Johnstone Auditing Chapters

Johnstone Auditing Chapters

Johnstone Auditing Chapters

 

Question 1

Required

Green, CPA, is considering audit risk, including fraud risk, at the financial statement level in planning the audit of National Federal Bank (NFB) Company's financial statements for the year ended December 31, 20X5. Audit risk at the financial statement level is influenced by the risk of material misstatements, which may be indicated by a combination of factors related to management, the industry, and the entity. In assessing such factors Green has gathered the following information concerning NFB's environment.

Company Profile

NFB is a federally insured bank that has been consistently more profitable than the industry average by marketing mortgages on properties in a prosperous rural area, which has experienced considerable growth in recent years. NFB packages its mortgages and sells them to large mortgage investment trusts. Despite recent volatility of interest rates, NFB has been able to continue selling its mortgages as a source of new lendable funds.

NFB's board of directors is controlled by Smith, the majority stockholder, who also acts as the chief executive officer. Management at the bank's branch offices has authority for directing and controlling NFB's operations and is compensated based on branch profitability. The internal auditor reports directly to Harris, a minority shareholder, who also acts as chairman of the board's audit committee.

The accounting department has experienced little turnover in personnel during the five years Green has audited NFB. NFB's formula consistently underestimates the allowance for loan losses, but its controller has always been receptive to Green's suggestions to increase the allowance during each engagement.

Recent developments

During 20X5, NFB opened a branch office in a suburban town thirty miles from its principal place of business. Although this branch is not yet profitable due to competition from several well-established regional banks, management believes that the branch will be profitable by 20X7. Also, during 20X5, NFB increased the efficiency of its accounting operations by installing a new, sophisticated computer system.

Items to be answered:

Based only on the information above, indicate by marking the appropriate button whether the following factors indicate an increased (I) or decreased (D) audit risk.

Factor Increased audit risk Decreased audit risk
1. Branch management authority
2. Government regulation
3. Company profitability
4. Demand for product
5. Interest rates
6. Availability of mortgage funds
7. Involvement of principal shareholder in management
8. Branch manager compensation
9. Internal audit reporting relationship
10. Accounting department turnover
11. Continuing audit relationship
12. Internal controls over accounting estimates
13. Response to proposed accounting adjustments
14. New unprofitable branch
15. New computer system
Factor Increased audit risk Decreased audit risk
1. Branch management authority
2. Government regulation
3. Company profitability
4. Demand for product
5. Interest rates
6. Availability of mortgage funds
7. Involvement of principal shareholder in management
8. Branch manager compensation
9. Internal audit reporting relationship
10. Accounting department turnover
11. Continuing audit relationship
12. Internal controls over accounting estimates
13. Response to proposed accounting adjustments
14. New unprofitable branch
15. New computer system
1. I Since branch managers have the authority to direct and control the entity's operations and are compensated based on branch performance, they have an incentive to commit fraud and represent a fraud risk factor that increases audit risk.
2. D Government regulation indicates another level of oversight, which reduces audit risk.
3. D When an entity is profitable, it has less incentive to commit fraudulent financial reporting, reducing audit risk.
4. D A strong demand for an entity's product, as indicated by its ability to continue selling despite volatile interest rates, reduces the incentive for fraudulent financial reporting, reducing audit risk.
5. I The fact that interest rates are volatile increase the likelihood that an error will be made in making interest calculations and in reporting interest related transactions. This increases audit risk, due to the increased possibility of errors, but does not represent a fraud risk factor.
6. D The availability of mortgage funds facilitates the entity's ability to do business profitably, reducing the incentive for fraudulent financial reporting and reducing audit risk.
7. D In general, when an owner is involved in management, it increases oversight over employees and decreases the risk of fraud.
8. I Since branch managers are compensated on the basis of branch performance, they would be incentivized to overstate branch results representing a fraud risk factor that increases audit risk.
9. D The fact that the internal auditors report to an independent member of the board of directors increases their independence and their potential effectiveness. This reduces the likelihood that violations of internal controls will go undetected, reducing audit risk.
10. D A lack of turnover of accounting personnel indicates that existing personnel will be more familiar with the transactions and policies of the entity and are less likely to make errors, reducing audit risk.
11. D A long-term relationship between auditor and client increases the auditor's familiarity with the client and has the potential of increasing the effectiveness of the auditor's risk assessment, reducing audit risk.
12. I The fact that estimates of loan losses are consistently understated indicates, as a minimum, that the company does not have effective policies when it comes to developing estimates, increasing audit risk. Such underestimates may be intentional on the part of management to improve the appearance of results, indicating a fraud risk factor.
13. D The fact that the client responds favorably to the auditor's proposed adjustments indicates that the entity is at least willing to issue financial statements that are fairly presented, reducing audit risk.
14. I The acquisition of an unprofitable branch may have the tendency to make results look unfavorable and, as a result, management may be motivated to minimize the negative impact by overstating the unprofitable branch’s results. This represents a fraud risk factor that increases audit risk.
15. I A new computer system increases the likelihood of error as personnel become familiar with the system. This increases audit risk.

Question 1

Items 1 through 15 pertain to an auditor's risk analysis of an entity. Select the best answer for each item.

Bond, CPA, is considering audit risk at the financial statement level in planning the audit of Toxic Waste Disposal (TWD) Company's financial statements for the year ended December 31, 20X6. TWD is a privately owned entity that contracts with municipal governments to remove environmental wastes. Audit risk at the financial statement level is influenced by the risk of material misstatements, which may be indicated by a combination of factors related to management, the industry, and the entity.

Required

Based only on the information below, indicate whether each of the following factors ( Items 1 through 15) would most likely increase (I) decrease (D) or have no effect (N) on audit risk and the risk of material misstatement.

