9e SM CHP# 10 1-15-13 FINAL

Solutions for Chapter 10
True/False Questions
10-1 F
10-2 F
10-3 T
10-4 T
10-5 T
10-6 F
10-7 F
10-8 F
10-9 F
10-10 T
10-11 T
10-12 T
10-13 T
10-14 F
10-15 F
10-16 F
10-17 T
10-18 F
Multiple Choice Questions
10-19 C
10-20 D
10-21 E
10-22 A
10-23 E
10-24 D
10-25 B
10-26 D
10-27 A
10-28 E
10-29 B
10-30 C
10-31 A
10-32 E
10-33 E
10-34 B
10-35 B
10-36 C
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10-1
Review and Short Case Questions

10-37
(a)
GeneralCheckingAccounts.Ageneralcheckingaccountisusedformostcash
transactions.Theorganizationsregularcashreceiptsanddisbursementsareprocessedthrough
thisaccount.Insomecases,thereceiptsarereceiveddirectlybythebankthroughalockboxor
electronicfundstransfers(EFT)andaredirectlydepositedintheclientsaccountbythebank.
Mostorganizationshavecashbudgetstoassistinplanningdisbursements,andtheyhavecash
managementarrangementswiththebanktotemporarilyinvestexcessfundsininterestbearing
securities.
(b)
CashManagementAccounts.Goodcashmanagementrequirestheorganizationtoearn
thegreatestpossiblereturnonidlecashbalances.Mostorganizationshavedevelopedagreements
withtheirfinancialinstitutionstomoveexcesscashintoandoutofshorttermsavingsaccounts
togenerateextrareturns.Theauditorwillneedtounderstandtherelationshipswiththese
financialinstitutions,thecontrolsapplicabletocashtransfers,andtheriskstotheclient
occurringfromerrorsorfinancialproblemsassociatedwiththefinancialinstitution.
(c)
ImprestPayrollAccounts.Someorganizationsdisbursetheirpayrollthroughanimprest
bankaccount,intowhichcashisdepositedasneededtocoverpayrollcheckswhentheyare
issued.Iftheemployeescashallpayrollchecks,thebankbalancereturnstozero.Theneedfor
animprestpayrollaccountisdisappearingasmostorganizationsnowdirectlydeposit
employeesearningsintotheirrespectivebankaccounts.
(d)
PettyCashAccounts.Almostallorganizationsuseoneormorepettycashfundsto
disbursefundstoemployeeswhoareauthorizedtomakevariouspurchasesonbehalfofthe
organization.Thepettycashfundshouldhaveasufficientamountofmoneytopayforroutine
expenses.Whilemostpettycashfundsinvolveonlyasmallamountofmoney,itisimportantto
recognizethatthereisariskoffraudassociatedwiththisfund,asillustratedintheProfessional
JudgmentinContextfeature.Theauditorshouldconsidertheamountoffundsthatare
cumulativelydisbursedthroughthepettycashaccountthroughouttheyear.Thecumulative
disbursementsmadethroughpettycashfundscanbecomesignificant.
10-38
(a)
Lockboxes.Thecollectionofcashandreductionofthepossibilityoffraudcanbe
facilitatedbytheuseoflockboxes.Customersareinstructedtosendpaymentsdirectlytothe
companyataspecificpostofficeboxnumber,whichisadepository(lockbox)atthe
organizationsbankinginstitution.Thebankreceivesandopenstheremittances,preparesalist
ofcashreceiptsbycustomer,creditstheclientsgeneralcashaccount,andnotifiestheclient
aboutdetailsofthetransactions.Notificationcanbeeitheradocumentlistingcustomerreceipts
oranelectroniclistofthesameinformation.Thefinancialinstitutionperformsthisprocessing
forafee.Theclientspersonnelusethedatasentbythebanktoupdatecashandaccounts
receivable.
10-2
(b)
ElectronicFundsTransfers.Manyorganizationshaveadoptedelectronicfundstransfers
(EFT)asanintegralpartoftheirbusiness.Cashtransfersaremadeautomaticallyand
instantaneously;checksarenotused.Overtime,EFTwillreducetheuseoflockboxesandother
cashcollectionapproaches,althoughtheywillstillbemaintainedforcustomerswhoareunable
tomakeelectronictransfers.
(c)
CashManagementAgreementswithFinancialInstitutions. Financialinstitutionsprovide
automatedservicessuchascashmanagementprogramsformanyoftheirclients.Theauditor
shoulddeterminethat(1)adequateproceduresareusedformonitoringtheriskassociatedwith
theinvestmentsand(2)controlsareusedtoassurethatinvestmentsarenotsubjecttoundue
risks.
(d)
CompensatingBalances. Mostcompanieshaveshorttermloansandlinesofcreditwith
theirprimaryfinancialinstitution.Thelineofcreditprovidesthecompanywithaprenegotiated
loan,availableforusewhenthecompanyneedsit.Thefinancialinstitutionsusuallyrequirethe
companytomaintainaspecifiedbalanceinanoninterestbearingaccount.Theamountavailable
fortheloanisthecreditlineminusthecompensatingbalance.Iftheamountsarematerial,the
companyisrequiredtodisclosethecompensatingbalancearrangementanditseffectonthe
effectiverateofinterest.
10-39
1. E
2. A
3. D
4. C
5. B
10-40
Cash is inherently risky because a high volume of activity flows through the account, it is liquid,
automated systems can cause problems if inadequately controlled, debt covenants are often tied
to cash balances, and cash can be easily manipulated and stolen.
Inherent risk for cash is usually assessed as high because of the following reasons:
Volume of activityThe volume of transactions flowing through the account during the
year makes the account more susceptible to error than most other accounts.
LiquidityThe cash account is more susceptible to fraud than most other accounts
because cash is liquid and easily transferable.
Automated systemsThe electronic transfer of cash and the automated controls over cash
are such that if errors are built into computer programs, they will be repeated on a large
volume of transactions.
Importance in meeting debt covenantsMany debt covenants may be tied to cash
balances or to maintaining minimum levels of working capital. Debt covenants specify
10-3
restrictions on the organization to protect the lender. Typical covenants restrict cash
balances, specify the maintenance of minimum working capital, and may restrict the
companys ability to pay dividends. The covenants may affect managements actions in
its endeavor to present financial statements that do not violate the debt covenants.
Can be easily manipulatedAs the Koss fraud described in the Professional Judgment in
Context feature illustrates, cash can be manipulated or stolen by a CFO or other personnel
with power over the account balances and a lack of oversight.
At Koss Corporation, petty cash was inherently risky because transactions processed through it
did not flow through the standard controlled accounts payable process, which enabled Sachdeva
to accomplish the theft.
10-41
We disagree with the auditor's assessment of inherent risk of cash transactions as low. Granted,
the accounting for cash is not overly complex. However, the liquidity of the cash accounts,
coupled with their susceptibility to fraud or misappropriation, makes the inherent risk of the
accounts at least moderate - if not high. Most organizations recognize the high inherent risk
associated with the accounts and have implemented effective controls to reduce control risk.
10-42
1. Doesthecompanyhavesignificantcashflowproblemsinmeetingitscurrentobligationson
atimelybasis?A
2. Arethereanyrestrictionsingettingaccesstocash?Forexample,doesthecompanyhave
cashinsweepaccounts,orotheraccountswithfinancialinstitutionsthatmaybeintrouble,
andthatmayrestrictaccesstocash?B
3. Doestheinternalauditdepartmentconducttimelyreviewsofthecashmanagementandcash
handlingprocess?Ifyes,reviewrecentinternalauditreports.B
4. Doesthecompanyusecashbudgetingtechniques?Howeffectivearethecompanyscash
managementbudgetingtechniques?A
5. Arebankreconciliationsperformedonatimelybasisbypersonnelindependentof
processing?Isfollowupactiontakenpromptlyonallreconcilingitems?B
6. Doesthecompanyusethecashmanagementservicesofferedbyitsbanker?Whatisthe
natureofthesearrangements?A
7. Hasthecompanymadesignificantchangesinitscashprocessingduringthepastyear?Have
anymajorchangestakenplaceinthecompanyscomputerizedcashmanagement
applicationsduringtheyear?A
8. Havecashmanagementservicearrangementsbeenreviewedbymanagementandtheboard
ofdirectors?Arethearrangementsmonitoredonacurrentbasis?B
9. Doesthecompanyhaveloanorbondcovenantsthatinfluencetheuseofcashorthe
maintenanceofworkingcapitalratios?A
10-4
10. Arecashtransactions,includingelectroniccashtransfers,properlyauthorized?What
authorizationisrequiredtomakeelectroniccashtransfers?B
11. Doesthecompanyusealockboxcollectcashreceipts?Whatistheagreementwiththe
financialinstitution?Whatarethecompanyscontrolsassociatedwiththelockbox
agreement?B
12. Isthereanyreasontosuspectthatmanagementmaydesiretomisstatethecashbalance?A
13. Domanagementandtheboardperiodicallyreviewthecashmanagementprocess?Doesthe
cashmanagementorganizationprovideforeffectivesegregationofduties,review,and
supervision?B
14. Whoisauthorizedtomakecashtransfers,includingelectronicfundtransfers,andwhatare
theproceduresbywhichthatauthorizationisverifiedbeforethetransferstakeplace?What
proceduresdoesmanagementusetoassurethattheauthorizationprocessismonitored?B
10-43
Thefollowingisalistofcommonschemesrelatingtocashreceipts:
Inventory is sold, but the employee making the sale does not record the sale and steals the
cash.
An employee receives a check and deposits it, but does not record the sale; then the employee
writes a check out to himself and does not record the disbursement.
The employee collects a customer payment, steals the cash, and writes off the accounts
receivable as uncollectible.
The employee steals a payment from Customer X. To cover the theft, the employee applies a
payment from Customer Y to Customer Xs account. Before Customer Y has time to notice
that their account has not been appropriately credited, the employee applies a payment from
Customer Z to Customer Ys account. This type of conduct is known as lapping.
The employee makes a sale but does not record it, and steals the cash. This type of conduct is
known as skimming.
Thefollowingisalistofcommonschemesrelatingtocashpayments:
The employee purchases merchandise and records the sale at an unauthorized discounted
amount.
The employee sells merchandise to a friend at a discounted price; the friend returns the
merchandise for a refund at the undiscounted price; the two split the profits.
The employee steals cash and conceals it by recording a fictitious discount.
The employee writes a check to a fictitious vendor, and deposits the check into an account that
he controls that has been set up in the name of the fictitious vendor.
Discussing frauds that students have heard about in their community yields lively class
discussion.
10-44
10-5
a.
Lapping occurs when an employee steals from one customer, then applies payment from
a second customer to cover the theft, then applies payment from a third customer to cover the
incorrect balance in the second customers account, and so forth.
b.
Skimming occurs when an employee makes a sale but does not record it, and steals the
cash.
10-45
a.
1, 2, 3, 4, 6
b.
1, 3, 6
c.
1, 2, 3, 4, 6
d.
e.
1, 2, 3, 6
f.
2, 6
g.
h.
1,2,3,4,5,6, 2, 3,4,5,6
10-46
Common controls for petty cash include:
Limiting access to petty cash funds by keeping funds in a locked box and restricting the
number of employees who that access
Requiring receipts for all petty cash disbursements with the date, amount received, purpose
or use for the funds, and name of the employee receiving funds listed on the receipt
Reconciling the petty cash fund before replenishing it
Keeping customer receipts separate from petty cash funds
10-47
1. A list of incoming receipts is prepared by the person who opens the remittances and who
delivers the list to a person independent of the deposit function. a
2. An authorized individual makes regular collection calls on past-due accounts. c
3. Online entry that includes the input of a control total and/or has total is used for each payment.
b
4. A duplicate deposit slip is prepared by someone other than the person opening the mail. a
5. The company systematically sends past-due notices to delinquent customers. c
6. Deposits are made daily. a
7. Prenumbered batch control tickets include control totals of number of remittances to be
processed and total dollars to be applied. b
10-6
8. Past-due accounts are periodically reviewed by senior collection officials to determine

