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for Solutions Chapter 7 Audit Evidence: A Framework Review Questions: 7-1. Audit evidence is all the information used by auditors in arriving at the conclusions on which the audit opinion is based. The basic sources of evidence are knowledge of the business and industry, analytical procedures, tests of controls, and direct tests of account balances and transactions. 7-2. The auditor must decide how much evidence is needed (extent), what kind of evidence is needed (nature), and when to gather the evidence (timing). 7-3. The assertions form the framework for gathering sufficient, competent audit evidence as required by the professional standards. The assertions tie into generally accepted accounting principles in that those assertions are also embodied in GAAP. The five main assertions are defined as: Existence/occurrence. The assets, liabilities, and equity interests exist and all transactions reflected in the financial statements actually occurred. Completeness. All assets, liabilities, equity interests, and transactions that should have been recorded have been recorded, i.e., nothing is left out of the financial statements. Rights/obligations. The entity holds or controls the legal ownership to assets, and liabilities are legally owed by the entity. Valuation/allocation. Assets, liabilities, and equity interests are included in the financial statements at appropriate amounts and any resulting valuation or allocation adjustments are appropriately recorded. Presentation/disclosure. Assets, liabilities, and equity interests are appropriately classified on the financial statements, and are adequately described in the footnotes to the financial statements. 7-4. Valuation is usually one of the most important assertions to address in most audits. The intent of this question is to have the students think about the detail required by GAAP in forming specific assertions to be tested with individual accounts. The basic components of the valuation assertion for investments in marketable securities are these: The securities are initially recorded at cost and are thereafter valued at market. Cost includes all costs, including brokerage fees, to purchase the securities. 7-5 Market is: o Defined as aggregate market value determined either by classes of securities or treating all securities as one class. o Measured by year-end market prices, assuming a liquid market such that sales of the securities would not have a major impact on market value. All gains/losses due to sales during the current period are properly reflected in the accounts. Carrying values of marketable securities sold are removed. All adjustments required for the unrealized adjustments to market value are properly recognized. The basic characteristics that distinguish the reliability of audit evidence are: More reliable information Directly observable evidence Evidence derived from well controlled information system Evidence from independent outside sources Documented evidence Original documents Less reliable information Indirectly observable evidence Evidence derived from a poorly controlled system or easily overridden information system Evidence from within the clients organization Verbal evidence Photocopies or facsimiles 7-6. Audit risk and reliability of audit evidence are related. If audit risk is low rather than high, it implies that the auditor has to gather more evidence of the same quality, more reliable evidence, or some combination of each. For example, if audit risk has been established at a minimal amount because the auditor is concerned with overstatement of sales and accounts receivable, the auditor may seek more persuasive evidence such as subsequent payment of a receivable, direct contact with the customer by the auditor, or verification of invoices by direct reference to shipping documents (as opposed to only a confirmation of the account balance sent to a customer address at a post office box number). The auditor would be seeking more reliable evidence. In other situations, the auditor would control audit risk by taking larger sample sizes that statistically control the risk of making an incorrect inference as a result of the audit tests. 7-7. An audit adjustment is a correction of a misstatement of the financial statements that was or should have been proposed by the auditor, whether or not recorded by management, which could, either individually or when aggregated with other misstatements, have a material effect on the company's financial statements. The PCAOB requires that auditors document audit adjustments, both proposed and recorded, so that there is a record of important issues that the auditor considered and was concerned about during the conduct of the audit. In fact, auditors are required to discuss audit adjustments with the audit committee, so documentation helps establish a record of complying with the requirements regarding audit committee communications. If an audit is reviewed upon inspection by the PCAOB, documentation regarding proposed adjustments, especially those that management refused to book (i.e., reflect in the adjusted financial statements), would shed light on the areas that were the most contentious and judgmental in terms of financial reporting and disclosure. By evaluating adjustments in a given year, and especially in a pattern over time, the PCAOB can get a sense of how aggressive management is in its financial reporting choices and how the auditor responds to management. 7-8. All things being equal, external documentary evidence is considered more reliable than internally generated evidence. However, it is seldom that "all things are equal". External documentary evidence is generally more reliable when provided by independent, knowledgeable external parties. Examples of external documentation are original vendor invoices that are in the clients possession and confirmations sent directly to the auditors by third parties. Internal documentary evidence can be very reliable when it is developed within a strong internal control environment. Examples of internal documentation are sales invoices, receiving reports, payroll records, and purchase orders. 7-9. Directional testing is the design of audit tests to search primarily for either over-or understatements for particular accounts. It takes advantage of the double entry bookkeeping system. The auditor is normally concerned with overstatement of assets or revenues and understatement of liabilities or expenses because there are greater risks associated with misstatements in those particular directions. Directional testing can lead to audit efficiency because audit tests of an account in one direction provide evidence on other related accounts. An example is auditing accounts receivable for an overstatement, which also provides indirect evidence on the potential overstatement of sales. Efficiency comes from planning the audit to consider the relationships among a number of different accounts. 7-10. The efficiency of directional testing comes from the double entry method of bookkeeping. If an asset increases, it must come from the recognition of revenue, the decrease of another asset, a misclassification of an expense item as an asset, or an increase in a liability. Thus, testing an asset for overstatement can provide information on potential understatement of another asset or expense or overstatement of revenue or a liability. Accounts receivable example. Testing for overstatements provides evidence on overstatement of sales and understatement of expenses. If Accounts Receivable is overstated because of fictitious sales, sales are also overstated. If receivables are overstated because of an inadequate allowance for doubtful accounts at year-end when the allowance for bad debt is increased the corresponding debit belongs to Bad Debt Expense, thus providing evidence on potential understatement of the related expense account. Inventory example. Tests of overstatement of inventory provide indirect evidence regarding overstatement of revenues or liabilities and direct evidence regarding understatement of expenses. If inventory is misstated, the corresponding entry is to Cost of Goods Sold. If inventory is overstated because of recording the receipt of inventory before title passes, accounts payable will also be overstated. If ending inventory is overstated because inventory was sold but the entry to record the cost of goods sold was not made, Cost of Goods Sold is understated. The evidence on revenue is more indirect. If the tests indicate that cost of goods sold represents only 55 percent of sales this year, but it had previously been over 60 percent (let's say for the last five years) and there is no major change in product mix or production technology, the tests may indicate potential fictitious sales. The auditor's evidence is based on an analytical reasoning process. 7-11. Observation is best suited for testing the existence assertion, e.g. the existence of inventory and the adequacy of the clients physical inventory count procedures can be observed. It may be indirectly useful in helping test some valuation assertions. For example, the auditor can observe the quality of inventory and make reasonable inferences about the value of inventory. Observation is strong evidence when physical existence is important. However, it is weak because observation can lead to misleading inferences. For example, observing that an object exists does not warrant the inference that it is owned by the company. Similarly, observing an item in good shape does not mean that it is properly valued because it could still be technologically obsolete or be assigned the wrong unit cost. 7-12. Inquiries of management are subject to management bias and seldom can be used without corroborating evidence. The strength of management responses must also be tempered by the auditors evaluation and assessment of the integrity of management and the potential motivation to misstate an account balance. Management representations are best suited to situations covering management intent, or gathering corroborating evidence on valuation and existence issues, for example, intent related to the use of marketable securities (trading, available for sale or held to maturity), refinancing long-term debt, and the collectibility of a receivable. However, representations of the latter sort must always be corroborated by outside evidence. Higher risk situations should lead the auditor not to rely on management representations. 7-13. In order to answer this question, the student must identify the attributes of paper evidence that seem to make it more reliable. Some of these attributes might include: Clear identification of approval Easy to identify modification of record Evidence might exist outside of clients system, for example, in vendors files Evidence may have been created from outside the clients system In virtually every case, the same attributes can be built into a well-designed computerized information system. If the client has strong access controls to minimize the possibility of unauthorized addition, deletion, or modification of electronic documents and if electronically stored information contains the same attributes as those described above, it should be reasonable to assume that the information would be as reliable. 