Auditing Questions And Answers

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Auditing Questions and€Answers
Audit Reports
1)€€€€€ Explain why auditors’ reports are important to users of financial statements and why it is desirable to have
standard wording.
&: Auditor’s reports are important to users of financial statements because they inform users of the auditor’s opinion as
to whether or not the 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 unqualified report and the
reasons and implications of such deviations. Having standard wording improves communications for the benefit of user
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 and explain the meaning of each part. How do
the parts compare with those found in qualified report?
&: The unqualified audit report consists of:
€
Report title€ Auditing standards require that the report be titled and that the title includes the word independent.
1.
Audit report address€ The report is usually addressed to the company, its stockholders, or the board of directors.
2.
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 bal.
ance sheet dates and the accounting periods for the income statement and statement of cash flows. Third, it states
that the statements are the responsibility of management and that the auditor’s responsibility is to express an
opinion on the statements based on an audit.
3.
Scope paragraph.€ The scope paragraph is a factual statement about what the auditor did in the audit. The remain
der briefly describes important aspects of an audit.
4.
Opinion paragraph.€ The final paragraph in the standard report states the auditor’s conclusions based on the result
of the audit.
5.
Name of CPA firm.€ The name identifies the CPA firm or practitioner who performed the audit.
6.
Audit report date.€ The appropriate date for the report is the one on which the auditor has completed the most im
portant auditing procedures in the field.
7.
€
The same seven parts are found in a qualified report as in an unqualified report. There are also often one or more addi
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tional paragraphs explaining reasons for the qualifications.
3)€€€€€ What are the purposes of the scope paragraph in the auditor’s report? Identify the most important infor
mation included in the scope paragraph.
&: The purposes of the scope paragraph in the auditor’s report are to inform the financial statement users that the audit
was conducted in accordance with generally accepted auditing standards, in general terms what those standards mean,
and whether the audit provides a reasonable basis for an opinion.
€
The information in the scope paragraph includes:
The auditor followed generally accepted auditing standards.
1.
The audit is designed to obtain reasonable assurance about whether the statements are free of material misstate
ment.
2.
Discussion of the audit evidence accumulated.
3.
Statement that the auditor believes the evidence accumulated was appropriate for the circumstances to express
the opinion presented.
4.
4)€€€€€ What are the purposes of the opinion paragraph in the auditor’s report? Identify the most important infor
mation included in the opinion paragraph.
&: The purpose of the opinion paragraph is to state the auditor’s conclusions based upon the results of the audit evi.
dence. The most important information in the opinion paragraph includes:
The words “in our opinion” which indicate that the conclusions are based on professional judgment.
1.
A restatement of the financial statements that have been audited and the dates thereof or a reference to the intro
ductory paragraph.
2.
A statement about whether the financial statements were presented fairly and in accordance with generally ac.
cepted accounting principles.
3.
€
5)€€€€€ On February 17, 2006, a CPA completed the field work on the financial statements for the Buckheizer Tech
nology Corporation for the year ended December 31, 2005. The audit in satisfactory in all respects except for the
existence of a change in accounting principle from FIFO to LIFO inventory valuation., which results in an ex7
planatory paragraph to consistency. On February 26, the auditor completed the tax return and the draft of the
financial statements. The final audit report was completed, attached to the financial statements, and delivered
to the client on March 7. What is the appropriate date on the auditor’s report?
&: The auditor’s report should be dated February 17, 2006, the date on which the auditor completed the most important
auditing procedures in the field.
€
6)€€€€€ What five circumstances are required for a standard unqualified report to be issued?
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&: An unqualified report may be issued under the following five circumstances:
All statements—balance sheet, income statement, statement of retained earnings, and statement of cash
flows—are included in the financial statements.
1.
The three general standards have been followed in all respects on the engagement.
2.
Sufficient evidence has been accumulated and the auditor has conducted the engagement in a manner that en.
ables him or her to conclude that the three standards of field work have been met.
3.
The financial statements are presented in accordance with generally accepted accounting principles. 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.
7)€€€€€ Describe the additional information included in the introductory, scope, and opinion paragraphs in a com
bined audit report on financial statements and the effectiveness of internal control over financial reporting.
What is the nature of the additional paragraphs in the audit report?
&: The introductory, scope and opinion paragraphs are modified to include reference to management’s report on interna
control over financial reporting, and the scope of the auditor’s work and opinion on internal control over financial report
ing. The introductory and opinion paragraphs also refer to the framework used to evaluate internal control. Two addi.
tional paragraphs are added between the scope and opinion paragraphs that define internal control and describe the in
herent limitations of internal control.
8)€€€€€ 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?
&: When adherence to generally accepted accounting principles 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 generally accepted accounting principles would have resulted in misleading statements. The opinion
should be unqualified, but it should refer to the separate paragraph during the portion of the opinion in which generally
accepted accounting principles are mentioned.
9)€€€€€ Distinguish between an unqualified report with explanatory paragraph or modified wording and a qualifi
report. Give examples when an explanatory paragraph or modified wording should be used in an unqualified
opinion.
&: An unqualified report with an explanatory paragraph or modified wording is the same as a standard unqualified repor
except that the auditor believes it is necessary to provide additional information about the audit or the financial state.
ments. For a qualified report, either there is a scope limitation (condition 1) or a failure to follow generally accepted ac
counting principles (condition 2). Under either condition, the auditor concludes that the overall financial statements are
fairly presented.
Two examples of an unqualified report with an explanatory paragraph or modified wording are:
The entity changed from one generally accepted accounting principle to another generally accepted accounting
principle.
1.
A shared report involving the use of other auditors.
2.
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€
10)€ Describe what is meant by a reports involving the use of other auditors. What are the three options avail7
able to the principal auditor and when should each be used?
&: When another CPA has performed part of the audit, the primary auditor issues one of the following types of reports
based on the circumstances.
No reference is made to the other auditor. This will occur if the other auditor audited an immaterial portion of the
statement, the other auditor is known or closely supervised, or if the principal auditor has thoroughly reviewed the
other auditor’s work.
1.
Issue a shared opinion in which reference is made to the other auditor. This type of report is issued when it is im
practical 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.
2.
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.
3.
€
11)€ The client has restated the prior7year statements because of a change from LIFO to FIFO. How should be this
reflected in the auditor’s report?
&: Even though the prior year statements have been restated to enhance comparability, a separate explanatory para.
graph is required to explain the change in generally accepted accounting principles in the first year in which the change
took place.
12)€ Distinguish between changes that affect consistency and those that may affect comparability but not con
sistency. Give an example of each.
&: Changes that affect the consistency of the financial statements may involve any of the following:
Change in accounting principle
1.
Change in reporting entity
2.
Corrections of errors involving accounting principles.
3.
€
An example of a change that affects consistency would be a change in the method of computing depreciation from
straight line to an accelerated method. A separate explanatory paragraph is required if the amounts are material.
Comparability refers to items such as changes in estimates, presentation, and events rather than changes in accounting
principles. For example, a change in the estimated life of a depreciable asset will affect the comparability of the state.
ments. In that case, no explanatory paragraph for lack of consistency is needed, but the information may require disclo
sure in the statements.
13)€ List the three conditions that require a departure from unqualified opinion and give one specific example of
each those conditions.
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&: The three conditions requiring a departure from an unqualified opinion are:
The scope of the audit has been restricted.€ One example is when the client will not permit the auditor to confirm ma
terial receivables. Another example is when the engagement is not agreed upon until after the client’s year.end
when it may be impossible to physically observe inventories.
1.
The financial statements have not been prepared in accordance with generally accepted accounting principles.€ An ex
ample is when the client insists upon using replacement costs for fixed assets.
2.
The auditor is not independent.€ An example is when the auditor owns stock in the client’s business.
3.
€
14)€ Distinguish between a qualified opinion, adverse opinion, and a disclaimer of opinion, and explain the cir7
cumstances under which each is appropriate.
&: A qualified opinion states that there has been either a limitation on the scope of the audit or a 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.
An adverse opinion states that the auditor believes the overall financial statements are so materially misstated or mis.
leading that they do not present fairly in accordance with GAAP the financial position, results of operations, or cash
flows.
A disclaimer of opinion states that the auditor has been unable to satisfy him or herself as to whether or not the overall
nancial statements are fairly presented because of a significant limitation of the scope of the audit, or a non.independen
relationship under the Code of Professional Conduct between the auditor and the client.
Examples of situations that are appropriate for each type of opinion are as follows:
€
OPINION
TYPE
EXAMPLE SITUATION
Disclaimer
€
Material physical inventories not observed and the inventory cannot be verified through other proce.
dures.
Lack of independence by the auditor.
Adverse A highly material departure from GAAP.
Qualified Inability to confirm the existence of an asset which is material but not extremely material in value.
€
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15)€ Define materiality as it is used in audit reporting. What conditions will affect the auditor’s determination of
materiality?
&: The common definition of materiality as it applies to accounting and, therefore, to audit reporting is:
A misstatement in the financial statements can be considered material if knowledge of the misstatement would affect a
decision of a reasonable user of the statements.
