CHAPTER 4 Engagement Planning LEARNING OBJECTIVES

Review Checkpoints 1. List and describe the activities auditors undertake before beginning an engagement. Identify the procedures and sources of information auditors can use to obtain knowledge of a clients business and industry. Perform analytical procedures to identify potential problems. List and discuss matters of planning auditors should consider for clients who use computers and describe how a computer can be used as an audit tool. Review audit documentation for proper form and content. 1, 2, 3, 4 Exercises, Problems and Simulations 53, 54, 55, 62, 66

2.

5, 6, 7, 8, 9

52, 56, 59, 65

3.

10, 11, 12, 13, 14, 15 16, 17, 18, 19, 20, 21, 22

47, 48, 49, 51, 58, 63, 64

4.

57, 60

5.

23, 24, 25

50, 61

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SOLUTIONS FOR REVIEW CHECKPOINTS

4.1 A CPA can use the following sources of information to help decide whether to accept a new audit client.

Financial information prepared by the prospective client: Annual reports to shareholders Interim financial statements Securities registration statements Annual report on SEC Form 10-K Reports to regulatory agencies Inquiries directed to the prospect's business associates: Banker Legal counsel Underwriter Other persons, e.g., customers, suppliers Predecessor auditor, if any, communication, re: integrity of management, disagreements with management

Analysis: Special or unusual risk related to the prospect Need for special skills (e.g., computer or industry expertise) Internal search for relationships that would compromise independence CPAs can search business press articles and stories and legal files on the Lexis-Nexis system or on the Internet for news about chairman of the board, the CEO, the CFO, and oftentimes other high-ranking officers. CPAs can engage an outside search firm (private investigators) to conduct additional searches for information. CPAs are looking for information about client risk factors--companies accused of fraud, companies under SEC or other regulatory investigation, companies that have changed auditors frequently, and companies showing recent losses. 4.2 Client consent is required because the Code of Professional Conduct prohibits the predecessor auditor from revealing confidential information to the successor without the consent. Confidentiality remains even when the auditor-client relationship ends. A successor auditor should inquire specifically about: Management's integrity Disagreements the predecessor may have had with management about accounting principles and audit procedures. Communications the predecessor gave the former client about fraud, illegal acts, and internal control recommendations. The predecessor auditor's understanding about the reasons for the change of auditors (particularly about the predecessor's termination).

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4.3

Engagement letter benefits: Helps establish an understanding between client and auditor of the terms of the engagement and the nature of the work. Helps avoid quarrels and misunderstandings between client and auditor. Helps avoid disputes over the audit fee. Helps avoid legal liability assertions based on failure to do work that the CPA may not have contemplated or agreed to do. A termination letter is a letter from a former auditor (fired or resigned) to a former client specifying terms for future services and the auditor's understanding of the circumstances of termination.

4.4

Persons and skills normally assigned to a "full service" audit team:

Audit personnel: Engagement partner Second (concurring) audit partner Audit manager Senior accountant(s) Statistical auditing specialist, if needed Computer auditing specialist, if needed Industry specialist, if needed Tax partner 4.5 Methods and sources of information for understanding a client's business and industry: Inquiry, including review of prior year audit documentationof personnel who worked on the audit in prior years are available to convey their understanding of the business, inquiry and interviews with the company's management, directors, and audit committee. Observation--take a tour of the company's physical facilities, keeping eyes open for activities and things that should be reflected in the accounting records. The tour is the time to see company personnel in their normal workplaces. Study numerous sources--AICPA industry accounting and auditing guides, specialized trade magazines and journals, registration statements and 10-K reports filed with the SEC, general business magazines and newspapers (Business Week, Forbes, Fortune, Harvard Business Review, Barron's, and the Wall street Journal). 4.6 Find information about real estate valuation (tax appraisal) in the city and county tax assessor-collector files and about aircraft ownership from the Federal Aviation Administration. Names of licensed doctors in the state medical society directory. Assumed business names in the state or county assumed named registry. Liens on personal property in the UCC documents filed, by borrower name, in the county clerk or State's Secretary of State or commercial department office. The problem with evidence obtained from related parties is that the source is potentially biased, and the information may be self-serving and misleading. Benefits of preliminary assessment of materiality: Fine-tune the audit for effectiveness and efficiency. Help auditors avoid surprises related to: Finding out too late about not auditing enough. Finding out later about auditing too much.