7-14. Reprocessing is an extended form of recalculation and begins with an initial source document and traces the document through the full recording process, including the appropriate journalizing and the posting of transactions to accounts as well as verifying the accuracy of mathematical calculations. Reprocessing addresses the assertion that all existing transactions are properly recorded (completeness). Vouching is complementary to reprocessing. Vouching involves taking a sample of already recorded transactions and tracing them back to their original source, usually a source document. Vouching addresses the assertion that all recorded transactions are valid (occurrence). Both assertions are important to the overall audit process. Simply performing reprocessing will not tell the auditor whether fictitious transactions might exist in the account. Similarly, vouching tells the auditor about transactions that have been recorded but provides no evidence to ensure that all transactions got recorded. 7-15. There are two reasons to seek additional corroboration to the external documentation obtained from the client: (1) because the documentation is obtained from the client, it is subject to modification and (2) more important, the existing documentation may not answer all the important questions the auditor needs to address in evaluating contingencies or other related accounts. 7-16. Confirmations are a form of testimonial evidence and therefore the assumptions that underlie testimonial evidence also apply to confirmations, which are whether: The confirmations will receive a conscientious review and response from the individual from whom the confirmation is requested. The respondent is knowledgeable and has a sufficient basis on which to respond to the request. The respondent is being asked to confirm information they can independently confirm. The respondent is not biased toward giving a particular response (i.e., does not stand to benefit from a particular response). The party receiving the confirmation request is likely to respond to it. 7-17. There are a number of reasons to believe it is more efficient to test account balances at year end rather than testing the related transactions throughout the year. However, it is not always the case that this will be true -- or likely be true in an EDI environment. It is generally easier to test most balance sheet accounts at year end because there are usually fewer items in the ending balance than there are transactions that have taken place during the year. Further, reliable evidence generally exists to facilitate the direct testing of the account balances. For example, it is easier for the auditor to test ending inventory by observing the physical count and making test counts or to send confirmations or review subsequent payments as evidence of the overall validity of the accounts receivable yearend balance than to test all of the transactions related to those accounts. The advantages of testing account balances at year end may change in heavily integrated systems, such as EDI systems. Year end data may not exist in an independent form that provides the strength of evidence generally sought by auditors. Further, both auditors and management may find they need to test the systems throughout the year to ensure they are operating correctly. Thus, auditors may be able to attest to a companys financial position by testing the process leading to the financial statements. 7-18. There are three primary purposes of audit programs: They provide evidence of audit planning They provide guidance to the audit team They are used to help monitor the progress of the audit. 7-19. There are three basic factors for must be considered in developing an audit program. First, the auditor assesses the risk of material misstatement and determines how much testing of internal controls needs to be performed and how much substantive testing of account balances should be performed. The next factor to consider is the materiality of the account balance and of the items that make up that balance. The third factor is the relevant assertions that need testing. 7-20. Audit documents record the work performed by the auditor. They document the items sampled, the work done, the conclusions reached, the auditor performing the tests, the date completed, and the auditor's assessment of potential misstatements in the account balance or transactions tested. A well-developed audit document contains: A heading that includes the name of the audit client, explanatory title, and the balance sheet date. The initials of the auditor performing the audit test and the date it was completed. The initials of the senior, manager, or partner who reviewed the document and the date the review was completed. A description of the nature of the test performed and the findings. An assessment of whether the test indicates the possibility of material misstatement in an account. This represents the auditors conclusion. Tick marks and legend indicating the nature of the work performed by the auditor. An index to identify the location of papers. A cross reference to other related documents, when applicable. 7-21. Yes, a memo explaining the auditor's conclusion and rational is an audit document. The auditor's reasoning process is a critical part of the process of evidence evaluation and written information explaining it should thus be included as part of the audit documentation. 7-22. To answer this question, the student must think through the characteristics that the auditor is looking for in paper documentation. For example, the auditor needs to know that a purchase order has been properly approved, is written to fill a request or a production schedule, and is issued to a vendor as the result of a contractual agreement or competitive bid and therefore reflects competitive prices for the quality of goods needed by the organization, and that shipments of goods are received only if they are in accordance with its terms. The major implication is that the auditor will have to determine if the client has sufficient controls to ensure that the same characteristics are retained in automated purchase orders, or other similarly computerized documents. The likely implications are that the auditor will focus more attention on the controls used by the organization to restrict access to the purchasing component of the information system to those authorized to commit the organization to a purchase and on the process by which authorized personnel initiate the purchase documents. A blanket, computerized, purchase order is authorized by personnel who initially determine that automatic reorders ought to be generated whenever quantities reach a specific level or whenever an approved production plan dictates the need for more inventory. The auditor will likely focus more testing on the computer system by evaluating the design of the purchasing application program and by submitting test data to determine whether it processes transactions as dictated by the application documentation. 7-23. The concept is that the audit documents contain the evidence that the audit was conducted in accordance with generally accepted auditing standards including documentation of the planning process, the audit evidence gathered, the auditor's conclusions regarding that evidence, the reasoning process utilized by the auditor in reaching conclusions regarding the sufficiency of the audit and the conclusions thereof, and the conclusions of the audit. The documents are like a complete "book" of the audit. As such, it should be possible for anyone reviewing the documents to be able to read the "book" without the aid of a "storyteller" (the auditor). It is also critical that the audit documentation be complete and show the audit was conducted with due professional care in case the audit is challenged in a liability case. 7-24. Estimating an account balance through reference to outside data or other information gathered from outside the accounting system would be reliable when the following conditions are met: The auditor has evidence that the outside data are reliable The outside data are not influenced, or cannot be influenced, by management There is a direct logical link between the data and the account balance being estimated. 7-25 It may be a challenge for auditors to react negatively toward companies preferences to reduce reserves because the components of those reserve accounts, and the estimates used to determine an appropriate ending balance are subjective and judgmental. It is also important to stress to students that it can also be a challenge to stand up to management when they wish to increase reserve accounts (i.e., thereby setting up cookie jar reserves) because management may argue that they are just being conservative. If the auditor argues against client management setting up the cookie jar reserves in the first place, but ultimately allows management to do so, management may then argue later (when they wish to tap into the reserves to bolster sagging income) that the auditor was right in the first place and say that they, management, are just doing what the auditor wanted them to do all along. The basic point to make is that auditors need to develop their own independent estimates and steadfastly adhere to what they believe is appropriate valuation. If they do not, they may be subject to subsequent game playing by management. Multiple Choice Questions: 7-26. 7-27. 7-28. 7-29. 7-30. 7-31. 7-32. 7-33. 7-34. b. a. a. b. (See solution 7-10 for related discussion) c. c. c. d. d. Discussion and Research Questions: 7-35. a. Audit Assertion Existence (all recorded payables exist). Completeness (All existing payables are recorded). b. Audit Evidence and Procedures Examine documentation supporting accounts payable detail at the balance sheet date, (e.g., vendor's invoices and monthly statements). Examine a sample of payments made after year-end to determine whether they should have been recorded as a payable. Examine all open items (items not yet recorded but for which documentation has been received) at year-end to determine whether they should be recorded as a payable. Reconcile major vendor monthly statements or confirmations with recorded accounts payable. Perform analytical procedures on major expense accounts to determine whether there is any evidence that the expense accounts might be understated in comparison with previous years. a. Audit Assertion Existence (all recorded payables exist). b. Audit Evidence and Procedures Examine documentation supporting accounts payable detail at the balance sheet date, (e.g., vendor's invoices and monthly statements). Perform a cutoff test using receiving reports of items received just before year end that should be recorded as payables according to the shipping terms. Rights/Obligations (Amounts recorded represent legal or business obligations of the organization). Valuation (Accounts payable is properly valued according to GAAP). Presentation and disclosure (The account is properly classified and any contingencies are disclosed). c. Review invoices, etc., in connection with the first two assertions to determine that the client has actually received the goods or services by year end and thus has a legal obligation for payment. Review documents to determine whether any of the payables carry purchase commitments that ought to be disclosed. Most of the procedures in connection with the first three assertions establish the valuation. Examination of payments and invoices should determine the correct amounts at which the liability should be recorded. Review financial statements and footnotes for adequate disclosure. Designating the company high risk because of the items in the scenario renders less reliable the first two procedures identified for the completeness assertion. There is no evidence that the client will pay all its obligations on a timely basis, and management might be motivated to systematically understate its obligations. Therefore, more evidence from the last two procedures for testing completeness will be needed. The auditor should reconcile with recorded accounts payable the monthly statements or confirmations from all major vendors and, perhaps, a sample of the other vendors, as a basis to determine whether all trade payables have been properly recorded. The auditor should also perform analytical procedures on major expense accounts to determine whether there is any evidence that the expense accounts might be understated in comparison with previous years. In addition, the auditor should perform a more extensive cutoff test using receiving reports of items received just before year end that should be recorded as payables according to the shipping terms. 