AUDIT
CASES
Chapter 1
1. Following is a list of various professional services. Identify each by its apparent characteristics as
audit engagement, attestation engagement, or assurance engagement. Because audits are a subset of
attestation engagements, which are a subset of assurance engagements, choose the most specific
description.
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Real estate demand studies: Assurance service
Ballot for awards show: Assurance service
Utility rates applications: Assurance service
Newspaper circulation audits: Assurance service
Third-party reimbursement maximization: Assurance service
Annual financial report to stockholders: Audit service
Rental property operations review: Assurance service
Examination of financial forecasts and projections: Attestation service
Customer satisfaction surveys: Assurance service
Compliance with contractual requirements: Attestation service
Benchmarking/best practices: Assurance service
Evaluation of investment management policies: Assurance service
Information systems security reviews: Assurance service
Productivity statistics: Assurance service
Internal audit strategic review: Assurance service
Financial statements submitted to a bank loan officer: Audit service
2. Controller as Auditor.The chairman of the board of Hughes Corporation proposed that the board
hire as controller a CPA who had been the manager of the team that conducted Hughes
Corporation’s audit engagement. The chairman thought that hiring this person would make the
annual audit unnecessary and would consequently result in saving the
professional fee paid to the auditors. The chairman proposed to give this new controller a full staff to
conduct such investigations of accounting and operating data as necessary.
Evaluate this proposal.
When Hughes Corporation hired the CPA, she or he can no longer be considered independent with respect to the annual audit and, as a
result, can no longer perform an independent audit of the financial statements. It is true that the in-house CPA can perform all
procedural analyses that would be required of an independent audit; however, it is extremely unlikely that the CPA could inspire the
confidence of users of financial statements outside the company. Because she or he is no longer independent of the company, the
CPA cannot modify the perception of potential conflict of interest that creates demand for the independent audit. As a matter of ethics
rules, this CPA would be prohibited from signing the standard unqualified attest opinion. Moreover, if Hughes were a public
company, under Sarbanes-Oxley, it would be restricted from hiring one of its auditors into a senior accounting position for a full year
under Section 206 of the law.
3. Complete the following chart indicating the corresponding Auditing Standards Board Assertions and
whether the assertion relates to the transactions, balances, or disclosers.
PCAOB Assertion
Corresponding ASB assertion
Nature of assertion
Existence or Occurrence
Existence
Balance
Occurrence
Transactions
Disclosures
Rights and Obligations
Rights and Obligations
Balances
Disclosures
Completeness
Completeness
Transactions
Balances
Disclosures
Valuation and Allocation
Cutoff
Transactions
Accuracy
Transactions
Disclosures
Valuation
Balances
Disclosures
Presentation and Disclosure
Classification
Transactions
Disclosures
Understandability
Disclosures
4. Management Assertion. Your audit manager has asked you to explain the PCAOB assertions by
using an account on the balance sheet at your audit client. For the accounts receivable account,
please define each of the PCAOB assertions, using the accounts receivable account as a way to
illustrate each assertion. You are encouraged to reference Exhibit 1.5 to help you answer this
question.
Existence or Occurrence - Assertions about existence or occurrence address whether assets or liabilities of the entity exist at a given
date and whether recorded transactions have occurred during a given period. For example, management asserts that Accounts
Receivable on the balance sheet represent valid amounts owed to the company that were likely provided the in exchange for goods or
services from the company.
Completeness - Assertions about completeness address whether all transactions and accounts that should be presented in the financial
statements are so included. For example, management asserts that all amounts that should be recorded and included in the financial
statements as accounts receivable actually have been recorded.
Valuation or Allocation - Assertions about valuation or allocation address whether asset, liability, equity, revenue, and expense
components have been included in the financial statements at appropriate amounts. For example, management asserts that Accounts
Receivable are stated at net realizable value.
Rights and Obligations - Assertions about rights and obligations address whether assets are the rights of the entity and liabilities are
the obligations of the entity at a given date. For example, management asserts that the Accounts Receivable on the balance sheet really
are owned by the company. As a result, they have not factored (i.e., sold) any of the balances that are listed on the balance sheet.
Presentation and Disclosure - Assertions about presentation and disclosure address whether particular components of the financial
statements are properly classified, described, and disclosed. For example, management asserts that the presentation of accounts
receivable and the related allowance for doubtful accounts have been presented and are disclosed in accordance with GAAP.
5. Bigdeal Corporation manufactures paper and paper products and is trying to decide whether to
purchase Smalltek Company. Smalltek has developed a process for manufacturing boxes that can
replace containers that use flurocarbons for expelling a liquid product. The price may be as high as
$45 million. Bigdeal prefers to buy Smalltek and integrate its products while leaving Smalltek
management in charge of day-to-day operations. A major consideration is the efficiency and
effectiveness of Smalltek's operations. Bigdeal wants to obtain a report on the operational efficiency
and effectiveness of the Smalltek sales, production, and research and development departments.
Required: Who can Bigdeal engage to produce the report resulting from this operational audit?
Several possibilities exist. Are there any particular advantages or disadvantages in choosing from
among them?
One possibility is someone from the management advisory services department of a CPA firm. The major advantage may be total
objectivity. The CPA firm has no stake in making a report reflect favorably or unfavorably on Smalltek (provided there are no prior
relations of the CPA firm with Bigdeal managers that may suggest a bias or with Smalltek). The possible disadvantage is that the CPA
firm may not possess the required expertise in Smalltek’s industry or type of business.