Items to be answered

Company Profile
  1. This was the first year TWD operated at a profit since 20X2 because the municipalities received increased federal and state funding for environmental purposes.
  2. TWD's Board of Directors is controlled by Mead, the majority stockholder, who also acts as the chief executive officer.
  3. The internal auditor reports to the con¬troller and the controller reports to Mead.
  4. The accounting department has experienced a high rate of turnover of key personnel.
  5. TWD's bank has a loan officer who meets regularly with TWD's CEO and controller to monitor TWD's financial performance.
  6. TWD's employees are paid biweekly.
  7. Bond has audited TWD for four years.

Recent developments

  1. During 20X6, TWD changed its method of preparing its financial statements from the cash basis to generally accepted accounting principles.
  2. During 20X6, TWD sold one half of its controlling interest in United Equipment Leasing (UEL) Co. TWD retained significant interest in UEL.
  3. During 20X6, litigation filed against TWD in 20X1 alleging that TWD discharged pollutants into state waterways was dropped by the state. Loss contingency disclosures that TWD included in prior years' financial statements are being removed for the 20X6 financial statements.
  4. During December 20X6, TWD signed a contract to lease disposal equipment from an entity owned by Mead's parents. This related party transaction is not disclosed in TWD's notes to its 20X6 financial statements.
  5. During December 20X6, TWD completed a barter transaction with a municipality. TWD removed waste from a municipally owned site and acquired title to another contaminated site at below market price. TWD intends to service this new site in 20X7
  6. During December 20X6 TWD increased its casualty insurance coverage on several pieces of sophisticated machinery from historical cost to replacement cost.
  7. Inquiries about the substantial increase in revenue TWD recorded in the fourth quarter of 19X6 disclosed a new policy. TWD guaranteed to several municipalities that it would refund the federal and state funding paid to TWD if any municipality fails federal or state site clean-up inspection in 20X7.
  8. An initial public offering of TWD's stock is planned for late 20X7.
1. D Increased federal and state funding providing a profitable year would decrease audit risk and risk of material misstatement since management will have less of a need to overstate profits.
2. I Control of the board of directors by a majority stockholder who is also the chief executive officer (management is dominated by a single individual) gives one individual the opportunity to circumvent internal controls, increasing audit risk and the risk of material misstatement.
3. I The internal auditor should report directly to the board of directors or the audit committee. Reporting to the controller and indirectly to the majority stockholder increases audit risk and the risk of material misstatement.
4. I A high turnover of personnel in the accounting department results in a greater likelihood of errors and may indicate problems, increasing audit risk and the risk of material misstatement.
5. D Regular meetings between the controller and a bank loan officer increase the likelihood that problems will be detected and communicated, decreasing audit risk and the risk of material misstatement.
6. N The frequency with which employees are paid has no impact on audit risk or the risk of material misstatement..
7. D A continuing auditor will have greater familiarity with the client and their business and industry, decreasing audit risk and the risk of material misstatement..
8. I Changing the method of accounting, even to a more favorable method, increases the likelihood of errors, increasing audit risk and the risk of material misstatement.
9. I Selling one-half of a controlling interest in another company means that the equity method would be applied instead of the preparation of consolidated financial statements. This would increase audit risk due to the reduced ability to obtain information and also increase the risk of material misstatement.
10. D The elimination of a loss contingency due to a lawsuit being dropped eliminates the possibility of understating a potential liability reducing audit risk and the risk of material misstatement.
11. I Entering into a significant related party transaction increases the possibility that the transaction will not be properly accounted for, increasing audit risk and the risk of material misstatement.
12. I Acquiring title to a contaminated site is an unusual transaction and creates a contingent liability, depending on the nature of the contamination. As a result, both audit risk and the risk of material misstatement are increased.
13. N Insurance coverage would have little to no effect on audit risk and the risk of material misstatement.
14. I Guaranteeing a refund to municipalities failing federal or state clean-up inspection creates a contingent liability and increases audit risk.
15. I With an initial public offering planned; there is greater incentive to overstate profitability and financial position, increasing audit risk.

Question 1

Items 1 through 15 represent a series of unrelated statements, questions, excerpts, and comments taken from various parts of an auditor's working paper file. Below the items is a list of the likely sources of the statements, questions, excerpts, and comments. Select, as the best answer for each item, the most likely source. Select only one source for each item. A source may be selected once, more than once, or not at all.

  1. Partner's engagement review program.
  2. Communication with predecessor auditor.
  3. Auditor's engagement letter.
  4. Management representation letter.
  5. Standard financial institution confirmation request.
  6. Auditor's communication with the audit committee.
  7. Auditor's report.
  8. Letter for underwriters.
  9. Audit inquiry letter to legal counsel.
  10. Accounts receivable confirmation.

