HOMEWORK CHAPTERS 14 thru 18
14-27(a)The confirmation of accounts receivable is a generally accepted auditing procedure. In contrast, the confirmation of accounts payable is not a generally accepted auditing procedure, although the procedure is often followed.
Two reasons may be given for the foregoing differences. First, management fraud would tend to overstate the assets and understate the liabilities. Confirmation is generally more effective for tests of existence (overstatement) than completeness (understatement). Second, the evidence supporting accounts receivable records is usually supplied by the company's internally produced documents, whereas the evidence supporting accounts payable, such as vendors' invoices and statements, is produced by outside sources.
For these reasons, the emphasis of the accounts receivable audit is to obtain evidence supporting the amount recorded. On the other hand, determining that all payables are recorded is the primary objective of the accounts payable audit. It follows that confirmations are very useful in supplying supporting evidence for receivables but that auditing procedures other than confirmation are required to verify that all payables are recorded.
(b)The number of confirmation requests to be made for both accounts receivable and accounts payable would be determined by the auditors' assessments of control risk. Accounts receivable to be confirmed on a positive basis would be selected from the following groups:
(1)Accounts with large balances to account for a major part of the dollar value of receivables.
(2)Accounts placed with collection agencies or accounts with customers that are bankrupt, in receivership, or in other financial difficulties.
(3)Accounts in dispute.
(4)Old or inactive accounts.
(5)A representative number of accounts with small balances.
(6)Accounts that have been written off as uncollectible.
(7)Accounts with credit balances.
The selection of accounts payable for confirmation would be from the following groups:
(1)Large accounts including important suppliers even though the account balance is small at balance sheet date.
(2)Accounts for which monthly statements are unavailable.
(3)Accounts with unusual transactions.
(4)Accounts with zero balances that had substantial activity earlier in the year.
14-34(a)(2)Because a significant portion of the search for unrecorded liabilities deals with transactions recorded after year-end, it is least likely to be completed before the balance sheet date.
(b)(1)The auditors do not have as an objective the determination of whether accounts payable are past due.
(c)(4)Examining selected cash disbursements in the period subsequent to the year-end is the best audit procedure for determining the existence of unrecorded liabilities. All liabilities must eventually be paid, and will therefore be reflected in the accounts when paid if not when incurred. By close study of payments made subsequent to the balance sheet date, the auditors may find items that should have appeared in the balance sheet.
(d)(4)Auditors will usually find in the client's possession externally created evidence such as vendors' invoices and statements that substantiate the accounts payable. No such external evidence is on hand to support accounts receivable.
(e)(2)The most efficient way in which the duplicate recording of a purchase transaction may be detected is by reconciling the related payable accounts with vendors' statements.
(f)(1)Each vendor's invoice should be compared with the receiving report (to determine that it was received) and the purchase order (to determine that it was ordered). Answer (2) is incomplete because of the omission of the purchase order. Answers (3) and (4) are incorrect because the receiving report, prepared by the company itself, provides better evidence of what has been received than the vendor's packing slip.
(g)(2)Accounts payable confirmations are ordinarily sent to suppliers with whom the client has done the most business. This is because the largest potential for an understatement may exist due to the client having established high levels of credit. A sample of other accounts will ordinarily also be selected.
(h)(1)The best procedure to determine valuation of payables is confirmation. Examination of cash disbursements in the subsequent period is more directed towards completeness of payables. Analytical procedures may be useful but would not be as effective as confirmation with respect to the valuation assertion.
(i)(1)Because an understatement of liabilities overstates income, auditors are ordinarily most concerned with the completeness assertion for payables. Note, however, that in circumstances in which a client may be motivated to understate income (e.g., to minimize taxes), existence becomes a bigger concern.
(j)(4)Auditors audit estimates through (1) independently developing an estimate, (2) reviewing management’s process, and (3) reviewing subsequent events. There often is no one to send a confirmation related to the estimate.
(k)(3)The individual who signs the checks should ordinarily be provided with supporting documents that provide support for the disbursement. That individual should then manually or electronically “cancel” the documents so that the amount isn’t paid a second time.
(l)(2)Vouching from the purchases journal to the supporting documents provides evidence with respect to the existence assertion for purchases.
14-38SOLUTION: Rex Wholesaling (Estimated time: 20 minutes)
Taylor should perform, the following additional substantive audit procedures:
(1)Foot the client-prepared schedule.
(2)Tie the general ledger accounts payable controlling account to the client-prepared accounts payable schedule.
(3)Examine vendors' statements in support of items on the client-prepared schedule.
(4)Examine other documents (such as approved vouchers) in support of items on the client-prepared schedule.
(5)Review the general ledger controlling account for non-cash debits or unusual items, and investigate them.
(6)Confirm, with positive confirmation requests, account balances from selected vendors.
(7)Examine unpaid invoices on hand (to ascertain whether any were erroneously omitted from the client-prepared schedule of accounts payable).
(8)Examine documents in support of invoices paid subsequent to the year end (to ascertain whether the payable was recorded in the appropriate year).