Another possibility is the Bigdeal internal audit department. The major advantage may be that the internal audit department has a
thorough appreciation of Bigdeal’s managerial effectiveness and efficiency standards and a long-standing familiarity with Bigdeal’s
business. The possible disadvantage could be that the internal auditors may not be independent or objective enough from internal
management pressures for making or breaking the deal for reasons other than Smalltek’s efficiency and effectiveness.
Another possibility is a non-CPA management consulting firm. The major advantage of objectivity would be similar to the CPA firm,
and such firms often have experts in manufacturing, sales, and research and development management. The major disadvantage could
be a lack of appreciation and familiarity with Bigdeal’s management standards (as possessed by the Bigdeal internal auditors). In
addition, such firms are typically very expensive.
6. Your neighbor Loot Starkin invited you to lunch yesterday. Sure enough, it was no “free lunch”
because Loot wanted to discuss the annual report of Dodge Corporation. He owns Dodge stock and
just received the annual report. Loot says, “Our auditors prepared the audited financial statements
and gave an unqualified opinion, so my investment must be safe.” Required: What misconceptions
does Loot Starkin seem to have about the auditor’s role with respect to Dodge Corporation?
The auditors did not prepare the Dodge
Corporation financial statement.
Inform your neighbor that Dodge management is primarily responsible for preparing the
financial statements and deciding upon the appropriate accounting principles.
An unqualified opinion does not mean
that an investment is safe. Rather, it
merely means that the financial
statements are free of material
misstatement.
Tell your neighbor that the financial statements are a historical record of the business’
performance. The value of Loot’s investment depends on future events, including the
many factors that affect market prices. Thus, the financial statements are just one piece
of information that should be analyzed. Tell Loot that the unqualified opinion means
only that the statements conform to the appropriate reporting framework (e.g., GAAP)
and that the financial statements are free of material misstatement.
7. Audits may be characterized as (a) financial statement audits, (b) compliance audits, (c) economy
and efficiency audits, and (d) program results audits. The work can be done by independent
(external) auditors, internal auditors, or governmental auditors (including IRS auditors and federal
bank examiners). Following is a list of the purposes or products of various audit engagements:
1. Proprietary school’s training expenses
2.
Advertising agency financial statements
3.
Dept. of Defense launch vehicle
4.
Municipal services
5.
Tax shelters
6.
Test pilot reporting
7.
Bank solvency
8.
Materials inspection by manufacturer
9.
States’ reporting chemical use data
10.
Sports complex forecast
Type of Audit
Economy and efficiency or program results
Financial statement
Economy and efficiency or program results
Economy and efficiency
Compliance
Compliance
Compliance
Compliance or Economy and Efficiency
Program goal
Financial statement
Type of Auditor
Governmental (GAO) auditors
Independent CPAs
Governmental (GAO) auditors
Internal auditors
IRS auditors
Internal auditors
Bank examiners
Internal auditors
Governmental (GAO) auditors
Independent CPAs
8. You are engaged to examine the financial Statement of Spillane Company for the year ended
December 31st. Assume that on November, Spillane borrowed $500,000 from Second National Bank
to finance plan expansion. The long-term agreement provided for the annual payment of principal
and interest over five years .The existing plant was pledged as security for the loan. Due to the
unexpected difficulties in acquiring the building site, the plant expansion did not begin on time. To
use the borrowed funds, management decided to invest in stocks and bonds and on November 16th
invested the $500,000 in publicly traded securities.
Develop specific assertions related to securities based on management’s five (PCAOB) general
assertions.
Existence. Obtain evidence that the securities are bona fide and held by Spillane or a responsible custodian.
Occurrence. Obtain evidence that the loan transaction and securities purchase transactions actually took place during the year under
audit.
Completeness. Obtain evidence that all the securities purchase transactions were recorded.
Rights. Obtain evidence that Spillane owned the securities.
Obligation. Obtain evidence that $500,000 is the amount actually owed on the loan.
Valuation. Obtain evidence of the cost and market value of the securities held at December 31. Decide whether any write-downs to
market are required by the appropriate reporting framework.
Presentation and disclosure. Obtain evidence of the committed nature of the assets, which should mean they should be in a
noncurrent classification like the loan. Obtain evidence that restrictions on the use of the assets are disclosed fully and agree
with the loan documents.
CHAPTER 2
1)Performance Principle: Planning. Your public accounting practice is located in a city of 15,000 people. The
majority of your work, conducted by you and two assistants, consists
of compiling clients’ monthly statements and preparing income tax returns for individuals
from cash data and partnership returns from books and records. You have a small number of audit clients; given
the current size of your practice, you generally consider it a challenge to accept new audit clients. One of your
corporate clients is a retail hardware store. Your work for this client has been limited to preparing the corporate
income tax return from a trial balance submitted by the bookkeeper. On December 26, you receive from the
president of the corporation a letter containing the following request: We have made arrangements with First
National Bank to borrow $500,000 to finance the
purchase of a complete line of appliances. The bank has asked us to furnish our auditors’ certified statement as
of December 31, which is the closing date of our accounting year. The trial balance of the general ledger should
be ready by January 10, which should allow ample time to prepare your report for submission to the bank by
January 20. In view of the importance of this certified report to our financing program, we trust you will arrange
to comply with the preceding schedule.
Required:
From a theoretical viewpoint, discuss the difficulties that are caused by such a short notice
audit request.