Items to be answered

  1. All transactions have been recorded in the accounting records and are reflected in the financial statements.
  2. In connection with an audit of our financial statements, management has prepared, and furnished to our auditors, a description and evaluation of certain contingencies.
  3. Provision has been made for any material loss to be sustained in the fulfillment of, or from the inability to fulfill, any sales commitments.
  4. Fees for our services are based on our regular per diem rates, plus travel and other out-of-pocket expenses.
  5. The objective of our audit is to express an unmodified opinion on the financial statements, although it is possible that facts or circumstances encountered may preclude us from expressing an unqualified opinion.
  6. We are not aware of any instances of non-compliance with laws and regulations that have not been fully disclosed.
  7. Are you aware of any facts or circumstances that may indicate a lack of integrity by any member of senior management?
  8. If a difference of opinion on a practice problem existed between engagement personnel and a specialist or other consultant, was the difference resolved in accordance with firm policy and appropriately documented?
  9. Although we have not conducted a comprehensive, detailed search of our records, no other deposit or loan accounts have come to our attention except as noted below.
  10. At the conclusion of our audit, we will request certain written representations from you about the financial statements and related matters.
  11. Significant assumptions used by us in making accounting estimates, including those measured at fair value, are reasonable.
  12. As discussed in Note 14 to the financial statements, the Company has had numerous dealings with businesses controlled by, and people who are related to, the officers of the Company.
  13. There were unreasonable delays by management in permitting the commencement of the audit and in providing needed information.
  14. If this statement is not correct, please write promptly, using the enclosed envelope, and give details of any differences directly to our auditors.
  15. The Company has suffered recurring losses from operations and has a net capital deficiency that raises substantial doubt about its ability to continue as a going concern.
1. D The auditor would want management to provide assurance that all transactions have been recorded in the accounting records and are reflected in the financial statements. This relates to the completeness assertion.
2. I In order for the auditor to obtain information about contingencies from the entity's legal counsel, management will prepare a list of contingencies for the auditor and prepare a letter of inquiry.
3. D Management, in its letter of representation to the auditor, will give the auditor assurance that any contingent losses resulting from the inability to fulfill sales commitments have been accrued.
4. C To avoid a misunderstanding with the client, the auditor will prepare an engagement letter which will include information about how fees for services are determined.
5. C To avoid a misunderstanding with the client, the auditor will prepare an engagement letter which will include a statement as to the objective of the engagement, the expression of an opinion on the financial statements, and the fact that circumstances could preclude the expression of an opinion.
6. D Management, in its letter of representation to the auditor, will give the auditor assurance that they are not aware of any instances of non-compliance with laws and regulations that have not been fully disclosed.
7. B The auditor will want to be aware of any circumstances that may indicate that members of senior management lack integrity. This information can be learned from a predecessor auditor.
8. A When reviewing the engagement prior to the issuance of an opinion, a partner will want to make certain that all differences of opinion that may effect information on the financial statements have been resolved.
9. E Among the issues that an auditor will want to learn from a financial institution will be whether the entity has loans or other accounts about which the auditor is not aware. A request for this information is included on a standard bank confirmation.
10. C To avoid a misunderstanding with the client, the auditor will prepare an engagement letter which will include an indication that the auditor will be expecting a letter of representations from the client.
11. D In its letter of representation, management will assure the auditor that the significant assumptions used in making accounting estimates, including those measured at fair value, are reasonable.
12. G The auditor may wish to emphasize a matter, such as the existence of related party transactions, by adding an emphasis-of-matter paragraph to the auditor's report.
13. F When management does not cooperate with the auditors, such as through unreasonable delays in permitting audit procedures, the auditor will communicate the problem to the board of through communication with the audit committee.
14. J In an accounts receivable confirmation, a customer will be asked to review the balance owing as of a particular date and respond directly to the auditor as to agreement or disagreement.
15. G The auditor will generally emphasize going concern doubts by including an emphasis-of-matter paragraph in the audit report.

Question 1

Darren, CPA, is auditing the financial statements of Menter, Inc. for the year ended January 31, 20X5. Darren has compiled a list of possible errors and irregularities that may result in the misstatement of Menter Inc. financial statements, and a corresponding list of internal control procedures that, if properly designed and implemented, could assist Menter Inc. in preventing or detecting the errors and irregularities.

Required

For each possible error and irregularity numbered 1 through 15, select one internal control procedure from the answer list that, if properly designed and implemented, most likely could assist Menter Inc. in preventing or detecting the errors and irregularities. Each response in the list of internal control procedures may be selected once, more than once, or not at all.

Possible Errors and Irregularities

  1. Invoices for goods sold are posted to incorrect customer accounts.
  2. Goods ordered by customers are shipped, but are not billed to anyone.
  3. Invoices are sent for shipped goods, but are not recorded in the sales journal.
  4. Invoices are sent for shipped goods and are recorded in the sales journal, but are not posted to any customer account.
  5. Credit sales are made to individuals with unsatisfactory credit ratings.
  6. Goods are removed from inventory for unauthorized orders.
  7. Goods shipped to customers do not agree with goods ordered by customers.
  8. Invoices are sent to allies in a fraudulent scheme and sales are recorded for fictitious transactions.
  9. Customers' checks are received for less than the customers' full account balances, but the customers' full account balances are credited.
  10. Customers' checks are misappropriated before being forwarded to the cashier for deposit.
  11. Customers' checks are credited to incorrect customer accounts.
  12. Different customer accounts are each credited for the same cash receipt.
  13. Customers' checks are properly credited to customer accounts and are properly deposited, but errors are made in recording receipts in the cash receipts journal.
  14. Customers' checks are misappropriated after being forwarded to the cashier for deposit.
  15. Invalid transactions granting credit for sales returns are recorded.

Items to be answered:

Internal Control Procedures
  1. Shipping clerks compare goods received from the warehouse with the details on the shipping documents.
  2. Approved sales orders are required for goods to be released from the warehouse.
  3. Monthly statements are mailed to all customers with outstanding balances.
  4. Shipping clerks compare goods received from the warehouse with approved sales orders.
  5. Customer orders are compared with the inventory master file to determine whether items ordered are in stock.
  6. Daily sales summaries are compared with control totals of invoices.
  7. Shipping documents are compared with sales invoices when goods are shipped.
  8. Sales invoices are compared with the master price file.
  9. Customer orders are compared with an approved customer list.
  10. Sales orders are prepared for each customer order.
  11. Control amounts posted to the accounts receivable ledger are compared with control totals of invoices.
  12. Sales invoices are compared with shipping documents and approved customer orders before invoices are mailed.
  13. Pre-numbered credit memos are used for granting credit for goods returned.
  14. Goods returned for credit are approved by the supervisor of the sales department.
  15. Remittance advices are separated from the checks in the mailroom and forwarded to the accounting department.
  16. Total amounts posted to the accounts receivable ledger from remittance advices are compared with the validated bank deposit slip.
  17. The cashier examines each check for proper endorsement.
  18. Validated deposit slips are compared with the cashier's daily cash summaries.
  19. An employee, other than the bookkeeper, periodically prepares a bank reconciliation.
  20. Sales returns are approved by the same employee who issues receiving reports evidencing actual return of goods.
Task-based Simulation Solution 4


