Solution Manual For Auditing A Risk Based Approach 11th Edition Karla M Johnstone Zehms Audrey A Gramling Larry e Rittenberg 2

Solution Manual for Auditing: A Risk
Based-Approach, 11th Edition, Karla M.

Johnstone-Zehms, Audrey A. Gramling, Larry E.
Rittenberg
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Solution Manual for Auditing: A Risk Based-Approach, 11th Edition, Karla M. Johnstone-Zehms,
Financial Statement Auditing: A Risk-Based Approach, 11e
Solutions for Chapter 6

Answers to “Check Your Basic Knowledge” Questions
6-1 T 6-11 d
6-2 F 6-12 c
6-3 a 6-13 T
6-4 b 6-14 F
6-5 T 6-15 d
6-6 F 6-16 b
6-7 b 6-17 T
6-8 b 6-18 F
6-9 F 6-19 b
6-10 T 6-20 d
Review Questions and Short Cases
6-1
Sufficiency is defined as: “The measure of the quantity of audit evidence. The quantity of the
audit evidence needed is affected by the auditor’s assessment of the risks of material
misstatement and also by the quality of such audit evidence.” (ISA 500.5)
Appropriateness is defined as: “The measure of the quality of audit evidence; that is, its
relevance and its reliability in providing support for the conclusions on which the auditor’s
opinion is based.” (ISA 500.5)
Sufficiency relates to the question of “how much” audit evidence must be collected. Sufficiency
will be affected by evidence appropriateness. Appropriateness is affected by the relevance of the
evidence—i.e., it must provide insight on the validity of the assertion being tested—and by the
reliability of the evidence—i.e., whether it is convincing. In all cases, the auditor must collect
appropriate evidence.
6-2
What is determined to be sufficient and appropriate will be affected by the client’s risk of
material misstatement (i.e., inherent and control risks) or risk of material weakness, and will vary
across accounts and assertions. Both the U.S. and international auditing standards encourage
auditors to focus on accounts and assertions with the greatest likelihood of material
misstatement. There are cost implications associated with differences in sufficiency and
appropriateness of evidence for accounts and assertions, with varying risk levels. For example,
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6-1
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consider an account in which there is little risk of misstatement, internal controls are effective,
and the client has relatively noncomplex transactions. Here, the available audit evidence is
relevant and reliable, and the quality of that evidence is high. In such a case, the auditor could
likely perform less rigorous substantive procedures or only a minimal amount of substantive
procedures, and the audit would therefore be less costly to conduct. Conversely, consider an
account where there is high risk of misstatement and internal controls over that account are not
effective. Here, the available audit evidence from the client is of lower quality. Therefore, the
auditor will have to find other high quality evidence to corroborate evidence obtained from
within the client’s systems. Ultimately, these factors require the auditor to perform more, and
more rigorous, substantive procedures, which are costly. When the auditor is testing an assertion
where there is a high risk of material misstatement, the auditor will likely plan to obtain more
evidence and higher quality evidence than when the auditor is testing an assertion where there is
a low risk of material misstatement.
6-3
The AICPA’s AU-C 500 defines the appropriateness of audit evidence as “The measure of the
quality of audit evidence (that is, its relevance and reliability in providing support for the
conclusions on which the auditor’s opinion is based)”. Appropriateness of audit evidence is a
measure of its quality, including the relevance of the evidence—i.e., it must provide insight on
the validity of the assertion being tested—and the reliability of the evidence—i.e., whether it is
convincing. The relevance of evidence relates to the connection between the audit procedure
being performed and the assertion being audited. The relevance of audit evidence considers the
assertion being tested, and is affected by several factors including the purpose of the procedure
being performed, the direction of testing, and the specific procedure or set of procedures being
performed. The reliability of evidence is influenced by its source and nature, and depends on the
circumstances under which it is obtained.
6-4
Directional testing is the design of audit tests to search primarily for either over- or
understatements for particular accounts (but not both). It takes advantage of the double entry
bookkeeping system. The auditor is normally concerned with overstatement of assets or revenues
and understatement of liabilities or expenses because there are greater risks associated with
misstatements in those particular directions. Direction of testing relates to the relevance aspect of
evidence appropriateness. If the auditor is concerned with the overstatement (existence) of
revenues, the direction of testing will be from the recorded transactions to the supporting
documentation. If the auditor’s direction of testing was from the supporting documentation to the
recorded transactions, that evidence would be relevant for testing completeness, but not for
testing existence.
6-5
Exhibit 6.2 compares testing related to the existence and completeness assertions. Panel A
illustrates the auditor’s work flow when testing for existence. This process is referred to as
6-2
vouching. Vouching involves taking a sample of recorded transactions and obtaining the original
source documents supporting the recorded transaction. For example, for a sample of items
recorded in the sales journal the auditor will obtain the related shipping documents and customer
orders. Vouching provides evidence on the assertion that recorded transactions are valid
(existence/occurrence). Panel B of Exhibit 6.2 illustrates the auditor’s work flow when testing for
completeness. This process is referred to as tracing. Tracing is sometimes referred to as
reprocessing. Tracing involves taking a sample of original source documents and ensuring that
the transactions related to the source documents have been recorded in the appropriate journal
and general ledger. For example, the auditor might select a sample of receiving reports and trace
them to the acquisitions journal and the general ledger.
6-6
All things being equal, external documentary evidence is considered more reliable than internally
generated evidence. However, it is seldom true that "all things are equal." External documentary
evidence is generally more reliable when provided by independent, knowledgeable external
parties.
Examples of external documentation are original vendor invoices that are in the client’s
possession and confirmations sent directly to the auditors by third parties. Internal documentary
evidence can be very reliable when it is developed within a strong internal control environment.
Examples of internal documentation are sales invoices, receiving reports, payroll records, and
purchase orders.
6-7
Sufficiency is the measure of the quantity of audit evidence. The quantity of audit evidence
needed is affected by the auditor’s assessment of the risks of material misstatement (the higher
the assessed risks, the more audit evidence is likely to be required) and also by the quality of
such audit evidence (the higher the evidence quality, the less evidence may be required). The
amount of evidence must be of sufficient quantity to convince the audit team of the effectiveness
of internal control or the accuracy of an account balance or assertion.
6-8
When performing tests of controls, the amount of evidence the auditor needs to obtain depends
on whether the client has tested controls as a basis for its assertion on the effectiveness of
internal control. Furthermore, the type of control being tested will affect the auditor’s sample
size. If the auditor is testing a manual control related to transaction processing, sample sizes will
be based on guidelines developed for attribute testing using sampling techniques (discussed in
Chapter 8). For the most part, these sample sizes will vary between 30 and 100 transactions. In
contrast, as discussed in Chapter 3, some controls related to transaction processing are
automated controls built into computer applications. If the auditor has tested general computer
controls, such as controls over program change, and has concluded that those controls are
effective, the tests of computerized application controls could be as small as one for each kind of
6-3
control of interest to the auditor. However, in most cases a control addresses a wide variety of
circumstances, and the auditor may choose to examine exception reports to identify how unusual
transactions are handled.
Another factor influencing sample sizes for tests of controls is the frequency with which a
control is performed. For monthly controls, such as a bank reconciliation, the auditor could
choose one month and perform a test of control, such as inspection of documentation or
reperformance. In contrast, if a control is performed multiple times each day, such as controls
over sales transactions, the auditor will use a larger sample.
Controls over adjusting entries require additional consideration, as adjusting entries represent a
high risk of material misstatement. The auditor’s extent of tests of controls over adjusting entries
will be inversely related to the control environment; in other words, the better the control
environment, the smaller the sample size will be, and vice versa. The testing also varies directly
with the materiality of the account balance and the auditor’s assessment of the risk that the
account balance might be misstated. The auditor wants to review a number of transactions to
determine that (a) other controls are not being overridden by management; (b) there is support
for the adjusting entries—for example, underlying data analyses; and (c) the entries are properly
approved by the appropriate level of management. If the number of transactions is high, the
auditor might use statistical sampling. If the number of transactions is low, the auditor may
choose to focus on the larger transactions.
6-9
Procedure How Used (examples) Assertion(s) Tested