From a theoretical viewpoint (and, in fact, from a practical viewpoint as well) such short notice of a request for an audit causes
difficulties with planning the audit work, establishing staffing requirements, and reviewing the work; all of these features are
important elements in the exercise of due care. The December 26 - January 20 period is a serious time constraint for an initial audit
engagement. The greatest difficulties involve due care as well as the ability to appropriately perform the engagement (planning and
supervision, determining materiality levels, identifying and assessing risks of material misstatement, and obtaining sufficient
appropriate evidence). In view of the short notice and the time constraint, there may be some question as to whether an audit could
be adequately completed by January 20
2) Performance Principle. Identify how each of the following statements related to the performance principle by
considering which element(s) of the principle are related to the statement. (A statement may be related to more
than one element) Use the following elements in providing your response:
• Reasonable assurance etc
a.
Risk assessment (Evaluating the effectiveness of the client’s internal control is used to assess control risk. Control risk, along
with the inherent risk, forms the basis for the auditors’ assessment of the risk of material misstatement).
b.
Planning and supervision (Obtaining an understanding of the client’s industry is performed in the planning stages of
the audit examination).
c.
The concept of reasonable assurance acknowledges that auditors cannot reduce the risk of failing to detect a
material misstatement to zero. In addition, the concept of reasonable assurance is also related to the risk of material
misstatement and audit evidence, since the risk of material misstatement and audit evidence will be used to limit the
failure to detect a material misstatement to an appropriate (low) level. However, these processes cannot be relied
upon to reduce this risk to zero.
d.
Audit evidence (Obtaining confirmations from the client’s customers is an example of a substantive procedure that
provides external evidence, which is a highly reliable form of evidence).
e.
Planning and supervision (Preparing a written audit plan is done in the planning stages of the audit examination).
f.
This statement may relate to the audit evidence element, as it affects the type of audit evidence that is obtained
during the examination. In addition, because auditors are required to design substantive procedures to provide
reasonable assurance (but not absolute assurance), this statement is also related to reasonable assurance. Finally, the
fact that auditors are concerned with misstatements that have a significant effect on financial statement users’
decisions indicates that this statement is related to the materiality element.
g.
This statement considers the significance of a misstatement, or materiality. In addition, the likelihood that the
account balance contains a material misstatement is inherent risk, which is evaluated during the risk assessment
stage of the audit.
h.
The concept of reasonable assurance acknowledges that auditors cannot provide absolute assurance because of
mistakes and misinterpretations in evaluating evidence
3) Respond to each of the following comments that you heard related to the audit of Swan Company, a public
entity.
a. “We don’t need to consider the risk of material misstatement in our work because we really can’t do anything
to reduce that risk.”
While auditors typically cannot influence the susceptibility of accounts to misstatements or the effectiveness of the entity’s internal
control (both of which comprise the risk of material misstatement), this risk needs to be considered in order to determine the
nature, timing, and extent of further audit procedures.
b. “Because the client has not implemented effective internal controls, we need to gather more reliable
evidence. This means we need to test a greater number of transactions and obtain more reliable forms of
evidence.”
This statement is correct; if internal control is less effective, auditors are required to gather more sufficient and more appropriate
evidence. However, in addition to the number of transactions and reliability of evidence, auditors should also consider the relevance
of the evidence they gather and the extent to which that evidence supports the assertions of interest.
c. “We will really need to spend a lot of time and effort on this audit. Because this client has just filed for a
bond offering, we can’t allow for any misstatements in the financial statements. We need to guarantee the
accuracy of the client’s financial statements.”
Auditors are not required to provide absolute assurance as to the fairness of the financial statements, which is what is being
suggested in this statement. While it is true that a great deal of time and effort is necessary in an audit
engagement, auditors are only required to provide reasonable assurance with respect to the ability to detect
material misstatements.
d. “Because this company has $140 million in revenues, we really shouldn’t be concerned about smaller
accounts because they are not likely to have a major impact on the financial statements.”
This statement relates to the concept of materiality and is appropriate. However, it is important to note that the consideration of
materiality in an audit is highly complex and requires an extremely high level of professional judgment.
e. “I know it will be more time consuming and expensive, but we are required to physically inspect the stock
certificates held by the client rather than obtain confirmation from the custodian. After all, our own direct
observation is more reliable than receiving a confirmation.”
While physical inspection of the stock certificates will provide more reliable evidence than confirming the certificates held with the
custodian, it may not be necessary for auditors to conduct such an inspection. In many cases, a less reliable, but
still effective procedure such as confirmation with the custodian would be appropriate.
4) Ray, the owner of a small company, asked Holmes, a CPA, to conduct an audit of the company's records.
Ray told Holmes that an audit was to be completed in time to submit audited financial statements to a bank as
part of a loan application. Holmes immediately accepted the engagement and agreed to provide an auditor's
report within 3 weeks. Ray agreed to pay Holmes a fixed fee plus a bonus if the loan was granted. Holmes hired
two accounting students to conduct the audit and spent several hours telling them exactly what to do. Holmes
told the students not to spend time reviewing internal controls but instead to concentrate on proving the
mathematical accuracy of the ledger accounts and summarizing the data in the accounting records that support
Ray's financial statements. The students followed Holmes's instructions and after 2 weeks gave Holmes the
financial statements, which did not include footnotes. Holmes reviewed the statements and prepared an
unqualified auditor's report. The report did not refer to generally accepted accounting principles or to the
consistent application of such principles.