alternative collection procedures. c
9. An agreement exists between the bank and the company on cash-handling activities, including
when the remittances are added to the clients account. a
10. Management monitors controls to follow up on discrepancies in accounts receivable postings.
a
10-48
There are many possible responses to this question. One possible solution is based on
information originally provided by Canada Border Services Agency at www.cbsa-asfc.gc.ca
a.
Students might indicate that the CBSA should have the following controls in place to
assure proper cash receipt, handling, depositing, and recording:
Payments are deposited within 24 hours.
Payments are recorded within four working days.
Customs revenue reports are prepared for all bank deposits.
Financial institutions are chosen based on their proximity to the port of entry location.
Deposit slips are stamped by the financial institution and returned to the CBSA office within
one working day.
b.
If an audit were to be conducted the audit might consist of the following steps:
Interviews are conducted with management and staff, at multiple locations.
A review of applicable legislation and regulations, policies, procedures and guidelines is
conducted.
An examination and analysis of location statistics is completed, with comparison across
different locations.
Observation of physical controls and processes is completed by conducting a walk-through of
the facilities, reviewing manual and automated records of cash collected, reviewing
monitoring controls, and by talking to regional staff.
The selection of documented samples from selected offices for detailed examination and
analysis is made, including reconciliation with basic recording controls, deposits in the
banks, and confirmations of bank accounts.
10-49
1. The company reports consistent profits over several years, but cash flow are declining. b
2. Operating cash flow is consistent with sales and net income. a
3. The timeliness of accounts receivable collections declines, but credit policies are unchanged. b
4. Operating cash flow is not significantly different from the prior year. a
5. Investment income is consistent with the level of and returns expected from investments. a
6. There are unexpected declines in the petty cash account. b
10-7
10-50
The major components of an audit program for cash receipts and cash management controls
include:
Procedures
Examples: Inquire of management about the existence of lines of credit etc., Review the
company risk analysis and assess the motivation to misstate or manage cash, document internal
controls over cash by completing the internal control questionnaire or by flowcharting the
process. See Exhibit 10.3 for further examples.
General Tests of Controls
Examples: Review the frequency of monitoring activities; determine their effectiveness through
reviews of the reports, indications of management actions, descriptions of corrective actions
taken, and interviews with key personnel.
Testing of Controls over Cash Receipts if Monitoring Controls are Not Effective
Examples: Perform a walkthrough of the processing of cash collections, starting with their
receipt through the preparation of documents for processing.
Testing of Specific Control Activities
Examples: For a sample of cash receipts, determine that the following procedures takes place:
each payment is given a unique identifier, which is subsequently entered into the system; the
payments received are the same as the amount applied to the update of accounts receivable. See
Exhibit 10.3 for further examples.
Documenting Work Performed
Examples: Document the control risk assessment, including the types of misstatements that
might occur because of any deficiencies in controls. Write a brief memo citing implications for
the remainder of the audit.
10-51
Periodic reconciliation of cash accounts is one of the most important control procedures an
organization can implement. Without such reconciliations, there could be numerous
misstatements (both intentional and unintentional) in the cash account. Many frauds have been
covered up by either omitting or intentionally misstating a bank reconciliation.
If the client does not perform periodic bank reconciliations, as often happens in smaller
organizations, the auditor will generally compensate by preparing an independent bank
10-8
reconciliation at year-end and requesting a bank cut-off statement to verify most of the
reconciling items.
Professional skepticism would be heightened if the client does not perform a periodic
reconciliation of cash because the question the auditor should ask is Why?. The downside risk
to the client is high if they do not perform this control, and it is not a terribly difficult or timeconsuming task. The auditor should heighten professional skepticism because there should be a
concern that the client is intentionally misstating the cash balance.
10-52
a.
The confirmation provides information on the current balances of all accounts and any
loans the client has with the financial institution. The confirmation will also seek information on
the nature of financial relationships with the bank. These relationships could include
compensating balance arrangements, line of credit arrangements, investing authorization of client
funds by the financial institution, and other financing or investing arrangements. A second type
of a confirmation is sent to gather information on any debt of others for which the client may be
a guarantor. This latter instance often happens with smaller organizations where there are
guarantees for various related party transactions.
b. The bank cut-off statement is the same as a regular bank statement, but is sent directly to the
auditor usually before the end of the month following year-end. The cut-off statement is useful
for verifying many of the reconciling items on a year-end bank reconciliation such as deposits in
transit, outstanding checks, and bank charges.
c. A bank transfer statement is an audit document which lists all transfers between client bank
accounts starting a short period before year-end and continuing for a short-period after year-end.
The purpose of the document is to ensure that cash in transit is not recorded twice (kiting).
10-53
Kiting takes place by transferring funds from one bank account to another bank account, but not
recording the deposit and withdrawal in the same period. For example, a December 31 transfer
would record the receipt in one account on December 31 but not record the disbursement on the
other account until January resulting in the recording of the transferred amount twice as of
December 31. Management has manipulated, or inadvertently misrecorded items, such that cash
is recorded twice.
The client should carefully label all inter-company transfers in order to avoid kiting. Although
extra procedures can be incorporated, normal control procedures that would lead to timely
recording of all transactions should be sufficient to prevent kiting.
The primary audit procedure to detect kiting is the bank transfer schedule. Such a statement lists
all the inter-company transfers during the last few days of one year and the next few days of the
next year. The auditor then verifies the recording of the transactions and the date the transactions
10-9
cleared the bank to determine if all the items are appropriately recorded in the correct time
period.
10-54
a.
b.
202
101 & 303
10-55
Audit Finding
1. Kiting
Audit Procedure
Preparation of an inter-bank transfer schedule noting the dates
the deposits and disbursements were recorded.
2. Employee
pockets cash
and destroyed
supporting
documentation.
Confirmation of accounts receivable balances.

Review of client procedures for dealing with customer
complaints.
Review of summary reports on nature of customer complaints
and follow-up to customer complaints.
3. Employee
confiscates
cash but
prepares a
turnaround
document to
show extra
cash discount.
Analytical review of discounts recorded in comparison with

company policy and past amounts.
4. Controller
defalcation
covered up
through
understating
outstanding
checks.
Independent testing of the year-end bank reconciliation.
5. Certificates of
Deposit seem
to be earning a
lower than
usual rate.
Testing of marketable securities through a typical worksheet

which lists investments, date of investment, interest rate, interest
earned, etc. The auditor should recompute expected interest
earned and compare with the amount recorded.
Sample selection of discounts taken and comparison with

authorized discounts.
Tests of transactions including the examination of support for

disbursements.
Confirmation of securities and interest rate with the financial
10-10
Audit Finding
6. Cash
remittances are
lost or are not
recorded on a
timely basis.
7. Substantial
bank service
charges have
not been
recorded by the
client.
Audit Procedure
institution holding the securities.
Detailed cash trace.
Selection of cash receipts and testing via tracing through the
recording process, including the prompt deposit.
Perform testing of year-end client bank reconciliation. Obtain
bank cut-off statement as a basis for testing items in the yearend reconciliation.
8. Loan negotiated for Review of company policies

a subsidiary by an regarding authorization to
unauthorized
make loans.
divisional manager.
Confirmation with banks as
to existence of loans and
guarantees made on loans of
others. Review of major new
loans and investigation for
the authority to make the
loans. Review of Board of
Director minutes for
important new loans.
Corporate policies and vigilant

review of policies by the Board of
Directors.
9. Check was
recorded twice to
cover a cash
shortage.
Periodic review of old outstanding

checks by someone independent of
the cash management function.
Independent year-end bank

reconciliation.
Statistical sample of
disbursements and support
for disbursements.
Internal audits to periodically

evaluate adherence to corporate
policies.
Review of all major loans by top
management.
Independent bank reconciliation.
10-11
10-56
a.
Schedule of Amount Taken by Cashier

Pembrook Company
Computation of Amount Abstracted by Cashier
Cash per books, November 30
Add: Credit by bank
Adjusted Cash Balance
$ 18,901.62
100.00
$ 19,001.62
Less: Adjusted Bank Balance:

Bank Balance, November 30
Less: Outstanding Checks:
62
183
284
8621
8623
8632
$15,550.00
116.25
150.00
253.25
190.71
206.80
145.28 1,062.29
Cash which should be on hand for deposit:

Cash Reported
Estimated Amount of Theft
14,487.71
$ 4,513.91
3,794.41
$ 719.50
b.
It appears that the cashier removed $719.50. The most likely methods used to conceal
the theft would be:
Not listing all outstanding checks on the bank reconcilements.