1. Observation Observe client personnel This is a test of control,
taking a physical inventory. but can be used to provide
indirect evidence about
the following assertions:
Completeness, Existence,
Valuation
2. Reperformance Recount selected inventory Completeness
counted by client personnel
and agree to client count
sheets.
3. Inspection of Physically inspect selected Existence, Valuation
Assets inventory items.
4. Inquiry Ask whether there is any
inventory 1. Rights
1. in on consignment, 2. Completeness
2. out on consignment or 3. Valuation
stored in public warehouses,
3. that is obsolete or slow
moving.
5. External Confirm inventory out on Existence, Completeness,
6-4
Procedure How Used (examples) Assertion(s) Tested
Confirmation consignment or in a public Valuation, Rights
warehouse.
6. Inspection of Analyze sales/purchase Valuation, Existence,
Documentation contracts for any special terms. Completeness
7. Recalculation Recalculate quantity times unit Valuation
cost, and foot the file.
8. Analytical Calculate inventory turnover Any of the five assertions
Procedures and number of day’s sales in
inventory.
9. Scanning Scanning inventory sub ledger Any of the five assertions
for unusual entries.
6-10
Type of Audit Procedure Assertions Tested

a. Analytical procedures Any of the five assertions
b. Inspection of documentation Completeness
c. Recalculation Valuation
d. Inspection of documentation Existence
e. Inspection of documentation Existence, Valuation
f. Inspection of assets Existence
g. Inspection of assets Existence, Valuation
h. Inspection of documentation Valuation, Completeness
i. External confirmation Existence
j. Analytical procedures Valuation, Completeness
k. Inquiry of company personnel Completeness, Disclosure, Valuation
l. Inquiry of company personnel Valuation
m. Reperformance Completeness, Existence, Valuation
n. Inquiry of company personnel Multiple assertions depending on the controls
o. Inspection of documentation Completeness, Existence, Valuation
p. External confirmation Completeness, Valuation, Disclosure
6-11
1. Continued decline in market share, and a market shift (or an increase in or acceleration of
market shift) away from sales of trucks or sport utility vehicles, or from sales of other more
profitable vehicles in the United States.
Account: Sales revenue

Assertion: Existence. There exist incentives for management in geographic regions
experiencing slowdowns to inappropriately record next year’s sales in this year’s income
statement. Therefore, auditors should ensure that sales by geographic region are recorded
accurately and actually exist in the year in which they are recorded.
6-5
2. Continued or increased price competition resulting from industry overcapacity, currency
fluctuations, or other factors.
Account: Inventory.
Assertion: Valuation. Price competition may drive down the market value of inventory.
The auditor should ensure that inventory is written down to reflect lower of cost or market
values.
3. Lower than anticipated market acceptance of new or existing products.
Account: Inventory.
Assertion: Valuation. Lack of market acceptance of a product may drive down the market
value of inventory. The auditor should ensure that inventory is written down to reflect
lower of cost or market values.
4. Substantial pension and postretirement healthcare and life insurance liabilities impairing
our liquidity or financial condition.
Account: Pension liabilities.

Assertion: Valuation, presentation, and disclosure. The auditor must ensure that pension
obligations are valued appropriately and are adequately disclosed in the footnotes.
5. Worse than assumed economic and demographic experience for our postretirement benefit
plans (e.g., discount rates, investment returns, and healthcare cost trends).
Account: Pension liabilities.

Assertion: Valuation, presentation, and disclosure. The auditor must ensure that pension
obligations are valued appropriately and are adequately disclosed in the footnotes.
6. The discovery of defects in vehicles resulting in delays in new model launches, recall
campaigns, or increased warranty costs.
Account: Inventory, warranty expense/liability.

Assertion: Valuation, completeness. The auditor must ensure that inventory values reflect
reductions to reflect defect issues. The auditor must ensure that Ford completely reflects
all appropriate expenses associated with the defect and warranty issues because there is an
incentive on the part of management to minimize the recognition of such expenses.
7. Unusual or significant litigation or governmental investigations arising out of alleged

defects in our products or otherwise.
Account: Litigation liabilities.

Assertion: Presentation and Disclosure. The auditor must ensure that management
adequately discloses litigation because they have an obvious incentive not to do so.
6-6
6-12
a. Relevance means that the evidence addresses the assertion. For example, inspecting the
client’s inventory addresses the existence of the inventory, but does not address the
disclosure or rights assertions.
Reliability of evidence implies that the auditor can trust the evidence because the auditor
trusts the source of that evidence. For example, auditors generally believe that evidence
they receive directly, evidence developed under conditions of effective internal control,
and external evidence from a reliable source are all more reliable that evidence gathered
when those conditions do not exist.
b. The reliability of audit evidence is judged by its ability to provide convincing evidence
related to the audit objective being evaluated. In considering the reliability of audit
evidence, it is instructive to review the text of ISA 500 (A31), which states:
The reliability of information to be used as audit evidence, and therefore of the

audit evidence itself, is influenced by its source and its nature, and the
circumstances under which it is obtained, including the controls over its
preparation and maintenance where relevant. Therefore, generalizations about the
reliability of various kinds of audit evidence are subject to important exceptions.
Even when information to be used as audit evidence is obtained from sources
external to the entity, circumstances may exist that could affect its reliability. For
example, information obtained from an independent external source may not be
reliable if the source is not knowledgeable, or a management’s expert may lack
objectivity (ISA 500, A31).
This statement highlights the importance of considering the source of the evidence in
assessing its reliability. The IAASB, in ISA 500, has established the following
generalizations about the reliability of audit evidence:
More Reliable Less Reliable

Directly obtained evidence (e.g., Indirectly obtained evidence (e.g., an
observation of a control) inquiry about the working of a control)
Evidence derived from a well- Evidence derived from a poorly controlled
controlled information system system or easily overridden information
system
Evidence from independent outside Evidence from within the client’s
sources organization
Evidence that exists in documentary Verbal evidence
form
Evidence from original documents Evidence obtained from photocopies or
facsimiles, or digitized data (would depend
on the quality of controls over their
preparation and maintenance)
6-7
c.
Judgment Nature of Error Explanation

Error Relevance, Reliability, or Both
Yes or No
1. Yes Both Assuming the auditor exercised due care
in taking the sample, then all of the items
not returned and which cannot be
substantiated should be treated as an error,
and the misstatement should be projected
to the financial statements as a whole.
In this case, the auditor is simply “fishing”

for better evidence and would be cited for
lack of due professional care.
2. No Reliability The auditor needed to follow up to

determine the existence of the inventory.
The auditor will have to ensure that the
inventory exists and the warehouse has
proper procedures to segregate the client’s
inventory from that of other companies.
3. Yes Relevance The problem with this procedure is that

the auditor is primarily concerned with the
understatement of accounts payable.
Tracing from recorded payables to source
documents does not address the potential
understatement. The auditor needed to use
other procedures.
4. Yes Reliability The problem is that management could

very well be biased. The auditor needs to
determine (a) if there is a ready market for
the securities, (b) management’s past
actions regarding similar securities (hold
or sell), and (c) current cash needs of the
client. For example, if the client is in a
situation where cash is short, it is likely it
will have to cash in the securities – no
matter what management says their intent
is.
5. No Relevance The auditor has already chosen a reliable

6-8
source of evidence. Given the higher risk
because of the poor internal controls, the
auditor has appropriately expanded the
sample size for a reliable source of
evidence.
6. Yes and Reliability and Relevance While it is good to review the inventory
No with the marketing manager, the auditor
should also be aware that the marketing
manager is most likely biased in assuming
the items are good. The auditor should
seek other sources of evidence including
an analysis of sales, inventory turnover,
introduction of competitive products, and
lower of cost or market analysis.
6-13
In deciding to perform analytical procedures as a substantive audit procedure, the auditor