Conditions that affect the auditor’s determination of materiality include:
<€€€€€€ Potential users of the financial statements
<€€€€€€ Dollar amounts of the following items: net income before taxes, total assets, current assets, current liabilities, and
owners’ equity
Nature of the potential misstatements—certain misstatements, such as fraud, are likely to be more important to users o
the financial statements than other misstatements.
16)€ Explain how materiality differs for failure to follow GAAP and for lack of independence.
&: Materiality for lack of independence in audit reporting is easiest to define. If the auditor lacks independence as defined
by the Code of Professional Conduct, it is always considered highly material and therefore a disclaimer of opinion is alway
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.
17)€ How does the auditor’s opinion differ between scope limitations caused by client restrictions and limitations
resulting from conditions beyond the client’s control? Under which of these two would the auditor be most likely
to issue a disclaimer of opinion? Explain.
&: The auditor’s opinion may be qualified by scope limitations caused by client restrictions or by limitations resulting
from conditions beyond the client’s control. The former occurs when the client will not, for example, permit the auditor t
confirm material receivables or physically observe inventories. The latter may occur when the engagement is not agreed
upon until after the client’s year.end when it may not be possible to physically observe inventories or confirm receivables
A disclaimer of opinion is issued if the scope limitation is so material that the auditor cannot determine if the overall fi
nancial statements are fairly presented. If the scope limitation is caused by the client’s restriction the auditor should be
aware that the reason for the restriction might be to deceive the auditor. For this reason, a disclaimer is more likely for
client restrictions than for conditions beyond anyone’s control.
When there is a scope restriction that results in the failure to verify material, but not pervasive accounts, a qualified opin
ion may be issued. This is more likely when the scope limitation is for conditions beyond the client’s control than for re
strictions by the client.
18)€ Distinguish between a report qualified as to opinion only and one with both a scope and opinion qualifica
tion.
&: A report with a scope and an opinion qualification is issued when the auditor can neither perform procedures that he
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or she considers necessary nor satisfy him or herself by using alternative procedures, due to the existence of conditions
beyond the client’s or the auditor’s control, but the amount involved in the financial statements is not highly material. An
important part of a scope and opinion qualification is that it results from not accumulating sufficient audit evidence, ei
ther because of the client’s request or because of circumstances beyond anyone’s control.
A report qualified as to opinion only results when the auditor has accumulated sufficient competent evidence but has
concluded that the financial statements are not correctly stated. The only circumstance in which an opinion only qualifi
cation is appropriate is for material, but not highly material, departures from GAAP.
€
19)€ Identify the three alternative opinion that may be appropriate when the client’s financial statements are
not accordance with GAAP. Under what circumstances is each appropriate.
&: The three alternative opinions that may be appropriate when the client’s financial statements are not in accordance
with GAAP are an unqualified opinion, qualified as to opinion only and adverse opinion. Determining which is appropriate
depends entirely upon materiality. An unqualified opinion is appropriate if the GAAP departure is immaterial (standard
unqualified) or if the auditor agrees with the client’s departure from GAAP (unqualified with explanatory paragraph). A
qualified opinion is appropriate when the deviation from GAAP is material but not highly material; the adverse opinion is
appropriate when the deviation is highly material.
20)€ Discuss why the AICPA has such strict requirements on audit opinions when the auditor is not independent.
&: The AICPA has such strict requirements on audit opinions when the auditor is not independent because it is importan
that stockholders and other third parties be absolutely assured that the auditor is unbiased throughout the entire en.
gagement. If users develop the attitude that auditors are not independent of management, the value of the audit functio
will be greatly reduced, if not eliminated.
21)€ When an auditor discovers more than one condition that requires departure from or modification of stan
dard unqualified report, what should the auditor’s report include?
&: When the auditor discovers more than one condition that requires a departure from or a modification of a standard
unqualified 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 sit
uation the lack of independence overshadows the scope limitation. Accordingly, the scope limitation should not be men
tioned.
22)€ What responsibility does the auditor have for information on the company’s web site that may be inked to
electronic versions of the company’s annual financial statements and auditor’s report? How does this differ
from the auditor’s responsibility for other information in the company’s annual report that includes the finan
cial statements and auditor’s report?
&: Under current auditing standards, auditors are not required to read information contained in electronic sites, such as
the company’s Web site, that also contain the company’s audited financial statements and the auditor’s report. Auditing
standards do not consider electronic sites to be “documents.”€ This is different from the auditor’s responsibility for pub
lished (hard copy) documents that contain information in addition to audited financial statements and the auditor’s re
port. In this latter example, the auditor is responsible for reading other information that is published with audited finan
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cial statements and the auditor’s report to determine whether it is materially inconsistent with information in the audited
financial statements.
€
€
The Audit Process.Audit Responsibilities and objectives
1)€€€€€ State the objective of the audit of financial statements. In general terms, how do auditors meet that objec
tive?
J: The objective of the audit of financial statements by the independent auditor is the expression of an opinion on the fair
ness with which the financial statements present financial position, results of operations, and cash flows in conformity
with generally accepted accounting principles.
The auditor meets that objective by accumulating sufficient competent evidence to determine whether the financial
statements are fairly stated.
2)€€€€€ Distinguish between management’s and auditor’s responsibility for the financial statements being audited
J: It is management’s responsibility to adopt sound accounting policies, maintain adequate internal control and make fair
representations in the financial statements. The auditor’s responsibility is to conduct an audit of the financial statements
in accordance with auditing standards and report the findings of the audit in the auditor’s report.
3)€€€€€ Distinguish between the terms errors and fraud. What is the auditor’s responsibility for finding each?
J: An error is an unintentional misstatement of the financial statements. Fraud represents intentional misstatements. The
auditor is responsible for obtaining reasonable assurance that material misstatements in the financial statements are de
tected, whether those misstatements are due to errors or fraud.
An audit must be designed to provide reasonable assurance of detecting material misstatements in the financial state
ments. Further, the audit must be planned and performed with an attitude of professional skepticism in all aspects of the
engagement. Because there is an attempt at concealment of fraud, material misstatements due to fraud are usually
more difficult to uncover than errors. The auditor’s best defense when material misstatements (either errors or fraud)
are not uncovered in the audit is that the audit was conducted in accordance with auditing standards.
4)€€€€€ Distinguish between fraudulent financial reporting and misappropriation of assets. Discuss the likely diff
fference between those two types of fraud on the fair presentation of financial statements.
J: Misappropriation of assets represents the theft of assets by employees. Fraudulent financial reporting is the intentiona
misstatement of financial information by management or a theft of assets by management, which is covered up by mis
stating financial statements.
Misappropriation of assets ordinarily occurs either because of inadequate internal controls or a violation of existing con
trols. The best way to prevent theft of assets is through adequate internal controls that function effectively. Many times
theft of assets is relatively small in dollar amounts and will have no effect on the fair presentation of financial state.
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ments. There are also the cases of large theft of assets that result in bankruptcy to the company. Fraudulent financial re
porting is inherently difficult to uncover because it is possible for one or more members of management to override in
ternal controls. In many cases the amounts are extremely large and may affect the fair presentation of financial state.
ments
5)€€€€€ “It is well accepted in auditing that throughout the conduct of the ordinary audit, it is essential to obtain
large amounts of information from management and to rely heavily on management’s judgments. After all, the
financial statements are management’s representations, and simple, it is extremely difficult, if not impossible,
for the auditor to evaluate the obsolescence inventory as well as management can in a highly complex business
Similarly, the collectability of accounts receivable and the continued usefulness of machinery and equipment
are heavily dependent on management’s willingness to provide truthful responses to questions.” Reconcile the
auditor’s responsibility for discovering material misrepresentations by management with these comments.
J: True, the auditor must rely on management for certain information in the conduct of his or her audit. However, the au
ditor must not accept management’s representations blindly. The auditor must, whenever possible, obtain competent ev
idential matter to support the representations of management. As an example, if management represents that certain in
ventory is not obsolete, the auditor should be able to examine purchase orders from customers that prove part of the in
ventory is being sold at a price that is higher than the company’s cost plus selling expenses. If management represents
an account receivable as being fully collectible, the auditor should be able to examine subsequent payments by the cus
tomer or correspondence from the customer that indicates a willingness and ability to pay.
6)€€€€€ List two major characteristics that are useful in predicting the likelihood of fraudulent financial reporting
in an audit. For each of the characteristics, state two things that the auditor can do to evaluate its significance
in the engagement.
J:
CHARACTERISTIC AUDIT STEPS
Management’s characteristics and in.
fluence over the control environment.
1. <€€ Investigate the past history of the firm and its management.
<€€ Discuss the possibility of fraudulent financial reporting with previous auditor
and company legal counsel after obtaining permission to do so from management.
Industry conditions.
1.
€
€
<€€ Research current status of industry and compare industry financial ratios to the
company’s ratios. Investigate any unusual differences.
<€€ Read AICPA’s Industry Audit Risk Alert for the company’s industry, if available.