Under-footing outstanding checks shown on the reconciliation.
Subtracting an item from the bank balance that should be added to the book balance.
c. Some of the control procedures that would have been effective in preventing or detecting the
irregularity would include:
Someone other than the cashier should trace cash receipts to the deposits in the bank.
Someone other than the cashier should be responsible for preparing the bank reconciliation.
d. Additional audit procedures that might be performed:
Prepare an independent bank reconciliation as of November 30. Verify the items on the
reconcilement by obtaining a cut-off statement from the bank, or make arrangements to
receive the 12-31 bank statement directly from the bank. Foot all the items on the bank
reconcilement.
10-12
10-57
Code No.
1.
Actions to be Taken by Auditor

The auditor should use the standard bank cash confirmation form to confirm both
bank balances.
The auditor should compare the bank balances to the amounts on the
confirmations returned by the banks and the bank statements. Differences should
be investigated.
The auditor should ascertain why Bank A has a cash balance that was not
transferred to the general account.
The auditor should arrange to obtain copies of the bank statements directly from
the bank for subsequent weeks through the auditors cutoff date.
2.
The auditor should examine the bank statements of the subsequent week to
determine whether these deposits have been properly credited to the Toyco
account. Discrepancies should be investigated.
3.
The auditor should review the status of these deposits by examining the bank
statements of the subsequent week to determine if these deposits were properly
resubmitted and credited to the proper account.
The auditor should review the frequency of invalid deposits and recommend the
company strengthen controls in this area.
4.
The auditor should examine all sales and deposit documents prepared on
December 29. Because no journal entry was made on that date for Bank A, the
auditor should trace postings of the days sales into the proper account.
If there were no Bank A credit card sales on December 29, the $2,000 bank
deposit should not have been credited to the Toyco bank account. If so, the auditor
should suggest that Toyco contact the bank to adjust the bank error. The auditor
should compare the documents that support the Bank B ledger debit of $5,400 to
those that support the $5,500 deposit to the bank account. Differences should be
accounted for and adjustments should be made when necessary.
5.
The bank charge should be explained and discussed with the client.
6.
The auditor should examine the clients accounting records to determine why the
cash transfer from Bank B to the depository bank account was not recorded in the
companys books of account.
10-13
7.
The auditor should verify the Bank B service charge and should verify why there
is no charge for Bank A.
8.
The auditor should obtain reasons why charge backs for stolen cards have not
been recorded, and should examine the internal control over the acceptance of
credit cards.
9.
The auditor should examine the bank statements of the subsequent week to
determine whether all sales returns for the preceding week have been recorded by
the banks. The auditor should determine that these unadjusted amounts agree with
the general ledger account balances.
10-58
a. The purposes of a bank confirmation are to obtain information about the correctness of yearend account balances as well as to obtain information about indebtedness and guarantees of
indebtedness. If the auditor directly receives a cut-off bank statement shortly after year-end,
that statement would provide accurate information about the balance in the clients general
checking account. However, it would not provide information about the balances in other
accounts, nor would it provide information regarding indebtedness to the bank. Thus, if other
accounts exist, the auditor should still send the confirmation. Further, the auditor should
separately confirm the existence of loans or guarantees with loans with all financial
institutions with which the client had any significant business activities during the year under
audit. Note that in 2010 the PCAOB issued a proposed Auditing Standard that has
requirements for bank confirmations.
b. The primary other information gathered using a bank confirmation is information on
indebtedness. The confirmation is one means of identifying a potential understatement of a
liability. The information will be used in the audit of liabilities and determining the potential
need for disclosure of loan guarantees.
c.
Scenarios and Related Audit Procedures:

1. There is concern that the auditor is not familiar with the bank. Past frauds have
taught the profession that an unknown bank with only a P.O. box as a mailing
address could be a dummy company set up by the client. Assuming the amounts
deposited in the distant bank are material, the auditor should consider:
Inquiring of an office of the audit firm (if a multiple office firm) located near
the distant city about the existence and financial health of the banking
institution.
Corroborate the confirmation with a phone call to the banking institution.
Review the existence and financial health of the bank by reviewing the
annual review of banks in an industry source such as those published by the
Risk Management Association (RMA).
10-14
Consider personally visiting the financial institution (if none of the above
procedures leads to satisfaction regarding the institution) to hand carry the
confirmation.
2. Unfortunately, the banking community often makes mistakes while preparing

confirmations for the auditors. Thus, the auditor should not necessarily jump to
the conclusion that the clients amounts are in error. The auditor should
communicate directly with the financial institution (and the individual preparing
the confirmation) to reconfirm the amounts. If differences persist, the auditor
should then investigate the differences to determine if errors exist within the client
accounts.
3. The auditor should pursue the matter first with the client. If the client believes the
confirmation is in error, the auditor might consider a personal discussion with the
financial institution. If the financial institution reconfirms the existence of the
loan, the auditor should investigate further and should conduct the remaining part
of the audit with greater skepticism because of the potential cover-up by the
client.
10-59
Basic audit procedures that should be performed by Kautz in gathering evidence in support of
each of the items (a) through (f) are as follows:
Balance per bank (item a)
1. Confirm by direct written communication with bank.
2. Obtain and inspect a January 2014 cutoff bank statement directly from the bank
(examine opening balance.)
Deposit in transit (item b)
1. Verify that the deposit was listed in the January 2014 cutoff bank statement on a
timely basis.
2. Trace to the cash receipts journal.
3. Inspect the client's copy of the deposit slip for the date of deposit.
Outstanding checks (item c)
1. Trace to the cash disbursements journal.
2. Examine all supporting documents for those outstanding checks that were not
returned with the cutoff bank statement.
3. Examine checks accompanying the January 2014 cutoff bank statement and trace
all 2013, or prior, checks to the outstanding check list.
4. Ascertain why check number 837 is still outstanding if possible.
10-15
NSF check returned (item d)

1. Follow up on the ultimate disposition of the NSF check.
2. Examine all supporting documents.
Note collected (item e)
1. Examine bank credit memo.
Balance per books (item f)
1. Foot this total and compare this balance with the general ledger balance.
10-60
a. The procedures that would be used to audit the bank transfer statement include:
All items listed on the schedule should be traced to both sets of books to determine the
time period in which they were recorded.
Deposits in transit should be verified by reference to the cut-off bank statement obtained
directly from the bank.
b. The journal entries (for the consolidated company) that would be required as a result of the
bank transfer statement would be:
Cash
Inter-Company Payable
45,000
45,000
(This cash transfer was listed as a disbursement from the branch, but was not recorded as a
receipt at the home office until the subsequent year. Therefore, the cash balance did not show
up on either set of books at year-end and needs to be adjusted.)
Inter-company Receivable
Cash
14,000
14,000
(The cash was not disbursed from the branch's account until January, and was thus included
in the branch account at year-end. The home office recorded the receipt of the item in
December and deposited it in December. Thus, the 14,000 was recorded on the books of both
the branch and the central office.) All of the other transfers are appropriately recorded in the
correct time period.
10-16
10-61
Weakness
a. Inadequate segregation
of duties in the mail
room.
b. No remittance advice is
prepared.
c. Supporting documents
not cancelled.
d. Inadequate segregation
of duties dealing with
customer complaints.
e. Untimely bank
reconciliations not
prepared by an
independent person.
Substantive Audit Procedure