Briefly describe each of the principles underlying AICPA auditing standards and indicate how the action(s) of
Holmes resulted in a failure to comply with each principle.
Responsibilities
1.
Auditors are responsible for appropriate
competence and capabilities to perform the
audit.
2.
Auditors are responsible for complying with
relevant ethical requirements.
3.
Auditors are responsible for maintaining
professional skepticism and exercising
professional judgment throughout the
planning and performance of the audit.
Performance
1.
It was inappropriate for Holmes to hire the two students to
conduct the audit. The examination must be conducted by persons
with proper education and experience in the field of auditing.
Inexperienced persons can assist, if they are supervised.
2.
To satisfy the independence requirement, Holmes must be without
bias with respect to the client under audit. Because of the financial
interest in the bank loan, Holmes is neither independent in fact nor
appearance with respect to the assignment undertaken. In
addition, because of a number of actions (hiring unqualified
individuals, failure to supervise those individuals, etc.), Holmes did
not appear to exhibit due care.
3.
The fact that Holmes merely accepted the financial statements
without questioning any evidence demonstrates lack of
professional skepticism (as well as a lack of good professional
judgment).
1.
This element recognizes that early appointment of auditors has
advantages for auditors and the client. Holmes accepted the
engagement without considering the availability of staff. In
addition, Holmes failed to supervise the assistants. The work
performed was not adequately planned.
1.
The auditor must adequately plan the work
and must properly supervise any assistants.
2.
The auditor must determine and apply
appropriate materiality level or levels.
2.
There was no discussion that appropriate materiality levels were
determined or applied for the audit by either Holmes or the two
accounting students. Thus, compliance with this element is difficult
to assess.
3.
The auditor must assess the risk of material
misstatement based on the entity and its
environment.
3.
Holmes did not study the client’s internal control nor did the
assistants. There appears to have been no audit examination at all.
The work performed was more an accounting service than it was
an auditing service.
4.
The auditor must obtain sufficient
appropriate audit evidence about whether
4.
No evidence was obtained to support the financial statements. The
auditors merely checked the mathematical accuracy of the records
material misstatements exist.
Reporting
1.
The auditor expresses, in the form of a
written report, an opinion in accordance with
the auditor’s findings or states that an opinion
cannot be expressed. The opinion states
whether the financial statements are
presented fairly, in all material respects, in
accordance with the appropriate financial
reporting framework.
and summarized the accounts. Standard audit procedures and
techniques were not performed.
1.
Because a proper examination was not conducted, the report
should indicate that no opinion can be expressed as to the fair
presentation of the financial statements in accordance with
generally accepted accounting principles.
5) In each of the following, identify which of the elements of the fundamental principles is most applicable. In
addition, discuss what action(s) (if any) you believe auditors should take with respect to these issues.
(A) An entity has contacted you about performing its audit engagement. You have not previously served a client
in the entity’s industry, which has many industry-specific accounting issues that are both technical and
complex.
This situation is related to the competence and capabilities element of the responsibilities principle. In this case, auditors can
accept this engagement assuming that they take appropriate measures to obtain the knowledge necessary to
perform the audit and understand important issues affecting this client. It is important to note that the
existence of industry-specific accounting issues will require auditors to obtain the knowledge necessary to
complete the engagement.
(B) An entity has entered into a number of lease agreements. Based on the requirements of GAAP, you believe
that these obligations meet the criteria for being classified as capital leases; however, the entity has elected to
treat these leases as operating leases, providing full and complete disclosure of this treatment in the footnotes to
the financial statements.
This situation is related to the reporting principle, which addresses the conformity of the financial statements with GAAP. If
the client elects to treat these leases as operating leases in violation of GAAP, auditors should issue either a
qualified or adverse opinion, depending upon the materiality of the departure from GAAP.
(C) Because of a disagreement with its current auditors, an entity has contacted you about conducting its
current-year audit. However, because the previous auditors have just recently resigned from the engagement,
you have some questions as to whether an audit can be completed in time to meet the entity’s deadlines for
providing audited financial statements to a lender.
This situation is related to the performance principle, which indicates that the audit should be properly planned. In this case,
auditors should evaluate whether the client’s deadline will allow an audit to be properly planned and
conducted according to generally accepted auditing standards. The fact that this would be an initial audit
makes this possibility even more questionable than usual.
(D) Based on the effectiveness of the entity’s internal control, you have assessed control risk at low levels and
decided that a smaller number of customer accounts need to be confirmed.
This situation is related to the performance principle, which requires auditors to obtain sufficient appropriate audit evidence.
Given the low level of control risk, auditors would then proceed to perform the necessary auditing procedures, which provide the
basis for their opinion on the client’s financial statements. In this case, confirming a smaller number of customer accounts would
be appropriate
(E) An entity has contacted you about performing their audit engagement. This entity became aware of your
firm because the husband of one of your partners is currently serving as the entity’s chief financial officer
This situation is related to the responsibilities principle, which requires auditors to be independent. In this particular case, the fact
that one of the partner’s husband is an officer of the prospective client would likely result in the firm declining this particular
engagement because of a lack of independence..
(F) One of your clients is currently a potential defendant in several cases because of the damage caused by one
of its products. Because this entity does not believe that it is likely to receive an unfavorable outcome from this
litigation, it did not disclose the potential litigation in the footnotes accompanying their financial statements.
This situation is related to the reporting principle. Auditors should insist upon disclosure of the potential litigation and, if the
client refuses, issue either a qualified opinion or adverse opinion, depending upon the materiality of the omission of the
disclosures. In addition, the auditors’ report should provide information regarding the omitted disclosures.