Consider the impact of specific risks that are identified on the conduct of the audit.
Operating characteristics and financial
stability.
1. <€€ Perform analytical procedures to evaluate the possibility of business failure.
<€€ Investigate whether material transactions occur close to year.end.
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€
€
7)€€€€€ Describe what is meant by the cycle approach to auditing. What are the advantages of dividing the audit
into different cycles?
J: The cycle approach is a method of dividing the audit such that closely related types of transactions and account bal.
ances are included in the same cycle. For example, sales, sales returns, and cash receipts transactions and the accounts
receivable balance are all a part of the sales and collection cycle. The advantages of dividing the audit into different cycle
are to divide the audit into more manageable parts, to assign tasks to different members of the audit team, and to keep
closely related parts of the audit together.
8)€€€€€ Identify the cycle to which each of the following ledger accounts would ordinarily be assigned: sales, ac7
count payable, retained earnings, account receivable, inventory and repairs and maintenance.
J:
GENERAL LEDGER ACCOUNT CYCLE
Sales
Accounts Payable
Retained Earnings
Accounts Receivable
Inventory
Repairs & Maintenance
Sales & Collection
Acquisition & Payment
Capital Acquisition & Repayment
Sales & Collection
Inventory & Warehousing
Acquisition & Payment
€
9)€€€€€ Why are sales, sales R&A, bad debts, cash discounts, AR, and allowance for uncollectible accounts all in7
cluded in the same cycle?
J: There is a close relationship between each of these accounts. Sales, sales returns and allowances, and cash discounts
all affect accounts receivable. Allowance for uncollectible accounts is closely tied to accounts receivable and should not
be separated. Bad debt expense is closely related to the allowance for uncollectible accounts. To separate these account
from each other implies that they are not closely related. Including them in the same cycle helps the auditor keep their
relationships in mind.
10)€ Define what is meant by a management assertion about financial statements. Identify the five board cate
gories of management assertions.
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J: Management assertions are implied or expressed representations by management about classes of transactions and
the related accounts in the financial statements. These assertions are part of the criteria management uses to record an
disclose accounting information in financial statements. SAS 31 (AU 326) classifies five broad categories of assertions:
€
Existence or occurrence
1.
Completeness
2.
Valuation or allocation
3.
Rights and obligations
4.
Presentation and disclosure
5.
€
11)€ Distinguish between the general audit objectives and management assertions. Why are the general audit
objectives more useful to auditors?
J: General audit objectives follow from and are closely related to management assertions. General audit objectives, how
ever, are intended to provide a framework to help the auditor accumulate sufficient competent evidence required by the
third standard of field work. Audit objectives are more useful to auditors than assertions because they are more detailed
and more closely related to helping the auditor accumulate sufficient competent evidence.
12)€ An acquisition of fixed7asset repair by a construction company is recorded on the wrong date. Which trans
action7related audit objective has been violated? Which transaction7related audit objective has been violated if
the acquisition had been capitalized as a fixed asset rather than expensed?
J:
€
RECORDING MISSTATEMENT
TRANSACTION7RELATED AUDIT
OBJECTIVE VIOLATED
Fixed asset repair is recorded on the wrong date.
€
Repair is capitalized as a fixed asset instead of an expense.
Timing
€
€
Classification
€
13)€ Distinguish between the existence and completeness balance7related audit objectives. State the effect on
nancial statements (overstatement or understatement) of a violation of each in the audit of accounts receiv7
able.
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J: The existence objective deals with whether amounts included in the financial statements should actually be included.
Completeness is the opposite of existence. The completeness objective deals with whether all amounts that should be in
cluded have actually been included.
In the audit of accounts receivable, a nonexistent account receivable will lead to overstatement of the accounts receiv.
able balance. Failure to include a customer’s account receivable balance, which is a violation of completeness, will lead to
understatement of the accounts receivable balance.
14)€ What are specific audit objectives? Explain their relationship to the general audit objectives.
J: Specific audit objectives are the application of the general audit objectives to a given class of transactions or account
balance. There must be at least one specific audit objective for each general audit objective and in many cases there
should be more. Specific audit objectives for a class of transactions or an account balance should be designed such that,
once they have been satisfied, the related general audit objective should also have been satisfied for that class of trans
actions or account.
15)€ Identify the management assertion and general balance7related audit for the specific balance7related audit
objective: All recorded fixed assets exist at the balance sheet date.
J: For the specific balance.related audit objective, all recorded fixed assets exist at the balance sheet date, the manage.
ment assertion and the general balance.related audit objective are both “existence.”
16)€ Explain how management assertions, general balance7related audit objectives, and specific balance7related
audit objectives are developed for an account balance such as accounts receivable.
J: Management assertions and general balance.related audit objectives are consistent for all asset accounts for every au
dit. They were developed by the Auditing Standards Board, practitioners, and academics over a period of time. One or
more specific balance.related audit objectives are developed for each general balance.related audit objective in an audit
area such as accounts receivable. For any given account, a CPA firm may decide on a consistent set of specific balance.
related audit objectives for accounts receivable, or it may decide to use different objectives for different audits.
17)€ Identify the four phases of the audit. What is the relationship of the four phases to the objective of the au
dit of financial statements?
J: The four phases of the audit are:
€
Plan and design an audit approach.
1.
Perform tests of controls and substantive tests of transactions.
2.
Perform analytical procedures and tests of details of balances.
3.
Complete the audit and issue an audit report.
4.
€
The auditor uses these four phases to meet the overall objective of the audit, which is to express an opinion on the fair
ness with which the financial statements present fairly, in all material respects, the financial position, results of opera.
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tions and cash flows in conformity with GAAP. By accumulating sufficient competent evidence for each audit objective,
the overall objective is met. The accumulation of evidence is accomplished by performing the four phases of the audit.
€
€
€
€
€
€
€
€
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€
€
The Audit Process.Audit Evidence
1)€€€€€ Discuss the similarities and differences between evidence in a legal case and evidence in an audit of finan
cial statements.
@: In both a legal case and in an audit of financial statements, evidence is used by an unbiased person to draw conclu.
sions. In addition, the consequences of an incorrect decision in both situations can be equally undesirable. For example,
if a guilty person is set free, society may be in danger if the person repeats his or her illegal act. Similarly, if investors rely
on materially misstated financial statements, they could lose significant amounts of money. Finally, the guilt of a defen
dant in a legal case must be proven beyond a reasonable doubt. This is similar to the concept of sufficient competent evi
dence in an audit situation. As with a judge or jury, an auditor cannot be completely convinced that his or her opinion is
correct, but rather must obtain a high level of assurance.
The nature of evidence in a legal case and in an audit of financial statements differs because a legal case relies heavily on
testimony by witnesses and other parties involved. While inquiry is a form of evidence used by auditors, other more reli
able types of evidence such as confirmation with third parties, physical examination, and documentation are also used
extensively. A legal case also differs from an audit because of the nature of the conclusions made. In a legal case, a judge
or jury decides the guilt or innocence of the defendant. In an audit, the auditor issues one of several audit opinions after
evaluating the evidence.
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2)€€€€€ List the four major evidence decisions that must be made on every audit.
@: The four major audit evidence decisions that must be made on every audit are:
Which audit procedures to use.
1.
What sample size to select for a given procedure.
2.
Which items to select from the population.
3.
When to perform the procedure.
4.
€
3)€€€€€ Describe what is meant by an audit procedure. Why is it important for audit procedures to be carefully
worded?
@: An audit procedure is the detailed instruction for the collection of a type of audit evidence that is to be obtained. Be
cause audit procedures are the instructions to be followed in accumulating evidence, they must be worded carefully to
make sure the instructions are clear.
4)€€€€€ Describe what is meant by an audit program for accounts receivable. What four things should be included
in an audit program?
@: An audit program for accounts receivable is a list of audit procedures that will be used to audit accounts receivable fo
a given client. The audit procedures, sample size, items to select, and timing should be included in the audit program.
5)€€€€€ State the third standard of field work. Explain the meaning of each of the major phrases of the standard.
@: Sufficient competent evidential matter is to be obtained through inspection, observation, inquiries and confirmations
to afford a reasonable basis for an opinion regarding the financial statements under audit. There are three major phrase
of the standard.
€
PHRASE MEANING OF PHRASE
Sufficient competent evidence
€
The auditor must obtain evidence that is reliable and there must be a reasonable quantity of
that evidence.
€
Through inspection, observation,
inquiries and confirmations
€
These are the major types of evidence available for the auditor to use.
€
€ €
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To afford a reasonable basis for
an opinion regarding the financial
statements
The auditor cannot expect to be completely certain that the financial statements are fairly pre
sented but there must be persuasive evidence. The collection of evidence gathered by the au
ditor provides the basis for the auditor’s opinion.
€
6)€€€€€ Explain why the auditor can be persuaded only with a reasonable level of assurance, rather than convinced
that the financial statements are correct.