Expand confirmations with customers, select
a sample of daily deposits and trace to
accounts receivable credits for payments.
Same as b.
Search for duplicate payments. ACL can be
used for this.
Expand review of subsequent collections,
follow-up on old uncollected receivables by
direct correspondence with the identified
customers and/or discuss collectability with
management.
Prepare a year-end bank reconciliation using
the clients cash records and a bank cutoff
statement. Expand confirmations.
Each students answer will likely differ as to which causes them most concern and thus
heightened professional skepticism. Two of the most likely answers are (e) because of the lack of
timeliness and lack of segregation of duties of this important controls and (d) because of the risk
that the individual with inappropriate segregation of duties is stealing money and covering it up
by manipulating customer correspondence regarding monthly statements.
10-62
a. Confirmation responses are written responses provided by external third parties and are
generally considered to be strong sources of audit evidence about the existence and valuation
of bank account balances. However, the confirmations are designed to also provide evidence
on other issues such as complex banking relationships (trade finance arrangements, derivative
transactions), and indebtedness and guarantees. Even if a bank account balance is small and
the auditor is not greatly concerned about the existence of that small cash balance, the auditor
will obtain other useful information by sending a confirmation to that bank.
b. In Step One, the auditor structures the problem, considering the relevant parties to involve in
the decision process, identifying various feasible alternatives, considering how to evaluate the
alternatives, identifying uncertainties or risks, and determining how to structure the problem.
The problem that the auditor is addressing is the extent to which substantive procedures
(sending of bank confirmations) should be performed. To illustrate these tasks, the auditor
should structure the problem to address not only the relevant assertions related to cash, but to
also obtain relevant information related to liabilities or other relationships the client might
have with the financial institution
10-17
In Step Two, the auditor assesses the consequences of the potential alternatives.
Considerations at this stage include determining the dimensions on which to evaluate the
alternatives and considering how to weight those dimensions. In this case, the alternatives
relate to designing the substantive audit procedures related to sending bank confirmations to
what extent will this procedure be used, how many of the financial institutions should receive
confirmations, should the balance of the bank account be considered when determining
whether to send a bank confirmation.. The dimensions on which to evaluate the alternatives
include considerations of appropriate auditing for assertions related to cash and for assertions
related to other information obtained through bank confirmations (e.g., are all of the clients
liabilities recorded or does the client have debt or guarantees with a particular financial
institution).
In Step Three, the auditor assesses the uncertainties in the situation. For example, the
auditor tries to assess the likelihood of various consequences associated with potential
alternatives. Some consequences are more likely than others, and some are more costly than
others. In this case, the uncertainties include whether the clients cash exists and whether the
client has loan, guarantees or other relationships with its financial institutions. Because the
cash balances at some banks are small, the auditor may not have much concerns about the
existence of those cash balances (because they are immaterial); but the other uncertainties
remain.
In Step Four, the auditor evaluates the alternatives against some decision rule. For
auditors, decision rules related to evidence gathering decisions are often articulated in terms of
professional auditing standards. In our example, the primary criterion is simple: follow the
professional auditing standards and gather sufficient competent evidence to assess whether the
clients cash exists and whether the client has recorded all other financial arrangements and
liabilities (including guarantees).
In Step Five, the auditor considers the sensitivity of the conclusions reached in steps two,
three, and four to incorrect assumptions. For example, in this case, the assumptions involve
uncertainty regarding whether the client has recorded all financial arrangements and liabilities
(including guarantees).
In Step Six, the auditor gathers information in an iterative process that affects
considerations about the consequences of potential alternatives and the uncertainties
associated with those judgments. Importantly, the auditor considers the costs and benefits of
information acquisition, knowing that gathering additional evidence requires time, effort, and
money. Given that audits are a for-profit enterprise, cost-benefit considerations in evidence
gathering are particularly important. A good auditor knows when to say when and decides to
stop collecting evidence at the right time. In contrast, some auditors stop evidence collection
too soon, thereby yielding inadequate evidence on which to make a decision. Still others
continue evidence collection even though the current evidence is adequate, thereby
contributing to inefficiency and reduced profitability in the audit. In this case, if the auditor
decides to not send bank confirmations to those banks where the client has a banking
relationship, but with small account balances, the auditor may be under-auditing.
10-18
The auditor iterates through steps one through six repeatedly until satisfied that a decision can
prudently be made. In Step Seven, the auditor needs to make the difficult determination of
whether they have sufficiently analyzed the problem, and whether the risk of making an
incorrect decision has been minimized to an acceptable level by collecting adequate,
convincing evidence. Ultimately, they must make and document the decision that they have
reached.
10-63
The three major categories of marketable securities are: temporary investments in debt or equity
securities, short-term cash management securities, and other short-term hybrid securities
(derivatives).
The GAAP classification scheme includes the following categories: held-to-maturity securities,
trading securities, and available-for sale securities.
Thus, the auditor has a major judgmental challenge in:
Corroborating managements intent in classifying the assets, including gathering
information about managements trades in the investments, the importance of market
value to management compensation
Determining fair market value
10-64
1. B
2. C
3. D
4. E
5. A
10-65
1. Managementmanipulationoftheclassificationofthesecuritiestoachievepreferable
valuationtreatment,i.e.,marketvalueversusamortizedcost(a)
2. Lackofpoliciesovervaluationorclassificationofsecurities(b)
3. Managementmanipulationofthevaluationofmarketvalueifthesecuritiesarethinlytraded
(a)
4. Lackofpoliciesoverpurchaseorsaleofsecurities(b)
5. Lackofmonitoringofchangesinsecuritiesbalances(b)
6. Lackofsegregationofdutiesbetweenindividualsresponsibleformakinginvestment
decisionsandthoseresponsibleforthecustodyofsecurities(b)
7. Riskoftheftofthesecuritiesiftheyarenotphysicallycontrolled,orifauthorizationand
monitoringovertheirpurchaseorsaleisnotadequate(b)
8. Riskofsuddenmarketdeclines,whichwouldadverselyaffectthevaluationofthesecurities
(a)
9. Lackofinvolvementoroversightbyinternalauditinrelationtosecurities(b)
10-19
10-66
1. Doestheinternalauditdepartmentconductregularauditsofthecontrolsovermarketable
securities?Ifyes,reviewrecentreports.(b)
2. Ifmanagementhaschangedtheclassificationofsecuritiesduringtheyearfromeithertrading
securitiesoravailableforsalesecuritiestoheldtomaturitysecurities,aretheamounts
significant?Weretheyreviewedbytheauditcommittee?Dotheauditcommitteeandthe
boardconcurwiththechange?(b)
3. Doesthecompanyregularlyinvestinmarketablesecurities?Howmaterialarethebalances
inmarketablesecuritiesaccounts?(a)
4. Doesthecompanyhavewrittenpoliciesandguidelinesregardinginvestmentsinmarketable
securities?Arethepoliciesapprovedbytheboardofdirectors?Whatprocessisusedto
authorizeinvestmentsinmarketablesecurities?(b)
5. Doesthecompanyhaveaclearpolicyastowhethermarketablesecuritiesareproperly
classifiedastradingsecurities,availableforsalesecurities,orheldtomaturitysecurities?Is
thereevidencethatthecompanyfollowsthepolicy?(b)
6. Hasmanagementchangedtheclassificationofsecuritiesduringtheyearfromeithertrading
securitiesoravailableforsalesecuritiestoheldtomaturitysecurities?Ifyes,whatisthe
reasonforthechange?(a)
7. Ifaliquidmarketdoesnotexistforthemarketablesecurities,howdoesmanagement
estimatethevalueofthesecuritiesthatneedtobemarkedtocurrentmarketvalue?(b)
8. Doesthecompanyprovideforeffectivesegregationofdutiesamongindividualsresponsible
formakinginvestmentdecisionsandthoseresponsibleforthecustodyofsecurities?(b)
9. Isthereareadymarketforthesecurities?(a)
10-67
a.
The board of directors does not monitor policies regarding marketable securities.
The auditor would assess control risk as higher. More importantly, the auditor would be
concerned if the company had material investments in marketable securities and would need
to perform an independent assessment of the risk associated with the securities. In other
words, since the procedure is not independently performed within the company, and if the
amounts are material, the auditor should perform the assessment to determine the potential
risk of default and then determine whether or not there are valuation or disclosure issues that
should be addressed in the financial statements.
b. The company's internal auditors do not have any computer audit expertise and have not
conducted audits of the cash or marketable securities account during the past three years.
The auditor's main concern is that an important part of the overall control environment is not
operating. Since there are no internal audits, the auditor should consider that factor in
developing the assessment of control risk and would assume that control risk is higher than it
otherwise would have been.
10-20
c. Management does not have written guidelines for investments in marketable securities. The
financial executive has been successful in procuring good returns on investments in the past
and management does not want to tamper with success.
Assess risk as higher. This is a concern because there is no independent oversight of
management's investments. Past, but short-run returns on investments in management
securities can be illusory. Management may have been taking unusually large risks in order
to earn the returns. The accounting for the returns may be incorrect. The auditor should
always be concerned when the board of directors does not wish to challenge management or
make management accountable.
10-68
The audit procedures that would be applicable to completing the audit of marketable securities
include:
1. All beginning balance figures (Marketable securities, allowance, and general ledger):
Verify beginning balance by tracing amount to adjusted ending balance per the prior year's
audit documentation.
2. Marketable Securities (ending balance):
Obtain a detailed trial balance of the securities constituting the year-end balance. Either
observe the existence of the securities or confirm the existence of the securities with a trustee
holding the securities for the client's account. (Existence or Occurrence Assertion)
Test the recorded cost of each item (or a sample of items depending on number of items and
materiality) and verify the cost by tracing the item to prior year's working papers or to
broker's advices for the current year purchases. (Valuation or allocation)
Foot the detailed trial balance of securities.
The auditor should separately examine the security issued by XYNO Corporation since it is a
related party. The auditor should note all information that will be needed for separate
disclosure of the related party transaction.
The auditor should also examine the security issued by Allis Chalmers (a customer) to
determine if there is anything unusual about the investment. For example, is the investment
tied to the amount or type of business between the client and the customer? Would the
security be more appropriately classified as a note receivable, rather than an investment in
marketable securities?
3. Allowance to Reduce Securities to Market Value:
Obtain the Wall Street Journal or some other financial reporting service indicating the market
value of the securities at the end of the year. Use the reported market value and
independently compute the market value of securities at year-end. (Again, if the client had
10-21
large numbers of securities and had already performed this procedure, the auditor would
sample as part of the tests.)
Comment: It would appear that the client has not performed this procedure because the
allowance account is the same as the previous year.
Compute the needed adjustment, on an aggregate basis, to reduce securities to the lower of
cost or market.
Review any proposed adjustment with the audit client.
4. Interest Income:
Use the list from the trial balance to obtain information on the amount of interest bearing
securities held during the year, the interest rate, and the time period held for each security.
After the time periods and interest rates are verified, (done in connection with the testing of
ending balances), recompute the approximate amount of interest that should have been
recorded. Compare the computed amount with the recorded amount. If significant differences
are obtained, then review the client's recording of interest income during the year and
examine independent evidence, e.g. bank statements or cash receipts to verify the interest
income.
5. Dividend Income:
Similarly to step 4, obtain a listing of the securities held, etc. Use a standard dividend reporting
service such as Standard and Poor's to recompute the amount of dividends that should have
been received for the amount of time the securities were held. Recompute dividend income
and compare with the recorded amount. If there are significant differences, investigate by
examining underlying supporting evidence for dividends received (cash remittances, etc.)
6. Net Gain on Disposal of Securities:
7.
Obtain a schedule from the client of gains/losses. Selectively examine support for the client's
computations by examining broker confirmations of sales, tracing cost to previously audited
records, and re-computing amounts.
Determine that the securities are properly classified.
The investments in securities are classified as:

1. Held-to-maturity
2. Trading securities
3. Available for sale
The held-to-maturity securities are valued at amortized cost, subject to an impairment test. The
trading and available for sale securities are valued at fair market value. The auditor should
10-22
corroborate managements intent in classifying the assets, including gathering information about
managements trades in the investments, the importance of market value to management
compensation, and the reliability of managements assertions and how those assertions have
played out in the past (i.e., if management has held the securities to the maturities that they have
promised in the past).
10-69
a.
Identification of areas of inherent risk and control risk, with a focus on the control
environment factors:
1. Company is dominated by its CEO. Note - earlier chapters indicated that this domination is a
red flag for fraud potential as well as high risk.
2. Company is intent on a "turnaround" and appears to be willing to take unusually high risks to
accomplish a greater reported return.
3. The company is shifting its major business from manufacturing to high risk investments. The
company is not investing in research to maintain a manufacturing presence and may thus
become dependent on the swings in the marketplace for its future return.
4. The audit committee does not appear to be effective.
5. The audit committee does not enhance the independence of the internal audit department.
6. The CEO has a lucrative incentive pay contract that encourages pursuit of higher risk
investments. The CEO has indicated he believes in high risk investments.
7. The investment account has grown to 30% of assets and contains many "high fliers."
8. The investment account also contains a wide variety of junk bonds and new financial
instruments.
9. There may be problems with a related party transaction with the brokerage fees.
10 There is a question over the control of the securities. The fact that the securities are
distributed in three locations may indicate that the securities are more susceptible to
manipulation.
11 The stock has appreciated and the CEO's pay is partially made in stock options. There is a
high incentive to push for higher reported earnings to meet stock market expectations.
b.
Outline of an Audit Program
The audit program for the company must recognize the existence of larger risks inherent in the
investment portfolio. These risks include the number of places in which the securities are held,
10-23
the related party nature of the transactions, and the increasing risk associated with the investment
portfolio.
1. Ask the client to prepare a working paper schedule of marketable securities for the year
listing all securities held during the year. Foot the schedule and tie the balance to the balance
per the general ledger.
2. Test the existence of the marketable securities held at year-end as follows:
Assuming the brokerage company is an independent, reputable company, confirm the

year-end holdings directly with the brokerage company.
Observe the securities at the company at year-end. Observe the nature and the validity of
the securities. If there are questions on the validity of the certificates, confirm the
amounts held directly with the issuer of the security. Determine the validity of the issuer
by reference to a corporate directory.
Observe the securities held at the consulting firm at the same time the securities are
observed within the company. Note - the need for observing the securities concurrently
occurs because there is a question about the independence of the consulting firm.
3. For securities where a ready market value is available at year-end (and the auditor concludes
the items could be marketed without impairing the market) obtain the closing market value of
the securities by reference to closing prices in the Wall Street Journal or other independent
financial service at year-end.
4. For securities where the market is thin, or there is question about the market value of the
securities:
Request a market value estimate from the independent brokerage firm - including an
analysis of the potential effect of the volume of the organization's holdings on the market.
Determine if a ready market exists for the securities by reference to market trading.
Determine if the company has collateralized the securities. Determine the company's
control over the collateral. If realization is a concern, determine the market value of the
underlying collateral.
Determine if a market value exists for the securities. If there is not a ready market value,
determine the nature of any accounting adjustments and disclosure needed.
5. Review selected purchases during the year by reference to broker's advices and cash
disbursements to verify the cost of the securities.
6. Review selected disposals during the year by reference to broker's advices and cash receipts
to determine the amount of gain or loss on the securities. Recompute the gain or loss.
7. Use an independent reporting service and recompute the amount of interest or dividend
income recorded for the year. (Depending on volume of transactions, this procedure might be
performed analytically for the whole account, or may be performed on a statistical sample of
transactions.)
10-24
8. Review any internal audit reports on marketable securities or operation of the securities
account during the year.
9. Review and schedule all the transactions with the consulting company during the year.
Review ownership records, inquire of management, and so forth to determine whether the
consulting company should be considered a related party. If it is a related party, determine the
appropriate disclosure.
10. Evaluate the fairness of financial presentation. Document the assessment in an audit working
paper.
c. There are many factors that the auditor would evaluate in forming an opinion on the
companys internal control. Some of the considerations are:
Tone at the Top:
Complete control is in the hands of one person.

There is very little risk analysis.
There is little monitoring of the investment activities.
Compensation package encourages high risk taking because it emphasizes above normal
returns, but little penalty for failure.
There are no guidelines on the quality of the investments that can be held by the company.
Other Control Issues:
No specific authorization for securities not held at brokerage house

There is no specific review of independent authorization of the stock holdings.
Although the company is doing well, it does not appear that top management fully understands,
monitors, or manages the risk associated with the new investments. Because of this lack of
understanding and attention, the auditor should consider the possibility that the company has
significant deficiencies or even material weaknesses in its internal control over financial
reporting. This assessment would be true even if the company has adequate accounting over the
transactions processing.
10-25
Contemporary and Historical Cases

10-70
a.
Inherent risks:
Weak regulatory oversight
The company used paper copies for bank statements, and the auditor or regulators did not
require electronic confirmation
Fraud risks:
The CEO had a very lavish lifestyle

The company had received complaints from customers and other anonymous individuals
alerting regulators to possible irregularities in the past
Control risks:
Unusually intense CEO involvement in the cash account