7-36. a. 1 2 3 4 5 6 7 8 9 1 0 Account Balance Assertion Existence (A/R, Sales & COGS) Completeness (Inv) Completeness (Inv & A/P) Completeness (Expense) Existence (Asset) Completeness (Liability & Loss) Existence (A/R, Sales & COGS) Completeness (Inv) Completeness (Wage Exp. & Salaries Payable) Completeness (Cash & A/P) Existence (Cash) Completeness (A/R) Completeness (Leased Asset & Lease Obligation) Existence (Lease Expense) Completeness (Amortization Expense and Interest Expense) Valuation (A/R & Sales) b. Recording FOB destination sales would be acceptable to the auditor if that policy is followed consistently from year to year and the amount of such sales near year-end is fairly consistent. In that case, net income is not significantly affected, but accounts receivable and retained earnings will be overstated. Retained earnings will be overstated when this policy is first implemented and will carry forward to subsequent years. c. Items 1 and 5 affect net income by the amount of the gross margin. Items 2, 7, & 8 affect only the balance sheet. Items 3, 4, 6, & 10 affect net income by the total amount of the transaction/event/error. Item 9 affects net income by the difference between lease expense and the total of amortization and interest expense. If the company takes a physical inventory at the end of the year and then adjusts the account balances to the physical count, then any of the inventory misstatements could affect reported income. For example, on item 2, the company has received the goods but has not recorded either the inventory or the payable. The company has understated both assets and liabilities and there would apparently not be an income effect. However, if the company counts the inventory because it is on hand, and then adjusts the inventory to what is on hand, the company would be making the journal entry below: Inventory COGS $ xx,sss.oo $ xx,sss.oo Thus, if the company takes a formal inventory count, there will be a profit effect for all inventory that is not recorded appropriately. 7-37. Procedure Observation How Used (examples) Observe client personnel taking a physical inventory. Physical Physically exam selected inventory Examination items. Inquiry Ask whether there is any inventory 1. in on consignment, 2. out on consignment or stored in public warehouses, 3. that is obsolete or slow moving. Confirmation Confirm inventory out on consignment or in a public warehouse. Examination of Analyze sales/purchase contracts for Documents any special terms. Recomputation Recalculate quantity times unit cost and foot the file. Reprocessing Select receiving documents near year end and trace to inventory records Vouching Trace a sample of inventory costs to vendor invoices. Analytical Calculate inventory turnover and Procedures number of days sales in inventory. Assertion(s) Tested Completeness, Existence, Valuation Existence, Valuation 1. Rights 2. Completeness 3. Valuation Existence, Completeness, Valuation, Rights Valuation, Existence, Completeness Valuation Completeness Valuation, Rights Valuation 7-38. Evidence a. Classification b. Reliability c. Account Balance & Assertion 1. Vendor invoices External Moderate to high Inventory and expenses: Valuation, completeness, rights & obligation Accounts Payable: Existence, valuation, completeness, obligation Sales and Accounts Receivable: Valuation and completeness 2. Vendor External monthly statements 3. Sales Internal invoices High Moderate (depends on conditions under which generated) Expenses (cost of goods sold): Valuation, completeness 4. Shipping Internal (clientInternal: Moderate Sales and receivables: documents generated External: High completeness, existence, for sales documents, e.g., valuation. packing slips), Inventory: Existence and external (bill of lading from independent trucking firm) 5. Bank External (but High, but subject to Cash: Existence, Statements usually obtained downgrade because it is completeness, valuation, from client) usually obtained from client rights 6. Employee Internal payroll time cards 7. Receiving Internal reports for (generated as goods the goods are received received) from vendors 8. Sales Contracts Moderate to high. Although Wage expense: Occurrence, internal, it is influenced by a valuation completeness. number of dependent factors. Wages payable: Existence, valuation, completeness Moderate (depends on the Inventory: Existence, quality of controls and completeness, valuation (to independence of the the extent it properly receiving function from identifies items received) other activities) Internal/ external, High, if signed and may be authenticated by both parties generated internally, but contain signatures and other authentication of legal documents 9. Purchase Internal/External High, if signed and Commitm (similar to sales authenticated by both parties ent contracts Contracts identified above) 10. Lease Internal/External High, if signed and agree(similar to sales authenticated by both parties ments and purchase contracts identified Sales: Valuation Contingencies: Existence and disclosure Contingent liabilities: Existence, valuation, disclosure. Inventory: Valuation. Capitalized lease assets & obligations: Existence, valuation, obligation Capitalized lease assets: above) 11. Estimated Internal Warranty Schedules 12. Purchase order stored on client computer and received by EDI 13. Credit Rating Reports 14. Vendor Invoice Existence, valuation, rights, disclosure Warranty expense: Valuation Moderate to low (depending on conditions under which prepared and availability of Warranty liability: independent data to support Completeness, valuation, schedule) disclosure External, but since High, but only if auditor is it is stored on able to determine that the the clients data cannot be subject to computer, it is management manipulation potentially or alteration. If not, the subject to auditor must assess the manipulation reliability as low. and should be treated as internal unless the auditor can establish that the information is safe from client manipulation. Note the same is true for an external document found in a client file. External Moderate to high. Even though external, there have been questions about the quality of the companies providing the service. External High, but only if auditor is able to determine that the data cannot be subject to management manipulation or alteration. If not, the auditor must assess the reliability as low Sales: valuation. Accounts receivable: valuation. Accounts or loans receivable: Valuation Inventory rights and valuation, accounts payable existence and valuation 7-39. a. Confirmations are generally considered more reliable than inquiries of the client because they represent independent evidence generated from outside the organization and are thus free of bias that may affect responses to internal inquiries. The opposite holds true when the respondent (1) has a bias towards a particular type of response, (2) does not have sufficient knowledge to render a meaningful and independent response, or (3) does not take sufficient care to develop a meaningful response. Confirmations would not be reliable when the response is not relevant to the assertion being tested. b. Examples of Reliable and Less Reliable Evidence Examples of Reliable Evidence Examples of Less Reliable Evidence Accounts receivable confirmation response from a major customer who has a long history of doing business with the client and has a reputation for outstanding controls Independent testing of the quality of electronics or other high-tech equipment Review of an independent, certified appraisal as to the values to be assigned to property, plant, and equipment as part of an acquisition An accounts receivable confirmation from a residential customer of a local electric utility Visual inspection of the electronics or other hightech equipment. Management's schedule of the book value of equipment acquired as part of an acquisition, adjusted for a market rate of inflation Comparison of previous years data on a Comparison of previous years data as a basis for company that had been audited for estimating expenses on a first-year audit the last 10 years as a basis for client that had never been audited before. estimating the likelihood that miscellaneous expenses might be misstated Review of invoices to determine the price of Management's schedule of construction costs to equipment purchased. make an addition to an existing factory. The characteristics that distinguish between the reliable and less-reliable audit evidence include: Independent, outside, objective documentation, such as vendor invoices versus management's schedule (without further testing) of construction cost c. The ability of a third party to generate a meaningful response to a confirmation request. The likelihood of a meaningful response is related to the third party's independence, existence of a good control structure, and an information system from which to generate data to respond to the request. Reliability of data used as a basis for making a projection utilizing analytical procedures. Previously audited data are more reliable than similar data that had never been subjected to audit testing. Independent appraisal information from certified appraisers as opposed to internally generated (and potentially biased) management estimates. Physical examination is considered strong evidence because the auditor directly obtains the information. The auditor does not have to rely on an intermediate party or on documents that could be altered by the client. The evidence is limited, however, in that it does not address many assertions. It is difficult to tell whether an inventory part, for example, is really obsolete without gathering sales data (except in the rare cases in which goods are visibly damaged, dusty, or in some state of disrepair). Physical examination of inventory is of limited use when the auditor does not have the expertise to identify the products, such as auditing jewelry, petroleum products, or advanced electronic equipment. The auditor would have difficulty determining whether a product was fully operational or whether there was only a "shell" present without developing some means to independently test the products. d. Characteristics of internal documentation that would likely lead the auditor to evaluate its reliability as high would include: e. Documentation developed as part of a strong control system, with