1. C With monthly statements mailed to all customers with outstanding balances, an incorrect posting of an invoice to a customer's account is likely to be noticed by the customer and brought to the appropriate party's attention.
2. G By starting with the population of shipping documents and comparing them to sales invoices when goods are shipped, any good shipped that are not billed will result in shipping documents that will not be able to be matched to an invoice.
3. F To determine if all sales invoices are recorded in the sales journal, the auditor can check for missing numbers if the sales invoices are prenumbered or can work from a population of all sales invoices and trace them to the sales journal. In addition, the auditor can compare a summary of daily sales to the amount recorded for that day in the sales journal to determine if there are unrecorded invoices.
4. K By comparing control totals of invoices to amounts posted to the accounts receivable ledger, it can be ascertained that all invoices are posted to someone's account.
5. I To avoid making sales to individuals with unsatisfactory credit ratings, the company can require that all credit sales be to customers who have already been approved and are listed on an approved list or require authorization from an appropriate party with credit granting authority.
6. B Removal of goods from inventory for unauthorized orders can be prevented if the custodian of goods in the warehouse is not allowed to release the goods without an approved sales order.
7. D Shipping nonconforming goods to customers can be avoided if shipping clerks are required to compare goods that are about to be shipped to the customer's sales order.
8. L Recording of invoices for fictitious transactions can be detected by tracing recorded transactions from the sales journal to the underlying shipping documents to make certain that the invoices represent goods that were actually shipped.
9. P By comparing total amounts posted to the accounts receivable ledger to validated bank deposit slips, the auditor can determine that amounts posted to the accounts were actually deposited and did not represent amounts greater than what was actually received.
10. C If customers' checks are misappropriated before being forwarded to the cashier for deposit, they will not be entered as reductions to the customers' accounts. As a result, when monthly statements are mailed to the customers, they will detect the fact that their balance is overstated.
11. C If customers' checks are credited to incorrect customers' accounts, those making the payment will notice that their balance is overstated when they receive the monthly statements mailed to all customers with outstanding balances.
12. P If different customer accounts are each credited for the same cash receipt, the total credits posted to the accounts receivable ledger will exceed the amount deposited which can be detected by comparing the total amount posted to the validated deposit slip.
13. S If errors are made in recording receipts in the cash receipts journal, the bank account will not reconcile. These errors can be detected if someone other than the person making the errors reconciles the bank account.
14. P If customers' checks are misappropriated after being forwarded to the cashier for deposit, the amount deposited will be lower than the amount credited to the customers' accounts and can be detected by comparing the two amounts.
15. N Granting credit for invalid sales returns can be avoided if the supervisor of the sales department approves all returns of goods for credit.

Question 1

An auditor had decided to use probability-proportional-to-size (PPS) sampling, also called dollar-unit or cumulative monetary unit (CMU) sampling in the audit of the client's accounts receivable balance. The auditor discovered 3 misstatements while doing their testing. Complete the spreadsheet below and calculate the total projected misstatement.

Recorded amount Audit Amount Sampling interval Difference Tainting % Projected misstatement
1st misstatement $400 $320 $1,000
2nd misstatement $500 $0 $1,000
3rd misstatement $3,000 $2,500 $1,000

To solve this problem, first calculate the differences from each misstatement found. Then divide the difference by the recorded amount to get the tainting percentage (for example 400-320 = 80/400=20%). Then multiply the tainting percentage by the sampling interval. That will give you the projected misstatement for that misstatement applied to the entire sampling interval. So, 20% x 1,000 = $200. Remember that if the recorded amount is LARGER than the interval, then no tainting percentage is used, the difference calculate for that misstatement is the actual projected misstatement for that misstatement (3,000 is larger than $1,000, so the difference of $500, is the actual projected misstatement for the 3rd misstatement). We then sum the total of the 3 projected misstatements to calculate our total projected misstatement of $1,700.

Recorded amount Audit Amount Sampling interval Difference Tainting % Projected misstatement

(interval x tainting %)
1st misstatement $400 $320 $1,000 $80 20% (80/400) $200
2nd misstatement $500 $0 $1,000 $500 100% (500/500) $1000
3rd misstatement $3,000 $2,500 $1,000 $500 N/A (since 3,000 is

larger than 1,000)
$500

Question 1

Required:

Question Number 4 consists of 15 items pertaining to analytical procedures. Select the best answer for each item.

Analytical procedures are evaluations of financial information made by a study of plausible relationships among financial and nonfinancial data. Understanding and evaluating such relationships are essential to the audit process.

The following financial statements were prepared by Holiday Manufacturing Co. for the year ended December 31, 20X5. Also presented are various financial statement ratios for Holiday as calculated from the prior year's financial statements. Sales represent net credit sales. The total assets and the receivables and inventory balances at December 31, 20X5, were the same as at December 31, 20X4.

Holiday Manufacturing Co.

Balance Sheet

December 31, 20X5

Assets
Cash $240,000
Receivables $400,000
Inventory $600,000
Total current assets $1,240,000
Plan and equipment - net $760,000
Total assets $2,000,000
Liabilities and Capital
Accounts payable $240,000
Notes payable $400,000
Other current liabilities $600,000
Total current liabilities $1,240,000
Long-term debt $760,000
Common stock $760,000
Retained earnings $500,000
Total liabilities and capital $2,000,000

Holiday Manufacturing Co.