(G) You are performing tests of the client’s controls over the processing of revenue trans- actions to determine
whether these controls are operating effectively and can be relied upon to prevent or detect misstatements.
This situation is related to the performance principle, which requires auditors to assess the risk of material
misstatement, which includes obtaining an understanding of the entity and its internal control. Once this
understanding has been obtained, auditors would then proceed to perform the necessary substantive audit
procedures.
(H) One of your supervisors has requested a number of clarifications based on her review of your work on an
audit engagement. A subsequent meeting with her has resolved these clarifications, and you both have
concluded that your work supports the opinion on the client’s financial statements.
This situation is related to the performance principle, which requires proper planning and supervision. An important element of
supervision is critical review of work performed by persons at various levels within the firm. Because the supervisor’s review of
the work performed by the assistant indicates that the work supports the opinion on the financial statements, no further actions
are necessary.
CHAPTER 3
1)The eight general audit procedures produce evidence about the principal management assertions in financial
statements. However, some procedures are useful for producing evidence about certain assertions, and other
procedures are useful for producing evidence about other assertions. The assertion being audited can influence
the auditors€™ choice of procedures.
Required:
Opposite each general audit procedure, write the management assertions most usefully audited by using
eachprocedure.
Audit Procedures
a. Inspection of records
or documents (vouching)
b. Inspection of records
or documents (tracing)
c. Inspection of records
or documents (scanning)
d. Inspection of tangible
assets
e. Observation
f. Confirmation
g. Inquiry
h. Recalculation
i. Reperformance
j. Analytical procedures
PCAOB Assertions
Existence or occurrence
ASB Assertions
Existence, occurrence
Completeness
Completeness
Raises questions that may be relevant to all
assertions but may not produce actual “evidence.”
Because it is performed on recorded amounts, it
works best for existence or occurrence, valuation
and allocation, rights and obligations, and
presentation and disclosure. When applied to
source documents, it might work for the
completeness assertion.
Existence
Occurrence
Valuation and allocation
Rights and obligations
Completeness
Existence or occurrence, valuation
Existence, valuation
Existence or occurrence, valuation
Existence or occurrence
Rights (ownership)
Valuation (sometimes)
Existence, valuation
Existence
Rights (ownership)
Valuation (sometimes)
Completeness (sometimes)
Completeness (sometimes).
All assertions; however, responses typically yield
more assertions that in turn are subject to audit
with corroborating evidence.
Existence, valuation
Valuation
Existence or occurrence
Valuation
All assertions; however, responses typically yield more
assertions that in turn are subject to audit with
corroborating evidence
Existence, valuation
Valuation
Existence
Occurrence
Valuation
Completeness
Accuracy
Classification
Completeness
2) Communications between Predecessor and Successor Auditors. Assume that Smith & Smith. CPAs, audited
Apollo Shoes Inc., last year. Now CEO Larry Lancaster wishes to engage Anderson, Olds, and Watershed,
CPAs (AOW) to audit its annual financial statements. Lancaster is generally pleased with the services provided
by Smith & Smith, but he thinks the audit work was too detailed and interfered excessively with normal office
routines. AOW has asked Lancaster to inform Smith & Smith of the decision to change auditors, but he does not
wish to do so. Required: List and discuss the steps AOW should follow with regard to dealing with a
predecessor auditor and a new client before accepting the engagement.
The procedures Anderson, Olds, and Watershed, CPAs (AOW) should follow prior to accepting the engagement include the
following:
Explain to Lancaster the need to inquire of Smith & Smith and request permission to make such inquiries.
Ask Lancaster to authorize Smith & Smith to respond fully to all inquiries because Smith & Smith would be prohibited from disclosing
confidential information without former client permission.
Advise Smith & Smith of Lancaster’s decision to change auditors. Advising Smith & Smith would be a good business judgment as well
as an act of professional courtesy.
Make reasonable inquiries of Smith & Smith regarding matters that will aid in deciding whether to accept the engagement. (AOW
should ask about facts that might bear on the integrity of management, disagreements with management about accounting and
auditing matters, and Smith & Smith’ understanding of the reason[s] for the change of auditors.)
If Smith & Smith does not respond fully to AOW’s questions, consider the implications of the limited response in deciding whether to
accept the engagement.
After weighing all information received from Smith & Smith, inform Lancaster that a first-time audit is more time consuming than a
recurring audit because the new audit team is generally unfamiliar with the client’s operations and does not have the benefit of past
knowledge of company affairs to use as a guide.
Discuss with Lancaster the estimated required audit time and fee arrangement with a clear explanation of the purpose and scope of
the audit. Any work that can be done by client personnel should also be discussed so that excess audit time might be eliminated and
proposed report deadlines can be reasonably met. To satisfy AOW’s quality control objective, use procedures such as reviewing
Apollo’s financial statements; inquiring of third parties such as Apollo’s banks, legal counsel, investment bankers, and others in the
business community as to Apollo’s reputation; and evaluating AOW’s ability to serve Lancaster and Apollo properly with reference to
industry expertise, size of engagement, and available staff.
Accept the engagement and confirm the understandings in an engagement letter if AOW has no reservations and after all significant
factors have been considered, discussed, and agreed to.