sufficient checks and balances and supervisory review that the auditor has a strong sense that errors or fictitious documents would be prevented or detected Lack of strong economic incentives for management to develop fictitious documents or to manipulate the financial reporting system to overstate income. Internal checks on the evidence that exist outside the accounting system so that misstatements or errors in the documents would be discovered. Employees, for example, are likely to follow-up on any mistakes in recording their weekly or monthly paycheck. Documentation subject to review by parties outside the organization or outside the department that originally developed the documentation (strong segregation of duties). Documentation reviewed by internal legal counsel or to which outside parties are also signatories. The validity of the documentation easily corroborated by the auditor. Analytical procedures and tests of details are both aimed at detecting misstatements in an account balance. Analytical procedures are effective in determining potential misstatement of an account balance (either overstatement or understatement). Tests of details are primarily oriented to providing information to determine whether an account is overstated. Tests of details are considered to be more reliable because the auditor is examining detailed documentation and other evidence in support of the account balance. The auditor can statistically select items to examine and draw statistical inferences about the results. On the other hand, analytical review procedures depend heavily on the plausible relationships established in the analytical model and the quality of the independent data used to make the estimates. f. Analytical procedures are particularly effective in two situations: 1. There is a logical relationship between the account being estimated and some other account being audited. The data from the audited account can be used directly to estimate the account being tested by the analytical procedures. 2. The account, particularly liability accounts, may be understated. It is often difficult to test the completeness assertion if the client does not have strong controls to ensure that all transactions are recorded. Analytical procedures can be effective in pointing to the possibility that material amounts are not recorded. Analytical procedures can also be effective in identifying situations in which relationships between accounts don't seem to be logical. By identifying such relationships in which an account appears to be either over- or understated, the auditor can systematically go through a process of hypothesizing the most likely cause of misstatement and then go about testing the most likely explanations in order. By focusing on the most likely explanations of unexpected results, the auditor can test in a most efficient manner. g. Situations in which an auditor might use recomputation would include: 1. Testing extensions on inventory (price by quantity equal extended cost). 2. Footing various files or detail of accounts to determine whether they agree with the amount recorded in the general ledger. 3. Recomputing the detail of sales invoices, including the extensions, totals, and amount of sales tax liability. 4. Recomputing employee pay and withholding amounts. 5. Recomputing the client's estimate for doubtful accounts or warranty liabilities. It is important that recomputation take place because it is the only way to ensure that an account balance is presented correctly. For example, audit work that determines that inventory is correctly priced and includes the right quantities does not substantiate the amounts included in the balance sheet until the auditor tests extensions and foots the account. The auditor-prepared spreadsheet can be either a recomputation or an independent estimate. It could be used as a recomputation if the auditor submits the client's estimated data to be run by the spreadsheet. On the other hand, the auditor could use the spreadsheet and independently generated data to make an independent estimate of an account balance that could be compared with the client's estimate of the account balance. 7-40. a. Relationships between accounts: Account Audited 1. Marketable Equity Securities a 1. Related Account a 2. Audit Relationship and Evidence Dividend income Investment securities have dividend terms that can be verified by examination of a standard dividend-reporting service. Gain or loss on sale of Gains or losses on sales can be verified as part securities of the audit process of identifying current ownership and valuation of the securities. Unrealized gain or loss The analysis to determine the year-end market on securities. adjustment leads to a debit or credit to the unrealized gain or loss account (if any entry is needed). 2. Bond Payable Interest expense, including proper amortization of discount or premium An amortization schedule can be established when the liability is recognized. Interest payments are specified by the bond terms. A microcomputer spreadsheet could be set up to calculate total interest expense associated with the liability for the life of the bond. 3. Property, plant, and equipment Depreciation schedules are established when the property is acquired and can be verified by recomputation. Depreciation and accumulated depreciation. Once depreciation has been established, the auditor can estimate the current year's depreciation by taking previous depreciation and adjusting for additions (new equipment) and disposals. Depending on the use of accelerated methods and age of equipment, such estimates can be quite accurate. 4. Equity Method Income from Equity Investments Investments The client will record its share of the investees income or loss as an increase/decrease in the investment account and as income/loss on the income Account Audited a 1. Related Account a 2. Audit Relationship and Evidence statements. The best evidence is audited financial statements of the investee. 5. Capitalized Leases Lease Amortization 6. Capitalized Lease Obligations Interest Expense Similar to goodwill amortization described above. An amortization schedule can be established when the lease is capitalized. The process of capitalizing the lease generates an interest rate to be used as part of the amortization of the lease obligation. A spreadsheet can be developed and carried forward for each audit. 7. Notes Payable Interest Expense Establishment of the note results in a stated interest rate (as for bonds) that can be used to estimate interest rate expense for each period. 8. Estimated Warranty Liability (Reserve) Warranty Expense The Warranty Expense account is normally debited for all warranty work performed during the year and is then adjusted for changes in the liability account at the end of the year. 9. Preferred Stock Preferred Dividends Preferred Dividends specifically provides for (including dividend stated dividends that can be used to expense for calculate actual payment of dividends or redeemable calculate dividends in arrears. preferred stock). b. It is generally easier to test balance sheet accounts at year-end because there are fewer items that make up the account balance than there are transactions affecting that balance and usually the asset and liability accounts have other outside sources of evidence that the auditor can use to test the account balances. For certain accounts, such as fixed assets, if the opening balances have been audited, the auditor will focus on the major changes in the balance during the year. 7-41. 1. Testing Inventory for overstatement also tests (1) Cost of Goods Sold for understatement (completeness) if inventory sold has not been charged to Cost of Goods Sold, (2) Accounts Payable for overstatement (existence) if inventory has been added to the records that should not have been included, (3) Inventory Shortage (completeness) for inventory that is missing due to theft, and (4) Tools or Other Fixed Assets for understatement (completeness) due to a misclassification. 2. Testing Revenue for understatement also tests (1) Accounts Receivable for understatement (completeness) due to unrecorded credit sales, (2) Cash for understatement (completeness) due to unrecorded cash sales, and (3) Unearned Revenue for overstatement (existence) due to a failure to recognize earned revenue. 3. Testing Accounts Receivable for overstatement also tests (1) Sales for overstatement (existence) due to recording credit sales that have not taken place, (2) Cash for understatement (completeness) due to failure to record a cash collection, (3) Sales Taxes Payable for overstatement (existence) due to charging sales tax to a tax exempt organization, (4) the Allowance for Doubtful Accounts for overstatement (valuation) due to a failure to write off a known uncollectible customers balance, and (5) Receivables from Officers and Employees for understatement (completeness) due to misclassification. 4. Testing Accrued Salaries for understatement also tests (1) Salaries Expense for understatement (completeness) due to failure to accrue year-end salaries and (2) Cash for overstatement (existence) due to failure to record the payment of salaries 5. Testing Repairs and Maintenance Expense for overstatement also tests (1) Property, Plant, and Equipment for understatement (completeness) due to expensing a cost that should have been capitalized and (2) another expense account for understatement (completeness) due to misclassification. 6. Testing the adequacy of the Allowance for Doubtful Accounts also tests (1) Bad Debt Expense for understatement (completeness) and overstatement (existence), (2) Accounts Receivable for overstatement (existence) due to failure to write off uncollectible accounts, and (3) Cash for understatement (completeness) due to failure to record a collection of an account previously written off. 7-42. Type of Audit Procedure Assertions Tested a. Analytical procedures Valuation b. Reprocessing Completeness, Valuation c. Recomputation Valuation d. Vouching Existence, Valuation Type of Audit Procedure e. Examination of Documentation Assertions Tested Existence, Valuation f. Examination of documents Existence, Valuation g. Physical Examination h. Examination of documents Existence, Valuation Valuation, Completeness i. Confirmations Existence, Valuation j. Analytical Procedure Valuation, completeness k. Recomputation Valuation l. Inquiry of Company Personnel Completeness, Disclosure, Valuation m. Inquiry of Company Personnel Disclosure, Valuation n. Observation Completeness, Existence, Valuation o. Inquiry of Company Personnel Valuation - but only indirectly p. Examination of Documents Completeness, Existence, Valuation q. Confirmations Completeness, Valuation, Disclosure 7-43. a. The auditor should initially evaluate the considerations pertinent to testimonial evidence, including whether: The inquiry will receive a conscientious review and response The individual is knowledgeable and has a sufficient basis on which to respond The individual is not biased toward giving a particular response (i.e., the individual does not stand to benefit from a particular response) The personal integrity of the individual responding In addition to these factors, the auditor should consider potential management motivation to be elusive or less than candid in its responses because of a motivation to make the results of either department its or the organization as a whole look better than they actually were. The auditor should also consider the extent to which oral representations made by management can be corroborated through other evidence. b. Examples of Testimonial Evidence: Alternative Sources or Corroborative Evidence 1. Alternative Sources of Evidence 1. Subsequent payment of account balance by customer. 