Weak internal governance oversight since the CEOs son was the President and COO, so no
non-family experts or independent oversight occurred
b.
Oversight was relatively weak, particularly in terms of the confirmation process. The fact
that NFA did not follow up on customer complaints and an anonymous tip directly related to the
fraud is troubling.
c.
It is not necessarily problematic that Wasendorf served in an advisory role to NFA. The
agency likely thought that he was a leader with subject-matter expertise and that he would help
the regulator through that knowledge. But having him serve in this capacity may have caused a
conflict whereby the regulator was not as tough on Wasendorf and PFG as otherwise would have
been the case.
d.
Veraja-Snellings certification quality is highly questionable. It would be nearly
impossible for a one-person auditing firm to capably handle the oversight of this large, complex
entity. This case bears a strong similarity in this regard to the Madoff fraud and the one-person
auditing firm used in that case. There is nothing incorrect about receiving a paper copy of the
bank confirmation. The part of the process where the auditor erred was in not checking to see
what the valid address is for US Bank. Doing so would have revealed the scheme. It seems likely
that Veraja-Snelling was essentially doing a sham audit only to make money, thereby negating
any possibility for professional skepticism.
10-26
e.
AFrameworkforEthicalDecisionMaking
Step1.
Identifytheethicalissue(s).Theethicalissueiswhetherornotthebankshouldagreeto
theunusualcommunicationrelationshipbetweenWasendorfandbankemployees.
Step2.
Determinetheaffectedpartiesandidentifytheirrights.
USBank.HasarighttoconductitsbusinesswithinthelawsoftheUnitedStates;andhas
arighttoactinawaythatmakestheircustomers(Wasendorf)happy.
Wasendorf.HasarighttorequestthattheBankabidebyhiscommunicationrequests.
Auditorandregulators.Havearighttoreceiveaccuratebankconfirmationsandbank
statements.
InvestorsinPFG.Havearighttotheirinvestmentsandassociatedcash.
Step3.
Determinethemostimportantrights.
Mostimportant.InvestorsinPFG,becausetheyareunabletoknowaboutthecontrol
problems,andhavenorecoursefollowingthefraud.
Secondmostimportant.Auditorandregulatorsbecausetheconfirmationprocessisatthe
heartoftheauditandoversightprocesses.
Step4.
Developalternativecoursesofaction.
a. USBankcoulddonothing,whichisthecourseofactionthattheyactuallytook.
b. USBankcouldinsistthattheyhaveaccesstootherPFGemployees,andcouldquestion
Wasendorfshighlevelinvolvement.
c. USBankcouldcontactNFAtoalertthemtothefactthattheyhavenotreceivedabank
confirmationrequestandthattheyhaverestrictedaccesstoemployeesoftheircustomer
Step5.
Determinethelikelyconsequencesofeachproposedcourseofaction.
a. TheconsequencesarethatUSBankmayfaceactionfromtheindividualsthatlostmoney
inthefraud.
10-27
b. Wasendorfwouldhavebeenangry,andmayhaveswitchedbanks.
c. NFAwouldhavereceivedanotherredflagthatsomethingwaswrongatPFG.The
Bankwouldhaveservedasalegitimatealerttotheregulator,whereasananonymoustip
oracustomercomplaintislesslikelytoreceiveattentionorbelief.
Step6.
Assessthepossibleconsequences,includinganestimationofthegreatestgoodforthe
greatestnumber.Determinewhethertherightsframeworkwouldcauseanycourseof
actiontobeeliminated.
a. Thisoptionshouldbeeliminatedbecauseitdoesnotaddresstheprobleminanyway.
b. ThisoptionatleastgivestheBanksomeflexibilityintermsofseeinghowWasendorf
reactstotherequest;hisreactionmightgivetheBankasenseofwhattodonext.
c. Thisoptionwouldhavedonethegreatestgood,bothfortheBankitselfaswellasthe
individualsaffectedbythefraud.
Step7.
Decideontheappropriatecourseofaction.Representatives at US Bank should have
realized that something was strange in the control environment at PFG given the highly
unusual top-level involvement by the CEO. Financial institutions have an obligation to
protect the interests of individuals in society, not to just maintain a cordial working
relationship with the banks customers. The Bank should have pursued option (b) first,
and then option (c).
10-71
a.
The quote by Raju received a lot of media attention at the time, as one might imagine. It
probably speaks to the incredible stress that he was under trying to manage, maintain, and hide a
growing fraud that he had been perpetrating for years. It illustrates the emotional difficulty and
fear that a fraudster must sense. His reaction to that stress was markedly different from that of
Russell Wasendorf Sr. described in Peregrine Financial Group fraud from problem 10-70. In that
case, Wasendorf attempted suicide because of the fraud.
b.
The fundamental flaw was that the auditors relied on management to physically control
the confirmation process. After that, the auditors failed because they did not respond to obvious
discrepancies that were revealed during the process, and they did not respond to the reviewer that
pointed out their errors.
PwC was earning very high audit fees, and Satyam was a seemingly profitable, high-profile
client. There would certainly been incentives for the auditors to not annoy or stand up to the
client, thereby limiting the professional skepticism with regard to the confirmation process.
There was also speculation, backed up to a large extent by the fact that the PWC partners were
10-28
arrested, that they were a willing part of the fraud, the worst possible violation of skepticism
possible.
c.
The existence or occurrence assertion was violated.
d.
The following controls were violated or did not exist:
Segregation of duties: Raju and the other members of top management should not have had
the ability to record the fictitious entries. This is an example of a complete override of
controls by top management.
Authorization of transactions: Raju and other members of top management should not have
had the authority to set up over 6,000 fictitious employee records.
Periodic internal audits: since the chief internal auditor was involved in the fraud, the internal
audit function was obviously grossly ineffective.
Competent well-trained employees: this lack of control relates more to the PWC employees
rather than to Satyam. The auditors surely knew that the confirmation process was flawed,
but they did not appear to possess the fortitude and ethical sensitivity required to address the
flaws.
d.
Step1.Identifytheethicalissue.Asstatedinthecasesothatstudentsgetofftotheright
start,theethicalissueinthiscaseishowtoproperlyensurethatthereviewcommentsare
takenseriouslyandaddressed.
Step2.
Determinetheaffectedpartiesandidentifytheirrights.
PWC:therighttoconductanauditwithoutclientinterference
Satyam:therighttoreceiveaqualityauditthatisworththeauditfeepaid
Shareholders:therighttoreceiveaccuratefinancialstatementsandareliableaudit
opinion
ThePWCreviewingpartner:theright(andresponsibility)tomakesurehisorher
commentsareaddressed
Step3.
Determinethemostimportantrights.
Inthiscase,theobviouschoiceisshareholders.
Step4.
10-29
Developalternativecoursesofaction.
a.Donothing,ignoringthefactthatthereviewcommentshavebeenunaddressed.
b.Discussthematterfurtherwiththeengagementpartner,andattempttogethimto
addresstheweaknessesandlikelyobtainadditionalevidencetoaddresstheexistenceor
occurrenceassertionforcash.
c.GoupthechainofcommandatPwC,alerthigherlevelofficialsthattheengagement
teamisactinginappropriatelyandputmorepressureonthemtoremedytheir
confirmationprocessweaknesses.
Step5.
Determinethelikelyconsequencesofeachproposedcourseofaction.
a.Thisislikelywhathappenedintherealsituation,andofcoursetheconsequencewas
massivereputationandfinanciallossesforPWC,bothinIndiaandtheU.S.
b.Thiswouldhavelikelyangeredtheengagementpartner,andtheindividualmayor
maynothavedoneanythinganyway.GiventhatPWChadbeenconductingtheauditfor
manyyears,requestsfromthereviewpartnerlikelywouldhavegoneunheededwithout
furtherpressurefromhigherupinPWC.
c.Thiswoulddefinitelyhavecausedastir!Theconsequencewouldlikelyhavebeen
resignationfromtheengagementbyPWC,orimmediatedisclosureofthefraud.
Step6.
Assessthepossibleconsequences,includinganestimationofthegreatestgoodforthe
greatestnumber.Determinewhethertherightsframeworkwouldcauseanycourseof
actiontobeeliminated.
a.Givenwhatweknowabouttheultimateconsequences,thisoptionshouldhavebeen
eliminated.
b.Thislikelywouldnothaveworkedanyway,butitmighthavebeenagoodfirststartfor
thereviewpartner.
c.Thiswouldhaveachievedthegreatestgoodforthegreatestnumber.Ultimatelythe
fraudwouldhaveunraveledanyway,sothesooneritisrevealed,thebetterforthe
shareholders.
Step7.
Decideontheappropriatecourseofaction.
10-30
Startwithalternative(b),butthenbepreparedtomoveonquicklytoalternative(c).
10-31
10-72
a. In cases in which inherent and control risks are low, and the cash balance is immaterial,
relying on client-provided mailing addresses and bank statements is unlikely to lead to
heightened audit risk. Therefore, auditors should use professional judgment and not rely on
low-cost procedures for material line items, even if inherent and control risks are low. In the
case of Parmalat, it seems highly unlikely that $5 billion would have been immaterial. Thus,
relying on a client provided mailing address in that setting seems to be an example of poor
audit judgment.
b. The Internet allows for easy access to locating mailing addresses, or verifying client-provided
mailing addresses. In addition, electronic confirmation processes enable auditors to ensure the
security and authenticity of information flows in the confirmation process.
c. One factor is having a balance of over $5 billion in one bank. Traditionally, bank accounts
over $100,000 have not been insured. Beginning in October 2008 deposits at FDIC-insured
institutions were insured up to at least $250,000 On July 21, 2010, President Barack Obama
signed the Dodd-Frank Wall Street Reform and Consumer Protection Act into law, which, in
part, permanently raises the current standard maximum deposit insurance amount (SMDIA) to
$250,000. The standard deposit insurance amount is $250,000 per depositor, per insured bank,
for each account ownership category. Another factor is that good cash management requires
that excess cash be invested in safe investments to earn some income. Apparently, there was
inadequate segregation of duties surrounding cash.
Application Activities
10-73
Answers will vary depending on student discussion. For a good summary with a large number of
practical examples, see The Journal of Accountancy (December 2001 issue) for an article titled
Enemies Within. Following is the link to the article:
http://www.journalofaccountancy.com/Issues/2001/Dec/EnemiesWithin
10-74
Answers will vary depending on the timing of when this question is completed, but should make
for lively classroom discussion.
10-75
a.
Deloitte and Grant Thornton.
b.
The amount sought in recovery was over $10 billion.
c.
The lawsuits against Deloitte and Grant Thornton were ultimately dismissed.
10-32
10-76
FYE 2010 and 2011
a. cash trends
Yahoo
Cash has been stable in the
$1.5 billion range for the
last several years.
Google
Cash has stable in the $10$13 billion range for the
last several years.
b. interest returns and

investment returns trends
Interest and investment

income were about $23
million and $19 million in
2010 and 2011,
respectively.
No new debt has been
issued recently, and the
Company has very low
levels of debt (about $135
million), which is very low
compared to its cash
position.
2010: 4,345,548/1,625,872
= 2.67
2011: 3,452,536/1,207,361
= 2.86
2010: (1,526,427 +
1,028,900)/1,625,872 =
1.57
2011: (1,562,390 +
1,037,474)/1,207,361 =
2.15
Interest and other income

were about $415 and $584
million in 2010 and 2011,
respectively.
Cash flow to sales:

2010: 1,240,190/6,324,651
= 0.20
2011: 1,323,806/4,984,199
= 0.27
Cash flow to sales:

2010: 11,081/29,321 =
0.38
2011:14,565/37,905 = 0.38
c. analyze cash balances,

and changes therein, in
relation to new or retiring
debt obligations
d. current assets/current
liabilities
e. cash + cash equivalents
+ net receivables)/current
liabilities
f. compare operating cash

flow/sales to operating
cash flow/net income
Cash flow to income:

2010: 1,240,190/1,244,628
= 1.00
2011: 1,323,806/1,062,669
= 1.25
Comparison
Both
companies
have ample
cash on hand.
Google has a
much larger
amount.
The Company issued about

$3 billion in long-term
debt in 2011, which is low
compared to its cash
position.
Google
recently issued
debt, but the
amount is low
relative to the
cash position.
2010: 13,630/9,996 = 1.36

2011: 9,983/8,913 = 1.12
Yahoo is in a
stronger
position in the
current ratio.
The two
companies are
relatively
similar in terms
of the quick
ratio.
2010: (13,630 +
4,252)/9,996 = 1.79
2011: (9,983 +
5,427)/8,913 = 1.73
Cash flow to
sales and cash
flow to income
are both better
at Google.
Cash flow to income:

2010: 11,081/8,505 = 1.30
2011:14,565/9,737 = 1.50
10-33
10-77
Audit Deficiencies for Jaspters + Hall
The Force Protection Audit
Failure to confirm the existence of cash

Failure to evaluate the classification of deferred revenue, which represented a continuing
failure that was identified by PCAOB inspectors in a previous inspection
Failure to obtain audit evidence concerning a deferred tax benefit, and Hall admitted to
PCAOB inspectors that he did not understand the accounting for this account
Failure to obtain written representations from management
Failure to establish and document an understanding with the client regarding services to
be performed
Failure to prepare documentation regarding significant findings on the audit
Failure to properly use the work of a specialist
Failure to retain audit documentation
The Bio-Warm Audit
Failure to perform audit procedures relating to an acquisition and related goodwill

recording
The Siena Technologies Audit
Failure to perform audit procedures relating to an acquisition and related goodwill

recording
Failure to properly use the work of a specialist
The GeneThera Audit
Failure to perform any audit planning procedures