3) The president of All-purpose Loan Company had a genuine dislike for external auditors. Almost any conflict
generated a towering rage. Consequently, the company changed auditors often. The firm of Wells & Ratley
(W&R), CPAs, was recently hired to audit the 2017 financial statements. W&R succeeded the firm of Canby &
Company (C&C), which had obtained the audit after Albrecht & Hubbard (A&H) had been fired. A&H audited
the 2016 financial statements and rendered a report that contained an additional paragraph explaining an
uncertainty about All-purpose Loan Company’s loan loss reserve. Goodbye A&H! The president then hired C&C
to audit the 2017 financial statements and Chris Canby started the work, but before the audit could be
completed, Canby was fired and W&R was hired to complete the audit. C&C did not issue an audit report
because the audit was not finished.
Required:
Does the Wells & Ratley firm need to initiate communications with Canb
Wells & Ratley (W&R) needs to initiate communications with both predecessor auditors. The situation is unusual, but W&R needs to
obtain complete information from all predecessors involved since the last audit (2013 financial statements). Both Canby & Co. and
Albrecht & Hubbard (A&H) are predecessors. (If Canby & Co. had completed the 2016 audit and W&R had been hired to perform the
2017 audit, then Canby & Co. would be the only predecessor. A&H would be history.)
Inquiry of only one of the predecessors would not result in complete information because the circumstances surrounding each
auditor change may be different. The two predecessors, having served at different times and for different lengths of time, may have
different knowledge about Allpurpose Loan Company and its president.
If the company is public and subject to SEC reporting requirements, forms 8-K for both changes should have also been filed.
4) You are a CPA in a regional public accounting firm that has ten offices in three states. Mr. Shine has
approached you with a request for an audit. He is the president of Hitech Software and Games Inc., a five-yearold company that has recently grown to $500 million in sales and $200 million in total assets. Shine is thinking
about going public with a $25 million issue of common stock, of which $10 million would be a secondary issue
of shares he holds. You are very happy about this opportunity because you know Shine is the new president of
the Symphony Society board and has made quite a civic impression since he came to your medium-size city
seven years ago. Hitech is one of the growing employers in the city. Referencing this week's lecture, respond to
the following:
- Discuss the sources of information and the types of inquiries that you and the firm's partners may make in
connection with accepting Hitech as a new client.
- Do professional audit standards require any investigation of prospective clients? Why or why not?
- Suppose Shine also told you that ten years ago his closely-held hamburger franchise business went bankrupt.
Upon investigation, you discover from former auditors (your own firm in another city) that Shine was
fraudulent in its application of franchise-fee income recognition rules and presented such difficulties that your
firm resigned from the audit (before the bankruptcy). Do you think the partner in charge of the audit practice
should accept Hitech as a new client?
a.
The sources of information and types of inquiries may include:
Financial information
prepared by the prospective client
Inquiries directed to
the prospect’s business associates
Predecessor auditor, if any,
communication regarding
Analysis
Annual reports to shareholders.
Banker.
Integrity of management.
Special or unusual
Interim financial statements.
Legal counsel.
Disagreements
with management
risk related to the
Securities registration statements.
Underwriter.
prospect.
Annual report on SEC Form 10-K.
Other persons (e.g., customers, suppliers).
Need for special skills
(e.g., computer or
industry expertise)
Reports to regulator agencies.
Internal search for
relationships that
would compromise
independence
Internal search for relationships that would compromise independence
In addition, auditors can search business press articles and stories and legal files on the Lexis-Nexis system or on the Internet for
news about chairman of the board, the CEO, the CFO, and often other high-ranking officers. Auditors can engage an outside search
firm (private investigators) to conduct additional searches for information. Auditors are looking for information about client risk
factors: companies accused of fraud, subjected to SEC or other regulatory investigation, changed auditors frequently, and incurred
recent losses.
b.
Yes. AICPA Quality Control Standards require firms to investigate all prospective audit clients.
c.
Students can decide this acceptance question either way although the brief facts prejudice the conclusion toward
nonacceptance. The CPA’s own firm decided to resign only 10 years ago, presumably over matters of owner–
manager integrity, yet, Mr. Shine appears to be a respected member of his new community. Maybe his cavalier
accounting attitude is behind him. Then again, maybe it is not. This is something that the auditor will have to
determine.
5) Using the Computer to Discover Intentional Financial Misstatements in Transactions and Account Balances.
AMI International is a large office products company. Headquarters management imposed pressure on
operating division managers to meet profit forecasts. The division managers met these profit goals using several
accounting manipulations involving the record-keeping system that maintained all transactions and account
balances on computer files. Employees who operated the computer accounting system were aware of the
modifications of policy the managers ordered to accomplish the financial statement manipulations. The
management and employees carried out these activities:
1.Deferred inventory write-downs for obsolete and damaged goods.
2.Kept open the sales entry system after the quarterly and annual cutoff dates, recording sales of goods shipped
after the cutoff dates.
3.Recorded as sales transactions that had been coded as leases of office equipment.
4.Recorded shipments to branch offices as sales.
5.Postponed recording vendors’ invoices for parts and services until later, but the actual invoice date was
faithfully entered according to accounting policy.
Required:
Describe one or more procedures that could be performed with CAATs to detect signs of each of these
transaction manipulations. Limit your answer to the actual work accomplished by the computer software
1.
2.
3.
4.
Inventory write-downs for obsolete and damaged goods were deferred.
Scanning. Scan inventory records on the date of issue filed and select old last-issue dates for further investigation
regarding need to write down or write off.
The sales entry system was kept open after the quarterly and annual cutoff dates, recording sales of goods shipped
after the cutoff dates.