4.7 4.8

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4.9 4.10

Prior to using internal auditors, external auditors should consider internal auditors' objectivity and competence. Five types of general analytical review procedures: 1. 2. 3. 4. 5. Compare financial information with prior period(s). Compare financial information with budgets or forecasts. Study predictable financial information patterns based on the entity's experience. Compare financial information to industry statistics. Study financial information relationships to nonfinancial information.

4.11

The purpose of performing preliminary analytical procedures in the audit planning stage is to direct attention to potential problem areas so the audit work can be planned to reduce the risk of missing something important. The steps auditors can use to apply comparison and ratio analysis to unaudited financial statements are: (1) develop an expectation, (2) define a significant difference, (3) calculate predictions and compare them with the recorded amount, (4) investigate significant differences, and (5) document each of the above steps. The ratios in Appendix 4.A are: current ratio, days' sales in receivables, doubtful accounts ratio, days' sales in inventory, receivables turnover, inventory turnover, cost of goods sold ratio, return on equity, and Altman's financial distress ratios and discriminant score. Students may be able to name other relevant ratios. A planning memo summarizes all the important overall planning information and documents that the audit team is following generally accepted auditing standards. The memo becomes a basis for preparing the audit program. Auditors usually prepare a planning memorandum summarizing the preliminary analytical procedures and the materiality assessment with specific directions about the effect on the audit. This planning memo also usually includes information about: 1. 2. 3. 4. 5. 6. 7. 8. 9. Investigation or review of the prospective or continuing client relationship. Provision of special services or reports and needs for special technical or industry expertise. Staff assignment and timing schedules. The assessed level of control risk. Significant industry or company risks. Computer system control environment. Utilization of the companys internal auditors. Identification of unusual accounting principles problems. Schedules of work periods, meeting dates with client personnel, and completion dates.

4.12

4.13

4.14

4.15

4.16

General characteristics of transactions that are typically computerized: Frequent, repetitive, large number. General characteristics of transactions that typically are not computerized: Infrequent, occasional, small number.

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4.17

The "audit trail" (sometimes called "management trail" as it is used more in daily operations than by auditors) is the source documents, journal postings and ledger account postings maintained by a client in order to keep books. These are a "trail" of the bookkeeping (transaction data processing) that allow auditors to follow the sequence of processing on (or because of) a transaction with a tracing or vouching procedures. In a manual system this "trail" is usually visible to the eye with posting references in the journal and ledger and hard-copy documents in files. But in a computer system, the audit trail in advanced systems may not be in a human-readable form and may exist for only a fraction of a second. Further, the posting references may not exist and the "records must be read using the computer rather than the naked eye. Most systems still have hard-copy papers for basic documentation, but in some advanced systems even these might be absent. There are several control implications of an electronic audit trail. The first implication is that concern for an audit trail needs to be recognized at the time a system is designed. Techniques such as integrated test facility, audit files and extended records must be specified to the systems designer. The second control implication is that if the audit trail exists only momentarily in the form of transaction logs or master records before destructive update, the external auditor must review and evaluate the transaction flow at various times throughout the processing period. Alternatively, the external auditor can rely more extensively on the internal auditor to monitor the audit trail.

4.18

The important differences between manual and computer accounting systems are in these areas: (1) transaction trails, (2) uniform processing of transactions, (3) segregation of functions, (4) potential for errors and frauds, (5) potential for increased management supervisions, and (6) initiation or subsequent execution of transactions by computer. Additional planning considerations when computer processing is involved are:

4.19

The extent to which the computer is used in each significant accounting application. The complexity of the computer operations used by the entity, including the use of an outside service center. The organizational structure of the computer processing activities. The availability of data. The computer-assisted audit techniques to increase the efficiency of audit procedures. The need for specialized skills. 4.20 Computer Assisted Audit Tools and Techniques (CAATTs) collectively is a set of preprogrammed editing, operating, and output routines that can be called into use with a simple, limited set of programming instructions by an auditor who has one or two weeks intensive training. Six audit procedures that can be performed using CAATTs software are: 1. 2. 3. 4. 5. 6. Recalculation. Confirmation. Document Examination (limited). Scanning. Analytical Procedures. Fraud Investigation.

4.21

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4.22

Advantages of using CAATTs to perform recalculations are primarily speed and accuracy. With CAATTS it is just as easy to recalculate all client computations as it would be to test a sample of calculations. Any differences from client computations can be printed out for investigation. When using CAATTs to select samples and print confirmations, the advantages include the use of preprogrammed statistical routines to randomly select the sample and the speed with which confirmations can be prepared on preprinted forms.