2. Corroborative Evidence 1. None Review customer's orders, invoices, and independent shipping documents evidencing shipment of items. 2. Review and analyze sales after year-end 2. Review industry trade journals for economic to determine if there is any change in trend. data regarding industry as a whole and for an evaluation of company products. Review recent sales and sales after year-end to determine whether they are made at lower or close-out prices. Discuss prospects for the product line sales with sales manager or field representatives. Review other business journals for analysis of company, its prospects, and products. Review governmental correspondence if there is any evidence of product problems. Review and analyze merchandise returns to determine whether there is any apparent trend or problem with the product line. 3. Confirm intent with a management representation letter. Review board of directors minutes to determine whether investments were approved as short-term or long-term investments (significant long-term investments were likely approved by board; short-term investments likely did not require board approval). 4. Review correspondence from the Food and Drug Administration (FDA) verifying approval. If still questionable, confirm with the FDA by sending a confirmation, or by contacting the FDA directly. 3. Review past history of management actions to determine whether such securities have traditionally been treated as short-term investments. 4. Review for shipments of the product. Review trade journals for any reports on the progress of FDA approval for the product. 7-44. a. Assertion b. Most Persuasive Source of Evidence Tested 1. Existence and 1. Confirming with the business organization under the assumptions valuation of that receivables The business organization has an information system that provides a better basis to ensure a knowledgeable response. The business is familiar with making such responses and recognizes that it is part of business. The business generally is free from bias in making the response, which comes from the accounts payable department not from management. (2) Valuation of inventory Existence of inventory The above conditions are usually true, but it should be recognized that they may not hold true across all businesses and thus it is a mistake to assume that business confirmations are always more reliable. (2) Inventory turnover and sales analysis by product line are more reliable because visual inspection of electronic products yields little information either operationally or functionally, about the status of the product. The auditor needs sales data to better determine whether a product can be sold at existing sales prices for the quantities on hand. Visual inspection provides direct evidence of the existence of the inventory whereas the analytical procedures provide only indirect evidence. (3). Existence of (3). Observing the counting of the client's inventory is more inventory persuasive because (a) the auditor obtains the information directly (including procedures utilized to gain assurance that inventory owned by the client is counted) and (b) although the warehouse is independent, there have been questions about the conscientiousness with which they respond to such requests. In addition, some warehouses do not have strong control structures set up whereby they could easily respond to such requests. (4). Existence and valuation of the cash account (4). Directly receiving a cut-off bank statement from the bank is the most persuasive because it contains information such as canceled checks for verifying the client's year-end account balance Most auditors also confirm the year-end balance with the financial institution because they seek information regarding bank loans to a. Assertion Tested b. Most Persuasive Source of Evidence the client and other contingent liabilities. But if the objective is to test the existence and valuation of cash, the bank cut-off statement provides the most persuasive evidence. (5). Existence of (5). Physically examining the sheet metal is more persuasive inventory because it is easier to identify, the quality is usually stamped directly on the metal, and there generally are no major obsolescence problems with sheet metal. The opposite of each item applies to the examination of sophisticated electronics equipment. (6). Existence of (6). Confirmation of the year-end bank balance is more persuasive. cash versus the First, a factual determination of the actual balance can be made. completeness Second, the bank is an independent party with strong controls and of a contingent regulation aimed at not misstating a client balance. On the other liability hand, although the outside legal counsel is independent, it is a client advocate and therefore its estimates may be affected by its optimism in effectively presenting the client's case. Estimates received from outside attorneys are more likely to reflect minimum losses than expected losses. (7). Existence and valuation of the liability account (7). It is not clear which is more persuasive. The first approach can be persuasive if it included a step to independently determine that the data entered into the client's spreadsheet is accurate and that the model had proved to be a good predictor of the actual warranty liability over a period of time. However, information that these two assumptions hold is not presented, and barring those assumptions, the second approach appears to be more persuasive. The second choice implies that the auditor independently gathered reliable data and tested the accuracy of the estimate over time and within the statistical parameters allowed by regression analysis. (8). Completeness of the recording of accounts payable (8). Requesting vendor statements is the most persuasive if the auditor has sufficient information to ensure that all major vendors are contacted, assuming that most vendors respond to the auditor's request. Most auditors use the first approach (examining open items and a sample of payments after year-end), which provides persuasive evidence if the client pays its bills on a regular and timely basis and has sufficient controls to ensure that all bills are identified for payment and if management is not motivated to understate accounts payable because of financial difficulty. (9). Completeness of a liability (savings deposit is a liability of the financial institution although it is an asset for the client) (9). The testing of the client's procedures is probably the most persuasive because (a) an independent department investigates and resolves all customer inquiries, and (b) strong regulatory controls ensure that the accounting systems to record savings deposits are strong. On the other hand, research has shown that individual customers do not do a good job (as measured by the accuracy of their responses) in confirming their savings or checking balances. This observation holds because the customers (a) must first complete a bank reconciliation to accurately respond (b) have come in many cases to rely on the accuracy of the bank and do not have their own independent recording system; and (c) have a natural bias not to report overstatements but to report understatements. (10). Existence and valuation (10). The auditor is confirming an asset account in this situation versus confirming a liability in (9). The confirmation with the borrower is the more persuasive evidence because it tells the auditor something about the customer's current acknowledgment of the debt. 7-45. a. Special risks that might concern the auditor regarding this account include A significant related-party transaction exists and may be more pervasive than just the year-end account balance. Three major customers are experiencing financial difficulties and thus might not be able to repay their loans. The client continues to sell products to the three customers experiencing difficulties adding to receivables that may ultimately not be collectible. The account balance has grown rapidly and substantially during the year. b. Assertions and audit procedures - Notes Receivable Assertions Auditing Procedures to Address Assertions Existence (All Examine notes receivable evidencing ownership, terms, and recorded notes parties involved. represent bona fide receivables). Inquire of management about the continued ownership of the notes (i.e., they have not been sold or are contingently due to some other parties). Also, obtain a confirmation from the bank to identify any discounted notes. Confirm with the customers the existence and terms of the notes. Assertions Auditing Procedures to Address Assertions Examine subsequent payments on notes. Completeness: All Examine the notes as stated above. notes are properly recorded in the Inquire of management as to the existence of any other notes. correct time period. Rights: The company Examine the notes as stated above. has the right to future payments to be received on the notes and can legally sell or otherwise realize the value of the notes. Valuation: The notes Obtain customer acknowledgment of the debt (see confirmation are properly valued procedure identified with existence assertion). at their net realizable value. Review credit status with Eagle River credit manager to assess credit risk. Determine whether it has current financial statements of the companies. Review outside credit analysis of companies by examining their Dun and Bradstreet report or similar credit analysis. Review notes for continuing payment to determine whether company is meeting periodic interest payments. Review accounts receivable for the same customers to determine whether the company is currently paying its accounts receivable. Discuss with management the adequacy of any allowance developed for the notes. Document your understanding of the valuation issues and assessment of collectibility problems. Review the value of any collateral for the notes. Presentation and disclosure: The notes are properly disclosed on the Review financial statements, including footnotes, for proper disclosure. Determine whether any additional disclosure is needed. Assertions Auditing Procedures to Address Assertions face of the financial statement. Any additional disclosure deemed necessary regarding collectibility problems is adequately disclosed in a footnote. Other: Determine Review audit documentation for completeness. sufficiency of audit work and reach Document, via memo, the assessment of audit work and financial conclusions. statement presentation of the notes receivable. 