Analytical procedures. Summarize and resequence sales data by shipment date or shipping document number to
detect next-period shipments recorded in the accounting period under audit and then perform the next procedure.
Confirmation. Select and print information about these customers regarding accounts receivable confirmation at the
cutoff date.
Transactions coded as leases of office equipment were recorded as sales.
Scanning. Scan the sales file on the transaction code field to detect the leased equipment recorded as sales (then
examine the underlying source documentation).
Shipments to branch offices were recorded as sales.
Scanning. Scan the customer name or code field for comparison to known names or codes used for
branch offices (select matches for more document examination).
Analytical procedures. To
accomplish the same purpose, compare data on separate files—branch name and code file—to sales customer
name and code fields.
5. Vendors’ invoices for parts and services were not recorded until later, but the actual invoice date was faithfully
entered according to accounting policy. Document examination (limited). Enter balances from period-end vendor
statements and compare to the company’s accounts payable records.
CHAPTER 4
1) Which of the following relationships between types of analytical procedures and sources of information
are most logical
a.
Incorrect.
Physical production statistics are not a source of information for “comparison of current
account balances with prior periods.”
b.
Correct.A client’s budgets and forecasts are sources of information for “comparison of current account
balances with expected balances.”
c.
Incorrect.
Published industry ratios are not a source of information for “evaluation of current
account balances with relation to predictable historical patterns.”
d.
Incorrect.
The company’s own historical financial statements are not a good source of information
for “evaluation of current account balances in relation to nonfinancial information.”
2) Analytical Procedures and Interest Expense. Weyman Z. Wannamaker is the chief financial officer of
Cogburn Company. He prides himself on being able to manage the company's cash resources to minimize the
interest expense. Consequently, on the second business day of each month, Weyman pays down or draws cash
on Cogburn's revolving line of credit at First National Bank in accordance with his cash requirements forecast.
You are the auditor. You find the information on this line of credit in the following table. You inquired at First
National Bank and learned that Cogburn Company's loan agreement specifies payment on the first day of each
month for the interest due on the previous month's outstanding balance at the rate of "prime plus 1.5 percent."
The bank gave you a report that showed the prime rate of interest was 8.5 percent for the first six months of the
year and 8.0 percent for the last six months.
Required:
a. Prepare an audit estimate of the amount of interest expense you expect to find as the balance of the interest
expense account related to these notes payable
The audit estimate of interest expense for these notes is about $24,400
.
b. Which of the types of analytical procedures did you use to determine this estimate?
The type of analytical procedure is “study of the relationships of current-year account balances with relevant
nonfinancial information.” While the interest rate may not seem to be an item of “nonfinancial
information,” it is not a direct entry or element in the client’s financial statements. Three of the other
four types of analytical procedures do not describe the estimate (because it does not compare to prior
periods, to budget, or to industry information). However, a case might be made that the estimate is
an “evaluation of a relationship of current-year account balances (notes payable) to other currentyear balances (related interest expense) for conformity with a predictable pattern (interest rate
relation) based on the company’s experience.
c. Suppose that you find that the interest expense account shows expense of $23,650 related to these notes.
What could account for this difference?
The recorded interest expense appears to be too small. The company may have forgotten or miscalculated
the year-end interest expense accrual. (In fact, this amount was specified because the missing
amount is approximately the $750 of the accrual for the December interest.)
d. Suppose that you find that the interest expense account shows expense of $24,400 related to these notes.
What could account for this difference?
The recorded interest expense is about right. Some differences in timing and calculation might explain the
small difference, but it is not material enough to warrant further work.
e. Suppose that you find that the interest expense account shows expense of $25,200 related to these notes.
What could account for this difference?
The recorded interest expense appears to be too large. Maybe the company has other debt on which
interest is being paid, but the debt is not recorded in the accounts. (In fact this amount was
specified in terms of an extra $100,000 being borrowed in July at 9.5% interest, not recorded, but
paid back by August 1 before the next recorded borrowing. This would account for about $800
additional interest: $100,000 x 9.5% x 1/12 = $792.) Could be that Weyman found he could borrow
the company’s cash for himself, earn interest, and then pay back the principal!) Actually, this kind
of maneuver could have been carried out in any month and not noticed by auditors who saw only
the first-of-the-month balances.
3) Johnson & Company, CPAs, audited Guaranteed Savings & Loan Company. M. Johnson had the assignment
of evaluating the collectability of real estate loans. Johnson was working on two particular loans: (1) a $4
million loan secured by Smith Street Apartments and (2) a $5.5 million construction loan on Baker Street
Apartments now being built. The appraisals performed by Guaranteed Appraisal Partners Inc. showed values in
excess of the loan amounts. On inquiry, Bumpus, the S&L vice president for loan acquisition, stated, “I know
the Smith Street loan is good because I myself own 40 percent of the partnership that owns the property and is
obligated on the loan.”
Johnson then wrote in the audit documentation: (1) the Smith Street loan appears collectible as Bumpus
personally attested to knowledge of the collectability as a major owner in the partnership obligated on the loan;
(2) the Baker Street loan is assumed to be collectible because it is new and construction is still in progress; and
(3) the appraised values all exceed
the loan amounts.
Required:
a. Do you perceive any problems with related-party involvement in the evidence used by Johnson? Explain.
b. Do you perceive any problems with Johnson’s reasoning or the appropriateness of evidence used in that
reasoning?