Income Statement

Year Ended December 31, 20X5

Sales $3,000,000
Cost of goods sold
Material $800,000
Labor $700,000
Overhead $300,000 $1,800,000
Gross margin $1,200,000
Selling expenses $240,000
General and administrative expenses $300,000 $540,000
Operating income $660,000
Less interest expense $40,000
Income before taxes $620,000
Less federal income taxes $220,000
Net income $400,000

Items to be answered

  1. Items 1 through 9 below represent financial ratios that the auditor calculated during the prior year's audit. For each ratio, calculate the current year's ratio from the financial statements presented on the previous page, select the answer from List A. Calculations should be rounded, if necessary, to the same number of places as the prior year's ratios. Answers on the list may be selected once, more than once, or not at all.
Ratio Holiday Mfg. Co. 12/31/X5 Holiday Mfg. Co. 12/31/X4 List A

Ratio calculations
1. Current ratio 2.5 A 0.6
2. Quick ratio 1.3 B 0.7
3. Accounts receivable turnover 5.5 C 1.0
4. Inventory turnover 2.5 D 1.5
5. Total asset turnover 1.2 E 1.6
6. Gross margin percentage 35% F 2.0
7. Net Operating margin percentage 25% G 3.0
8. Times interest earned 10.3% H 3.1
9. Total debt to equity percentage 50% I 4.5
J 5.0
K 7.5
L 10.0
M 15.5
N 16.5
O 13%
P 22%
Q 28%
R 33%
S 38%
T 40%
U 60%
V 67%

Required:

  1. Items 10 through 15 represent an auditor's observed changes in certain financial statement ratios or amounts from the prior year's ratios or amounts. For each observed change, select the most likely explanation or explanations from List B. Select only the number of explanations as indicated. The observed changes are not related to the calculations in requirement a, above, and are independent of each other. Answers on the list may be selected once, more than once, or not at all.

Items to be answered:

Auditor's observed changes (not related to Items 1-9 and independent of each other).

  1. Inventory turnover increased substantially from the prior year. (Select 3 explanations)
  2. Accounts receivable turnover decreased substantially from the prior year. (Select 3 explanations)
  3. Allowance for doubtful account increased from the prior year, but allowance for doubtful accounts as a percentage of accounts receivable decreased from the prior year. (Select 3 explanations)
  4. Long-term debt increased from the prior year, but interest expense increased a larger-than-proportionate amount than long-term debt. (Select 1 explanation)
  5. Operating income increased from the prior year although the entity was less profitable than in the prior year. (Select 2 explanations)
  6. Gross margin percentage was unchanged from the prior year although gross margin increased from the prior year. (Select 1 explanation)

List B

Explanations

  1. Items shipped on consignment during the last month of the year were recorded as sales.
  2. A significant number of credit memos for returned merchandise that were issued during the last month of the year were not recorded.
  3. Year-end purchases of inventory were overstated by incorrectly including items received in the first month of the subsequent year.
  4. Year-end purchases of inventory were understated by incorrectly excluding items received before the year-end.
  5. A larger percentage of sales occurred during the last month of the year, as compared to the prior year.
  6. A smaller percentage of sales occurred during the last month of the year, as compared to the prior year.
  7. The same percentage of sales occurred during the last month of the year, as compared to the prior year.
  8. Sales increased at the same percentage as cost of goods sold, as compared to the prior year.
  9. Sales increased at a greater percentage than cost of goods sold increased, as compared to the prior year.
  10. Sales increased at a lower percentage than cost of goods sold increased, as compared to the prior year.
  11. Interest expense decreased, as compared to the prior year.
  12. The effective income tax rate increased, as compared to the prior year.
  13. The effective income tax rate decreased, as compared to the prior year.
  14. Short-term borrowing was refinanced on a long-term basis at the same interest rate.
  15. Short-term borrowing was refinanced on a long-term basis at lower interest rates.
  16. Short-term borrowing was refinanced on a long-term basis at higher interest rates.
1. H The current ratio is current assets of $1,240,000 divided by current liabilities of $400,000 or 3.1.
2. E The quick ratio is liquid assets, consisting of cash and accounts receivable for a total of $640,000 (240,000 + 400,000), divided by current liabilities of $400,000 or 1.6.
3. K Accounts receivable turnover is sales of $3,000,000 divided by average accounts receivable. Since the beginning and ending accounts receivable are the same at $400,000 that is also the average. As a result accounts receivable turnover is 7.5 times.
4. G Inventory turnover is cost of sales of $1,800,000 divided by average inventory. Since the beginning and ending inventories are the same at $600,000 that is also the average. As a result, inventory turnover is 3 times.
5. D Total asset turnover is sales of $3,000,000 divided by average total assets. Since the beginning and ending total assets are the same at $2,000,000 that is also the average. As a result, total assets turnover is 1.5 times.
6. T The gross margin percentage is the gross margin of $1,200,000 divided by sales of $3,000,000 or 40%.
7. P The net operating margin percentage is the operating income of $660,000 divided by sales of $3,000,000 or 22%.
8. N Times interest earned is net income before interest and taxes, which is $660,000 divided by interest of $40,000 resulting in a ratio of 16.5 times.
9. U The total debt to equity percentage is total liabilities, including current liabilities and long-term debt with a total of $750,000 (400,000 + 350,000), divided by total stockholders’ equity, consisting of common stock and retained earnings for a total of $1,250,000 (750,000 + 500,000), resulting in a ratio of 60%.
10. ABD Inventory turnover is cost of goods sold divided by average inventory. It will increase if cost of goods sold increases or if average inventory decreases. If items shipped on consignment were recorded as sales (A), cost of sales would be overstated and inventory would be understated increasing inventory turnover. If credit memos for merchandise returned were not recorded (B), inventory would also be understated and cost of goods would be overstated. If year-end purchase of inventory were understated (D), year-end inventory would be understated resulting in a reduction in average inventory and an increase in the ratio.
11. ABE Accounts receivable turnover is sales divided by average accounts receivable. It will decrease if there is a decrease in sales or an increase in average accounts receivable. If items shipped on consignment were recorded as sales (A), both sales and accounts receivable would be overstated and the increase to accounts receivable would be proportionately higher resulting in a decrease to accounts receivable turnover. If credit memos for merchandise returned were not recorded (B), again both sales and accounts receivable would be overstated with the increase to accounts receivable proportionately higher resulting in a decrease to accounts receivable turnover. If a larger percentage of sales occurred at the end of the current year compared to the previous year (E), the ending accounts receivable balance would be higher, increasing average accounts receivable and decreasing accounts receivable turnover.
12. ABE When the ratio of the allowance for doubtful accounts to accounts receivable decreases, either the allowance must decrease or accounts receivable must increase. Since the allowance increased, accounts receivable must have increased by a proportionately greater amount. Recording items shipped on consignment as sales (A) would overstate accounts receivable as would failure to record credit memos for merchandise returned (B). If a larger percentage of sales occur at the end of the current year compared to the previous year (E), the ending accounts receivable balance would be higher, also decreasing the ratio.
13. P When interest expense increases by a proportionately higher amount than the increase in long-term debt, it will generally indicate that the interest rate on the newer long-term debt is higher than the rate paid on the previous debt. This would be the case if short-term borrowings were refinanced on a long-term basis at higher interest rates (P).
14. LP If operating income increases and net income decreases, there must have been an increase in either nonoperating items like interest expense, or income taxes. This would be the case if there is an increase in the tax rate (L), or if short-term debt is refinanced on a long-term basis at a higher interest rate (P).
15. H If the gross margin percentage remained the same while the amount of the gross margin increased, both sales and cost of sales must have increased proportionately during the period (H).