Failure to adequately evaluate a material contingent liability
Failure to obtain evidence concerning a large number of equity transactions
Failure to adequately consider the risk of fraud
Failure to adequately document audit procedures
The Jaspers + Hall audit firm was de-registered from the PCAOB, but can reapply in five years.
The individual auditors received the same punishment. Given the repeated instances of audit
quality deficiencies, it is clear that the auditors were deliberately and unethically violating
auditing standards.
Audit Deficiencies for Ibarra P.C.
10-34
The Triad Industries Audit:
Failure to require the company to correct departures from GAAP, resulting in overstatements
of revenues and gross profit
Failure to confirm accounts receivable
In the year following the initial PCAOB inspection, the auditors continued to make the same
mistakes as in the prior year audit.
Failure to use appropriate language to express a going concern opinion, with continued
failure in the year following the initial PCAOB inspection
Failure to prepare required audit documentation
The Naturewell Audit:
Failure to require the company to correct departures from GAAP, resulting in

misclassification of short-term liabilities, inventory valuation
In the year following the initial PCAOB inspection, the auditors continued to make the
same mistakes as in the prior year audit.
Failure to prepare required audit documentation.
The California Clean Air Audit:
Failure to perform audit procedures relating to the recording of goodwill

Failure to obtain written representations from management, with continued failure in this
regard the following year
The BoysToys Audit:
Despite the fact that the Company was in liquidation, the auditors failed to issue a goingconcern audit opinion.
Failure to audit the cash balance
Failure to require the company to correct departures from GAAP, resulting in a 100%
overstatement of cash flow from investing activities
The Ibarra audit firm was de-registered from the PCAOB, but can reapply in two years. The
individual auditors received the same punishment. Given the repeated instances of audit quality
deficiencies, it is clear that the auditors were deliberately and unethically violating auditing
standards.
10-78
The status of the confirmation standard will depend on when the student completes this exercise.
As of this writing, the comment period had ended and a final standard had not been issued.
10-79
10-35
a.
ISA 505, External confirmations.
b.
1. External confirmation Audit evidence obtained as a direct written response to the auditor
from a third party (the confirming party), in paper form, or by electronic or other medium.
2. Positive confirmation request A request that the confirming party respond directly to the
auditor indicating whether the confirming party agrees or disagrees with the information in
the request, or providing the requested information.
3. Negative confirmation request A request that the confirming party respond directly to the
auditor only if the confirming party disagrees with the information provided in the request.
4. Non-response A failure of the confirming party to respond, or fully respond, to a positive
confirmation request, or a confirmation request returned undelivered.
5. Exception A response that indicates a difference between information requested to be
confirmed, or contained in the entitys records, and information provided by the confirming
party.
c.
The auditor should inquire as to managements reasons for the refusal, and seek audit
evidence as to their validity and reasonableness. The auditor should also evaluate the
implications of managements refusal on the auditors assessment of the relevant risks of material
misstatement, including the risk of fraud, and on the nature, timing and extent of other audit
procedures. Finally, the auditor should perform alternative audit procedures designed to obtain
relevant and reliable audit evidence.
d.
The auditor should obtain further audit evidence to resolve any doubts. The factors that
would cause the auditor to doubt reliability include if the auditor receives the confirmation
indirectly, or the confirmation appears not to come from the originally intended confirming party.
e.
The auditor should evaluate the implications on the assessment of relevant risks of
material misstatement, including the risk of fraud, and on the related nature, timing, and extent of
other audit procedures.
f.
The auditor should consider the following:

The assertions being addressed
Specific identified risks of material misstatement, including fraud risks
The layout and presentation of the confirmation request
Prior experience on the audit or similar engagements
The method of communication (e.g., paper or electronic form)
Managements authorization or encouragement to the confirming parties to respond to the
auditor.
The ability of the intended confirming party to confirm or provide the requested information.
10-80
10-36
Answers to this question will vary depending on the particular findings of the students, but
should make for lively classroom discussion.
Academic Research Cases
10-81
a.
The current audit process requires the auditor to confirm account balances for accounts
receivable, accounts payable, and cash accounts. The most prevalent method of confirming the
account balances is through the use of manual confirmations. However, regulations do not
require auditors to confirm the authentication of the confirmations that are returned to them.
Several high-profile audit failures have resulted in the detection of confirmations being falsified
by the audit client in order to prevent the auditor from detecting the fraud that was being
committed. The issue being addressed is the possible automation of the confirmation process and
the advantages as well as the issues involved in the implementation.
b.
This paper finds that two main elements are needed in order to automate confirmations.
The automation process must ensure the privacy and security of the confirmation communication
as well as establish a way to authenticate the parties involved in the confirmation process. The
advantages of automating the confirmation process include a reduced risk of confirmation fraud,
enhanced audit efficiency and enhanced compliance with recent audit standards.
c.
Manual conformations provide a more reliable means of auditing account balances during
an audit than the reliance on a clients internal records. However, instances of fraudulent
confirmations being returned to auditors has resulted in audit failures in some major U.S.
companies. Such situations have also led to legal problems for the auditors, as well as other
companies involved. Many companies, including banks, are becoming hesitant to return manual
cash confirmation requests because of legal liability issues. The loss of reliance on confirmations
to confirm account balances could lead to much more work on behalf of the auditor in order to
validate account balances. Audit quality could potentially improve with an automated
confirmation process as the issue of fraudulent confirmations would be greatly reduced thereby
helping to ensure that audit results are more accurate. Enhanced audit efficiency would be
provided by the reduced amount of time that it would take for a confirmation to be sent,
completed and returned to the auditor. Audit quality would also improve as the time an auditor
spends preparing confirmations as well as second requests would be reduced thereby allowing
the auditor additional time to perform other audit functions. Further, the authors recommend that
auditing standards be modified to require confirmations of cash balances, as well as marketable
securities and investments. The additional evidence should serve to help increase audit quality.
10-82
a.
Financial statement users have been placing increasing importance on companies cash
flow information. This study obtains an understanding of (1) whether companies respond to
incentives to upward manage cash flow from operations, and (2) how (classification and timing)
firms manipulate cash flow from operations (CFO) on the Statement of Cash Flows. To
10-37
disaggregate earnings management spillover effects, only situations involving restatements with
unchanged net income are examined.
The four identified incentives for managing upward CFO that are considered include financial
distress, long-term credit rating near the investment/non-investment grade cutoff, existence of
analyst cash flow forecasts (and also a need to meet or beat analysts forecasts), and higher
association between stock returns and CFO. The author hypothesizes that two methods used to
upward manage CFO are classification and timing. More specifically, the author examines
classification error restatements and specific classification choices (when no guidance was
provided) to understand if firms are exploiting the structural organization of the Statement of
Cash Flows to inflate CFO through classification. Specific timing choices aimed at delaying cash
outflows and expediting cash inflows are also considered as a possible manipulation method.
b.
The author finds that each of the four incentives identified are associated with inflating
reported CFO. Further, the author finds that the methods used to increase CFO include both
classification choices (at times resulting in restatements) and timing choices (for example,
shorter Q4 cash conversion cycles).
More specifically, there is a positive and significant association between incentives to inflate
CFO (financial distress, long-term credit rating near the investment/non-investment grade cutoff,
existence of analyst cash flow forecasts particularly firms that just meet or beat analyst case
flow forecasts, and association between stock returns and CFO) and unexpected CFO increases.
In terms of the method used to inflate CFO, the author finds that when these incentives are
present, firms are more likely to classify cash inflows in the operating section if the choice is at
their discretion (tax benefits from exercise of employee stock options prior to promulgation of
accounting guidance on the topic). However, the author finds that two incentives are not
significantly associated with this classification choice - long-term credit rating near the
investment/non-investment grade cutoff, and a need to meet or beat analysts forecasts.
Also when these incentives are present, it is more likely that a cash flow restatement results due
to classification errors that originally inflated CFO. However, for one incentive factor (meet or
beat analyst cash flow forecasts), it appears that companies do not use classification shifting.
In terms of findings related to management timing of cash flows, the author examines the cash
conversion cycle, which measures how long it takes a firm to collect cash on accounts receivable
after the firm pays cash for its inventory. In the fourth quarter (Q4), managers have an
opportunity to delay payments and accelerate receipts, thereby increasing CFO. A short
conversion cycle in Q4, along with an absence of such a practice throughout the year, suggests
that management is taking action to boost CFO at year end. Results indicate that the cash
conversion cycle in Q4 is shorter than that of the subsequent Q1, suggesting that the boost in Q4
reversed in the following months. The author finds that the incentives considered are associated
with shortening the cash conversion cycle in Q4. Additionally, these timing findings are stronger
for firms whose fiscal year does not coincide with the calendar year.
10-38
c.
First and foremost, the attention surrounding cash flow information is escalating.
Analysts and managers are issuing an increasing number of cash flow forecasts, and market
participants demand for cash flow information is increasing. As more attention is focused on
cash flow, managers face stronger motives to report higher levels of CFO. So, an understanding
of this behavior and the methods used to achieve it are required in order to conduct a thorough
audit and help assure that the financial information being auditing is materially correct (including
the classification of cash flows). The professionally skeptical auditor will consider managements
incentives when testing the statement of cash flows.
Additionally, consideration of reformatting the Balance Sheet and Income Statement into
segregated activities similar to the Statement of Cash Flows (operating, investing, financing) by
the FASB and the IASB would further highlight the CFO and could increase the propensity for
manipulation by management.
d.
To test the relationship between the identified incentives and upward management of
CFO, the author develops a sample of companies with publicly available data from 1998-2008.
However, companies in regulated industries, and banks and financial institutions are not included
in the sample. For the sample firms, the author develops a measure of unexpected CFO using
methodology from prior research. Regression analysis is then used to test the relationship
between unexpected CFO (the dependent variable) and the incentive factors (the independent
variables).
To understand if classification choices are employed as a manipulation method in response to
incentives, the author first obtains a sample consisting of 414 firm years of cash flow
restatements and a matched sample of firms without cash flow restatements. The author then uses
logistic regression to test the relationship between a restated cash flow statement (the dependent
variable) and the incentive factors (the independent variables)
The next classification test considers how firms classified a particular item, when given
discretion as to their choice. Prior to the mandatory expense of stock options, no guidance was
provided as to where the tax benefit from the exercise of employee stock options should be
classified. The author obtained a sample of firms from 1994 (when data is first available) to 2000
(when guidance is provided thereby eliminating management discretion as to classification) that
have a tax benefit related to stock options exercised as a separate line item, and then categorize
each firm as to whether the stock option item was classified under the operating section or the
financing section. The author uses a logistic regression to test the relationship between whether
the tax benefit is including the operation section or the financing section (the dependent variable)
and the incentive factors (the independent variables).
The timing test examines differences in the length of the last quarters cash conversion cycle
compared to the other quarters. If firms are delaying payments and accelerating collections
before the financial statement cutoff date (as a final effort to boost CFO), Q4s cash conversion
cycle will be shorter when compared to the other three quarters. The author uses the sample
obtained for testing the relationship between the identified incentives and upward management
of CFO. For the observations in this sample, the author develops a measure of the cash
10-39
conversion cycle and then uses regression analysis to test whether firms use timing (the
dependent variable) to manage CFO in response to incentives (the independent variables).
e.
This study has a number of limitations. First, the author uses an approach to determining
unexpected CFO from prior literature. This approach requires that firms have data available for a
ten year period, creating a natural bias towards more mature, stable firms. Further, it may be the
case that the approach for determining unexpected CFO may not have successfully captured all
components necessary to accurately predict CFO.
Further, the explanatory power of the models used in the classification and timing tests is low.
Ford and Toyota
10-83
Note to instructor: This answer is based upon the FYE 2009 annual reports for Ford and Toyota
as they appeared in the 8th edition. An updated solution as of FYE 2012 will be posted to the
Cengage website as soon as the applicable annual reports become available.
a. Cash and liquid assets: cash and cash equivalents.
Marketable securities: trading securities, available for sale securities, and held to maturity
securities.
b.
Cash and liquid assets: See Footnote 5. Cash and cash equivalents that are restricted as to
withdrawal or usage under the terms of certain contractual arrangements are recorded as restricted in
Other assets on our consolidated balance sheet. Restricted cash does not include required minimum
balances, or cash securing debt raised through securitization transactions ("securitization cash"). See
Note 19 for discussion of the minimum balance requirement related to the secured credit agreement that
we initially entered into in December 2006, and securitization cash. See Note 13 for additional information
regarding Automotive VIEs. For cash and cash equivalents, we review our disbursement accounts and
reclassify any aggregate negative balances to a liability account included in Payables on our balance
sheet.
Marketable securities: See Footnote 6. Ford holds various investments classified as marketable
securities including U.S. government and non-U.S. government securities, corporate obligations and
equities, and asset-backed securities. Highly-liquid investments with a maturity of 90 days or less at the
date of purchase are classified in Cash and cash equivalents. Investment securities with a maturity
date greater than 90 days at the date of the security's acquisition are classified as Marketable
securities.
Prior to 2008, we classified all marketable securities as trading, available-for-sale or held-to-maturity. The
unrealized gains and losses for available-for-sale securities were recorded, net of tax, as a separate
component of Accumulated other comprehensive income/(loss) and the unrealized gains and
losses for held-to-maturity securities were not recognized. On January 1, 2008, we elected to apply the
fair value option and recorded all available-for-sale or held-to maturity securities as trading securities. This
10-40
election resulted in a cumulative after-tax increase of about $12 million to the opening balance of
Retained earnings. Marketable securities acquired subsequent to January 1, 2008 have been recorded
as trading securities.
Trading securities are recorded at fair value with unrealized gains and losses recorded in Automotive
interest income and other non-operating income/(expense), net and Financial Services
income/(loss), net. Realized gains and losses are accounted for using the specific identification
method. See Note 4 for information on valuation methodologies.
c. Currency or commodity price fluctuations, substantial pension and postretirement health

