminary analytical
procedures
(3) Assess client’s business risk
(2) Understand the client’s business and
industry.
(1) Accept client and perform initial audit
planning.
(2) Understand the client’s business and
industry
(1) Accept client and perform initial audit
planning

33
34