considers the following:
• Does the company have adequate internal controls over the account? The more effective a
client’s internal controls, the greater reliance an auditor can place on substantive analytical
procedures. Importantly, if a company does not have effective internal controls the auditor
will rely more heavily on tests of details than on substantive analytical procedures, since the
auditor will have concerns about the quality of information that would be used in performing
the analytical procedure.
• Is the risk of material misstatement low enough that inferences from indirect evidence such
as substantive analytical procedures are appropriate to make conclusions about an account?
• Are the underlying data used in evaluating an account both relevant and reliable? External
sources of data that might be used to help develop expectations include analyst reports and
industry benchmarking data, while internal sources include budgets and forecasts, operational
information for current and prior periods, and information from discussions with
management.
• Are the relationships among the data logical and justified by current economic conditions?
Plausible relationships among data may reasonably be expected to exist and continue in the
absence of known conditions to the contrary.
6-14
A client estimate should be based on information gathered by the client, and a model developed
by the client. The client takes full responsibility for the quality of the estimate, and should
perform work to verify the veracity of the estimates. For example, the client should periodically
compare the amount of receivables written off versus the amount that is written off as bad debt
expense in creating the allowance. Auditors must be careful to use their own assumptions and
estimates in conducting analytical procedures rather than relying on those developed by the
6-9
client. An analytical procedure is a technique used by the auditor to assess the interrelationship
of accounts or data to determine whether or not the client’s recorded amounts appear to be
reasonable.
6-15
Given that inherent and control risks are high, then a substantive analytical procedure—as the
primary evidence in assessing the correctness of an account balance—would not be appropriate.
The relationship between sales and cost of sales could easily be manipulated if the client does not
have good internal controls and / or if the inherent risk of misstatement of the account is high.
Unless the auditor would be able to use external data to perform the procedure, it is likely that
the auditor will test this account primarily through substantive tests of details.
6-16
a. Determine interest rate, discount rate or premium, and multiply it by the face of the bond
to determine interest expense. This would be the auditor’s expectation. The auditor would
also need to set an appropriate threshold and would then compare the expectation with
the amount recorded by the client. The auditor would follow up on differences exceeding
the threshold. Furthermore, the auditor would need to disaggregate the data to an
appropriate level – possible disaggregating across different types of bonds with different
rates.
b. As an example, consider the audit of natural gas revenue at a utility company. The
auditor has tested controls over revenue recognition, including the processes of reading
gas meters and the proper pricing of gas sold to customer homes. The auditor has
concluded that internal controls are designed and operating effectively. Furthermore, the
auditor has concluded that consumers tend to pay their bills and that the consumer does
not have independent knowledge of the amount that should have been billed. Given that
data, the auditor develops a regression model based on:
• Previous year’s gas billings

• Changes in housing developments
• Changes in pricing of natural gas for the year
• Changes in efficiency of energy use (index of efficiency considering new
furnaces, insulation, and so forth)
• Economic growth in the area
Based on these data, the auditor develops a regression model that predicts expected
revenue within a tolerable range of error with 95 percent accuracy. If the auditor finds
that the recorded revenue is within that range, there may be no need for further
substantive testing of the account balance. Note that this conclusion is based on the
assessment that the risk of material misstatement is low. In areas where significant risks
of material misstatement exist, it is unlikely that audit evidence obtained from substantive
analytical procedures alone will be sufficient. In those situations, the auditor will likely
6-10
also need to perform substantive tests of details. However, if substantive analytical
procedures provide reliable evidence, the auditor may be able to alter the nature, timing,
or extent of detail testing.
c. Compare supplies expense to production expense on a yearly basis to determine if the

expense is fairly stable. In this approach, the auditor’s implicit expectation is that the
expense balance will be similar to the prior year. The auditor will use this expectation in
completing the analytical procedure.
d. The auditor could perform a cross-sectional regression analysis to identify stores that are
out of line – indicating waste, inefficiencies, or potential fraud at the stores that are out of
line. In this case, the auditor’s expectation is that the client’s cost of goods sold will be
similar to the industry average. The auditor will use this expectation in completing the
analytical procedure.
e. Determine number of people at each job level, length of service, and average salary for
job and service. Multiply the data to determine the auditor’s expectation. The auditor
would also set an appropriate threshold and would then compare the expectation with the
amount recorded by the client. If the auditor’s expectation is close (based on the
threshold) to the client’s recorded amount, the auditor may be satisfied with the audit
evidence collected. If the difference between the expectation and the client’s recorded
amount exceeds the threshold, the auditor will need to use appropriate procedures to
follow up.
6-17
While substantive analytical procedures can provide useful audit evidence, the auditor might
become concerned if things look “too good” or are too much in line with prior periods. A client
who has incentives to fraudulently increase revenue can do it in manner that suggests that trends
are continuing and that the company continues to keep pace with the industry. An auditor should
be professionally skeptical if things look too good or if the trend is identical to what has been
seen in the past. Additional tests of details may be useful in helping determining if the client has
fraudulently recorded sales. In this case, the senior may remind the junior auditor about the
importance of professional skepticism.
6-18
Exhibit 6.9 shows how the mix of tests may vary if the auditor performs substantive analytical
procedures. In both Box A and Box B, the auditor is taking a controls reliance approach for a
specific account or assertion, and part of the audit evidence is obtained from tests of controls. In
Box A, the auditor will obtain the remainder of the audit evidence through substantive tests of
details, which might include inspection of documentation, external confirmations, and
recalculations. Conversely, in Box B the auditor will obtain the remainder of the audit evidence
from both substantive analytical procedures and substantive tests of details. Note that the relative
6-11
percentages are judgmental in nature; the examples are simply intended to give you a sense of
how an auditor might select an appropriate mix of procedures.
One reason that an auditor may choose the approach in Box A rather than the approach in Box B
would be due to risk. If there is a higher level of risk of material misstatement, the auditor may
choose to rely more on direct tests of account balances. Another reason might relate to the
absence of plausible or predictable relationships. In such a setting, performing analytical
procedures would not be appropriate and the auditor would want to rely on direct tests of account
balances.
6-19
It may be a challenge for auditors to react negatively toward companies’ preferences to reduce
reserves because the components of those reserve accounts, and the estimates used to determine
an appropriate ending balance, are subjective and judgmental. It is also important to stress to
students that it can also be a challenge to stand up to management when they wish to increase
reserve accounts (i.e., thereby setting up cookie jar reserves) because management may argue
that they are just being conservative. If the auditor argues against client management setting up
the cookie jar reserves in the first place, but ultimately allows management to do so,
management may then argue later (when they wish to tap into the reserves to bolster sagging
income) that the auditor was right in the first place and say that they, management, are just doing
what the auditor wanted them to do all along. The basic point to make is that auditors need to
develop their own independent estimates and steadfastly adhere to what they believe is
appropriate valuation. If they do not, they may be subject to subsequent game-playing by
management.
Professional skepticism is important in this context because it involves anticipating and

evaluating management’s underlying motivations for the choices they make in financial
reporting. A professionally skeptical auditor will consider the pattern of management’s choices,
and will anticipate the reversal of reserve accounts; e.g., in periods of declining income.
6-20
Auditors need to understand the processes used by management in developing estimates,

including (a) controls over the process, (b) the reliability of underlying data in developing the
estimate, (c) use of outside experts by management (for example, how they were used and their
expertise), and (d) how management reviews the results of the estimates for reasonableness.
6-21
When obtaining audit evidence for certain accounts, auditors may need to rely on work
performed by an outside specialist/expert. (International auditing standards use the term expert
rather than specialist; for simplicity we use the term specialist but acknowledge that both terms
are appropriate) It may be that for some accounts expertise in a field other than accounting or
auditing is necessary to obtain sufficient appropriate audit evidence. For example, using the work
6-12
and relying on the valuation opinions of outside specialists are particularly relevant in auditing
natural resources and other long-lived assets in which subject-matter expertise is required. The
following are other examples where the auditor would likely rely on a specialist:
• The valuation of land and buildings, plant and machinery, jewelry, works of art, antiques,
and intangible assets
• The estimation of oil and gas reserves
• The interpretation of contracts, laws, and regulations
• The analysis of complex or unusual tax compliance issues
6-22
Auditing standards require the auditor to understand the role, knowledge, and objectivity of the
specialist and how the specialist’s work affects important financial accounts.
When using the work of a specialist, the auditor needs to evaluate the professional qualifications
of the individual. In making this evaluation, the auditor will consider:
• The professional certification, license, or other recognition of the competence of

the specialist in his or her field, as appropriate
• The reputation and standing of the specialist in the views of peers and others
familiar with the specialist’s capability or performance
• The specialist’s experience in the type of work under consideration
6-23
Some transactions that an auditor will be obtaining evidence about will be related-party
transactions. These are transactions that a client has with other companies or people that may be
related to either the client or to client’s senior management. Related-party transactions can occur
between:
• parents and subsidiaries
• an entity and its owners
• an entity and other organizations in which it has part ownership, such as joint
ventures
• an entity and an assortment of special-purpose entities (SPEs), such as those designed
to keep debt off the balance sheet
An example of a related-party transaction might be an exchange of property between an entity