Yes, there are problems. Verbal assurance of collectability from Bumpus, the S&L officer with an investment
in the Smith Street property, is the weakest type of information.
Bumpus is a related party and information from him ought to be regarded as biased.
Another problem lies in the appraisal company. With the name of Guaranteed Appraisal Partners, Inc., the
appraisers may be related, even owned by, the client, Guaranteed Savings & Loan Company. The audit team’s
general knowledge of financial institution difficulties in real estate lending and the widespread problems with
appraisers should alert them to the possible relation of the appraisers to the client. Further investigation
should be carried out to identify the appraisers.
b.
Do you perceive any problems with M. Johnson’s reasoning or the appropriateness of evidence
used in that reasoning?
Yes, there are problems. In addition to the dubious related-party sources of information just
mentioned, Johnson’s “assumption” about the collectability of the Baker Street loan is
unwarranted. Auditors are not entitled to “assume” collectability on any grounds with supporting
evidence. The fact that a loan is new or construction is still in progress is no reason to “assume”
collectability.
4) Analysis of Accounting Estimates. Oak Industries, a manufacturer of radio and cable TV equipment and an
operator of subscription TV systems, had a multitude of problems. Subscription services in a market area, for
which $12 million of cost had been deferred, were being terminated and the customers were not paying on time
($4 million receivables in doubt). The chances are 50-50 that the business will survive another two years. An
electronic part turned out to have defects that needed correction. Warranty expenses are estimated to range from
$2 million to $6 million. The inventory of this part ($10 million) is obsolete, but $1 million can be recovered in
salvage, or the parts in inventory can be rebuilt at a cost of $2 million (selling price of the inventory on hand
would then be $8 million with 20 percent of the selling price required to market and ship the products, and the
normal profit expected is 5 percent of the selling price). If the inventory were scrapped, the company would
manufacture a replacement inventory at a cost of $6 million, excluding marketing and shipping costs and
normal profit. The company has defaulted on completion of a military contract, and the government is claiming
a $2 million refund. Company attorneys think the dispute might be settled for as little as $1 million. The
auditors had previously determined that an overstatement of income before taxes of $7 million would be
material to the financial statements. These items were the only ones left for audit decisions about possible
adjustment. Management has presented the following analysis for the determination of loss recognition:
Required: Prepare your own analysis of the amount of adjustment to the financial statements. Assume that none
of these estimates have been recorded yet and give the adjusting entry you would recommend. Give any
supplementary explanations you believe necessary to support your recommendation.
The company has fudged the write-offs as being as small as possible, hoping to satisfy the auditors. Taken one at a time, only
the uncertainty about the deferred subscription costs is large enough to break the materiality threshold. But
the set of problems cannot be taken one at a time. Here is a suggested low-high audit estimate:
Low Estimate
Write-off deferred subscription costs (1)
$ 6,000,000
Provide allowance for bad debts (2)
$ 4,000,000
Provide for expected warranty expense (3) $ 2,000,000
Lower of cost or market inventory write-down (4)$ 5,600,000
Loss on government contract refund (5)
$ 1,000,000
Total write-offs and losses
$18,600,000
High Estimate
$12,000,000
$ 4,000,000
$ 6,000,000
$ 5,600,000
$ 2,000,000
$29,600,000
(1) The low estimate gives the benefit of doubt to the survival of the business, writing off half the deferred costs
as if one-half might be written off over the next two years. The company seems to have taken the 50%
probability ($6 million) and allocated half to each of the two years.
(2) The company seems ready to provide the allowance for all the doubtful accounts receivable.
(3) There is not much information for the audit team (such as a probability distribution).
It appears that the company plans to rebuild the inventory and recover as much as it can, namely the $4,400,000 that can be
realized from selling the rebuilt parts, but the lower of cost or market was figured incorrectly. The company seems to have
subtracted the selling price ($8 million) from the inventory cost ($10 million) to get the $2 million write-down. The correct
calculation is:
Net realizable value
Selling price proceeds
Cost to rebuild
Cost to market and ship (20% x $8 million)
Ceiling (net realizable value)
Floor; subtract “normal profit” (5% x $8 million)
Floor
$ 8,000,000
$(2,000,000)
$ (1,600,000)
$ 4,400,000
$ (400,000)
$ 4,000,000
Replacement cost is apparently $6 million for the modern part, so the “market” for lower of cost or market is NRV =
$4,400,000, and the inventory write-down is $10,000,000 – $4,400,000 = $5,600,000. Sale of the
rebuilt parts will produce zero profit in subsequent period(s):
Selling price
Cost of goods sold
Inventory sold (written-down cost)
Rebuilding cost
Cost to market and ship
Profit
$ 8,000,000
4,400,000
2,000,000
$(6,400,000)
($1,600,000)
$
0
For a contingency such as this government contract dispute, GAAP suggests recognizing loss at the lower end of a range for loss, so a
$1 million loss provision would satisfy GAAP.
Recommended adjustment:
Management’s suggestion of $11,000,000 cost/loss recognition is not sufficient. It “leaves” $7,600,000 income overstatement,
even using the auditors’ low estimate of $18,600,000. Even booking the low estimate “leaves” $10,000,000 unrecognized
(including the government contract contingency at $1 million instead of $2 million). The minimum adjustment, given the
limited information available in this problem, follows. Adequate disclosures should be made about the $6 million deferred
subscription costs remaining and the prospects for the business as well as about the warranty expense estimate because these
are the items that leave uncertain assets and liabilities in the financial statements.