(9)Inspect receiving reports (to test the accuracy of the year-end cutoff).
(10)Ascertain whether year-end outstanding checks to vendors were returned with the cutoff bank statement.
(11)Review correspondence files with respect to disputed items.
(12)Review open purchase orders for unusual or old items that may have been received but not recorded.
(13)Examine unmatched receiving reports.
(14)Make certain that the client representation letter includes the proper assertions concerning accounts payable.
(15)Investigate and resolve confirmation exceptions and other matters requiring follow-up.
15-33(a)Despite the fact that the options have a higher option price than the stock’s current price, they may well have value. Call options with option prices that are higher than the related stock prices are traded on option markets every day. Management should have a business valuation expert (specialist) value the options to determine the appropriate amount of compensation cost to be recognized.
(b)(1)Obtain a copy of the stock option plan for the auditors' permanent file and become thoroughly familiar with its provisions.
(2)Trace the approval of the plan to minutes of directors' and stockholders' meetings.
(3)Prepare a working paper for the permanent file showing the number of shares authorized by the plan, and the number granted, exercised, and expired each year. Design the working paper so that data can be added each year.
(4)Verify the number of shares granted in the current year by reference to minutes of directors' meetings. Verify market price at date of grant by reference to financial publications.
(5)Compute the number of options expired during the year and the number outstanding at the balance sheet date.
(6)Engage a specialist or use management’s specialist to value the stock options.
(7)Evaluate the reasonableness of the estimated value of the options used to compute compensation cost. This would include evaluating the qualifications and objectivity of the specialist. The auditors should also obtain and understanding of the methods and assumptions used by the specialist, make appropriate tests of data provided to the specialist, and evaluate whether the specialist’s findings support the related assertions in the financials statements.
15-34(a)(3)The client will not receive proceeds related to redemption of its interest-bearing
debt—it will pay off the debt.
(b)(1)Auditors will test the relationship between interest payments and recorded long term liabilities. When interest payments seem too high, it may be due to the existence of unrecorded liabilities. Also, the process of performing procedures to determine who interest is paid to may reveal unrecorded debt.
(c)(2)When debt provisions are violated, long term debt often becomes immediately payable, and therefore, a current liability.
(d)(2)A registrar and transfer agent keep information on the shares issued, outstanding, and the owners of that stock.
(e)(2)It is not customary to confirm stockholdings by direct communication with individual stockholders. For an actively traded stock, contacting individual stockholders would be very costly and not likely to produce a satisfactory proportion of replies.
(f)(1)The auditors should trace treasury stock purchase transactions to the certificates on hand. If the certificates are not on hand, they should be confirmed directly with the custodian. The articles of incorporation, answer (2), will not provide information on the details of specific stock issuances and treasury stock transactions. There is no interest on the treasury stock, and accordingly, answer (3) doesn't relate directly to treasury stock. Finally, it is far more likely that the overall board of directors, not the audit committee, will approve treasury stock transactions. Therefore, answer (4) is not correct.
(g)(1)Transactions in the owners' equity accounts are very few in comparison with the volume of entries in the other three groups. Consequently, the audit time required for owners' equity is usually much smaller than for revenue, assets, or liabilities.
(h)(3)The bond trustee will be able to provide information on both the sinking fund transactions and the year-end balance.
(i)(2)The auditors' examination of long-term debt always includes an examination of copies of debt agreements to ensure the client is not in violation of the covenants of these agreements. Answer (1) describes a procedure that is not performed. Answers (3) and (4) describe procedures that may be performed but they pertain more directly to other accounts.
(j)(1)Capital stock transactions should all be approved by the client's board of directors. Answer (2) is incorrect because there will be no cash receipt for stock repurchase transactions. Answers (c) and (d) are incorrect because cash disbursements will not be recorded and numbered stock certificates will not be on hand after stock sales.
(k)(3)An audit objective for owners’ equity is to determine that presentation and disclosure is appropriate. Answer (1) is incorrect because owners’ equity does not include long-term debt. Answer (2) is incorrect because common stock should not be valued at current market value. Answer (4) is incorrect because the term “equity accounting rule valuations” is of uncertain meaning.
(l)(1)A common difficulty for a sole proprietorship is segregating personal and business assets and personal net worth. For example, credit cards and cash accounts may be used for both personal and business use, thus complicating the accounting process.
16-36 (a)(4)Testing whether employee time reports are approved by supervisors is an example of a test of a control, not a substantive procedure.
(b)(3)The best procedure for the detection of a fictitious employee is a surprise observation of the distribution of paychecks. The fictitious employee’s paycheck will ordinarily not be picked up, and further audit procedures performed by the auditors may reveal that this is a fictitious employee.
(c)(4)The purpose of analytical procedures is to locate potential misstatements in the financial statements. The auditors should investigate this significant fluctuation to determine whether it results from a financial statement misstatement.
(d)(1)The three sections of a statement of cash flows relate to operations, financing, and investing. Capitalization is not one of the sections.
(e)(3)The search for unrecorded liabilities should be completed as of the last day possible—ordinarily near the date of the audit report.