7-46. a. The primary purpose of documentation is to document the work performed and evidence gathered during the course of the audit engagement. The documentation is organized in a specific manner to accumulate all evidence regarding particular accounts in one place where it can be analyzed and reviewed by senior audit executives. The documentation, as a whole, should be conclusive regarding the accounts audited and the conclusions reached by the auditor on the fairness of the financial statement presentations. b. The audit documentation is owned by the auditor. c. A review of prior year documentation can provide important information that can be used in the current years audit engagement. Some of the information that might be obtained includes: Major adjustments as a result of the audit representing areas of misstatement and therefore providing some indication of audit risk. Time budget and actual time spent by audit area providing information on overall allocation of audit time and areas that demanded additional time because of problems encountered in the audit. Assessment of control risk and major deficiencies in the client's overall control structure. The existence of control risk provides input in determining whether the audit should focus primarily on minimizing detection risk, and thus developing procedures consistent with this assessment. Previous audit personnel's assessment of risks and problems encountered in the audit. d. Identification of potential adjustments not made. The auditor may choose not to make some adjustments to the financial statements because the amounts are not material and the client does not wish to have the adjustments recorded. However, some of these misstatements, when coupled with current period misstatements, could amount to material misstatements on the income statement. The auditor should consider both beginning and end-of-period misstatements in determining potential materiality. Other items of continuing audit significance, some of which are identified in the permanent file, others in memos by audit executive personnel. 1. Yes, it is permissible to furnish a copy of previous documents to clients as a guide for developing documents for the current year. The overall approach for performing an audit is not a mystery to the client; in fact, the auditor describes the overall audit approach as part of the process of obtaining new clients and shares the overall audit approach with the audit committee each year. The auditor may have some legitimate concerns. The auditor should not identify all the specific items that will be examined as part of the audit approach or share memos describing audit conclusions with the client. If the auditor has a serious question regarding management integrity and the client is perceived as high risk, the auditor may choose not to share documents with the client because the papers might be used to assist the client in preparing fictitious documentation. 2. The auditor should do some testing to gain assurance that client prepared documentation is adequate. One procedure is to examine the journal containing all the original entries for selected periods of time to determine whether all items over $5,000 were completely and correctly listed on the document. 7-47. 1. The document should contain an indication that it was prepared by the client (PBC). 2. Not all columns were footed or crossfooted. They should be because the client prepared the document. 3. Total cost is not cross-referenced to the trial balance. 4. Depreciation of the additions was not recalculated. 5. There is no indication whether the life, salvage value, and depreciation method for the additions are proper. 6. The beginning cost balances were not traced to the prior years documents. 7. The explanation of - (verified) is too general. It should indicate that source documents were examined. 8. The disposal of the lathe was not audited. 9. There is no indication that the gain or loss on disposals was audited. 10. An index, the initials of the preparer, and the date of preparation are missing. 11. The heading does not indicate the nature of the document. 12. There is no conclusion. 13. There should be columns for the depreciation method, lives, and salvage values. 14. Total cost is not cross-referenced to the trial balance. Cases: 7-48 a. The proper valuation of the allowance for doubtful accounts is managements best estimate of the amount of the accounts receivable that will not be collected. This is somewhat subjective and, since it is an estimate it normally will not be as precise as those accounts based on recorded transactions. b. The company should utilize the following information: Aging of the receivables Past collection experience Changes in credit policies Changes in the economy as it affects the customers Subsequent collections c. The auditor should: Inquire as to the credit policies and approach management takes to make its estimate and determine if it is a reasonable approach. Analyze the relationship between the provision for doubtful accounts and actual write-offs over the last few years. Review an aging of the accounts receivable and: o Compare with the prior year aging for any significant changes o Review subsequent collections o Inquire about customers with old balances o Review customer correspondence files to identify reasons for late payments o Obtain credit reports for large overdue balances Consider changes in the economic climate affecting the clients customers. d. Sales to less credit-worthy customers will normally lead to larger write-offs and, thus, a larger allowance. e. A change in the economic climate will impact the estimate; historical experience will be less useful in making the estimate. 7-49. 1. Inquiry of client personnel. If Addeco admitted to the problem, it would save time and focus the investigation in certain areas. 2. Examination of internal and external documentation. From the internal side, invoices for the services performed should be examined and the date of service should be investigated. Confirmations with customers or other external documents will provide a more reliable source of evidence, if they are available. In a case like this where the clients of Adecco are large companies, it is fair to assume they have an adequate level of documentation, including dates, since they have to determine when to include the expenses in their financial statements. 7-50. An extra shipment of $9 million of disks. The primary evidence is found by reviewing receipts for merchandise returned after year-end. The auditor examines records of goods returned after year-end to determine whether the returns were material and the previous sale should be reversed. The auditor also discovers evidence on the extra shipment because the $9 million sale would result in a $9 million receivable. If the auditor attempts to confirm the receivable with the customer, it is likely that the customer would indicate that the sale was not appropriate. Shipments were made from a factory in Singapore. The client is asserting that title had passed and sales and receivables should be recognized. Confirmation of the terms of the sale with customers would indicate the validity of the assertion. Returned goods were recorded as usable inventory. The auditor should perform analytical procedures and compare the percentage of returned goods with that of previous years and industry averages. In addition, the auditor should take a sample of goods received during the year and trace the items sampled into the recording process to determine the accounting used. The auditor should inquire of inventory control personnel to determine the appropriate method to be used and to compare current inventory levels with previous levels to determine whether there has been an inventory buildup. Just-in-time warehouses and the recording of sales. The auditor should examine sales taking place near the end of the year to determine whether shipments were going to customers. The auditor could also review the taking of inventory in the warehouses and determine why some goods might not be included in inventory. Finally, if the goods were sitting in MiniScribe's warehouses, it is most likely that a customer would not confirm the existence of the sale. 7-51. a. The auditor could have used risk analysis to determine the likelihood that a material misstatement might have existed as follows: The auditor should have noted increased pressure to improve reported earnings due to the merger of the two firms. This should have heightened awareness to (a) accounts that require a great deal of judgment; and (b) accounts that are complex to estimate or audit. The auditor could have compared the companys results with that obtained for the industry as a whole. As an example, the auditor would have noted that the company was accelerating revenue recognition or delaying the write-off of old accounts. The auditor should have reviewed the clients internal control system, especially monitoring controls, to determine if there were sufficient controls whereby management reviewed unusual entries or items that varied from the expected. The auditor should always be alert to unusually large sales transactions that take place near the end of each quarter. b. Audit procedures (and audit evidence gathered) that would have detected the misstatement. Financial Statement Misstatement Irregular Charges Against Merger Reserves False Coding of Services sold to Customers Audit Procedures to Detect Error or Misstatement Reserves should be set up at the time of a merger in anticipation of future expenses directly associated with the merger. The client should have an information system in place to track all changes against these reserves. Any unusual entry to the reserves should be investigated. Thus, it would be unusual to debit reserves and credit revenue. The auditor should select a sample of all debits to the reserves and trace to supporting documents justifying the journal entry. The basis for the entry should be determined by examining underlying documents. Those that are not supported should have been reversed. First, analytical review procedures should be used to identify unusual increases in revenue, or increases in revenue that would be higher than expected given (a) the number of members; and (b) industry trends. Financial Statement Misstatement Audit Procedures to Detect Error or Misstatement Second, a sample of revenue recorded should be taken, particularly during periods of unusual increases in revenue, and traced back to the underlying supporting document to determine if they are recorded properly. Delayed recognition of Take a sample of recorded charge-backs and trace cancellation of back initial notice from the bank to see if the items memberships and "charge- are recorded on a timely basis. backs" (a charge-back is a Take a sample of bank charge back notices and trace rejection by a credit card- to the recording of the charge-back noting whether issuing bank of a charge to they were recorded on a timely basis. If not, make an a member's credit card estimate of unrecorded charge-backs to determine if account). the amount might be material at year-end. Compare the percentage of charge-backs recorded during this year with (a) previous year results; and (b) industry averages. Quarterly recording of fictitious Examine all unusually large increases in revenue at revenues the end of a quarter. Take a sample of all journal entries into the revenue account that come from other than the sales journal. Examine the journal entries in detail including examination of underlying support for the journal entries. If suspicious, send a confirmation of the sales and services provided to selected customers. c. The auditors assessment of management integrity and management motivation should affect all audits. In the above situation, the auditor had a great deal of reason to question managements motivation due to a merger and managements reputation to use accounting as a tool to increase reported earnings. Given the suspicions by the auditor, the auditor should have: Assessed risk of potential misstatement as higher than usual. Identified the accounts that are most susceptible to management manipulation. Developed a plan to compare recorded results with previous results and with industry averages and then investigate any unusual items. Determine whether sufficient controls existed to prevent errors or other misstatements. Investigated account balances that showed any (a) unusual activity during the end of any quarter, or (b) unusual increases in amounts. Investigated any account balance where the entries into the account are susceptible to management judgment, e.g. the charges against merger reserves. 