4.23

a.

In the permanent audit file: 1. 2. 3. 4. 5. 6. Copies or excerpts of the corporate or association charter, bylaws, or partnership agreement. Copies or excerpts of continuing contracts such as leases, bond indentures, and royalty agreements. A history of the company, its products, markets and background. Copies or excerpts of stockholders, directors, and committee minutes on matters of lasting interest. Continuing schedules of accounts whose balances are carried forward for several years, such as owners' equity, retained earnings, partnership capital and the like. Copies of prior years' financial statements and audit reports.

b.

In the front of the current working paper file. 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. Engagement letter. Staff assignments. Client organization chart. Memoranda of conferences with management. Memoranda of conferences with the director's audit committee Preliminary analytical review notes. Initial risk assessment notes. Initial materiality assessment notes. Engagement planning memorandum Audit engagement time budget. Internal control questionnaire and control analyses. Management controls questionnaire. Computer control questionnaire. Internal control system flow charts. Audit program. A working trial balance of general ledger accounts. Working paper record of preliminary adjusting and reclassifying entries. Memoranda of review notes and unfinished procedures (all cleared by the end of the fieldwork.)

4.24

The most important facet of the current audit evidence papers is the requirement that they show the audit decision problems and their conclusions. These papers must record the proposition to be audited, the evidence gathered, and the final decision. The documentation should demonstrate satisfaction of the fieldwork standards and provide support for the audit report. Word processing can be used in an audit to prepare audit programs, write audit memoranda, and write audit reports. A computer electronic spreadsheet can be used instead of paper and pencil to create the form of a bank reconciliation, with space provided for text lists of outstanding items (using the label input capability), and math formulas inserted for accurate arithmetic in the reconciliation. Printing such reconciliation is easy (and much prettier than most accountants' handwriting!).

4.25

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SOLUTIONS FOR MULTIPLE-CHOICE QUESTIONS

4.26 a. b. c. d. a. b. c. d. a. b. c. d. Incorrect Incorrect Correct Incorrect Incorrect Correct Incorrect Incorrect Incorrect Correct Incorrect Incorrect Confirmation is not an analytical procedure. Physical observation is not an analytical procedure. Analytical procedures incorporate information from a variety of sources. Tests of details are not analytical procedures. Analytical procedures are performed after the engagement letter is obtained. This is the "attention-directing" purpose. All the assertions are always important. This answer could be good even though it evokes the control risk assessment standard, but restriction to inventory makes it a poor choice. Physical production statistics are not a source of information for "comparison of current account balances with prior periods." A client's budgets and forecasts are sources of information for "comparison of current account balances with expected balances." Published industry ratios are not a source of information for "evaluation of current account balances with relation to predictable historical patterns." The company's own historical financial statements are not a good source of information for "evaluation of current account balances in relation to nonfinancial information." (All of the above). Analytical procedures can be used when planning the audit, when performing substantive procedures during an audit, and as a method of overall review at the end of an audit. Weaknesses in the company's internal control are not a subject for preliminary analytical procedures because auditors can't examine the internal controls at this particular time with these kinds of analyses. Individual transactions are not used in preliminary analytical procedures. Management assertions in financial statements are not the direct object of preliminary attention-directing analytical procedures. With preliminary analytical procedures, the auditors are looking for signs of accounts and relationships that may represent specific potential problems and risks in the financial statements. The successor must take responsibility for obtaining the client's consent for the predecessor to give information about prior audits. Cooperation from the predecessor is expected. Cooperation includes obtaining copies of some or all of the predecessor auditor's documentation. All of the above are expected. Although strongly encouraged, U.S. GAAS do not require a written engagement letter for audits. Client consents do not have to be in writing. A written audit program is required (SAS 22, AU 311). Written time budgets and schedules may be a good idea but they are not required.

4.27

4.28

4.29

d.

Correct

4.30

a. b. c. d.

Incorrect Incorrect Incorrect Correct

4.31

a. b. c. d.

True. True. True. Correct Incorrect Incorrect Correct Incorrect

4.32

a. b. c. d.

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4.33

a. b. c. d. a. b. c. d.