@: There are two primary reasons why the auditor can only be persuaded with a reasonable level of assurance, rather
than be convinced that the financial statements are correct:
€
The cost of accumulating evidence. It would be extremely costly for the auditor to gather enough evidence to be
completely convinced.
1.
Evidence is normally not sufficiently reliable to enable the auditor to be completely convinced. For example, confi
mations from customers may come back with erroneous information, which is the fault of the customer rather
than the client.
2.
€
7)€€€€€ Identify the two factors, that determine the persuasiveness of evidence. How are these two factors related
to audit procedures, sample size, items to select, and timing?
@: The two determinants of the persuasiveness of evidence are competency and sufficiency. Competency refers to the
degree to which evidence can be considered believable or worthy of trust. Competency relates to the audit procedures
selected, including the timing of when those procedures are performed. Sufficiency refers to the quantity of evidence an
it is related to sample size and items to select.
8)€€€€€ Identify the seven characteristics that determine the competence of evidence. For each characteristics,
provide one example of a type of evidence that is likely to be competent.
778€€€€€€€€€€€€€ @: Following are seven characteristics that determine competence and an example of each.
€
FACTOR
DETERMINING COMPETENCE
EXAMPLE OF
COMPETENT EVIDENCE
Relevance
€
Trace inventory items located in the warehouse to their inclusion in the inventory sub.
sidiary records
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€
Independence of provider
€
Confirmation of a bank balance
€
€
Effectiveness of client’s internal con.
trols
€
Use of duplicate sales invoices for a large well.run company
€
Auditor’s direct knowledge Physical examination of inventory by the auditor
€
Qualifications of provider
€
Letter from an attorney dealing with the client’s affairs
€
Degree of objectivity
€
Count of cash on hand by auditor
Timeliness Observe inventory on the last day of the fiscal year
€
9)€€€€€ List the seven types of audit evidence included in this chapter and give two examples of each.
@:
TYPES OF AUDIT EVI7
DENCE
EXAMPLES
Physical examina.
tion
1. <€€ Count petty cash on hand
<€€ Examine fixed asset additions
€
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Confirmation
1. <€€ Confirm accounts receivable balances of a sample of client customers
<€€ Confirm client’s cash balance with bank
€
Documentation
1. <€€ Examine cancelled checks returned with cutoff bank statement
<€€ Examine vendors’ invoices supporting a sample of cash disbursement transactions throughout the
year
€
Analytical proce.
dures
1. <€€ Evaluate reasonableness of receivables by calculating and comparing ratios
<€€ Compare expenses as a percentage of net sales with prior year’s percentages
€
€
€
€
TYPES OF AUDIT EVIDENCE EXAMPLES
Inquiries of the client
1. <€€ Inquire of management whether there is obsolete inventory
<€€ Inquire of management regarding the collectibility of large accounts receivable balances
€
Re.performance
1.
€
€
Observation
1.
€
<€€ Re.compute invoice total by multiplying item price times quantity sold
<€€ Food the sales journal for a one.month period and compare all totals to the general ledger
€
<€€ Observe client employees in the process of counting inventory
<€€ Observe whether employees are restricted from access to the check signing machine
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€ €
€
10)€ What are the four characteristics of the definition of a confirmation? Distinguish between a confirmation
and external documentation.
@: The four characteristics of the definition of a confirmation are:
Receipt
1.
Written or oral response
2.
From independent third party
3.
Requested by the auditor
4.
€
A confirmation is prepared specifically for the auditor and comes from an external source. External documentation is in
the hands of the client at the time of the audit and was prepared for the client’s use in the day.to.day operation of the
business.
11)€ Distinguish between internal documentation and external documentation as audit evidence and give three
examples of each.
@: Internal documentation is prepared and used within the client’s organization without ever going to an outside party,
such as a customer or vendor.
Internal documentation is prepared and used within the client’s organization without ever going to an outside party, such
as a customer or vendor.
Examples:
<€€€€€€ check request form
<€€€€€€ receiving report
<€€€€€€ payroll time card
<€€€€€€ adjusting journal entry
€
External documentation either originated with an outside party or was an internal document that went to an outside party
and is now either in the hands of the client or is readily accessible.
Examples:
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<€€€€€€ vendor’s invoice
<€€€€€€ cancelled check
<€€€€€€ cancelled note
<€€€€€€ validated deposit slip
€
12)€ Explain the importance of analytical procedures as evidence in determining the fair presentation of the fi
nancial statements.
@: Analytical procedures are useful for indicating account balances that may be distorted by unusual or significant trans
actions and that should be intensively investigated. They are also useful in reviewing accounts or transactions for reason
ableness to corroborate tentative conclusions reached on the basis of other evidence.
13)€ Identify the most important reasons for performing analytical procedures.
@: The most important reasons for performing analytical procedures are the following:
Understanding the client’s industry and business
1.
Assessment of the entity’s ability to continue as a going concern
2.
Indication of the presence of possible misstatements in the financial statements
3.
Reduction of detailed audit tests
4.
€
14)€ Your client, Harper Company, has a contractual commitment as a part of a bond indenture to maintain a
current ratio of 2.0. if the ratio falls below that level on the balance sheet date, the entire bond becomes
payable immediately. In the current year, the client’s financial statements show that the ratio has dropped
from 2.6 to 2.05 over the past year. How should this situation affect your audit plan?
@: The decrease of the current ratio indicates a liquidity problem for Harper Company since the ratio has dropped to a
level close to the requirements of the bond indenture. Special care should be exercised by the auditor to determine that
the 2.05 ratio is proper since management would be motivated to hide any lower ratio. The auditor should expand proce
dures to test all current assets for proper cutoff and possible overstatement and to test all current liabilities for proper
cutoff and possible understatement.
15)€ Distinguish between attention7directing analytical procedures and those intended to eliminate or reduce
detailed substantive procedures.
@: Attention directing analytical procedures occur when significant, unexpected differences are found between current
year’s unaudited financial data and other data used in comparisons. If an unusual difference is large, the auditor must de
termine the reason for it, and satisfy himself or herself that the cause is a valid economic event and not an error or mis
statement due to fraud.
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When an analytical procedure reveals no unusual fluctuations, the implication is minimized. In that case, the analytical
procedure constitutes substantive evidence in support of the fair statement of the related account balances, and it is
possible to perform fewer detailed substantive tests in connection with those accounts.
Frequently, the same analytical procedures can be used for attention directing and for reducing substantive tests, de.
pending on the outcome of the tests. Simple procedures such as comparing the current year account balance to the prio
year account balance is more attention directing (and provides less assurance) than more complex analytical procedures
i.e., those which rely on regression analysis. More sophisticated analytical procedures help the auditor examine relation
ships between several information variables simultaneously. The nature of these tests may provide greater assurance
than simple procedures.
€
€
16)€ Explain why the statement “Analytical procedures are essential in every part of an audit, but these tests are
rarely sufficient by themselves for any audit area” is correct or incorrect.
@: The statement is correct. Except for certain accounts with small dollar balances, analytical procedures are essential to
help the auditor identify trends in a client’s business and to see the relationship between the client’s performance and in
dustry averages. However, the auditor is responsible for gathering sufficient competent evidential matter through inspec
tion, observation and confirmation in addition to the evidence obtained as a result of the analytical procedures.
17)€ List the purposes of audit documentation and explain why each purpose is important.
@: The purposes of audit documentation are as follows:
To provide a basis for planning the audit. The auditor may use reference information from the previous year in or
der to plan this year’s audit, such as the evaluation of internal control, the time budget, etc.
1.
To provide a record of the evidence accumulated and the results of the tests. This is the primary means of docu.
menting that an adequate audit was performed.
2.
To provide data for deciding the proper type of audit report. Data are used in determining the scope of the audit
and the fairness with which the financial statements are stated.
3.
To provide a basis for review by supervisors and partners. These individuals use the audit documentation to evalu
ate whether sufficient competent evidence was accumulated to justify the audit report.
4.
€
Audit documentation are used for several purposes, both during the audit and after the audit is completed. One of the
uses is the review by more experienced personnel. A second is for planning the subsequent year audit. A third is to
demonstrate that the auditor has accumulated sufficient competent evidence if there’s a need to defend the audit at a
later date. For these uses, it is important that the audit documentation provide sufficient information so that the person
reviewing an audit schedule knows the name of the client, contents of the audit schedule, period covered, who prepared
the audit schedule, when it was prepared, and how it ties into the rest of the audit files with an index code.
The purposes of audit documentation are as follows:
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To provide a basis for planning the audit. The auditor may use reference information from the previous year in or
der to plan this year’s audit, such as the evaluation of internal control, the time budget, etc.
To provide a record of the evidence accumulated and the results of the tests. This is the primary means of
documenting that an adequate audit was performed.
1.
To provide data for deciding the proper type of audit report. Data are used in determining the scope of the
audit and the fairness with which the financial statements are stated.
2.
To provide a basis for review by supervisors and partners. These individuals use the audit documentation to
evaluate whether sufficient competent evidence was accumulated to justify the audit report.
3.
1.