7-52 a. Continued decline in market share, and a market shift (or an increase in or acceleration of market shift) away from sales of trucks or sport utility vehicles, or from sales of other more profitable vehicles in the United States. Account: Sales revenue Assertion: Existence. There exist incentives for management in geographic regions experiencing slowdowns to inappropriately record next years sales in this years income statement. Therefore, auditors should ensure that sales by geographic region are recorded accurately and actually exist in the year in which they are recorded. b. Continued or increased price competition resulting from industry overcapacity, currency fluctuations or other factors. Account: Inventory. Assertion: Valuation. Price competition may drive down the market value of inventory. The auditor should ensure that inventory is written down to reflect lower of cost or market values. c. Lower-than-anticipated market acceptance of new or existing products. Account: Inventory. Assertion: Valuation. Lack of market acceptance of a produce may drive down the market value of inventory. The auditor should ensure that inventory is written down to reflect lower of cost or market values. d. Substantial pension and postretirement healthcare and life insurance liabilities impairing our liquidity or financial condition. Account: Pension liabilities. Assertion: Valuation, presentation and disclosure. The auditor must ensure that pension obligations are valued appropriately and are adequately disclosed in the footnotes. e. Worse-than-assumed economic and demographic experience for our postretirement benefit plans (e.g., discount rates, investment returns, and health care cost trends). Account: Pension liabilities. Assertion: Valuation, presentation and disclosure. The auditor must ensure that pension obligations are valued appropriately and are adequately disclosed in the footnotes. f. The discovery of defects in vehicles resulting in delays in new model launches, recall campaigns or increased warranty costs. Account: Inventory, warranty expense. Assertion: Valuation, completeness. The auditor must ensure that inventory values reflect reductions to reflect defect issues. The auditor must ensure that Ford completely reflects all appropriate expenses associated with the defect and warranty issues because there is an incentive on the part of management to minimize the recognition of such expenses. g. Unusual or significant litigation or governmental investigations arising out of alleged defects in our products or otherwise. Account: Litigation liabilities. Assertion: Presentation and Disclosure. The auditor must ensure that management adequately discloses litigation because they have an obvious incentive not to do so. 7-53 1. Students should reflect on and discuss this issue in small groups. Individual answers to this question will of course differ by individual. The purpose of this question is to get students thinking about the pressures that a staff auditor may face in conducting high quality evidence gathering and documentation procedures. 2. Elizabeths misrepresentation of her work is important to the Firm because it provides inappropriate assurance regarding the clients account balance. If there are errors, Elizabeths inadequate procedures and inaccurate documentation will fail to alert the attention of higher level members of her audit team, thereby increasing the audit risk that her Firm assumes. 3. Elizabeth did do some things right once her misrepresentation was discovered. She readily confessed to her actions, expressed remorse, and promised not to engage in ghost tickmarking in the future. She could have become defensive, argumentative, and evasive about the situation but she did not. Ultimately, it was her positive attitude about the situation that saved her from getting fired in actual practice. In fact, in the actual practice situation, one reason that Elizabeth was retained by the Firm (rather than fired) was that she had always been a good performer with a good attitude in the past. She was viewed as an asset to the Firm, so her supervisors were willing to give her the benefit of the doubt in this situation. 4. Do you agree with the outcome? Do you think the Firm was too lenient? Too harsh? Answers to this question will of course differ by individual and group. Instructors should encourage groups to report out to the larger class in a discussion to highlight the rationale that individuals/groups used to arrive at their conclusion. In prior use of these materials, groups were about evenly split between whether the outcome was too lenient versus too harsh. As an example of one way to answer this question by applying the ethical decision making framework from Chapter 3, consider the following steps: Identify the ethical issue(s). The issue involves Elizabeths decision to engage in ghost tickmarking. Determine who are the affected parties and identify their rights. The parties affected by Elizabeths actions include: (1) The audit firm as a whole. The firm has a right to demand and expect high quality performance. (2) Elizabeths supervisors. The auditors in charge of (and responsible for) the job have the right to honesty and high quality work. (3) The client and its stakeholders. The client hires auditors to help them be sure that their financial records are accurate. If the audit firm does not catch an error, then the financial statements may be misstated. Determine the most important rights. The most important rights are those held by the client and its stakeholders. They are paying for high quality service, and if Elizabeths actions had not been discovered, they would not have received such service. Develop alternative courses of action. Student groups that believe the audit firm was too lenient generally argue that Elizabeth deserved to be fired outright for her actions, because of her dishonesty and the costs that it imposed on the audit firm and her colleagues (e.g., extra levels of review over the course of the year). Student groups that believe the audit firm was too harsh generally argue that Elizabeth made one isolated mistake and she deserves the benefit of the doubt and a chance to redeem herself. Student groups in the too harsh camp are usually especially annoyed that the firm initially did not consider firing Elizabeth, and then later did consider firing her. Determine the likely consequences of each proposed course of action. Consequences will depend on whether students believe the firm was too lenient or too harsh. Assume that students decided the firm was too lenient. In this case, the consequences will fall squarely on Elizabeths shoulders, as she will get fired and will have to start her career at another job, and with a potentially tarnished reputation. Now assume that students decided the firm was too harsh. In this case, the client does not suffer negative consequences because Elizabeths supervisor detected and corrected her mistakes. Thus, the negative consequences accrue to the firm and her supervisors, who bear the incremental costs in terms of time required to more closely supervise Elizabeth. Assess the possible consequences, including an estimation of the greatest good for the greatest number. Determine whether the rights framework would cause any course of action to be eliminated. Some student groups will conclude that the best course of action is for the firm NOT to fire Elizabeth, but to hold a training session anonymously describing the situation and warning other auditors in the office of the impropriety of ghost tickmarking. These students will argue that this will assure the greatest good in terms of improved performance by all auditors of the office, and the ability for others to learn from Elizabeths mistake. Decide on the appropriate course of action. Answers and ideas vary widely across student groups. Answers generally include (1) immediately firing Elizabeth, (2) not firing Elizabeth and simply counseling her and not noting the matter in her personnel record, (3) not firing Elizabeth but noting the matter in her personnel record, i.e., the actual outcome of the case, (4) not firing Elizabeth but using the situation to motivate staff training, and (5) firing Elizabeth and using the situation to motivate staff training and to send a strict message throughout the office. 7-54. 1. The PCAOB report summarized a problem with Deloittes evidence collection, evaluation, and documentation at a particular issuer client. Articulate why you believe the PCAOB was dissatisfied with the Firms performance. The PCAOB was concerned because Deloitte clearly did not challenge the issuers lack of willingness to write the physical plant asset down to net realizable value. Evidence of that lack of willingness is clear based on the shoddy audit documentation that the PCAOB uncovered, e.g., lack of calculations that would enable the audit team to calculate net realizable value and lack of auditor generated evidence with accompanying over-reliance on client-generated documentation. The PCAOB is concerned because the plant asset is recorded at historical cost, which is apparently significantly higher than what would be recorded at net realizable value. Thus, the issuers assets are overvalued on the balance sheet, which may affect users decisions based on the financial statements. And given that the write-down would have increased the issuers net loss by a substantial amount, the PCAOB seems to have just cause for concern. Because of power supply issues in a country, the output of the issuer's plant in that country was severely curtailed in 2003. The issuer entered into discussions with the government to sell the facility and determined that, at the low end of the range of potential sales prices, the book value of the facility could be impaired by an amount up to four percent of the issuer's net loss for the year ended December 31, 2003. The issuer determined, however, that it was not necessary to record an impairment loss at the end of 2003, in part because the issuer contended that, absent the power supply shortage, the facility could operate at full capacity. The Firm's work papers included issuer-generated support for the determination not to record an impairment loss, but that support did not include detailed calculations of the estimated future cash flows or probability-weighted cash flows, nor did it address when, or if, the plant would be able to return to near capacity. Such analyses, or other detailed information addressing the value of the plant, would be necessary for the Firm to perform an appropriate evaluation of management's assertion that it was not necessary to record an impairment loss at the end of 2003. 