Question 2

Guillermo, CPA, has been engaged to audit the financial statements of Cecilia Computer Outlets, Inc., a new client. Cecilia is a privately owned chain of retail stores that sells a variety of computer software and video products. Cecilia uses an in-house payroll department at its corporate headquarters to compute payroll data, and to prepare and distribute payroll checks to its 300 salaried employees. Guillermo is preparing an internal control questionnaire to assist in obtaining an understanding of Cecilia's internal control and in assessing risk of material misstatement.

Required:

Prepare a "Payroll" segment of Guillermo's internal control questionnaire that would assist in obtaining an understanding of Cecilia’s internal control and in assessing risk of material misstatement.

Do not prepare questions relating to cash payrolls, computer applications, payments based on hourly rates, piecework, commissions, employee benefits (pensions, health care, vacations, etc.), or payroll tax accruals other than withholdings.

Use the format in the following example:

  • Question
  • Yes
  • No

Are paychecks prenumbered and accounted for?

Payroll

Internal Control Questionnaire


  • Question
  • Yes
  • No
  1. Are paychecks prenumbered and accounted for?
  2. Are discretionary payroll deductions and withholdings authorized in writing by employees?
  3. Are the employees who perform each of the following payroll functions independent of the other five functions?
    • Personnel and approval of payroll changes
    • Preparation of payroll data
    • Approval of payroll
    • Singing of paychecks
    • Distribution of paychecks
    • Reconciliation of payroll account
  4. Are changes in standard data on which payroll is based (hires, separations, salary changes, promotions, deduction and withholding changes, etc.) promptly input to the system to process payroll?
  5. Is gross pay determined by using authorized salary rates and time and attendance records?
  6. Is there a suitable chart of accounts and/or established guidelines for determining salary account distribution and for recording payroll withholding liabilities?
  7. Are clerical operations in payroll preparation verified?
  8. Is payroll preparation and recording reviewed by supervisors or internal audit personnel?
  9. Are payrolls approved by a responsible official before payroll checks are distributed?
  10. Are payrolls disbursed through an imprest account?
  11. Is the payroll bank account reconciled monthly to the general ledger?
  12. Are payroll bank reconciliations properly approved and differences promptly followed up?
  13. Is the custody and follow-up of unclaimed salary checks assigned to a responsible official?
  14. Are differences reported by employees followed up on a timely basis by persons not involved in payroll preparation?
  15. Are there procedures (e.g. tickler files) to assure proper and timely payment of withholdings to appropriate bodies and to file required information returns?

Question 1

Required

Items 1 through 7 present various independent factual situations an auditor might encounter in conducting an audit. List A represents the types of opinions the auditor ordinarily would issue and List B represents the report modifications (if any) that would be necessary. For each situation, select one response from List A and one from List B. Select as the best answer for each item, the action the auditor normally would take. The types of opinions in List A and the report modifications in List B may be selected once, more than once, or not at all. Assume:

  • The auditor is independent.
  • The auditor previously expressed an unmodified opinion on the prior year's financial statements.
  • Only single-year (not comparative) statements are presented for the current year.
  • The conditions for an unmodified opinion exist unless contradicted in the factual situations.
  • The conditions stated in the factual situations are material.
  • No report modifications are to be made except in response to the factual situation.