€
Audit documentation are used for several purposes, both during the audit and after the audit is completed. One of the
uses is the review by more experienced personnel. A second is for planning the subsequent year audit. A third is to
demonstrate that the auditor has accumulated sufficient competent evidence if there’s a need to defend the audit at a
later date. For these uses, it is important that the audit documentation provide sufficient information so that the person
reviewing an audit schedule knows the name of the client, contents of the audit schedule, period covered, who prepared
the audit schedule, when it was prepared, and how it ties into the rest of the audit files with an index code.
18)€ What are the two criteria that auditors of public companies consider when determining whether memos,
correspondence, and other documents must be maintained in the audit files?
@: The two criteria used by auditors of public companies when determining whether memos, correspondence, and othe
documents must be maintained in the audit files are as follows:
€
The materials are created, sent, or received in connection with the audit or review.
1.
The materials contain conclusions, opinions, analyses, or financial data related to the audit or review.
2.
€
19)€ For how long does the Sarbanes7Oxley Act require auditors of public companies to retain audit documenta
tion?
@: The Sarbanes.Oxley Act of 2002 requires auditors of public companies to prepare and maintain audit schedules and
other information related to any audit report in sufficient detail to support the auditor’s conclusions, for a period of not
less than 7 years.
20)€ Explain why it is important for audit documentation to include each of the following: identification of the
name of the client, period covered, description of the contents, initial of the preparer, date of the preparation,
and an index code.
@: Audit schedules should include the following:
Name of the client€ Enables the auditor to identify the appropriate file to include the audit schedule in if it is removed from
the files.
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Period covered€ Enables the auditor to identify the appropriate year to which an audit schedule for a client belongs if it is
removed from the files.
Description of the contents€ A list of the contents enables the reviewer to determine whether all important parts of the au
dit schedule have been included. The contents description is also used as a means of identifying audit files in the same
manner that a table of contents is used.
Initials of the preparer Indicates who prepared the audit schedule in case there are questions by the reviewer or someone
who wants information from the files at a later date. It also clearly identifies who is responsible for preparing the audit
documentation if the audit must be defended.
Date of preparation Helps the reviewer to determine the sequence of the preparation of the audit schedules. It is also use
ful for the subsequent year in planning the sequence of preparing audit schedules.
Indexing€ Helps in organizing and filing audit schedules. Indexing also facilitates in searching between related portions of
the audit documentation.
21)€ Define what is meant by a permanent file, and list several types of information typically included. Why does
the auditor not include the contents of the permanent file with the current year’s audit file?
@: The permanent file contains data of an historical and continuing nature pertinent to the current audit. Examples of
items included in the file are:
€
Articles of incorporation
1.
Bylaws, bond indentures, and contracts
2.
Analysis of accounts that have continuing importance to the auditor
3.
Information related to the understanding of internal control:
4.
flowcharts
5.
internal control questionnaires
6.
Results of previous years’ analytical procedures, such as various ratios and percentages compiled by the auditors
7.
€
By separating this information from the current year’s audit files, it becomes easily accessible for the following year’s au
ditors to obtain permanent file data.
22)€ Distinguish between the following types of current period supporting schedules and state the purpose of
each: analysis, trial balance, and tests of reasonableness.
@: The purpose of an analysis is to show the activity in a general ledger account during the entire period under audit, ty
ing together the beginning and ending balances. The trial balance includes the detailed make.up of an ending balance. It
differs from an analysis in that it includes only those items comprising the end of the period balance. A test of reasonable
ness schedule contains information that enables the auditor to evaluate whether a certain account balance appears to be
misstated. One example of a test of reasonableness schedule is a schedule that compares current year expenses to prio
years’ amounts. This type of schedule is intended to show which accounts need investigation due to significant variances
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23)€ €Why is it essential that the auditor not leave questions or exceptions in the audit documentation without
an adequate explanation?
@: Unanswered questions and exceptions may indicate the potential for significant errors or fraud in the financial state
ments. These should be investigated and resolved to make sure that financial statements are fairly presented.
The audit files can also be subpoenaed by courts as legal evidence. Unanswered questions and exceptions may indicate
lack of due care by the auditor.
24)€ Define what is meant by a tick mark. What is its purpose?
@: Tick marks are symbols adjacent to information in audit schedules for the purpose of indicating the work performed
by the auditor. An explanation of the tick mark must be included at the bottom of the audit schedule to indicate what wa
done and who did it.
25)€ Who owns the audit files? Under what circumstances can they be used by other people?
@: Audit files are owned by the auditor. They can be used by the client if the auditor wants to release them after a carefu
consideration of whether there might be confidential information in them. The audit files can be subpoenaed by a court
and thereby become the property of the court. They can be released to another CPA firm without the client’s permission
if they are being reviewed as a part of a voluntary peer review program under AICPA, state CPA society, or state Board of
Accountancy authorization. The audit files can be sold or released to other users if the auditor obtains permission from
the client.
26)€ A CPA sells his auditing practice to another CPA firm and includes all audit files as part of the purchase
price. Under what circumstances is this a violation of the code of professional conduct?
@: It is a violation unless the CPA obtains permission from each client before the audit files for that client are released.
27)€ How does the auditor read and evaluate information that is available only in machine7readable form?
@: When evidence can be examined only in machine.readable form, auditors use computers to read and examine evi.
dence. There are commercial audit software programs designed specifically for use by auditors, such as ACL Software
and Interactive Data Extraction and Analysis (IDEA). Spreadsheet software packages can also be used by auditors to per
form audit tests on data that is available only in machine.readable form.
28)€ Explain the purposes and benefits of audit documentation software.
@: The purposes of audit documentation software are to convert traditional paper.based documentation into electronic
files and to organize the audit documentation. The benefits of audit documentation software, such as Automated Client
Engagement (ACE), are as follows:
€
<€€€€€€ The auditor can more efficiently prepare a trial balance, lead schedules, supporting audit documentation, financial
statements, and ratio analysis using the computer rather than by hand.
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<€€€€€€ The effects of adjusting journal entries are automatically carried through to the trial balance and financial state.
ments, making last.minute adjustments easier to make.
<€€€€€€ Tick marks and review notes can be entered directly into computerized files.
<€€€€€€ Data can be imported and exported to other applications. For example, a client’s general ledger can be downloaded
into ACE and tax information can be downloaded into a commercial tax preparation package after the audit is completed
€
€
€
€
€
€
€
€
€
€
€
€
€
€
€
€
€
€
€
The Audit Process.Audit Planning and Analytical Procedures
24 of 79 1/6/2017 10:03 AM

€
1)€€€€€ what benefits does the auditor derive from planning audits?
$: There are three primary benefits from planning audits: it helps the auditor obtain sufficient competent evidence for th
circumstances, helps keep audit costs reasonable, and helps avoid misunderstandings with the client.
2)€€€€€ Identify the eight major steps in planning audits.
$: Eight major steps in planning audits are:
Accept client and perform initial planning
1.
Understand the client’s business and industry
2.
Assess client business risk
3.
Perform preliminary analytical procedures
4.
Set materiality, and assess acceptable audit risk and inherent risk
5.
Understand internal control and assess control risk
6.
Gather information to assess fraud risks
7.
Develop overall audit plan and audit program
8.
€
3)€€€€€ What are the responsibilities of the successor and predecessor auditors when a company is changing audi
tors?
$: The new auditor (successor) is required by SAS 84 (AU 315) to communicate with the predecessor auditor. This enables
the successor to obtain information about the client so that he or she may evaluate whether to accept the engagement.
Permission must be obtained from the client before communication can be made because of the confidentiality require
ment in the Code of Professional Conduct. The predecessor is required to respond to the successor’s request for informa
tion; however, the response may be limited to stating that no information will be given. The successor auditor should be
wary if the predecessor is reluctant to provide information about the client.
4)€€€€€ What factors should an auditor consider prior to accepting an engagement? Explain.
$: Prior to accepting a client, the auditor should investigate the client. The auditor should evaluate the client’s standing in
the business community, financial stability, and relations with its previous CPA firm. The primary purpose of new client
investigation is to ascertain the integrity of the client and the possibility of fraud. The auditor should be especially con.
cerned with the possibility of fraudulent financial reporting since it is difficult to uncover. The auditor does not want to
needlessly expose himself or herself to the possibility of a lawsuit for failure to detect such fraud.
5)€€€€€ What is the purpose of an engagement letter? What subjects should be covered in such a letter?
$: An engagement letter is an agreement between the CPA firm and the client concerning the conduct of the audit and re
lated services. It should state what services will be provided, whether any restrictions will be imposed on the auditor’s
work, deadlines for completing the audit, and assistance to be provided by client personnel. The engagement letter may
also include the auditor’s fees. In addition, the engagement letter informs the client that the auditor cannot guarantee
that all acts of fraud will be discovered.
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6)€€€€€ Who is considered “the client” when auditing public companies?
$: Because the Sarbanes.Oxley Act of 2002 explicitly shifts responsibility for hiring and firing of the auditor from manage
ment to the audit committee for public companies, the audit committee is viewed as “the client” in those engagements.