2. Use the decision analysis framework from Chapter 3 to determine the appropriate steps that the Firm could have taken that would have ultimately been acceptable to the PCAOB. In Step One, the auditor structures the problem, considering the relevant parties to involve in the decision process, identifying various feasible alternatives, considering how to evaluate the alternatives, identifying uncertainties or risks, and determining how to structure the problem. To illustrate these tasks, the audit engagement team should have structured the problem to address both the clients valuation estimates, and the teams own independent valuation estimates. Toward that end, the team should have relied on valuation experts within Deloitte, or should have hired outside experts in valuing power plant assets. The team should have identified various alternatives, including that (1) the issuers valuation is correct and no write-down is necessary, or (2) the issuers valuation is incorrect, and a write-down is necessary. The team should have identified the risks, primarily that the plant assets would be over-valued on the balance sheet. The team should have structured the problem to provide evidence that it sought and evaluated independent evidence about the issuers plant asset. In doing so, they should have identified and followed appropriate GAAP for the potential write-down and they should have structured the problem to include some type of valuation process. In Step Two, the auditor assesses the consequences of the potential alternatives. Considerations at this stage include determining the dimensions on which to evaluate the alternatives and considering how to weight those dimensions. In this case, there are two potential alternatives. The dimensions on which to evaluate the alternatives include valuation estimates and considerations of appropriate GAAP for writing down physical assets. In Step Three, the auditor assesses the uncertainties in the situation. For example, the auditor tries to assess the likelihood of various consequences associated with potential alternatives. Some consequences are more likely than others, and some are more costly than others. In this case, the primary uncertainty whether or not the issuer would ultimately be able to operate the power plant at near full capacity, and whether they would ultimately sell the plan to the government of the country in which the plant is located. The issuers contention that they should not write down the asset because it could operate at full capacity seems hollow; the audit team must determine whether such operation might actually be feasible in the short term. In Step Four, the auditor evaluates the alternatives against some decision rule. For auditors, decision rules are often articulated in terms of generally accepted accounting principles. In our example, the primary criterion is simple: follow GAAP, which will almost certainly lead to a write-down. In Step Five, the auditor considers the sensitivity of the conclusions reached in steps two, three, and four to incorrect assumptions. For example, in this case, the assumptions involve uncertainty estimates of the future operational use of the plant. Perhaps the issuer can show that the plant re-started full operations shortly into the subsequent year, and that might provide evidence that a write-down is unnecessary because the plant was only inoperable for a very short period of time. Absent such evidence, the issuer will have difficulty asserting that the plant asset should be recorded at historical cost. In Step Six, the auditor gathers information in an iterative process that affects considerations about the consequences of potential alternatives and the uncertainties associated with those judgments. Importantly, the auditor considers the costs and benefits of information acquisition, knowing that gathering additional evidence requires time, effort, and money. Given that audits are a for-profit enterprise, cost-benefit considerations in evidence gathering are particularly important. A good auditor knows when to say when and decides to stop collecting evidence at the right time. In contrast, some auditors stop evidence collection too soon, thereby yielding inadequate evidence on which to make a decision. Still others continue evidence collection even though the current evidence is adequate, thereby contributing to inefficiency and reduced profitability in the audit. In this case, Deloitte clearly stopped evidence collection too soon, which caused the PCAOBs objection. Further evidence collection is clearly needed to support or refute the clients preference for not recording a write-down. The auditor iterates through steps one through six repeatedly until satisfied that a decision can prudently be made. In Step Seven, the auditor needs to make the difficult determination of whether they have sufficiently analyzed the problem, and whether the risk of making an incorrect decision has been minimized to an acceptable level by collecting adequate, convincing evidence. Ultimately, they must make and document the decision that they have reached. Ford Motor Company and Toyota Motor Corporation: A Framework for Audit Evidence 1. Consider Fords inventory account on the balance sheet, along with the accompanying footnote. What are the most important assertions that management is making with regard to its inventory? The following assertions are most important for the inventory account: Existence/occurrence. The assets, liabilities, and equity interests are able to be accounted for, either physically or via verification in the accounting system. For Ford, management is asserting that the inventory physically exists. Rights/obligations. The entity holds or controls the legal ownership to assets, and liabilities are the legally owed by the entity. For Ford, management is asserting that the inventory is actually owned by Ford, i.e., they have title to the inventory. Valuation/allocation. Assets, liabilities, and equity interests are included in the financial statements at appropriate amounts and any resulting valuation or allocation adjustments are appropriately recorded. For Ford, management is asserting that inventory is properly valued at $10,121,000,000. Presentation/disclosure. Assets, liabilities, and equity interests are appropriately classified on the financial statements, and are adequately described in the footnotes to the financial statements. For Ford, management is asserting that inventory is properly presented as an asset on the face of the balance sheet, and that the footnote describing FIFO and LIFO valuation methodologies is accurate and appropriate. Note that we do NOT list completeness as an important assertion for the inventory account. Managements motivation in the case of Ford is to overstate, rather than understate, its asset accounts. Therefore, it is unlikely that Ford management would inappropriately omit any assets such as inventory. 2. Ford, in particular, is working to change models from SUVs to more fuel efficient, smaller cars. How might that change affect the valuation of its bigger pick-ups and SUVs? Ford runs a risk that the SUVs and large sized pick-ups cannot be sold current retail prices, and more importantly, may require either: The company has a longer holding period on the vehicles, thus increasing the cost of financing inventory, and/or The company will have to sell the vehicles either at a lost or at a large discount from current expected selling prices. Either of these would suggest that the company has a lower of cost or market valuation problem and the auditor will have to explicitly address the potential that a large portion of inventory may need to be written down to reflect a significant decrease in the current market value of its assets. 3. What assertions are implied in the Property, Plant, and Equipment account? How would valuation be affected if the company decided to downsize and eliminate a line of pick-up trucks? The assertions are the same as indicated above: Completeness Existence Valuation or Allocation Presentation and Disclosure. For Ford, in particular, management has announced a plan to significantly reduce the scope of operations. It is doing so by closing plants, discounting non-profitable lines, and consolidating manufacturing into lower cost areas (either lower wages or lower costs of operations). If management decides to close a production line, then the auditor must develop impairment testing to ascertain the likely sales price of the plant. If the selling price (including the cost of equipment associated with the product line) is less than the current carrying value of the assets, the company must write down the plant and equipment to their best estimate of current market value of the assets. 4. Examine the assets on the balance sheet of Ford Motor Company. Identify the assets that are subject to (a) fair value adjustments, (b) impairment tests, or (c) other adjustments to either net realizable value or lower of cost or market value? What are the implications for audit evidence that will be gathered for those accounts? The overwhelming response should be that virtually all of the items on the asset side of the balance sheet are subject to one of those three situations noted above: Fair Value Adjustments Cash Equivalents Marketable Securities Loaned Securities Impairment Tests Net Investments in Operating Leases Retained interest in sold receivables Inventory Property, Plant, and Equipment Goodwill Discontinued Assets or Assets Held for Resale Other Assets Estimates Finance Receivables Other Receivables The main point we want the students to understand is that every asset on the books of Ford Motor Co. is subject to potential write-downs due to either changes in fair value, changes in the value of the assets, or changes in estimated cash to be received from the assets, e.g. net receivables. Thus, the auditors will look beyond historical cost in auditing each of these items. 5. Consider Fords debt account on the balance sheet, along with the accompanying footnote. What are the most important assertions that management is making with regard to its debt? Completeness. All assets, liabilities, and equity interests that should have been recorded have been recorded, i.e., nothing is left out of the financial statements. For Ford, management is asserting that they have not omitted any debt that should have been recorded as a liability. Rights/obligations. The entity holds or controls the legal ownership to assets, and liabilities are the legally owed by the entity. For Ford, management is asserting that it legally owes the debts listed on the balance sheet. Valuation/allocation. Assets, liabilities, and equity interests are included in the financial statements at appropriate amounts and any resulting valuation or allocation adjustments are appropriately recorded. For Ford, management is asserting that it owes $168,530,000,000. Presentation/disclosure. Assets, liabilities, and equity interests are appropriately classified on the financial statements, and are adequately described in the footnotes to the financial statements. For Ford, management is asserting that debt is properly presented as a debt on the face of the balance sheet, and that the footnote describing the additional lines of credit/liquidity sources is accurate and appropriate. Note that we do NOT list existence as an important assertion for the debt account. Managements motivation in the case of Ford is to understate, rather than overstate, its liability accounts. Therefore, it is unlikely that Ford management would inappropriately include more debt than necessary on the balance sheet. ... View Full Document

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