and an organization in which the entity has part ownership, such as a joint venture.
6-24
1. Inquire of the client about processes used to identify related-party transactions and the
client’s approach to accounting for related-party transactions.
6-13
2. Ask the client to prepare a list of all related parties. Supplement that list with disclosures that
have been made to the SEC of top officers and directors in the company. For smaller
businesses, supplement the list with a listing of known relatives who may be active in the
business or related businesses.
3. Ask the client for a list of all related-party transactions, including those with SPEs or variable
interest entities, that occurred during the year.
4. Discuss the appropriate accounting for all identified related-party transactions with the client
and develop an understanding of the appropriate disclosure for the financial statements.
5. Inquire of the client and its lawyers as to whether the client is under any investigation by
regulatory agencies or law officials regarding related-party transactions.
6. Review the news media and SEC filings for any investigations of related-party transactions
of the client.
7. Use generalized audit software to read the client’s files and prepare a list of all transactions
that occurred with related entities per the lists identified above. Compare the list to that
developed by the client to help determine the quality of the client’s information system.
8. Identify all unusual transactions using information specific to the client including
information on (a) unusually large sales occurring near the end of a period, (b) sales
transactions with unusual terms, (c) purchase transactions that appear to be coming from
customers, and (d) any other criteria the auditor might consider useful.
9. Review the transactions and investigate whether or not the transactions occurred with related
entities. If related parties can be identified, determine the purpose of the transactions and
consider the appropriate financial statement disclosure.
10. Determine whether any of the transactions were fraudulent, or were prepared primarily to
develop fraudulent financial statements. If there is intent to deceive, or if there is misuse of
corporate funds, report the fraud or misuse to the board of directors. Follow up to determine
if appropriate action is taken. If such action is not taken, consult with legal counsel.
11. Determine the appropriate accounting and footnote disclosure.
12. Prepare a memo on findings.
6-25
Audit documentation is the record that forms the basis for the auditor’s representations and
conclusions.
Exhibit 6.12 provides an example of a workpaper related to an inventory price test. A review of
Exhibit 6.12 indicates that audit workpapers should contain:
• A heading that includes the name of the audit client, an explanatory title, and the balance
sheet date
• The initials or electronic signature of the auditor performing the audit test and the date
the test was completed
• The initials or electronic signature of the manager or partner who reviewed the
documentation and the date the review was completed
• A unique workpaper page number (see C-1/2 in Exhibit 6.12; the page number is used to
cross-reference to other workpapers)
6-14
• A description of the tests performed (including the items looked at) and the findings
• Tick marks and a tick mark legend indicating the nature of the work performed by the
auditor († is an example of a tick mark used in Exhibit 6.12; the tick mark legend appears
near the bottom of the workpaper)
• A conclusion as to whether the work performed indicates the possibility of material
misstatement in an account
• A cross-reference to related documentation, when applicable (see references to other
workpapers, including B-1 and B-2, in Exhibit 6.12)
• A section that identifies all significant issues that arose during the audit and how they
were resolved
• A comprehensive and clear memorandum that delineates the auditor’s analysis of the
consistency of audit evidence and the conclusions reached regarding the fairness of the
financial presentation. (See references to other work performed at B-1 and B-2 in Exhibit
6.12. A second page of this workpaper, C-2/2, would likely include a more
comprehensive memo.)
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The concept is that audit documentation contains the evidence that the audit was conducted in
accordance with generally accepted auditing standards including documentation of the planning
process, the audit evidence gathered, the auditor's conclusions regarding that evidence, the
reasoning process utilized by the auditor in reaching conclusions, and the conclusions of the
audit. The documents are like a complete "book" of the audit. As such, it should be possible for
anyone reviewing the documents to be able to read the "book" without the aid of a "storyteller"
(the auditor). It is also critical that the audit documentation be complete and show the audit was
conducted with due professional care in case the audit is challenged in a liability case.
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An audit program documents the procedures to be performed in gathering audit evidence and is
used to record the successful completion of each audit step. The audit program provides an
effective means for:
• Organizing and distributing audit work

• Monitoring the audit process and progress
• Recording the audit work performed and those responsible for performing the work
• Reviewing the completeness and persuasiveness of procedures performed
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a. This is a good case for students to discuss in small groups in class. Individual answers to this
question will of course differ by individual. The purpose of this question is to get students
thinking about the pressures that a staff auditor may face in conducting high quality evidence
gathering and documentation procedures.
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b. Elizabeth’s misrepresentation of her work is important to the firm because it provides
inappropriate assurance regarding the client’s account balance. If there are errors, Elizabeth’s
inadequate procedures and inaccurate documentation will fail to alert the attention of higher
level members of her audit team, thereby increasing the audit risk that her firm assumes.
c. Elizabeth did do some things right once her misrepresentation was discovered. She readily
confessed her actions, expressed remorse, and promised not to engage in ghost tick marking
in the future. She could have become defensive, argumentative, and evasive about the
situation, but she did not. Ultimately, it was her positive attitude about the situation that
saved her from getting fired. In fact, in the actual practice situation one reason that Elizabeth
was retained by the firm (rather than fired) was that she had always been a good performer
with a good attitude in the past. She was viewed as an asset to the firm, so her supervisors
were willing to give her the “benefit of the doubt” in this situation.
d. Do you agree with the outcome? Do you think the firm was too lenient? Too harsh? Answers
to these questions will of course differ by student. Instructors should encourage groups to
report out to the larger class in a discussion to highlight the rationale that individuals/groups
used to arrive at their conclusion. In prior use of these materials, groups were about evenly
split between whether the outcome was too lenient versus too harsh. As an example of one
way to answer this question by applying the ethical decision making framework from
Chapter 1, consider the following steps:
• Identify the ethical issue(s). The issue involves Elizabeth’s decision to engage in ghost
tick marking.
• Determine who are the affected parties and identify their rights. The parties affected by
Elizabeth’s actions include:
(1) The audit firm as a whole. The firm has a right to demand and expect high
quality performance.
(2) Elizabeth’s supervisors. The auditors in charge of (and responsible for) the job
have the right to honesty and high quality work.
(3) The client and its stakeholders. The client hires auditors to help it be sure that
its financial records are accurate. If the audit firm does not catch an error, then the financial
statements may be misstated.
• Determine the most important rights. The most important rights are those held by the
client and its stakeholders. They are paying for high quality service, and if Elizabeth’s
actions had not been discovered they would not have received such service.
• Develop alternative courses of action. Student groups that believe the audit firm was too
lenient generally argue that Elizabeth deserved to be fired outright for her actions, because of
her dishonesty and the costs that it imposed on the audit firm and her colleagues (e.g., extra
levels of review over the course of the year). Student groups that believe the audit firm was
too harsh generally argue that Elizabeth made one isolated mistake and she deserves the
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benefit of the doubt and a chance to redeem herself. Student groups in the “too harsh” camp
are usually especially annoyed that the firm initially did not consider firing Elizabeth, and
then later did consider firing her.
• Determine the likely consequences of each proposed course of action. Consequences will
depend on whether students believe the firm was too lenient or too harsh. Assume that
students decided the firm was too lenient. In this case, the consequences will fall squarely on
Elizabeth’s shoulders, as she will get fired and will have to start her career at another job,
with a potentially tarnished reputation. Now assume that students decided the firm was too
harsh. In this case, the client does not suffer negative consequences because Elizabeth’s
supervisor detected and corrected her mistakes. Thus, the negative consequences accrue to
the firm and her supervisors, who bear the incremental costs in terms of time required to
more closely supervise Elizabeth.
• Assess the possible consequences, including an estimation of the greatest good for the
greatest number. Determine whether the rights framework would cause any course of action
to be eliminated. Some student groups will conclude that the best course of action is for the
firm NOT to fire Elizabeth, but to hold a training session anonymously describing the
situation and warning other auditors in the office of the impropriety of ghost tick marking.
These students will argue that this will assure the greatest good in terms of improved
performance by all auditors of the office and allowing others to learn from Elizabeth’s
mistake.
• Decide on the appropriate course of action. Answers and ideas vary widely across
student groups. Answers generally include (1) immediately firing Elizabeth; (2) not firing
Elizabeth but simply counseling her and not noting the matter in her personnel record; (3) not
firing Elizabeth but noting the matter in her personnel record—i.e., the actual outcome of the
case; (4) not firing Elizabeth but using the situation to motivate staff training; and (5) firing
Elizabeth and using the situation to motivate staff training and to send a strict “message”
throughout the office.
Fraud Focus: Contemporary and Historical Cases
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a. Altering audit documentation undermines the integrity of the Board’s inspection process
because it makes the inspectors’ jobs more difficult; the inspectors are being lied to about
‘what really happened’ on the engagement! As such, they are unable to make an
appropriate judgment about whether the audit was conducted in a quality manner. By
altering audit documentation, auditors are engaged in committing fraud because they are
purporting to have engaged in appropriate audit quality, when in fact they have not.
b. Students will vary in their responses to this question, which is designed to help them
imagine the pressure that we all feel when a powerful superior, who has the ability to
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sanction us for what the superior might claim is ‘sub-par’ performance, evaluates our
previous judgments.
c. Auditors in this setting might ‘go wrong’ when they (in Step 2) assess the consequences
of potential alternatives; that is, remaining steadfast in claiming that the audit
documentation provides a reasonable basis for their judgments and decisions as compared
to falsifying audit documentation. They may (in Step 3) not think about or downplay the
risks and uncertainties of doing so (e.g., regulatory scrutiny, regulatory penalties, and
reputational harm).
d. The factors that students might discuss include the relationship they have with their
superior, the respect and loyalty they have with regard to that individual, the pressures
they feel, and the consequences they might dread. The risks to subordinates in not
reporting inappropriate audit documentation of superiors include getting into trouble
themselves with the Firm and the PCAOB, along with potential personal retribution
executed on them by their superiors. Students will likely express fear of PCAOB
enforcement actions and associated (publicly available) penalties as motivations to
comply with the requirements of the PCAOB.
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a. The AICPA’s AU-C 500 defines the appropriateness of audit evidence as “The measure
of the quality of audit evidence (that is, its relevance and reliability in providing support
for the conclusions on which the auditor’s opinion is based)” and defines the sufficiency
of audit evidence as “The measure of the quantity of audit evidence. The quantity of the
audit evidence needed is affected by the auditor’s assessment of the risks of material
misstatement and also by the quality of such audit evidence.”
What is considered sufficient appropriate evidence will vary across clients depending on
the risk of material misstatement associated with the client. Thus, if there is a high level
of risk of material misstatement, the auditor will need more and higher quality evidence
than if there is a lower risk of material misstatement. Similarly, for a specific client the
auditor may assess the risk of material misstatement differently across accounts. For
example, there may be a higher risk associated with the valuation of accounts receivable
than with the existence of equipment. In that case, the auditor would want to obtain more
and higher quality evidence for the valuation of accounts receivable than for the existence
of equipment.
b. Substantive analytical procedures are a type of substantive test based on assessing