Items to be answered:

  1. In auditing the long-term investments account, an auditor is unable to obtain audited financial statements for an investee located in a foreign country. The auditor concludes that sufficient appropriate audit evidence regarding this investment cannot be obtained.
  2. Due to recurring operating losses and working capital deficiencies, an auditor has substantial doubt about an entity's ability to continue as a going concern for a reasonable period of time. However, the financial statement disclosures concerning these matters are adequate.
  3. A principal auditor decides to take responsibility for the work of another CPA who audited a wholly-owned subsidiary of the entity and issued an unmodified opinion. The total assets and revenues of the subsidiary represent 17% and 18%, respectively, of the total assets and revenues of the entity being audited.
  4. An entity issues financial statements that present financial position and results of operations but omits the related statement of cash flows. Management discloses in the notes to the financial statements that it does not believe the statement of cash flows to be a useful financial statement.
  5. An entity changes its inventory valuation method from FIFO to LIFO. The auditor concurs with the change although it has a material effect on the comparability of the entity's financial statements.
  6. An entity is a defendant in a lawsuit alleging infringement of certain patent rights. However, the ultimate outcome of the litigation cannot be reasonably estimated by management. The auditor believes there is a reasonable possibility of a significantly material loss, but the lawsuit is adequately disclosed in the notes to the financial statements.
  7. An entity discloses in the notes to the financial statements certain lease obligations. The auditor believes that the failure to capitalize these leases is a departure from generally accepted accounting principles.

List A

Types of Opinions

  1. An "except for" qualified opinion
  2. An unmodified opinion
  3. An adverse opinion
  4. A disclaimer of opinion
  5. Either an "except for" qualified opinion or an adverse opinion
  6. Either a disclaimer of opinion or an "except for" qualified opinion
  7. Either an adverse opinion or a disclaimer of opinion

List B

Report Modifications

  1. Describe the circumstances in an explanatory paragraph preceding the opinion paragraph without modifying the opinion paragraph.
  2. Describe the circumstances in an emphasis-of-matter paragraph following the opinion paragraph without modifying the other paragraphs.
  3. Describe the circumstances in an other-matter paragraph following the opinion paragraph without modifying the other paragraphs.
  4. Describe the circumstances in a basis-for-modification paragraph preceding the opinion paragraph and modify the opinion paragraph.
  5. Describe the circumstances in an emphasis-of-matter paragraph following the opinion paragraph and modify the opinion paragraph.
  6. Describe the circumstances in a basis-for-modification paragraph preceding the opinion paragraph and modify the introductory and opinion paragraphs.
  7. Describe the circumstances in an emphasis-of-matter paragraph following the opinion paragraph and modify the introductory and opinion paragraphs.
  8. Describe the circumstances within the introductory paragraph without adding any additional paragraphs.
  9. Describe the circumstances within the opinion paragraph without adding any additional paragraphs.
  10. Describe the circumstances within the introductory and opinion paragraphs without adding any additional paragraphs.
  11. Issue the standard auditor's report without modification.
1. FK The inability to obtain sufficient appropriate audit evidence is a scope limitation. We know that long-term investments is material. We do not, however, know if it is so material that a material misstatement would also result in a material misstatement to the financial statements taken as a whole. As a minimum, we will issue a qualified opinion since we cannot express an opinion about an item that is material to the financial statements. If it is pervasive, however, we would not be able to express an opinion on the financial statements taken as a whole and would issue a disclaimer. Either of these represents a modification of the opinion paragraph which would be preceded by a paragraph entitled either basis for qualification or basis for disclaimer of opinion, as appropriate.
2. BI As long as an entity properly discloses a substantial doubt about its ability to continue as a going concern, the auditor will issue a report with an unmodified opinion. Due to the significance of a going concern doubt, however, the auditor is required to draw attention to it. This will be done by including an emphasis-of-matter paragraph, which always immediately follows the opinion paragraph.
3. BR When an auditor decides to take responsibility for the work of another auditor, there should be no indication in the audit report that any portion of the financial statements was audited by another auditor. Neither the opinion nor any of the other paragraphs are modified since the auditor was able to obtain sufficient appropriate audit evidence and there were apparently no material misstatements.
4. AM The omission of the statement of cash flows is a violation of GAAP and would result in a qualified opinion. It’s omission does not, however, cause the remaining financial statements to be materially misstated and, as a result, an adverse opinion would not be appropriate. Since the introductory paragraph names that financial statements that are being audited, it will have to be modified to omit mention of the statement of cash flows. A basis for modification paragraph is required for any modified opinion, which would be before the opinion paragraph. In addition, the opinion paragraph is modified to indicate the qualification and to eliminate the reference to cash flows.
5. BI A user assumes financial statements were prepared in a manner consistent with the previous year unless the auditor report indicates otherwise. Since the auditor concurs with the change in accounting principles and since there is no indication that it was not accounted for and disclosed properly, there is no basis for a modified opinion. The auditor will alert users to the inconsistency with an emphasis-of-matter paragraph, which always immediately follows the opinion paragraph.
6. BI When the entity has a loss contingency that is reasonably possible, it is required to be disclosed but not accrued. If it is adequately disclosed, there is no basis for modifying the auditor's opinion and an unmodified opinion will be issued. Since it is material, however, the auditor will likely wish to bring it to the attention of users of the financial statements, which will be done by adding an emphasis-of-matter paragraph immediately following the opinion paragraph.
7. EK If the auditor believes there is a violation of GAAP that the client refuses to correct, the auditor will issue a qualified opinion if the matter is material to the financial statements but is not so material as to cause the financial statements taken as a whole to be materially misstated. If it is so material as to affect the fairness of the financial statements taken as a whole, an adverse opinion would be required. In either case, the opinion paragraph would be modified and a basis-for-modification paragraph will be added immediately before the opinion paragraph.

Question 1

Items 1 through 14 consists of items pertaining to possible deficiencies in an accountant's review report. Select the best answer for each item.