Incorrect Incorrect Correct Incorrect Correct Incorrect Incorrect Incorrect Incorrect Incorrect Incorrect Correct Incorrect Incorrect Correct Incorrect Incorrect Incorrect Correct Incorrect Incorrect Correct Incorrect Incorrect Incorrect Correct Incorrect Incorrect Incorrect Correct Incorrect

Audit documentation need to document compliance with GAAS. Extracts of contracts should go in the permanent file. Independence is not really a working paper matter. Materiality judgments will affect the amount of evidence shown in audit documentation. Evidence bears on the year under audit. Current-year evidence is usually not in the permanent file. The administrative audit documentation do not contain current-year evidence about particular balances. The planning memo does not contain evidence. Internal control analysis for the current year would be in the administrative or current file. The latest engagement letter would be in the administrative or current file. Memoranda of conference with management would be in the administrative or current file. Excerpts of the corporate charter and by-laws would not change often and would be in the permanent file. Materiality determination helps concentrate the audit work where it is most needed. Materiality determination helps auditors to do the "sufficient" amount of work. The kind of opinion cannot be determined until all the evidence is obtained and evaluated. Materiality determination helps auditors to do the "sufficient" amount of work. Spreadsheet software would not be appropriate for testing internal controls over computerized accounting applications. Word processing software would be best to prepare an audit program. Spreadsheet software is ideal for preparing a comparison of current year expenses with those from the previous year. Word processing software would be best for drafting a planning memo. All CAATTs are not in the same language. CAATTs can be transported to various clients having various systems. Input controls are important in their own right. The use is the means to accomplish testing, but the complete set of audit procedures can rarely be done entirely on the computer. These are functions of a client's computer system. Auditors can use the computer with ease. Machine operations do not leave "visible" evidence. Computer auditing is meant to gather good evidence with the least quantity of storage. The ratio of cost/sales does not increase. The numerator (cost of goods sold) increases relatively less than the denominator (sales) increases. The ratio of cost/sales does not remain unchanged.

4.34

4.35

a. b. c. d.

4.36

a. b. c. d.

4.37

a. b. c. d.

4.38

a. b. c. d. a. b. c. d. a. b. c.

4.39

4.40

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4.41

a. b. c. d. a. b. c. d.

Correct Incorrect Incorrect Incorrect Incorrect Correct Incorrect Incorrect Incorrect Incorrect Incorrect Correct

Client cooperation should be specified. Technical details are not in the engagement letter. Litigation matters are covered with respect to the request for an attorney's letter. Client representations about board minutes should be in the client's written representation letter. The audit report should not mention the fact that Costanza used a specialist, unless the specialists findings affect the auditors conclusions. Costanza should only mention the use of the specialist when the specialists findings affect the auditors conclusions. Costanza need not mention the use of a specialist if the auditor decides not to take responsibility for the specialists findings. Costanzas report should only mention the specialist if Vandalay does not agree with the specialists findings, resulting in an opinion other than unqualified. Interviewing internal auditors about their reporting responsibilities would assist the audit team in determining whether the internal auditors were objective, but would provide little evidence of related-party transactions. Reviewing accounting records for nonrecurring transactions occurring throughout the year would raise suspicions of fraud, but not necessarily relatedparty transactions. Inspecting communications with the clients legal counsel regarding recorded contingent liabilities would be helpful in determining contingent liabilities. Scanning the minutes for significant transactions with members of the Board of Directors would be helpful in identifying transactions with parties related to the client. A report to the audit committee on the results of testing of internal control over cash receipts would typically occur after the entire period could be tested, and therefore would be written after the balance sheet date. Confirmation letters to vendors confirming the amounts they owe to the client are part of substantive procedures performed on balance sheet account amounts. An attorneys letter regarding contingent liabilities would be written as close to the end of fieldwork as practicable. An engagement letter would be written before accepting an engagement, and therefore before the balance sheet date. Surprise counts of the clients petty cash fund may occur during planning, but are more typically performed close to the balance sheet date. Reporting internal control deficiencies to the audit committee would typically occur after internal control testing was complete. Performing a search for unrecorded liabilities would be performed as a substantive procedure after planning. Identifying related parties is an important part of planning.
Prior to accepting a new audit engagement, an audit firm should (a) attempt to contact the predecessor auditor, (b) evaluate the integrity of management, and (c) assess the firms resources.

4.42

4.43

a. b. c. d.

4.44

a. b. c. d.

Incorrect Incorrect Incorrect Correct Incorrect Incorrect Incorrect Correct Correct

4.45

a. b. c. d.

4.46

d.