7)€€€€€ Which services must be preapproved by the audit committee a public company?
$: All audit and non.audit services must be preapproved in advance by the audit committee for public companies.
8)€€€€€ Explain why auditors need an understanding of the client’s industry. What sources are commonly used by
auditors to learn about the client’s industry?
$: Auditors need an understanding of the client’s business and industry because the nature of the business and industry
affect business risk and the risk of material misstatements in the financial statements. Auditors use the knowledge of
these risks to determine the appropriate extent of audit evidence to accumulate.
The five major aspects of understanding the client’s business and industry, along with potential sources of information
that auditors commonly use for each of the five areas are as follows:
Industry and External Environment – Read industry trade publications, AICPA Industry Audit Guides, and regulatory
requirements.
1.
Business Operations and Processes – Tour the plant and offices, identify related parties, and inquire of management
2.
Management and Governance – Read the corporate charter and bylaws, read minutes of board of directors and
stockholders, and inquire of management.
3.
Client Objectives and Strategies – Inquire of management regarding their objectives for the reliability of financial re
porting, effectiveness and efficiency of operations, and compliance with laws and regulations; read contracts and
other legal documents, such as those for notes and bonds payable, stock options, and pension plans.
4.
Measurement and Performance – Read financial statements, perform ratio analysis, and inquire of management
about key performance indicators that management uses to measure progress toward its objectives.
5.
€
9)€€€€€ When a CPA has accepted an engagement from a new client who is manufacturer, it is customary for the
CPA to tour the client’s plant facilities. Discuss the ways in which the CPA’s observations made during the course
of the plant tour will be of help in planning and conducting the audit.
$: During the course of the plant tour the CPA will remember that an important aspect of the audit will be an effective
analysis of the cost system. Therefore, the auditor will observe the nature of the company’s products, the manufacturing
facilities and processes, and the flow of materials so that the information obtained can later be related to the functions
of the cost system.
The nature of the company’s products and the manufacturing facilities and processes will reveal the features of the cost
system that will require close audit attention. For example, the audit of a company engaged in the custom.manufacture
of costly products such as yachts would require attention to the correct charging of material and labor to specific jobs,
whereas the allocation of material and labor charges in the audit of a beverage.bottling plant would not be verified on th
same basis. The CPA will note the stages at which finished products emerge and where additional materials must be
added. He or she will also be alert for points at which scrap is generated or spoilage occurs. The auditor may find it advis
26 of 79 1/6/2017 10:03 AM

able, after viewing the operations, to refer to auditing literature for problems encountered and solved by other CPAs in
similar audits.
The auditor’s observation of the manufacturing processes will reveal whether there is idle plant or machinery that may
require disclosure in the financial statements. Should the machinery appear to be old or poorly maintained, the CPA
might expect to find heavy expenditures in the accounts for repairs and maintenance. On the other hand, if the auditor
determines that the company has recently installed new equipment or constructed a new building, he or she will expect
to find these new assets on the books.
In studying the flow of materials, the auditor will be alert for possible problems that may arise in connection with the ob
servation of the physical inventory, and he or she may make preliminary estimates of audit staff requirements. In this re
gard, the auditor will notice the various storage areas and how the materials are stored. The auditor may also keep in
mind for further investigation any apparently obsolete inventory.
The auditor’s study of the flow of materials will disclose the points at which various documents such as material requisi
tions arise. He or she will also meet some of the key manufacturing personnel who may give the auditor an insight into
production problems and other matters such as excess or obsolete materials, and scrap and spoilage. The auditor will be
alert for the attitude of the manufacturing personnel toward accounting controls. The CPA may make some inquiries
about the methods of production scheduling, timekeeping procedures and whether work standards are employed. As a
result of these observations, the internal documents that relate to the flow of materials will be more meaningful as ac
counting evidence.
The CPA’s tour of the plant will give him or her an understanding of the plant terminology that will enable the CPA to
communicate fluently with the client’s personnel. The measures taken by the client to safeguard assets, such as protec
tion of inventory from fire or theft, will be an indication of the client’s attention to internal control measures. The location
of the receiving and shipping departments and the procedures in effect will bear upon the CPA’s evaluation of internal
control. The auditor’s overall impression of the client’s plant will suggest the accuracy and adequacy of the accounting
records that will be audited.
10)€ An auditor often tries to acquire background knowledge of the client’s industry as an aid to audit work. How
does the acquisition of this knowledge aid the auditor in distinguishing between obsolete and current inven7
tory?
$: One type of information the auditor obtains in gaining knowledge about the clients’ industry is the nature of the client’s
products, including the likelihood of their technological obsolescence and future salability. This information is essential in
helping the auditor evaluate whether the client’s inventory may be obsolete or have a market value lower than cost.
11)€ Define what is meant by a related party. What are the auditor’s responsibilities for related parties and re
lated party transactions?
$: A related party is defined in SAS 45 (AU 334) as an affiliated company, principal owner of the client company, or any
other party with which the client deals where one of the parties can influence the management or operating policies of
the other.
Material related party transactions must be disclosed in the financial statements by management. Therefore, the auditor
must identify related parties and make a reasonable effort to determine that all material related party transactions have
been properly disclosed in the financial statements.
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12)€ Which types of loans to executives are permitted by the Sarbanes7Oxley Act?
$: Because of the lack of independence between the parties involved, the Sarbanes.Oxley Act prohibits related party
transactions that involve personal loans to executives. It is now unlawful for any public company to provide personal
credit or loans to any director or executive officer of the company. Banks or other financial institutions are permitted to
make normal loans to their directors and officers using market rates, such as residential mortgages.
€
13)€ Your firm has performed the audit of Rogers Company for several years and you have been assigned the au
dit responsibility for the current audit. How would you review of the corporate charter and bylaws for this audit
differ from that of the audit of a client who was audited by a different CPA firm in the preceding year?
$: In the audit of a client previously audited by a different CPA firm, it would be necessary to obtain a copy of the corpo
rate charter and bylaws for the permanent files and to read these documents and prepare a summary abstract of items
to test for compliance. In an ongoing engagement, this work has been performed in the past and is unnecessary each
year. The auditor’s responsibility is to determine what changes have been made during the current year and to update
and review the summary abstract prepared in previous years for compliance.
14)€ For the audit of Radline Manufacturing Company, the audit partner asks you to carefully read the new mort
gage contract with the First National Bank and abstract all pertinent information. List the information in a
mortgage that is likely to be relevant to the auditor.
The information in a mortgage that is likely to be relevant to the auditor includes the following:
€
The parties to the agreement
1.
The effective date of the agreement
2.
The amounts included in the agreement
3.
The repayment schedule required by the agreement
4.
The definition and terms of default
5.
Prepayment options and penalties specified in the agreement
6.
Assets pledged or encumbered by the agreement
7.
Liquidity restrictions imposed by the agreement
8.
Purchase restrictions imposed by the agreement
9.
Operating restrictions imposed by the agreement
10.
Requirements for audit reports or other types of reports on compliance with the agreement
11.
The interest rate specified in the agreement
12.
Any other requirements, limitations, or agreements specified in the document
13.
€
15)€ Identify two types of information in the client’s minutes of the board of directors meetings that are likely to
be relevant to the auditor. Explain why it is important to read the minutes early in the engagement.
$: Information in the client’s minutes that is likely to be relevant to the auditor includes the following:
28 of 79 1/6/2017 10:03 AM

Declaration of dividends
1.
Authorized compensation of officers
2.
Acceptance of contracts and agreements
3.
Authorization for the acquisition of property
4.
Approval of mergers
5.
Authorization of long.term loans
6.
Approval to pledge securities
7.
Authorization of individuals to sign checks
8.
Reports on the progress of operations
9.
€
It is important to read the minutes early in the engagement to identify items that need to be followed up on as a part of
conducting the audit. For instance, if a long.term loan is authorized in the minutes, the auditor will want to make certain
that the loan is recorded as part of long.term liabilities.
€
€
16)€ Identify the three categories of client objectives. Indicate how each objective may affect the auditor’s as7
sessment of inherent risk and evidence accumulation.
$: The three categories of client objectives are (1) reliability of financial reporting, (2) effectiveness and efficiency of opera
tions, and (3) compliance with laws and regulations. Each of these objectives affects the auditor’s assessment of inheren
risk and evidence accumulation as follows:
€
Reliability of financial reporting – If management sees the reliability of financial reporting as an important objective,
and if the auditor can determine that the financial reporting system is accurate and reliable, then the auditor can
often reduce inherent risk and planned evidence accumulation for material accounts. In contrast, if management
has little regard for the reliability of financial reporting, the auditor must increase inherent risk assessments and
gather more evidence during the audit.
1.
Effectiveness and efficiency of operations – This area is of primary concern to most clients. Auditors need knowledge
about the effectiveness and efficiency of a client’s operations in order to assess client business risk and inherent
risk in the financial statements. For example, if a client is experiencing inventory management problems, this would
most likely increase both the auditor’s assessment of inherent risk for the planned evidence accumulation for in
ventory.