relationships or trends in accounts or ratios. A primary benefit of performing substantive
analytical procedures is that they can reduce the need to perform additional substantive
tests of details. Using these procedures is not required by auditing standards. These
procedures should primarily be used when the following conditions are present:
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• The client should have effective internal controls over the data that will be used in
performing the analytical procedure so that the auditor will have more confidence
about the quality of that data.
• The risk of material misstatement should be low enough so that inferences from
indirect evidence such as substantive analytical procedures would be appropriate.
• The underlying data used in evaluating the account should be both relevant and
reliable.
• The relationships among the data being examined are logical and justified under
current economic conditions.
c. Auditors need to recognize that accounts based on management estimates are subject to
management bias. When considering the allowance for doubtful accounts, for example,
the bias can occur in the assumptions that management makes about such things as how
likely it is that the accounts will be collected. It is therefore important for auditors to
critically assess management assumptions with an appropriate level of professional
skepticism. When applying professional skepticism, auditors should take into account any
incentives or motivations that management might have for misstating their estimates or
coming up with estimates that put things in a more favorable light than warranted by
actual conditions.
d. A standardized audit program is a guide that should be adjusted when conditions dictate
that there should be adjustments. The danger that most audit firms have is that too many
‘standardized’ audit programs are approached rotely by the auditor, and the critical
thinking that should take place on the audit is not present. For the cases identified in the
PCAOB inspection reports, it may be some of the deficiencies could have been avoided if
the auditors had modified the standardized program to fit the client’s risks. However, for
many of the examples provided in the Why It Matters feature “Evidence-Related Findings
in PCAOB Inspection Reports” it appears (from the information provided by the
PCAOB) that the auditors did not even follow steps expected to be included in a
standardized program.
e. Auditors are expected to design an audit to identify any material misstatements – whether
from error or intentional misstatement (i.e., fraud). Evidence decisions that result in a
failure to obtain sufficient appropriate evidence heighten the risk that the auditor’s
procedures will not detect the fraudulent financial reporting, leading to the auditor
possibly issuing an unmodified opinion on financial statements which contain a material
misstatement.
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a. This excerpt identifies problems that the audit firm was having with obtaining evidence
from confirmations sent to the client’s banks. The auditors had not received replies from
the confirmations they sent to Longtop’s banks. So, they decided to visit the banks to
obtain the information. Those visits yielded some very troubling findings as outlined in
the case (e.g., false confirmations being sent to the auditors, debt identified by the bank
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but not included on the confirmations). The auditors then attempted to send follow-up
confirmations to the banks in an effort to obtain written documentation from them.
However, their efforts were interrupted by the client. While this may appear to be an
extreme example of difficulties with confirmations, it does highlight possible difficulties
as well as challenges in working in different cultural environments.
b. Assumptions that underlie confirmations include whether:
• The confirmation will receive a conscientious review and response from the
individual from whom the confirmation is requested.
• The respondent is knowledgeable and has a sufficient basis on which to respond to
the request.
• The respondent is being asked to independently confirm information, if able.
• The respondent is not biased toward giving a particular response (i.e., does not stand
to benefit from a particular response).
• The party receiving the confirmation request is likely to respond to it.
c. A professionally skeptical auditor will understand the various sources of bias that may
enter into the equation when it comes to the reliability of confirmations. As such, a
skeptical auditor will consider when such evidence may be unreliable, and will seek
corroborating evidence when appropriate. The auditors at DTT did have concerns about
the reliability of evidence from confirmation, and so attempted to obtain corroborating
evidence through follow-up visits to various banks that had been sent confirmations.
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a. The proper valuation of the allowance for doubtful accounts is management’s best
estimate of the amount of the accounts receivable that will not be collected. This is
somewhat subjective, and since it is an estimate it normally will not be as precise as those
accounts based on recorded transactions that have occurred.
b. The company should utilize the following information:
• Aging of the receivables

• Past collection experience
• Changes in credit policies
• Changes in the economy as it affects the customers
• Subsequent collections
c. The auditor should:
• Understand the process management uses to make its estimates.

• Inquire as to the credit policies and approach management determine if it is a
reasonable approach.
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• Analyze the relationship between the provision for doubtful accounts and write-offs
over the last few years.
• Review an aging of the accounts receivable and:
• Compare with the prior year aging for any significant changes
• Review subsequent collections
• Inquire about customers with old balances
• Review customer correspondence files to identify reasons for late payments
• Obtain credit reports for large overdue balances
• Consider changes in the economic climate affecting the client’s customers
d. Sales to less creditworthy customers will normally lead to larger write-offs and a larger
allowance.
e. A change in the economic climate will impact the estimate; historical experience will be
less useful in making the estimate. When the economy faces a downturn, the auditor
would likely expect that the allowance for doubtful accounts would increase.
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a.
Financial Statement Audit Procedures to Detect Error or
Misstatement Misstatement
Irregular Charges Against Merger Reserves should be set up at the time of a merger in
Reserves anticipation of future expenses directly associated
with the merger. The client should have an
information system in place to track all changes
against these reserves. Any unusual entry to the
reserves should be investigated. Thus, it would be
unusual to debit reserves and credit revenue. The
auditor should select a sample of all debits to the
reserves and trace to supporting documents justifying
the journal entry. The basis for the entry should be
determined by examining underlying documents.
Those that are not supported should have been
reversed.
False Coding of Services sold to First, analytical review procedures should be used to
Customers identify unusual increases in revenue, or increases in
revenue that would be higher than expected given (a)
the number of members and (b) industry trends.
Second, a sample of revenue recorded should be
taken, particularly during periods of unusual
increases in revenue, and traced back to the
underlying supporting document to determine if they
are recorded properly.
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Financial Statement Audit Procedures to Detect Error or
Misstatement Misstatement
Delayed recognition of Take a sample of recorded “charge-backs” and trace
cancellation of memberships and back initial notice from the bank to see if the items
"charge-backs" (a charge-back is are recorded on a timely basis.
a rejection by a credit card-issuing Take a sample of bank charge-back notices and trace
bank of a charge to a member's to the recording of the charge-backs, noting whether
credit card account). they were recorded on a timely basis. If not, make an
estimate of unrecorded charge-backs to determine if
the amount might be material at year-end.
Compare the percentage of charge-backs recorded
during this year with (a) previous year results and (b)
industry averages.
Quarterly recording of fictitious Examine all unusually large increases in revenue at
revenues the end of a quarter.
Take a sample of all journal entries into the revenue
account that come from other than the sales journal.
Examine the journal entries in detail – including
examination of underlying support for the journal
entries.
If something looks suspicious, send a confirmation
of the sales and services provided to selected
customers.
b. The auditor’s assessment of management integrity and management motivation should

affect all audits, and a professionally skeptical auditor will recognize and respond to this
fact. In this situation, the auditor had a great deal of reason to question management’s
motivation due to a merger and management’s reputation to use accounting as a tool to
increase reported earnings. Given the suspicions by the auditor, a professionally skeptical
auditor should have:
• Assessed risk of potential misstatement as higher than usual.