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SOLUTIONS FOR EXERCISES, PROBLEMS, AND SIMULATIONS

4.47 Analytical Procedures. Majestic appears to be: 1. 2. 3. 4. A large hotel (200 rooms versus 148) that charges slightly more than the average rate ($160 versus $120) and does not promote room occupancy too heavily (2.7% advertising versus 3.2%) hence its occupancy--paying guests--is not especially high (62.6% versus 68.1%), although this occupancy rate represents more average rooms per day (125 = 62.6% x 200) than the industry (101 = 68.1% x 148).

Majestic also appears to: 1. 2. Derive relatively more revenue from food and beverages (35.7%) than the industry (32.3%) and is more lavish in providing food and beverages Cost of food sold (42.1% versus 37.0%) Cost of beverages sold (43.6% versus 29.5%) Service--wages (39.6% versus 32.8%) Prepared by ____JR____ Date____1-15-0X_______

Memorandum--good working paper style Index AP 7 Majestic Hotel Preliminary Program Memorandum Analysis of Statistics FYE 3/31/0X

Analysis of the operating statistics in working paper AP-6 indicates that the following may be indicative of areas in the accounts where potential errors or frauds or other matters of audit concern may exist. These should be covered in our preliminary planning of the audit program. 1. 2. 3. 4. Room sales revenue is not up to the industry average ratio. Revenues may not be recorded properly--either not recorded or misclassified as food and beverage sales. Management fees appear considerably higher than the industry average. Expenses may be misclassified or a related party transaction may be involved. Utilities, repairs, and maintenance appear to be higher than the industry average. Some capitalizable expenditures may have been improperly classified as current expenses. Salaries and wages in both the rooms department and the food and beverages department appear to be high. The problem may be more employees than average, padded payrolls, or wage rates higher than average. The cost of food and beverages sold appears to be much higher than the industry average. This could be due to payment of higher unit prices (presumably for higher quality), use of greater quantities per serving, inventory pilferage, or erroneous inventory counts and pricing.

5.

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4.48

Audit Simulation: Preliminary Analytical Procedures

E X H I B I T 4.482 ALPHA.COM, INC. PRELIMINARY ANALYTICAL PROCEDURES DATA COMPARATIVE, COMMONSIZE FINANCIAL STATEMENTS Prior Year (Audited) Common Balance REVENUE AND EXPENSE: Sales (net) $9,000,000 Cost of goods sold 6,296,000 Gross margin 2,704,000 General expense 2,044,000 Depreciation 300,000 Operating income $360,000 Interest expense 60,000 Income taxes (40%) 120,000 Net income $180,000 ASSETS: Cash $600,000 Accounts receivable 500,000 Allowance doubtful accounts(40,000) Inventory 1,500,000 Total current assets $2,560,000 Fixed assets 3,000,000 Accum depreciation (1,500,000) Total assets $4,060,000 LIABILITIES AND EQUITY: Accounts payable $450,000 Bank loans, 8% 0 Accrued interest 60,000 Accruals and other 50,000 Total current liabilities $560,000 Long-term debt, 10% 600,000 Total liabilities $1,160,000 Capital stock 2,000,000 Retained earnings 900,000 Total liabilities and equity $4,060,000 Size 100.00% 69.96 30.04% 22.71 3.33 4.00% 0.67 1.33 2.00% 14.78% 12.32 0.99 36.95 63.05% 73.89 36.95 100.00% 11.08% 0.00 1.48 1.23 13.79% 14.78 28.57% 49.26 22.17 100.00% Current Year (Unaudited) Common Balance $9,720,000 7,000,000 2,720,000 $2,003,000 334,000 $383,000 75,000 123,200 $184,800 690,800 900,000 (90,000) 1,350,000 $2,850,800 4,500,000 (1,834,000) $5,516,800 $330,000 1,750,000 40,000 32,000 $2,152,000 400,000 $2,552,000 2,000,000 964,800 $5,516,800 Change Percent Size 100.00% 72.02 27.98% 20.61 3.44 3.94% 0.77 1.27 1.90% 12.52% 16.31 1.63 24.47 51.67% 81.57 33.24 100.00% 5.98% 31.72 0.73 0.58 39.01% 7.25 46.26% 36.25 17.49 100.00% Amount $ 720,000 704,000 16,000 (41,000) 34,000 $23,000 15,000 3,200 $4,800 Change 8.00% 11.18 0.59% 2.01 11.33 6.39% 25.00 2.67 2.67%