2.
Compliance with laws and regulations – It is important for the auditor to understand the laws and regulations that
affect an audit client, including significant contracts signed by the client. For example, the provisions in a pension
plan document would significantly affect the auditor’s assessment of inherent risk and evidence accumulation in
the audit of unfunded liability for pensions. If the client were in violation of the provisions of the pension plan docu
ment, inherent risk and planned evidence for pension.related accounts would increase.
3.
€
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17)€ What is the purpose of the client’s performance measurement system? Give examples of key performance
indicators for the following business: (1) a chain of retail clothing stores; (2) an internet portal; (3) a hotel chain.
$: The purpose of a client’s performance measurement system is to measure the client’s progress toward specific objec
tives. Performance measurement includes ratio analysis and benchmarking against key competitors.
Performance measurements for a chain of retail clothing stores could include gross profit by product line, sales returns
as a percentage of clothing sales, and inventory turnover by product line. An Internet portal’s performance measure.
ments might include number of Web site hits or search engine speed. A hotel chain’s performance measures include va
cancy percentages and supply cost per rented room.
€
18)€ Define client business risk and describe several sources of client business risk. What is the auditor’s primary
concern when evaluating client business risk?
$: Client business risk is the risk that the client will fail to achieve its objectives. Sources of client business risk include any
of the factors affecting the client and its environment, including competitor performance, new technology, industry con
ditions, and the regulatory environment. The auditor’s primary concern when evaluating client business risk is the risk of
material misstatements in the financial statements due to client business risk. For example, if the client’s industry is ex
periencing a significant and unexpected downturn, client business risk increases. This increase would most likely in.
crease the risk of material misstatements in the financial statements. The auditor’s assessment of the risk of
€
material misstatements is then used to classify risks using the audit risk model to determine the appropriate extent of
audit evidence.
€
19)€ Describe top management controls and their relation to client business risk. Give examples of effective
management and governance controls.
$: Management establishes the strategies and business processes followed by a client’s business. One top management
control is management’s philosophy and operating style, including management’s attitude toward the importance of in
ternal control. Other top management controls include a well.defined organizational structure, an effective board of di
rectors, and an involved and effective audit committee. If the board of directors is effective, this increases management’s
ability to appropriately respond to risks. An effective audit committee can help management reduce the likelihood of
overly aggressive accounting.
€
20)€ What are the purposes of preliminary analytical procedures? What types of comparisons are useful when
performing preliminary analytical procedures?
$: Analytical procedures are performed during the planning phase of an engagement to assist the auditor in determining
the nature, extent, and timing of work to be performed. Preliminary analytical procedures also help the auditor identify
30 of 79 1/6/2017 10:03 AM

accounts and classes of transactions where misstatements are likely. Comparisons that are useful when performing pre
liminary analytical procedures include:
€
<€€€€€€ Compare client and industry data
<€€€€€€ Compare client data with similar prior period data
<€€€€€€ Compare client data with client.determined expected results
<€€€€€€ Compare client data with auditor.determined expected results
<€€€€€€ Compare client data with expected results, using nonfinancial data
€
21)€ When are analytical procedures required to be performed during the audit? What is the primary purpose of
analytical procedures performed during the completion phase of the audit?
$: Analytical procedures are required during two phases of the audit: (1) during the planning phase to assist the auditor in
determining the nature, extent, and timing of work to be performed and (2) during the completion phase, as a final re.
view for material misstatements or financial problems. Analytical procedures are also often done during the testing
phase of the audit, but they are not required in this phase.
€
22)€ Gale Gordon, CPA, has found ratio and trend analysis relatively useless as a tool in conducting audits. For
several engagement, he computed the industry ratios included in publications by Robert Morris Associates and
compared them with industry standards. For most engagements, the client’s business was significantly differ
ent from the industry data in the publication and the client would automatically explain away any discrepancies
by attributing them to the unique nature of its operations. In cases in which the client had more than one
branch in different industries, Gordon found the ratio analysis no help at all. How could Gordon improve the
quality of his analytical procedures?
$: Gordon could improve the quality of his analytical tests by:
Making internal comparisons to ratios of previous years.
1.
In cases where the client has more than one branch in different industries, computing the ratios for each branch
and comparing these to the industry ratios.
2.
€
23)€ At the completion of every audit, Roger Morris, CPA, calculates a large number of ratios and trends for com
parison with industry averages and prior7year calculations. He believes the calculations are worth the relatively
small cost of doing them because they provide him with an excellent overview of the client’s operations. If the
ratios are out of line, Morris discusses the reasons with the client and often make suggestions on how to bring
31 of 79 1/6/2017 10:03 AM

the ratio back in line in the future. In some cases, these discussions with management have been the basis for
management consulting engagements. Discuss the major strengths and shortcomings in Morris’s use of ratio
and trend analysis.
$: Roger Morris performs his ratio and trend analysis at the end of every audit. By that time, the audit procedures are
completed. If the analysis was done at an interim date, the scope of the audit could be adjusted to compensate for the
findings. SAS 56 (AU 329) requires that analytical procedures be performed in the planning phase of the audit and near
the completion of the audit.
The use of ratio and trend analysis appears to give Roger Morris an insight into his client’s business and affords him an
opportunity to provide excellent business advice to his client.
24)€ Name the four categories of financial ratios and give an example of a ratio in each category. What is the pri
mary information provided by each financial ratio category?
$: The four categories of financial ratios and examples of ratios in each category are as follows:
€
Short.term debt.paying ability – Cash ratio, quick ratio, and current ratio.
1.
Liquidity activity – Accounts receivable turnover, days to collect receivables, inventory turnover, and days to sell in
ventory.
2.
Ability to meet long.term debt obligations – Debt to equity and times interest earned.
3.
Profitability – Earnings per share, gross profit percent, profit margin, return on assets, and return on common eq
uity
4.
€
€
€
€
€
€
€
€
€
€
€
32 of 79 1/6/2017 10:03 AM

€
€
€
The Audit Process.Materiality and Risk
1)€€€€€ Chapter 8 introduced the eight parts of the planning phase of an audit. Which part is the evaluation of ma
teriality and risk?
B: The planning phases are: accept client and perform initial planning, understand the client’s business and industry, as
sess client business risk, perform preliminary analytical procedures, set materiality and assess acceptable audit risk and
inherent risk, understand internal control and assess control risk, gather information to assess fraud risk, and develop
overall audit plan and audit program. Evaluation of materiality is part of phase five. Risk assessment is part of phase
three (client business risk), phase five (acceptable audit risk and inherent risk), phase six (control risk), and phase seven
(fraud risk).
2)€€€€€ Define the meaning of the term materiality as it is used in accounting and auditing. What is the relation7
ship between materiality and the phrase obtain reasonable assurance used in the auditor’s report?
B: Materiality is defined as: the magnitude of an omission or misstatement of accounting information that, in light of the
surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information
would have been changed or influenced by the omission or misstatement.
“Obtain reasonable assurance,” as used in the audit report, means that the auditor does not guarantee or insure the fair
presentation of the financial statements. There is some risk that the financial statements contain a material misstate.
ment.
3)€€€€€ Explain why materiality is important but difficult to apply in practice.
B: Materiality is important because if financial statements are materially misstated, users’ decisions may be affected, and
thereby cause financial loss to them. It is difficult to apply because there are often many different users of the financial
statements. The auditor must therefore make an assessment of the likely users and the decisions they will make. Materi
ality is also difficult to apply because it is a relative concept. The professional auditing standards offer little specific guid
ance regarding the application of materiality. The auditor must, therefore, exercise considerable professional judgment
in the application of materiality.
4)€€€€€ What is meant by setting a preliminary judgment about materiality? Identify the most important factors
affecting the preliminary judgment.
B: The preliminary judgment about materiality is the maximum amount by which the auditor believes the financial state
ments could be misstated and still not affect the decisions of reasonable users. Several factors affect the preliminary
judgment about materiality and are as follows:
1.€€€€€€€€ Materiality is a relative rather than an absolute concept.
33 of 79 1/6/2017 10:03 AM

2.€€€€€€€€ Bases are needed for evaluating materiality.
3.€€€€€€€€ Qualitative factors affect materiality decisions.
4.€€€€€€€€€€€€€€€€€€€€ Expected distribution of the financial statements will affect the preliminary judgment of materiality. If the
nancial statements are widely distributed to users, the preliminary judgment of materiality will probably be set lower
than if the financial statements are not expected to be widely distributed.
5.€€€€€€€€ The level of acceptable audit risk will also affect the preliminary judgment of materiality.
5)€€€€€ What is meant by using bases for setting a preliminary judgment about materiality? How would those
bases differ for the audit of a manufacturing company and a government unit such as school district?
B: Because materiality is relative rather than absolute, it is necessary to have bases for establishing whether misstate.
ments are material. For example, in the audit of a manufacturing company, the auditor might use as bases: net income
before taxes, total assets, current assets, and working capital. For a governmental unit, such as a school district, there is
no net income before taxes, and therefore that would be an unavailable base. Instead, the primary bases would likely be
fund balances, total assets, and perhaps total revenue.