benefits that may impair liquidity, negative automotive operating related cash flows for the near
to medium term (significant planned net operating cash outflows for the next few years), changes
in interest rates, gains or losses on the sale of marketable securities, failure of counterparties to
derivatives transactions, i.e., counterparty risk.
The audit implication of these risks relates to the uncertainty of the account balances, and to
determining whether management estimates regarding the valuation of these accounts are
reasonable and justifiable.
d.
Fords cash flow position has improved dramatically since the decline in 2008.
There is a fairly sizeable decline in acquisitions of retail and operating leases.
Purchases of securities continues its increasing trend and high level.
Proceeds from the sale of businesses declined significantly as the Volvo deal was
completed during 2009.
Ford continues to issue significant amounts of debt.
e.
Toyota Cash Flow Trends:
Toyotas past history of positive income trends was reversed in 2009, due to effects of the
worldwide recession and its own very significant problems with warranty liabilities and product
defect recalls.
The allowance for doubtful accounts nearly doubled since 2008.
Accounts/notes receivable, inventories, and other current assets reversed their trends and
are now decreasing significantly over 2008 numbers.
Net cash provided by operations declined significantly from 2008 to 2009.
Investing activities changes were relatively minor, although there was a dramatic decline
in the amount of money spent on purchasing marketable securities and a dramatic increase in the
amount of money received from selling such securities. This ultimately led to a dramatic
reduction in the net cash used in investing activities compared to the prior year.
Financing activities are relatively stable year over year, although it is important to note
that Toyota continues its trend of long-term debt issuances.
Differences Between Ford and Toyota:
The differences between the two companies are striking. In 2008, Ford was clearly struggling in
every way. This year, the trend has reversed. While Toyota is by no means in the dire financial
10-41
condition that Ford was a year ago, their cash flow and profitability position has changed as they
have dealt with their various 2009 crises. Ultimately Toyota is going to have to deal with their
negative net income. In contrast, Ford finally became profitable again after massive losses in
2008. One thing that both companies do have in common, however, are significant issuances of
long-term debt. Given the currently historic low interest rates, this is likely a prudent move.
However, in the future, payments of debt could become an issue.
f.
In 2007-2008, Fords negative operating cash flow situation was disconcerting because it
called into question Fords ability to maintain its liquidity position, maintain its debt load, and
pay very significant postretirement benefits that it owes. However, that negative trend has
reversed and the Company is doing much better in 2009. In contrast, Toyotas very strong
historical position has taken a hit in 2009, making that company appear relatively riskier than
just 12 months earlier.
o
o
o
o
o
o
The valuation of derivatives is still a concern for both Ford and Toyota given recent fluctuations
in economic conditions and interest rates. In summary, and as noted in the chapter, controlling
risks associated with sophisticated financial instruments involves:
Identifying the risk management objectives that management had in using the
financial instruments in the first place;
Understanding the transactions and products;
Understanding the accounting and tax implications;
Understanding managements corporate policies and procedures regarding
financial instruments, i.e., understanding the control structure;
Determining that management has a plan in place to monitor and evaluate results,
i.e., understanding the control structure; and
Determining that management understands the credit risks involved in the
instruments.
10-42

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Solutions for Chapter 10

Review and Short Case Questions

8. Past-due accounts are periodically reviewed by senior collection officials to determine

Confirmation of accounts receivable balances.

Analytical review of discounts recorded in comparison with

Independent testing of the year-end bank reconciliation.

Testing of marketable securities through a typical worksheet

Sample selection of discounts taken and comparison with

Tests of transactions including the examination of support for

Confirmation of securities and interest rate with the financial

8. Loan negotiated for Review of company policies

Corporate policies and vigilant

Periodic review of old outstanding

Independent year-end bank

Internal audits to periodically

Independent bank reconciliation.

Schedule of Amount Taken by Cashier

Less: Adjusted Bank Balance:

Cash which should be on hand for deposit:

Not listing all outstanding checks on the bank reconcilements.

d. Additional audit procedures that might be performed:

Actions to be Taken by Auditor

Scenarios and Related Audit Procedures:

2. Unfortunately, the banking community often makes mistakes while preparing

NSF check returned (item d)

Substantive Audit Procedure

2. Marketable Securities (ending balance):

3. Allowance to Reduce Securities to Market Value:

The investments in securities are classified as:

Outline of an Audit Program

Assuming the brokerage company is an independent, reputable company, confirm the

Complete control is in the hands of one person.

Other Control Issues:

No specific authorization for securities not held at brokerage house

Contemporary and Historical Cases

The CEO had a very lavish lifestyle

Unusually intense CEO involvement in the cash account

The existence or occurrence assertion was violated.

The following controls were violated or did not exist:

Deloitte and Grant Thornton.

The amount sought in recovery was over $10 billion.

b. interest returns and

Interest and investment

Interest and other income

Cash flow to sales:

Cash flow to sales:

c. analyze cash balances,

f. compare operating cash

Cash flow to income:

The Company issued about

2010: 13,630/9,996 = 1.36

Cash flow to income:

Failure to confirm the existence of cash

The Bio-Warm Audit

Failure to perform audit procedures relating to an acquisition and related goodwill

The Siena Technologies Audit

Failure to perform audit procedures relating to an acquisition and related goodwill

The GeneThera Audit

Failure to perform any audit planning procedures

The Triad Industries Audit:

The Naturewell Audit:

Failure to require the company to correct departures from GAAP, resulting in

The California Clean Air Audit: