Professional Documents
Culture Documents
Review Questions
13-1 The five types of tests auditors use to determine whether financial
statements are fairly stated include the following:
13-3 Tests of controls are audit procedures to test the operating effectiveness
of control policies and procedures in support of a reduced assessed control risk.
Tests of controls provide the primary basis for a public company auditors report
on internal controls over financial reporting. Specific accounts affected by
13-1
13-3 (continued)
performing tests of controls for the acquisition and payment cycle include the
following: cash, accounts payable, purchases, purchase returns and allowances,
purchase discounts, manufacturing expenses, selling expenses, prepaid insurance,
leasehold improvements, and various administrative expenses.
13-4 Tests of controls are audit procedures to test the operating effectiveness
of control policies and procedures in support of a reduced assessed control risk.
Examples include:
1. The examination of vendor invoices for indication that they have
been clerically tested, compared to a receiving report and purchase
order, and approved for payment.
2. Examination of employee time cards for approval of overtime hours
worked.
3. Examination of journal entries for proper approval.
4. Examination of approvals for the write-off of bad debts.
Substantive tests of transactions are audit procedures testing for monetary
misstatements to determine whether the six transaction-related audit objectives
have been satisfied for each class of transactions. Examples are:
1. Recalculation of amounts (quantity times unit selling price) on
selected sales invoices and tracing of amounts to the sales journal.
2. Examination of vendor invoices in support of amounts recorded in
the acquisitions journal for purchases of inventories.
3. Recalculation of gross pay for selected entries in the payroll journal.
4. Tracing of selected customer cash receipts to the accounts receivable
master file, agreeing customer names and amounts.
13-5 A test of control audit procedure to test that approved wage rates are
used to calculate employees' earnings would be to examine rate authorization
forms to determine the existence of authorized signatures.
A substantive test of transactions audit procedure would be to compare
a sample of rates actually paid, as indicated in the earnings record, to authorized
pay rates on rate authorization forms.
13-6 The auditor resolves the problem by making assumptions about the results
of the tests of controls and performing both the tests of controls and substantive
tests of transactions on the basis of these assumptions. Ordinarily the auditor
assumes an effective system of internal control with few or no exceptions
planned. If the results of the tests of controls are as good as or better than the
assumptions that were originally made, the auditor can be satisfied with the
substantive tests of transactions, unless the substantive tests of transactions
themselves indicate the existence of misstatements. If the tests of controls
results were not as good as the auditor assumed in designing the original tests,
expanded substantive tests must be performed.
13-2
13-7 The primary purpose of testing sales and cash receipts transactions is to
evaluate the internal controls so that the scope of the substantive tests of the
account balances may be set. If the auditor performs the tests of details of
balances prior to testing internal controls, no benefit will be derived from the tests
of controls. The auditor should attempt to understand the entity and its environment,
including internal controls, as early as practical through the analysis of the
accounting system, tests of controls, and substantive tests of transactions.
13-8 When the results of analytical procedures are different from the auditor's
expectations and thereby indicate that there may be a misstatement in the balance
in accounts receivable or sales, the auditor should extend the tests to determine
why the ratios are different from expectations. Confirmation of accounts receivable
and cutoff tests for sales are two procedures that can be used to do this. On the
other hand, if the ratios are approximately what the auditor expects, the other
tests can be reduced. This means that the auditor can satisfy the evidence
requirements in different ways and that analytical procedures and confirmation
are complementary when the results of the tests are both good.
13-3
13-10 (continued)
software programs and master file changes would have little effect
on the auditors testing of control #2. If the auditor identifies control
#2 as a key control in the sales and collection cycle, he or she would
most likely examine a sample of the underlying documents for the
accounts receivable clerks initials and reperform the comparisons.
13.11 The audit of fixed asset additions normally involves the examination of
invoices in support of the additions and possibly the physical examination of the
additions. These procedures are normally performed on a test basis with a
concentration on the more significant additions. If the individual responsible for
recording new acquisitions is known to have inadequate training and limited
experience in accounting, the sample size for the audit procedures should be
expanded to include a larger sample of the additions for the year. In addition,
inquiry as to what additions were made during the year may be made by the
auditor of plant managers, the controller, or other operating personnel. The
auditor should then search the financial records to determine that these additions
were recorded as fixed assets.
Care should also be taken when the repairs and maintenance expense
account is analyzed since lack of training may cause some depreciable assets to
be expensed at the time of acquisition.
13-12 The following shows which types of evidence are applicable for the five
types of tests.
13-4
13-13 Going from most to least costly, the types of tests are:
13-15 By identifying the best mix of tests the auditor can accumulate sufficient
appropriate evidence at minimum cost. The auditor can thereby meet the standards
of the profession and still be cost effective and competitive.
13-5
13-17 (continued)
13-19 If tolerable misstatement is low, and inherent risk and control risk are
high, planned tests of details of balances which the auditor must perform will be
high. An increase in tolerable misstatement or a reduction of either inherent risk
or control risk will lead to a reduction in the planned tests of details of balances.
13-20 The eight balance-related audit objectives and related procedures are as
follows:
GENERAL
BALANCE-
RELATED AUDIT
OBJECTIVE SPECIFIC OBJECTIVE AUDIT PROCEDURE
Detail tie-in Inventory on the inventory Check extensions of price
summary agrees with the times quantity on a sample
physical count, the basis, foot the detailed
extensions are correct, and inventory summary, and trace
the total is correctly added the balance to the general
and agrees with the general ledger and financial
ledger. statements.
Existence Inventory as stated in Trace inventory from final
financial statements actually inventory summary to actual
exists. inventory and physically count
selected items.
Completeness Existing inventory items Select items from the physical
have been counted and inventory and trace to the
included in the financial client's final summary to make
statements. sure that all items are included.
13-6
13-20 (continued)
GENERAL
BALANCE-
RELATED AUDIT
OBJECTIVE SPECIFIC OBJECTIVE AUDIT PROCEDURE
Accuracy Inventory items included in Perform price tests of inventory
the financial statements are by examining supporting
stated at the correct vendors' invoices for selected
amounts. inventory items and reverify
price times quantity.
Classification Inventory as included in the Compare the classification of
financial statements is inventory into raw materials,
properly classified. work in process, and finished
goods by comparing the
description on physical
inventory count tags with the
client's final inventory listing.
Cutoff Inventory cutoff is properly Trace selected receiving
recorded at the balance reports several days before
sheet date. and after the balance sheet
date to determine whether
inventory purchases are
recorded in the proper period
and related physical inventory
counts are included or
excluded from inventory.
Realizable value Inventory on the financial Inquire of factory employees
statements excludes and management regarding
unusable items. obsolescence of inventory, and
examine storeroom for
evidence of damaged or
obsolete inventory.
Rights and Inventory items in the Review contracts with suppliers
obligations financial statements are and customers for the
owned by the client. possibility of the inclusion of
consigned or other non-owned
inventory.
13-7
13-21 (continued)
information available. Additionally, public company auditors must begin their testing
of controls earlier in the year to ensure they are able to test a sufficient sample of
controls for operating effectiveness. Some controls may only be performed
monthly or quarterly. Thus, the public company auditor must begin testing early
in the year so that there is a sufficient number of months or quarters to test.
Procedures that may be performed prior to the end of the year are:
13-24
a. b.
1. TD of B Recalculation
2. TD of B Documentation
3. AP Analytical procedures
4. T of C Documentation
5. ST of T Documentation
6. AP Analytical procedures
7. TD of B Documentation
8. T of C Inquiry and observation
9. TD of B Confirmation
10. T of C Documentation
11. T of C Inquiry
13-8
13-25
a. b. c. d. e.
1. Acquisition and Recalculation Substantive S T of T Posting a
Payment summariz
13-9
13-26
PAPER
AUDIT TRAIL? TEST OF CONTROL
a. Yes Account for numbers included in the sequence
to determine that all documents are there.
* The primary concern in these two items is the separation of duties rather than
the existence of the deposit slip and prelisting. The primary test of control
procedure must therefore be observation.
13-27
a. b. c.
TRANSACTION-RELATED TEST OF SUBSTANTIVE
AUDIT OBJECTIVE CONTROL PROCEDURE TEST
* The objectives satisfied depend upon what she examines. She might, for
example, examine supporting documents for accuracy and even for account
classification. In that event, those two objectives would be added.
13-28
on performance summarization reconciliation of the master file or control account compare to control account
file and control account
6. Independent checks Classification Examine vendors' invoices Account classification Compare vendors' invoices to
on performance for indication of internal misstatements acquisitions journal for
verification reasonableness of account
classification
7. Proper authorization Occurrence Examine cancelled checks Invalid or unauthorized Examine supporting documents
for signature payment for appropriateness of
expenditures
8. Independent checks Occurrence Examine vendors' invoices Invalid or unauthorized Examine supporting documents
on performance Accuracy for indication of comparison payment for appropriateness of
expenditures
9. Adequate Occurrence Examine supporting Duplicate payment for an Examine supporting documents
documents or documents for indication of acquisition for every payment to selected
records cancellation vendors
10. Separation of duties Occurrence Observe check mailing Bookkeeper takes signed Compare payee name on
procedures and inquire check and changes payee cancelled check to supporting
about normal procedures name documents
13-12
13-29 a. 1. Automated control embedded in computer software
2. Manual control whose effectiveness is based significantly on
IT-generated information
3. Automated control embedded in computer software
4. Manual control whose effectiveness is based significantly on
IT-generated information
5. Manual control whose effectiveness is not significantly reliant
on IT-generated information
13-30 a. Although a client may have very effective internal controls, the auditor
cannot place complete reliance on them in evaluating whether the
financial statements are fairly stated. This reflects the inherent
limitations of internal control, and the need under auditing standards
to perform certain tests of balances such as confirmation of
receivables and observation of inventory.
c. 1. A
2. B
3. B, C
4. A, B, C
5. B (assuming similar other client characteristics)
6. B, C (depending on auditors judgment)
7. C
8. B, C
E
F
A B D
G H D
C D
PROCEDURES
TO OBTAIN AN TESTS OF
UNDERSTANDING SUBSTANTIVE DETAILS
OF INTERNAL TESTS OF TESTS OF ANALYTICAL OF
AUDIT CONTROL CONTROLS TRANSACTIONS PROCEDURES BALANCES
1 E E S E S
2 M N S M E
3 E E M E S, E*
E = Extensive amount of testing.
M = Medium amount of testing.
S = Small amount of testing.
N = No testing.
S,E* = Small amount of testing for the gross balance in accounts receivable; extensive testing
done for the collectibility of the accounts.
b. Audit risk for this audit should be low because of the plans to sell
the business, severe under-financing and a first year audit. The
lack of controls over accounts payable and the large number of
adjusting entries in accounts payable indicate the auditor cannot
consider the internal controls effective. Therefore the plan should
be to do extensive tests of details of balances, probably through
accounts payable confirmation and other end of year procedures.
No tests of controls are recommended because of the impracticality
of reduced assessed control risk. Some substantive tests of
transactions and analytical procedures are recommended to verify
the correctness of acquisitions and to obtain information about the
reasonableness of the balances.
13-32 (continued)
1. Internal control
2. Materiality of the account balance
3. Size of the populations
4. Makeup of populations
5. Initial vs. repeat engagement
6. Results of the current and previous audits
7. Existence of unusual transactions
8. Motivation of the client to misstate the financial statements
9. Degree of client integrity
10. Reliance by third parties on the audited financial statements
For an example, in the first audit, the partner has apparently made
the decision to emphasize tests of controls and substantive tests of
transactions and minimize tests of details of balances. That implies
effective internal controls and a low expectation of misstatement (low
inherent and control risk.) In the third audit, the partner apparently
has a high expectation of misstatements, and therefore believes it is
necessary to do extensive tests of controls and substantive tests of
transactions, as well as extensive tests of details of balances. Audit
two is somewhere between audit one and three.
b. The audit partners could have spent time discussing the audit
approach and scope with Bryan prior to the beginning of the field work.
13-33 (continued)
5, 9, 7, 2 8 1 3 4 6
Parts 5, 9, and 7 are all a part of planning and are therefore
done early. These are in the sequence shown in Chapter 8. As part
of planning the audit, the auditor obtains an understanding of
internal control and initially assesses control risk. The auditor then
performs tests of controls and substantive tests of transactions and
reassesses control risk.
Ideally, most analytical procedures are performed after the
client has prepared financial statements, but before tests of details
of balances are performed. Therefore, they should be done before
confirmation of accounts payable to provide information about the
expectation of misstatement.
Confirmation of accounts payable should be done as early
as possible after the balance sheet date to facilitate getting responses
back, performing alternative procedures for nonresponses, and
reconciling differences before the audit is completed.
Tests for review of subsequent events are normally the last
procedures done on the engagement before the audit report date.
The audit report is issued after the audit report date.
b. The time line shows that 5, 9, 7 and 2 are frequently done before
the balance sheet date.
Cases
13-35 a. The major deficiencies in the audit and the reasons for their
occurrence are:
13-35 (continued)
(2) Assess inherent risk. This would be done under both approaches.
(3) Obtain an understanding of internal control. This would be
done under both approaches, however, it may be more
extensive where control risk is reduced below the maximum
due to the knowledge gained through testing.
(4) Assess control risk at less than 100%. This would be done
only under the "reducing control risk" approach, given that
the client is a non-public entity.
(5) Perform analytical procedures. This would be done under
both approaches, although such procedures may be more
extensive where control risk is reduced below the maximum.
(6) Assess planned detection risk. This would be done under
both approaches.
b. The "reducing control risk" approach has several advantages:
1. It should result in lower overall audit cost. This will occur where
the client's business activity is complex and its volume of
transactions is large. In this type of situation, internal controls
can provide a great deal of assurance that many of the
financial statement assertions are correct, and the audit effort
to test those controls can be significantly less than full-scale
substantive tests of balances would require.
2. For very large audits, it would be impossible to complete the
audit on time and at an acceptable cost without relying on
controls. Large clients are usually publicly held and must file
their Form 10-K with the SEC within 60 days of their fiscal
year end. These large companies generally have many
locations, including worldwide operations. Controls must be
relied upon to do these audits.
3. The more detailed investigation of controls that is required to
reduce control risk, including testing, provides a better
understanding of the system. This not only may provide a more
concrete basis for conducting substantive tests, it creates more
opportunities to make useful recommendations to the client.
4. Performance of detailed tests of transactions creates the
opportunity to reveal employee defalcations that would
otherwise not be discovered. In addition, employee knowledge
that transactions will be examined serves as a deterrent to
defalcation in the first place.
c. The primary advantage of the "substantive" approach is one of
efficiency. Where clients are smaller, there is less opportunity to
adequately segregate core duties, which makes it more difficult to
rely on controls. Thus, the auditor focuses the audit work on the
balance sheet as of the end of the client's fiscal year. Furthermore,
13-36 Part I (continued)
by going into the client's office at one point in time and doing the
entire audit, auditor scheduling problems are reduced and there is
less disruption to the client.
13-36 Part II
a. .17 is the level of detection risk for tests of the inventory balance
that will provide an overall audit risk of .05 assuming tests of
controls and analytical procedures are conducted as planned and
achieve the expected results (i.e., don't indicate any misstatements
exceeding a tolerable amount). Thus, as individual tests of details
of inventory are planned, their design would be based on that level
of risk of failing to reveal a greater-than-tolerable misstatement.
b. TDR = .05
1.0 x 1.0 x .6
TDR = .08
c. The reduction of risk that can be taken for detailed tests of the
inventory balance means that more reliance must be placed on
those detailed tests. In this case, the degree of allowable risk is cut
in half. In terms of sample size, this will result in a significant
increase (the exact impact will depend on the sampling method
used). It is also possible the auditor may feel less comfortable
relying on analytical procedures to the extent otherwise planned,
and may believe some other detailed tests are appropriate.
13-36 Part III
It is not appropriate to "rework" the Audit Risk Model as proposed by the
staff person. The Audit Risk Model is a planning model that is based on
testing the hypothesis that the financial statements do not contain a
material misstatement. If an indication of a possible misstatement is
revealed by applying the model at any stage, the hypothesis must be
rejected and the audit plan revised to assume there is a material
misstatement that must be subjected to measurement. The staff person
should independently evaluate whether the increase in control risk
requires an increase in substantive tests.
Answer:
The auditors selection (i.e., mix) of audit procedures is impacted by
a number of factors including the availability of different types of
audit evidence, the costs associated with the various procedures,
effectiveness of the clients internal controls, and the presence of
inherent risk factors. The timing of audit procedures is influenced by
several factors including the effectiveness of the clients internal
controls, when the client needs the audit to be completed, when the
audit evidence will be most effective (i.e., interim versus year-end)
and available (e.g., electronic evidence may be available for a
limited period of time), and when members of the audit staff are
available.
Answer:
Visit the companies websites to determine the latest applicable
dates for reports. Student explanations will likely vary; however,
students should consider the possibility of an increased reliance on
tests of controls and the use of interim testing, the effectiveness of
the companys internal controls, and the presence of electronic
evidence. The audit report dates for these companies 2008 reports
range from approximately 45 days to 60 days after year-end. This
suggests extensive reliance on controls and testing prior to year-
end. This question provides a segue to a discussion regarding the
increasing pressure felt by companies to release financial statement
results soon after year-end and the resultant pressure on the
companys auditors to perform their audits more quickly. You may
wish to ask the students to consider how this pressure may impact
audit quality and risk.
(Note: Internet problems address current issues using Internet sources. Because
Internet sites are subject to change, Internet problems and solutions may change. Current
information on Internet problems is available at www.pearsonhighered.com/arens.)