6)€€€€€ Assume that Rosanne Madden, CPA, is using 5% of net income before tax, current assets, or current liabili
ties as her major guidelines for evaluating materiality. What qualitative factors should she also consider in de
ciding whether misstatements maybe material?
B: The following qualitative factors are likely to be considered in evaluating materiality:
a.€€€€€€€€ Amounts involving fraud are usually considered more important than unintentional errors of equal dollar
amounts.
b.€€€€€€€€ Misstatements that are otherwise minor may be material if there are possible consequences arising from contrac
tual obligations.
c.€€€€€€€€ Misstatements that are otherwise immaterial may be material if they affect a trend in earnings.
7)€€€€€ Distinguish between the terms tolerable misstatement and preliminary judgment about materiality. How
are they related to each other?
B: A preliminary judgment about materiality is set for the financial statements as a whole. Tolerable misstatement is the
maximum amount of misstatement that would be considered material for an individual account balance. The amount of
tolerable misstatement for any given account is dependent upon the preliminary judgment about materiality. Ordinarily,
tolerable misstatement for any given account would have to be lower than the preliminary judgment about materiality. In
many cases, it will be considerably lower because of the possibility of misstatements in different accounts that, in total,
cannot exceed the preliminary judgment about materiality.
8)€€€€€ Assume a company with the following balance sheet accounts:
Account Amount
34 of 79 1/6/2017 10:03 AM

Cash
Fixed Assets
€
Long7Term loans
M. Johnson Proprietor
$10,000
$60,000
$70,000
$30,000
$40,000
$70,000
€€€€€€€€€€€
€€€€€€€€€€€ You are concerned only about overstatement of owner’s equity. Set tolerable misstatement for the three
relevant accounts such that the preliminary judgment about materiality does not exceed $5,000. Justify your an
swer.
B: There are several possible answers to the question. One example is:
€
Cash€€€€€€€€€€€€€€€€€€€€€€€€€€€€€€€€€€€€€€€ $500€€€€€€€€€€ Overstatement
Fixed assets€€€€€€€€€€€€€€€€€€€€€€€€ $3,000€€€€€€€€€€ Overstatement
Long.term loans€€€€€€€€€€€€€€€€€ $1,500€€€€€€€€€€ Understatement
€
Note:€€ Cash and fixed assets are tested for overstatement and long.term loans for understatement because the audi.
tor’s objective in this case is to test for overstatements of owner’s equity.
€
The least amount of tolerable misstatement was allocated to cash and long.term loans because they are relatively easy
to audit. The majority of the total allocation was to fixed assets because there is a greater likelihood of misstatement of
fixed assets in a typical audit.
€
9)€€€€€ Explain what is meant by making an estimate of the total misstatement in a segment and in the overall fi
nancial statements. Why is it important to make these estimates? What is done with them?
B: An estimate of the total misstatement in a segment is the estimate of the total misstatements based upon the sample
results. If only a sample of the population is selected and audited, the auditor must project the total sample misstate.
35 of 79 1/6/2017 10:03 AM

ments to a total estimate. This is done audit area by audit area. The misstatements in each audit area must be totaled to
make an estimate of the total misstatements in the overall financial statements. It is important to make these estimates
so the auditor can evaluate whether the financial statements, taken as a whole, may be materially misstated. The esti.
mate for each segment is compared to tolerable misstatement for that segment and the estimate of the overall misstate
ment on the financial statements is compared to the preliminary judgment about materiality.
10)€ How would the conduct of an audit of a medium7sized company be affected by the company’s being a small
part of a large conglomerate as compared with it being a separate entity?
B: If an audit is being performed on a medium.sized company that is part of a conglomerate, the auditor must make a
materiality judgment based upon the conglomerate. Materiality may be larger for a company that is part of a conglomer
ate because even though the financial statements of the medium.sized company may be misstated, the financial state
ments of the large conglomerate might still be fairly stated. If, however, the auditor is giving a separate opinion on the
medium.sized company, the materiality would be lower than for the audit of a conglomerate.
11)€ Define the audit risk model and explain each term in the model.
B: The audit risk model is as follows:
€
PDR €€€€ =€€€€€€€€€€ € AAR€
IR x CR
Where PDR€€€€€€€ =€€€€€€€€€€€€ Planned detection risk
AAR€€€€€ =€€€€€€€€€€€€ Acceptable audit risk
IR€€€€€€€€€ =€€€€€€€€€€€€ Inherent risk
CR€€€€€€€ =€€€€€€€€€€€€ Control risk
Planned detection risk€ A measure of the risk that audit evidence for a segment will fail to detect misstatements exceeding
a tolerable amount, should such misstatements exist.
Acceptable audit risk€ A measure of how willing the auditor is to accept that the financial statements may be materially
misstated after the audit is completed and an unqualified opinion has been issued.
Inherent risk€ A measure of the auditor’s assessment of the likelihood that there are material misstatements in a segmen
before considering the effectiveness of internal control.
Control risk€ A measure of the auditor’s assessment of the likelihood that misstatements exceeding a tolerable amount in
a segment will not be prevented or detected by the client’s internal controls.
12)€ What is meant by planned detection risk? What is the effect on the amount of evidence the auditor must ac
cumulate when planned detection risk is increased from medium to high?
36 of 79 1/6/2017 10:03 AM

B: Planned detection risk is a measure of the risk that the audit evidence for a segment will fail to detect misstatements
exceeding a tolerable amount, should such misstatements exist. When planned detection risk is increased from medium
to high, the amount of evidence the auditor must accumulate is reduced.
13)€ Explain the causes of an increased or decreased planned detection risk.
B: An increase in planned detection risk may be caused by an increase in acceptable audit risk or a decrease in either con
trol risk or inherent risk. A decrease in planned detection risk is caused by the opposite: a decrease in acceptable audit
risk or an increase in control risk or inherent risk.
14)€ Define what is meant by inherent risk. Identify€ four factors that make for high inherent risk in audits.
B: Inherent risk is a measure of the auditor’s assessment of the likelihood that there are material misstatements in a seg
ment before considering the effectiveness of internal control.
Factors affecting assessment of inherent risk include:
€
<€€€€€€ Nature of the client’s business
<€€€€€€ Results of previous audits
<€€€€€€ Initial vs. repeat engagement
<€€€€€€ Related parties
<€€€€€€ Non.routine transactions
<€€€€€€ Judgment required to correctly record transactions and
<€€€€€€ Makeup of the population
€
15)€ Explain why inherent risk is set for segments rather than for overall audit. What is the effect on the amount
of evidence the auditor must accumulate when inherent risk is increased from medium to high for a segment?
Compare your answer with the one for question 12.
B: Inherent risk is set for segments rather than for the overall audit because misstatements occur in segments. By identi
fying expectations of misstatements in segments, the auditor is thereby able to modify audit evidence by searching for
misstatements in those segments.
When inherent risk is increased from medium to high, the auditor should increase the audit evidence accumulated to de
termine whether the expected misstatement actually occurs. The audit evidence goes in the opposite direction in Review
Question 9.12.
37 of 79 1/6/2017 10:03 AM

16)€ Explain the effect of extensive misstatements found in the prior year’s audit on inherent risk, planned de
tection risk, and planned audit evidence.
B: Extensive misstatements in the prior year’s audit would cause inherent risk to be set at a high level (maybe even 100%)
An increase in inherent risk would lead to a decrease in planned detection risk, which would require that the auditor in
crease the level of planned audit evidence.
17)€ Explain what is meant by term acceptable audit risk. What is its relevance to evidence accumulation?
B: Acceptable audit risk is a measure of how willing the auditor is to accept that the financial statements may be materi
ally misstated after the audit is completed and an unqualified opinion has been issued.
Acceptable audit risk has an inverse relationship to evidence. If acceptable audit risk is reduced, planned evidence should
increase.
18)€ Explain the relationship between acceptable audit risk and the legal liability of auditors.
B: When the auditor is in a situation where he or she believes that there is a high exposure to legal liability, the acceptable
audit risk would be set lower than when there is little exposure to liability. Even when the auditor believes that there is lit
tle exposure to legal liability, there is still a minimum acceptable audit risk that should be met.
19)€ State the three categories of factors that affect acceptable audit risk and list the factors that auditor can
use to indicate the degree to which each category exists.
B: The first category of factors that determine acceptable audit risk is the degree to which users rely on the financial
statements. The following factors are indicators of this:
€
<€€€€€€ Client’s size
<€€€€€€ Distribution of ownership
<€€€€€€ Nature and amount of liabilities
€
The second category of factors is the likelihood that a client will have financial difficulties after the audit report is issued.
Factors affecting this are:
€
<€€€€€€ Liquidity position
<€€€€€€ Profits (losses) in previous years
<€€€€€€ Method of financing growth
38 of 79 1/6/2017 10:03 AM

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