• Identified the accounts that are most susceptible to management manipulation.
• Developed a plan to compare recorded results with previous results and with
industry averages, and then investigate any unusual items.
• Determined whether sufficient controls existed to prevent errors or other
misstatements.
• Investigated account balances that showed any (a) unusual activity during the end
of any quarter or (b) unusual increases in amounts.
• Investigated any account balance where the entries into the account are
susceptible to management judgment; e.g., the charges against merger reserves.
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An extra shipment of $9 million of disks. The primary evidence is found by reviewing
receipts for merchandise returned after year-end. The auditor examines records of goods
6-22
returned after year-end to determine whether the returns were material and the previous
sale should be reversed. The auditor also discovers evidence on the extra shipment
because the $9 million sale would result in a $9 million receivable. If the auditor attempts
to confirm the receivable with the customer, it is likely that the customer would indicate
that the sale was not appropriate.
Shipments were made from a factory in Singapore. The client is asserting that title had
passed and sales and receivables should be recognized. Confirmation of the terms of the
sale with customers would indicate the validity of the assertion.
Returned goods were recorded as usable inventory. The auditor should perform
analytical procedures and compare the percentage of returned goods with that of previous
years and industry averages. In addition, the auditor should take a sample of goods
received during the year and trace the items sampled into the recording process to
determine the accounting used. The auditor should inquire of inventory control personnel
to determine the appropriate method to be used and to compare current inventory levels
with previous levels to determine whether there has been an inventory buildup.
Just-in-time warehouses and the recording of sales. The auditor should examine sales
taking place near the end of the year to determine whether shipments were going to
customers. The auditor could also review the taking of inventory in the warehouses and
determine why some goods might not be included in inventory. Finally, if the goods were
sitting in MiniScribe's warehouses, it is most likely that a customer would not confirm the
existence of the sale.
Application Activities
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a. Per AS 1210, a specialist is a person or firm possessing special skill or knowledge in a

particular field other than accounting or auditing.
6-23
b.
c.
6-24
d.
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a. Audit documentation is the record that forms the basis for the auditor’s representations
and conclusions. Audit documentation is important in that it facilitates the planning,
performance, and supervision of the audit and forms the basis of the review of the quality
6-25
of the work performed. Audit documentation includes records of the planning and
performance of the work, the procedures performed, evidence obtained, and conclusions
reached by the auditor.
b. PCAOB inspectors are concerned with audit deficiencies—regardless of whether they

result in misstated financial statements or audit opinions. A quality audit is one in which
the auditors adhere to professional standards. Professional standards require that the audit
be documented, and the documentation needs to be complete prior to issuing the audit
opinion. Incomplete documentation is an indicator of a low quality audit, and such
behavior would likely cause the PCAOB inspectors to question what other shortcuts the
auditors took when conducting the audit.
c.
• Identify the ethical issue(s). The issue involves whether to comply with a superior request
to alter an audit workpaper after the fact.
• Determine who are the affected parties and identify their rights. The parties that would
be affected by your actions include:
(1) The audit firm as a whole. The firm has a right to demand and expect high
quality performance.
(2) Your supervisors. The auditors in charge of (and responsible for) the job have
the right to honesty and high quality work.
(3) The client and its stakeholders. The client hires auditors to help it be sure that
its financial records are accurate. If the audit firm does not catch an error, then the
financial statements may be misstated.
• Determine the most important rights. The most important rights are those held by the
client and its stakeholders. They are paying for high quality service, and if you do not
complete a quality audit (which includes adhering to professional auditing standards) the
client and the stakeholders will not have received services they are expecting.
• Develop alternative courses of action. There are two obvious courses of actions: (1)
comply with the request or (2) decide to not comply with the request. Additionally, you
could seek out the advice of your mentor, call the firm hotline/whistleblower line, or
consult with others. You might consider having a conversation with your supervisor
about the request.
• Determine the likely consequences of each proposed course of action. : (1) Comply with
the request. There are many possibilities here. The action may never come to light.
Alternatively, the action may come to light through some review process (internal
inspection, PCAOB inspection, etc.). If this does occur, you might get fired, be
reprimanded, be required to take additional training, have your work more thoroughly
reviewed, have to start a new job with a tarnished reputation, etc.
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(2) Decide to not comply with the request By not complying with the request, you run the
risk that your supervisor will provide negative evaluations of your future work, describe
you as not being a team player to others in the firm, or in some other way internally
tarnish your reputation.
• Assess the possible consequences, including an estimation of the greatest good for the
greatest number. Determine whether the rights framework would cause any course of
action to be eliminated. The greatest good for the greatest number would result by
performing the services that the firm was hired to perform.
• Decide on the appropriate course of action. See discussion at previous bullet.
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a. The auditor is required by professional auditing standards to not only consider

information outside of the client’s records, but to actively solicit such information to
evaluate for consistency with the client’s record keeping, and to provide additional input
on critical evaluation decisions the auditor must address.
b. Inventory: There is a significant downturn in the industry. Presumably, this downturn

affects the ability to sell the inventory and therefore lowers the valuation of the inventory.
Recall that inventory always should be valued at the lower of cost or market; thus, the
auditor must consider current market conditions.
Inventory Sample Selection: If the client has already impaired part of the inventory, it
does not make any sense to test it further for impairment (potential understatement of
inventory). As noted throughout the text, the auditor is primarily concerned with the
overstatement of inventory. Thus, the auditor should have tested the inventory that had
not been examined for potential impairment.
Reasonableness of Assumptions. Increasingly, the financial statements are based on

important assumptions about asset realization. The auditor needs to evaluate those
assumptions in light of current economic situations.
Failure to Test a Significant Category of Inventory. The inventory category was 70% of
materiality. The auditor needs to consider all aspects of inventory in determining whether
inventory might be misstated. Remember that testing of most accounts, including
inventory, is based on samples; the auditor does not test 100% of most items. Thus, if
there are significant problems in the inventory not tested, it could, when aggregated with
other inventory categories, represent a material amount of misstatement.
Reliance on Management Inquiry related to the Joint Venture. The auditor should have:
• Read and understood the contract related to the joint venture

• Determined the client’s obligations
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• Evaluate the success of the JV to date in order to determine whether a liability
might exist
c. Inquiry of management cannot be considered sufficient evidence by itself because

management may be biased. The auditor should corroborate management’s assessment
and analysis with independent evidence.
d. Assumptions are assumptions! Yes, this is a common statement made by clients.

However, both accounting and auditing standards require that the assumptions be
reasonable and based on current economic conditions, the client’s current financial status,
and reasonable plans put forth by the client. For example, it is reasonable for an auditor to
question a client’s assumption that it will earn 12% per year over the next 20 years on its
investments in its pension obligation portfolio when most pension funds are earning 6%
or less over a long period of time.
e. The deficiencies identified by the PCAOB are evidence of a lack of professional

skepticism by the auditor. While it is not always easy to state that there is one cause for
the decrease in skepticism, the need to control audit costs could certainly have been a
factor. Another factor might be related to the culmination of the auditor’s experience
where most of the items identified do not lead to material misstatements. But recall that
audit risk has to be attained on all audits, not just on average.
f. A standardized audit program is a guide that should be adjusted when conditions dictate
that there should be adjustments. The danger that most audit firms have is that too many
‘standardized’ audit programs are approached rotely by the auditor, and the critical
thinking that should take place on the audit is not present.
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Answers will vary, but some potential situations that might be identified are listed below. For all
analytical procedures it is important that the student recognize the need for the auditor to first
develop an independent expectation with an appropriate level of precision. If this question is
covered in class, the instructor might want to probe the students as to what information would be
used in developing an expectation for their identified accounts.
• Testing systematic relationships between accounts; e.g., interest income compared to

bond holdings or saving, interest income compared to bond obligations.
• Testing logical relationships; e.g., depreciation expense related to prior year’s

depreciation, updated for additions and deletions of assets. This would be more efficient
than testing individual accounts.
• Computing independent calculations with data; e.g., calculating total salary expense by
job title in a CPA firm, or total expense for seniors in an office based on average pay
times number of people involved.
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• Making sophisticated revenue or expense estimates using regression analysis with various
model parameters.
• Analyzing time series data of accounts and relationships; e.g., the amount of supplies
expense related to production.
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a. and b.
The appropriate standard is AS 1105. The relevant information can be found in paragraphs 22-
28 of that standard. These paragraphs are excerpted below.
22. Designing substantive tests of details and tests of controls includes determining the
means of selecting items for testing from among the items included in an account or the
occurrences of a control. The auditor should determine the means of selecting items for
testing to obtain evidence that, in combination with other relevant evidence, is sufficient to
meet the objective of the audit procedure. The alternative means of selecting items for testing
are:
• Selecting all items;