Jordan & Stone, CPAs, audited the financial statements of Tech Co., a nonpublic entity, for the year ended December 31, 20X1, and expressed an unmodified opinion. For the year ended December 31, 20X2, Tech issued comparative financial statements. Jordan & Stone reviewed Tech's 20X2 financial statements and Kent, an assistant on the engagement, drafted the accountants' review report below. Land, the engagement supervisor, decided not to reissue the prior year's auditors' report, but instructed Kent to include a separate paragraph in the current year's review report describing the responsibility assumed for the prior year's audited financial statements. This is an appropriate reporting procedure.

Land reviewed Kent's draft and indicated in the Supervisor's Review Notes below that there were several deficiencies in Kent's draft.

Independent Accountant's Review Report

We have reviewed and audited the accompanying balance sheet of Tech Co. as of December 31, 20X2 and 20X1, and the related statements of income, retained earnings, and cash flows for the years then ended in accordance with Statements of Standards for Accounting and Review Services and Statements on Auditing Standards issued by the American Institute of Certified Public Accountants.

All information included in these financial statements is the representation of the management of Tech Co.

Review standards require us to perform procedures to obtain limited assurance that there are no material modifications that should be made to the financial statements. A review consists principally of inquiries of company personnel and analytical procedures applied to financial data. It is substantially less in scope than an audit in accordance with generally accepted auditing standards, the objective of which is the expression of an opinion regarding the financial statements taken as a whole.

Based on our review, we are not aware of any material modifications that should be made to the 20X2 financial statements. Because of the inherent limitations of a review engagement, this report is intended for the information of management and should not be used for any other purpose.

The 20X1 financial statements were audited by us and our report was dated March 2, 20X2. We have no responsibility for updating that report for events or circumstances occurring after that date.

Jordan and Stone, CPAs

March 1, 20X3

Required:

Items 1 through 14 represent deficiencies noted by Land. For each deficiency, indicate whether Land is correct C or incorrect I in the criticism of Kent's draft.

Items to be answered:

Supervisor's Review Notes

  1. There should be no reference to the prior year's audited financial statements in the first (introductory) paragraph.
  2. All the current-year basic financial statements are not properly identified in the first (introductory) paragraph.
  3. There should be no reference to the American Institute of Certified Public Accountants in the first (introductory) paragraph.
  4. The accountant's review and audit responsibilities should be referenced in a paragraph that follows management's responsibilities.
  5. The second paragraph (management responsibility) does not adequately describe management's responsibilities.
  6. There should be no comparison of the scope of a review to an audit in the third (auditor responsibility) paragraph.
  7. Limited assurance should be expressed on the current year's reviewed financial statements in the third (management responsibility) paragraph.
  8. There should be a statement that no opinion is expressed on the current year's financial statements in the first (introductory) paragraph.
  9. There should be a reference to "conformity with accounting principles generally accepted in the United States" in the fourth paragraph.
  10. There should be no restriction on the distribution of the accountant's review report in the third paragraph.
  11. There should be no reference to "material modifications" in the fourth paragraph.
  12. There should be an indication of the type of opinion expressed on the prior year's audited financial statements in the fifth (separate) paragraph.
  13. There should be an indication that no auditing procedures were performed after the date of the report on the prior year's financial statements in the fifth (separate) paragraph.
  14. There should be no reference to "updating the prior year's auditor's report for events and circumstances occurring after that date" in the fifth (separate) paragraph.
1. C When reviewed financial statements are issued on a comparative basis with audited financial statements for a prior period, a review report should be issued along with either the reissuance of the prior period's report or a separate paragraph describing the responsibility being assumed for the prior period's financial statements. Reference to the prior period's audited financial statements in the body of the review report, other than the separate paragraph, is not appropriate.
2. I All of the financial statements are identified by the reference to the balance sheet and the related statements of income, retained earnings, and cash flows.
3. C Reference to the AICPA is made in the third paragraph, which indicates the accountants' responsibilities, which include performing the engagement in accordance with SSARS issued by the AICPA.
4. I Although the accountant's responsibilities in relation to the review are indicated in the third paragraph, following the paragraph containing management's responsibilities, it includes only the accountant's responsibilities in relation to the review, not the audit.
5. C The second paragraph (management responsibility) should indicate management's responsibility for the preparation and fair presentation of the financial statements as well as for the design, implementation, and maintenance of internal control relevant to financial reporting.
6. C The scope of a review is compared to the scope of an audit so that users will understand that a review does not provide as much assurance as an audit. It is, however, included in the first (introductory) paragraph, not the third (auditor responsibility) paragraph.
7. I Limited assurance should be expressed in the fourth paragraph, following the auditor responsibility paragraph, not in the auditor responsibility paragraph itself.
8. C A review report should contain an indication in the introductory paragraph that, since a review is less in scope than an audit, no opinion is expressed.
9. C The fourth paragraph gives limited assurance that no modifications are necessary in order for the financial statements to conform to accounting principles generally accepted in the United States of America.
10 C Unless the engagement was to report on financial statements that are restricted to internal use, it is not appropriate to indicate a restriction on the distribution of the report.
11. I The fourth paragraph appropriately provides limited assurance by indicating that the accountant is not aware of any material modifications that need be made to the financial statements.
12. C Since the previous period's report is not being reissued, a separate paragraph should include an indication of the type of report issued on the previous period's financial statements, the date of the report and that no audit procedures have been performed since that date.
13. C The separate paragraph should include an indication that no audit procedures were performed after the date of the report on the prior year's financial statements.
14. C It is sufficient to indicate that no procedures were performed since the date of the report on the prior period's financial statements. There is no need for a reference to the fact that the report has not been updated for events and circumstances occurring after that date.