(f)(1)The total likely misstatements composed of(a) known misstatements, (b) projected misstatements and (c) other misstatements.
(g)(2)A loss contingency is a possible loss stemming form past events that will be resolved in the future.
(h)(3)A Type 1 subsequent event relates to a condition that came into effect before year-end; Type 1 subsequent events result in an adjusting journal entry. In this situation, the customer’s check may be assumed to have been uncollectible at year-end, and therefore it would be considered to be a Type 1 subsequent event. The other three replies refer to events most ordinarily considered to be Type 2 events—the events came into existence after year-end.
(i)(3)The representation letter should be dated as of the date the audit was completed.
(j)(4)The performance of analytical procedures is a required part of the final review stage of an audit and is therefore most likely to be included in that stage of the audit.
(k)(2)When the auditor becomes aware of facts existing at the report date that would have affected the report, s/he should next determine whether there are persons relying or likely to rely on the financial statements who would attach importance to the information. If such persons are believed to exist, the next step is to determine the best manner in which to disclose the information.
(l)(3)The settlement of litigation is most likely to result in an adjusting entry (i.e., be a "Type 1 subsequent event) because the cause of the litigation most likely occurred before 20X2.
16-39SOLUTION: Internal Control, Tests of Controls, Substantive Procedures (Estimated time: 20 minutes)
(a)(1)Separation of the human resources and approval functions is designed to prevent overpayment of payroll amounts or payments to fictitious employees.
(2) If the same employees perform the functions of timekeeping and distribution, they have an opportunity to report the attendance of individuals who have resigned, and divert their payroll checks to their own use.
(b)(1) and (2)Segregation of duties is tested by making inquiries as to which employees performed specific tasks throughout the year, and observing personnel performing those tasks. The auditors also should make inquiries as to who performs assigned tasks under unusual circumstances, such as prolonged illness of an employee.
(c)(1) and (2)To test for fictitious payroll transactions, the auditors might observe the distribution of paychecks on a surprise basis. Analytical procedures applied to payroll expenses, such as comparisons of this year's amounts to budgeted amounts or comparable amounts for prior years, might reveal a significant overstatement of payroll expenses.
17-26(a)(3)When the auditors take exception to the application of accounting principles in the client's financial statements, they will issue either an "except for" qualified, or adverse opinion, depending on the materiality of the problem.
(b)(2)The audit report should be dated no earlier than when the auditors have accumulated
sufficient competent evidence. This date is often the last day of fieldwork.
(c)(1)Reference to the work of another auditor is not, in itself, a qualification of the auditors' report. This reference does not lessen the auditors' collective responsibility. Rather, it merely divides this responsibility among two or more CPA firms.
(d)(4)This phrase violates the fourth standard of reporting, because it does not give the reader of the report a clear-cut indication of the auditors' opinion. The phrase appears to modify the standard opinion paragraph, but is not forceful enough to constitute qualifying language.
(e)(1)The auditor communicates through the auditors' report, and therefore only answer (1) is correct. Note that the client will include a discussion of the related party transactions in a note to the financial statements.
(f)(2)A disclaimer is appropriate because auditors must generally disclaim an opinion when a significant client imposed scope limitation is involved. Note here that if the limitation were circumstance imposed the auditors would have to decide between an "except for" qualified and disclaimer of opinion.
(g)(3)No explanatory paragraph is added when part of the audit is performed by other auditors. If the CPA wishes to take responsibility for the work of the other auditors, no modification is necessary. If the CPA does not wish to take such responsibility, each of the existing three paragraphs of the report are modified.
(h)(2)An audit report of a public client indicates that the audit was performed in accordance with standards of the Public Company Accounting Oversight Board (United States).
(i)(3)An audit report for a public client indicates that the financial statements were prepared in conformity with generally accepted accounting principles (United States). The PCAOB does not issue accounting standards.
(j)(3)Substantial doubt about a client’s ability to continue as a going concern results in either an unqualified report with explanatory language or a disclaimer of opinion. Accordingly answer (3) is correct since a qualified report is not appropriate.
(k)(2)When an unjustified change in accounting principles occurs, either a qualified or adverse opinion is appropriate as this represents a departure from generally accepted accounting principles. Accordingly, answer (2) is correct since an adverse opinion, but not a disclaimer of opinion is appropriate.
(l)(3)An emphasis of a matter paragraph is appropriate when an auditor wishes to emphasize a matter concerning the financial statements, but not a matter concerning the scope of the audit engagement. Accordingly, answer (3) is not a situation in which an emphasis of a matter paragraph is appropriate since confirming accounts receivable relates to the scope of the
18-32 (a)(1) PCAOB Standard No. 2 requires that the auditors to communicate both material
weaknesses and significant deficiencies to the audit committee.
(b)(2) An audit report on internal control is modified for material weaknesses, not
significant deficiencies.
(c)(1) Management must communicate both material weaknesses and significant
deficiencies to the audit committee.
(d)(1) PCAOB Standard No. 2 includes Ineffective oversight of financial reporting by the audit committee is considered an indicator of a material weakness in internal control.