• Selecting specific items; and
• Audit sampling.
23. The particular means or combination of means of selecting items for testing that is
appropriate depends on the nature of the audit procedure, the characteristics of the control or
the items in the account being tested, and the evidence necessary to meet the objective of the
audit procedure.
Selecting All Items

24. Selecting all items (100 percent examination) refers to testing the entire population of
items in an account or the entire population of occurrences of a control (or an entire stratum
within one of those populations). The following are examples of situations in which 100
percent examination might be applied:
• The population constitutes a small number of large value items;

• The audit procedure is designed to respond to a significant risk, and other means of
selecting items for testing do not provide sufficient appropriate audit evidence; and
• The audit procedure can be automated effectively and applied to the entire population.
Selecting Specific Items

25. Selecting specific items refers to testing all of the items in a population that have a
specified characteristic, such as:
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• Key items. The auditor may decide to select specific items within a population because
they are important to accomplishing the objective of the audit procedure or exhibit some
other characteristic, e.g., items that are suspicious, unusual, or particularly risk-prone or
items that have a history of error.
• All items over a certain amount. The auditor may decide to examine items whose
recorded values exceed a certain amount to verify a large proportion of the total amount of
the items included in an account.
26. The auditor also might select specific items to obtain an understanding about matters
such as the nature of the company or the nature of transactions.
27. The application of audit procedures to items that are selected as described in paragraphs
25-26 of this standard does not constitute audit sampling, and the results of those audit
procedures cannot be projected to the entire population.
Audit Sampling
28. Audit sampling is the application of an audit procedure to less than 100 percent of the
items within an account balance or class of transactions for the purpose of evaluating some
characteristic of the balance or class.
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The auditor should refer to the AICPA standards, as these are relevant to audits of nonpublic US
clients. The relevant standard is AU 500-C. Paragraph .10 of that standard indicates:
Inconsistency in, or Doubts Over Reliability of, Audit Evidence

.10 If
a. audit evidence obtained from one source is inconsistent with that obtained from
another or
b. the auditor has doubts about the reliability of information to be used as audit
evidence,
the auditor should determine what modifications or additions to audit procedures

are necessary to resolve the matter and should consider the effect of the matter, if any, on
other aspects of the audit. (Ref: par. .A53)
Additionally, paragraph .A53 notes:
.A53 Obtaining audit evidence from different sources or of a different nature may
indicate that an individual item of audit evidence is not reliable, such as when audit
evidence obtained from one source is inconsistent with that obtained from another. This
may be the case when, for example, responses to inquiries of management, internal audit,
and others are inconsistent or when responses to inquiries of those charged with
governance made to corroborate the responses to inquiries of management are
inconsistent with the response by management. Section 230, Audit Documentation,
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includes a specific documentation requirement if the auditor identified information that is
inconsistent with the auditor's final conclusion regarding a significant finding or issue.
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A purpose of this assignment is to give the students an opportunity to read an AAER. This
selected AAER is brief, yet provides some very interesting points for discussion.
a. Selected excerpts from the release are provided here to indicate the extent of evidence-
related deficiencies identified in the release.
Respondent failed to adequately plan the audits, obtain an understanding of

internal controls, and develop audit procedures responsive to identified risks. See
PCAOB Standards and Related Rules, AU §§ 311 and 319. Among other things,
Respondent did not understand AMG’s system of internal controls or competently
identify audit risks. For instance, with respect to her audit of AMG’s November
30, 2008 financial statements, Respondent did not consider accounts receivable to
be an area of heightened audit risk even though receivables had increased 75%
from 2007 to 2008, represented 44% of total assets, and were central to the
company’s borrowings under its line of credit, which had increased by 77%
compared to the previous year. Respondent also followed a generic audit
program, purchased off the internet, but failed to adjust audit procedures to
account for risks or circumstances unique to AMG.
Respondent also failed to exercise professional skepticism or obtain sufficient

competent evidential matter with respect to the company’s large, unusual quarter
end sales. See PCAOB Standards and Related Rules, AU §§ 230.07 and 326. She
merely relied on the former accounting manager’s verbal representations that he
had been too busy to invoice customers before then. This explanation, however,
was inconsistent with the receivables aging report in her audit work papers, which
showed small invoices prepared daily for these customers throughout the quarter.
In addition, Respondent failed to perform confirmation procedures in accordance

with PCAOB Standards and Rules AU § 330. Among other things, she improperly
allowed AMG management to control her confirmation of accounts receivable.
See PCAOB Standards and Rules AU § 330.28. Respondent gave the former chief
financial officer and former accounting manager blank confirmations to send to
AMG’s largest customers, and relied on them to mail the confirmations to
customers. Accordingly, Respondent did not know that confirmations were not
mailed to AMG’s two largest customers or that the confirmation responses she
ostensibly received from these customers had been falsified by someone at AMG.
Respondent also failed to evaluate exceptions noted on confirmation responses in

connection with her audit of the November 30, 2008 financial statements. For
instance, Respondent accepted the former accounting manager’s verbal
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explanation of a $323,000 exception noted on a returned confirmation without
performing any other procedures. Respondent should have performed additional
procedures with respect to this confirmation to obtain the evidence necessary to
reduce audit risk to an acceptably low level. Obtaining representations from
management is not a substitute for obtaining competent evidence, and an auditor
may not accept less than persuasive evidence merely because she believes
management is honest. See PCAOB Standards and Rules AU §§ 333.02, 230.09.
Respondent did not otherwise competently test sales or receivables. For example,
although Respondent examined certain invoices to determine if the year-end sales
cutoff was accurate, she relied on the former accounting manager to select the
invoices. She did not examine AMG’s sales journal to select her own sample of
invoices, although her audit program called for her to do so, and she only
skimmed the receivables aging report in her work papers without noticing details.
Had Respondent examined the sales journal and aging report to select her own
sample, she would have noted the large quarter end sales and discovered the false
invoices, with their vague descriptions and lack of supporting documentation.
Similarly, Respondent’s audit program called for her to complete certain steps to
test collectability of receivables, including the examination of credit memos.
Respondent examined certain credit memos, but relied on the former accounting
manager to select them. Had Respondent examined the sales journal to select a
sample of credit memos, she would have discovered the large credit memos that
reversed the false invoices.
b. The one instance in the release that refers to professional skepticism states:
Respondent also failed to exercise professional skepticism or obtain sufficient

competent evidential matter with respect to the company’s large, unusual quarter
end sales. See PCAOB Standards and Related Rules, AU §§ 230.07 and 326. She
merely relied on the former accounting manager’s verbal representations that he
had been too busy to invoice customers before then.
Also, by allowing client management to control the confirmation process, the auditor did
not employ an appropriate level of professional skepticism. Furthermore, allowing the
accounting manager to select items for testing (credit memos) indicates an inappropriate
level of professional skepticism by the auditor.
c. The release states:
Accordingly, it is hereby ORDERED, effective immediately, that Respondent is

denied the privilege of appearing or practicing before the Commission as an
accountant.
6-32
Students will vary in the extent to which they believe that the sanction is appropriate.
However, students will point out that the inappropriate actions were in some ways
extreme and certainly not indicative of an appropriate level of professionalism.
6-42
This Disciplinary Order describes audit failures related to audit evidence, as well as failures
related to other audit activities. Relevant excerpts focusing on audit evidence failures for one of
the firm’s issuers, Universal Travel Group, include:
During the Universal Travel audit, ACSB failed to exercise due professional care and
failed to obtain sufficient competent evidential matter to support its opinion on Universal
Travel's 2009 financial statements. Specifically, ACSB failed to obtain sufficient audit
evidence to test the existence and valuation of Universal Travel's reported accounts
receivable. In its 2009 Form 10-K, Universal Travel reported net accounts receivable
totaling $17.3 million, approximately 20% of its reported assets. During the 2009 audit,
the China Firm assistants sent out positive confirmations for receivables totaling $10.9
million or approximately 63% of the net accounts receivable balance. However, the
engagement team did not receive responses for accounts totaling one-third of the amounts
selected for confirmation and ACSB failed to perform alternative procedures with respect
to those nonresponses.
In its 2009 Form 10-K, Universal Travel reported that it generated revenue from four
lines of business, namely, air-ticketing, hotel reservations, packaged-tours, and air cargo
agency services. Universal Travel's financial statements disclosed that the issuer
recognized packaged-tour revenue at the time that the tour was completed and that total
revenues from its packaged-tour operations represented approximately 69% of Universal
Travel's reported revenue in 2009. ACSB failed to perform sufficient procedures to
determine whether Universal Travel recognized its revenue in accordance with its
disclosed policy.
Universal Travel's 2009 financial statements reported goodwill totaling $9.9 million or
11.5% of its total reported assets at December 31, 2009. ACSB failed to appropriately
test Universal Travel's goodwill for impairment. The working papers contained an
analysis prepared by the issuer that contained management's goodwill impairment
analysis. ACSB failed to perform sufficient procedures to test the assumptions and
estimates used in management's impairment analysis. Further, ACSB failed to perform
any audit procedures to corroborate management's representations concerning its
impairment analysis.
ACSB failed to obtain sufficient competent evidential matter relating to material

adjustments recorded in the issuer's consolidation at year-end, including an entry for $5
million in cash, representing 13.6% of total cash or 5.8% of Universal Travel's total
reported assets at December 31, 2009. ACSB failed to confirm or perform other audit
procedures to verify the existence of this amount.
6-33
NOTE: The Order includes audit evidence deficiencies for two other issuer clients of the audit
firm.
Academic Research Cases
6-43
A summary of the study can be accessed at http://commons.aaahq.org/posts/92d3a0eb79.
6-44
A summary of the study can be accessed at http://commons.aaahq.org/posts/5c5332268b.
Data Analytics Using ACL
6-45
ACL icons, commands, and equations in bold, data files in italics.
In this project, ACL can be used to identify potential fraud in the Pell grant program. It can be
used to identify:
1. Any student receiving more than the annual maximum grant ($3,125 is used in this case).
2. More than one student using the same social security number.
3. Any student using different social security numbers.
4. Any students receiving grants that should not be receiving grants.
It could also be used to recalculate the correct amount of grants for each term, but this is a lot of
work and the results indicate that, except for rounding, nothing new is detected.
Condition Approach
Number
To Begin Create a new project by clicking on the New Project icon or choose File, New,
Project from the menu and give it the name Pella. Be sure to save the project on the
medium that contains the data files.
Import the Pella file. Name it grants.
1 Objective: To check for a student getting more than $3,125 during one year.
Using the grants file (table):
1. The SSN field must be changed from Numeric to ASCII format. Choose Edit,
Table Layout. Double click on SSN, click the down arrow next to Numeric, find
and click on ASCII (above Numeric in the drop-down window), click the green
arrow in the left margin, and close this window by clicking the X in the upper
6-34
Condition Approach
Number
right-hand corner of this window.
2. Choose Analyze, Summarize from the menu. Then choose the following:
Summarize on - SSN,
Subtotal fields – Amount
Other Fields –LAST, FIRST
Click on the output tab and file. Give the new file the name Student Totals.
Using the Student Totals file, create a filter with the expression Amount > 3125.
Click OK.
This identifies the totals for Curtis, Ted $4,166.64 (SSN 103660779); Miller,
Wesley $5,468.73 (SSN 175387153); and Gastecki, Patrick $4,687.47 (SSN
311340189).
3. Double click on the grants file in the left window to make it active. Create a filter
with the expression Last = “Curtis” OR Last = “Miller” OR Last = “Gastecki”.
(Note: the name must be in quotations) Click OK.
Results: Curtis got a grant from schools 2 and 5 for the same term 1 (Fall Semester).
There are two different Millers. It shows that Gastecki received grants for each
semester, but the total does not exceed $3,125. Why does he show up? See step 2.
2 Objective: See if more than one person uses the same SSN.
Remove the filter to get the complete grant file:

1. Choose Data, Extract Data, If using the equation Term = 1. Name the file Term
1 in the window next to the To button. Click OK.
2. Using the Term 1 file, choose Analyze, Look for Duplicates on SSN. Hold down
the Ctrl key and click all fields to list them in the output. Click the Output tab at
the top of the screen and select either “Screen” or “Print.” If you sent the output
to the screen, the results can then be printed.
3. Repeat for Terms 2 & 3
Results: There are three pairs of SSN duplicates for Term 1. Two have the same SSN
with different names - SSN 311340189 (Novack & Gastecki) and SSN 175387153
(Miller & Shimansk). Curtis (SSN 103660779) got grants at both schools 2 & 5 for
the same term. For Terms 2 & 3, same results except no duplicate for Curtis.
3 Objective: See if the same person is using different SSNs.
Using the Extracted Files for Terms 1, 2, & 3 from Condition Number 2 above –
1. For each term check for duplicate last names, Analyze, Look for duplicates.
6-35
Solution Manual for Auditing: A Risk Based-Approach, 11th Edition, Karla M. Johnstone-Zehms,
Condition Approach
Number
2. Sequence on Last and include all fields in the output to screen.
3. Scan each list of duplicate last names for duplicate first names.
Results: In Term 3, Garnett, Colin used two SSNs - 751523222 at school 3 and
623933491 at school 6. This will also identify Curtis, Ted in Term 1 (see Condition
Number 1 and 2 above).
4 Objective: See if anyone with a need code 5 got a grant.
Using the grants file:

Create a filter with the expression NEED = 5 AND AMOUNT > 0
(Put all of this in one equation).
Results: Manuel, Roy has a need code of 5 but got grants in all three terms.
The items of potential fraud are:
Condition Social Name

Number Condition Security
Number
1 Student got a grant from both school 2 & 5 for the 103660779 Curtis, Ted
fall semester. Annual total exceeds the $3,125
annual limit.
2 Same SSN with different names. 311340189 Novack, Kristy
& Gastecki,
175387153 Patrick
Miller &
Shimansk
103660779
Curtis, Ted
shows up again.
3 Same name with different SSN. 623933491 Garnett, Colin
&
751523222
4 Grant received when need code indicates no grant 206098789 Manuel, Roy
should have been given.
6-36
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Solutions for Chapter 6

Review Questions and Short Cases

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Procedure How Used (examples) Assertion(s) Tested

Type of Audit Procedure Assertions Tested

Account: Sales revenue

3. Lower than anticipated market acceptance of new or existing products.

Account: Pension liabilities.

Account: Pension liabilities.

Account: Inventory, warranty expense/liability.

7. Unusual or significant litigation or governmental investigations arising out of alleged

Account: Litigation liabilities.

The reliability of information to be used as audit evidence, and therefore of the

More Reliable Less Reliable

Judgment Nature of Error Explanation

In this case, the auditor is simply “fishing”

2. No Reliability The auditor needed to follow up to

3. Yes Relevance The problem with this procedure is that

4. Yes Reliability The problem is that management could

5. No Relevance The auditor has already chosen a reliable

In deciding to perform analytical procedures as a substantive audit procedure, the auditor

• Previous year’s gas billings

c. Compare supplies expense to production expense on a yearly basis to determine if the

Professional skepticism is important in this context because it involves anticipating and

Auditors need to understand the processes used by management in developing estimates,

• The professional certification, license, or other recognition of the competence of

An example of a related-party transaction might be an exchange of property between an entity

• Organizing and distributing audit work

Fraud Focus: Contemporary and Historical Cases

b. Substantive analytical procedures are a type of substantive test based on assessing

b. Assumptions that underlie confirmations include whether:

b. The company should utilize the following information:

• Aging of the receivables

c. The auditor should:

• Understand the process management uses to make its estimates.

b. The auditor’s assessment of management integrity and management motivation should

• Assessed risk of potential misstatement as higher than usual.

a. Per AS 1210, a specialist is a person or firm possessing special skill or knowledge in a

b. PCAOB inspectors are concerned with audit deficiencies—regardless of whether they

• Decide on the appropriate course of action. See discussion at previous bullet.

a. The auditor is required by professional auditing standards to not only consider

b. Inventory: There is a significant downturn in the industry. Presumably, this downturn

Reasonableness of Assumptions. Increasingly, the financial statements are based on

• Read and understood the contract related to the joint venture

c. Inquiry of management cannot be considered sufficient evidence by itself because

d. Assumptions are assumptions! Yes, this is a common statement made by clients.

e. The deficiencies identified by the PCAOB are evidence of a lack of professional

• Testing systematic relationships between accounts; e.g., interest income compared to

• Testing logical relationships; e.g., depreciation expense related to prior year’s

• Selecting all items;

Selecting All Items

• The population constitutes a small number of large value items;

Selecting Specific Items

Inconsistency in, or Doubts Over Reliability of, Audit Evidence

the auditor should determine what modifications or additions to audit procedures

Additionally, paragraph .A53 notes:

Respondent failed to adequately plan the audits, obtain an understanding of

Respondent also failed to exercise professional skepticism or obtain sufficient