90,800 15.13% 400,000 80.00 (50,000) 125.00 (150,000) 10.00 $290,800 11.36% 1,500,000 50.00 (334,000) 22.27 $1,456,800 35.88% ($120,000) 26.67% 1,750,000 (20,000) 33.33 (18,000) 36.00 $1,592,000 284.29% (200,000) 33.33 $1,392,000 120.00% 0.00 64,800 7.20 $1,456,800 35.88%

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4.48

Audit Simulation: Preliminary Analytical Procedures (Continued)

E X H I B I T 4.483 ALPHA.COM, INC. SELECTED FINANCIAL RATIOS Prior Year Balance Sheet Ratios Current ratio 4.57 Days sales in receivables 18.40 Doubtful accounts ratio 0.0800 Days sales in inventory 85.77 Debt/equity ratio 0.40 Operations Ratios Receivables turnover 19.57 Inventory turnover 4.20 Cost of goods sold/sales 69.96% Gross margin % 30.04% Return on beginning equity 6.62% Financial Distress Ratios (Altman) Working capital/Total assets 0.49 Retained earnings/Total assets 0.22 EBIT/Total assets 0.09 Market value equity/Total debt 2.59 Net sales/Total assets 2.22 Discriminant Z Score 4.96 Market value of equity $3,000,000 Current Year 1.32 30.00 0.1000 69.43 0.86 12.00 5.19 72.02% 27.98% 6.37% 0.13 0.17 0.07 1.18 1.76 3.09 $3,000,000 Percent Change 71.02% 63.04% 25.00% 19.05% 115.19% 38.67% 23.54% 2.95% 6.86% 3.71% 74.29% 21.11% 21.70% 54.55% 20.52% 37.67%

In the ALPHA.COM example in Exhibits 43 and 44, the market value of the equity in the calculations is $3 million.

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4.48

Audit Simulation: Preliminary Analytical Procedures (Continued) Current (Unaudited) Potential Error ($300,000) ( 216,000) ($ 84,000) 18,000 ( 4,000) ($ 98,000) 35,000 ( 53,200) ($ 79,800) $ 0 ( 300,000) 0 216,000 53,200 ($ 30,800) 0 4,000 ($ 26,800) 0 0 35,000 18,000 $ 53,000 0 $ 53,000 0 (79,800) ($ 26,800) $ Current as Affected (?) $ 9,420,000 6,784,000 $2,636,000 2,021,000 330,000 $ 285,000 110,000 70,000 $ 105,000 $ 690,800 600,000 (90,000) 1,566,000 53,200 $2,820,000 4,500,000 (1,830,000) $5,490,000 $ 330,000 1,750,000 75,000 50,000 $2,205,000 400,000 $2,605,000 2,000,000 885,000 $5,490,000

REVENUE AND EXPENSE: Sales (net) Cost of goods sold Gross margin General expense Depreciation Operating income Interest expense Income taxes (40%) Net income ASSETS: Cash Accounts receivable Allowance doubtful accounts Inventory Tax receivable Total current assets Fixed assets Accumulated depreciation TOTAL ASSETS LIABILITIES AND EQUITY: Accounts payable Bank loans, 8% Accrued interest Accruals and other Total current liabilities Long-term debt, 10% TOTAL LIABILITIES Capital stock Retained earnings TOTAL LIABILITIES & EQUITY

$9,720,000 7,000,000 $2,720,000 2,003,000 334,000 $ 383,000 75,000 123,200 $ 184,800 $ 690,800 900,000 (90,000) 1,350,000 $2,850,000 4,500,000 (1,834,000) $5,516,800 $ 330,000 1,750,000 40,000 32,000 $2,152,000 400,000 $2,552,000 2,000,000 964,800 $5,516,800

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4.48

Audit Simulation: Preliminary Analytical Procedures (Continued) SOLUTION EXPLANATION: Many of the conclusions are based on the prior year being the best indicator of current year "accurate" figures. 1. Sales and Accounts Receivable may be overstated $300,000. ALPHA.COM, INC.s "more liberal return privileges" may have caused early recording of sales and receivables. A $300,000 error will bring the accounts receivable back near the prior year gross total. If $300,000 sales were recorded too early, the related Cost of Goods Sold should be restored to Inventory. Apparently the COGS is 72 percent of sales. The adjustment could be $216,000. HOWEVER, if the proper COGS ratio is approximately 70% as in the prior year instead of 72%, the COGS may be overstated (and the inventory understated) by another $188,400 (2% x $9,420,000). The Allowance for Bad Debts may need to be higher than the prior year because of credit and return terms. Leave it at $90,000 on $600,000 receivables, although this 15 percent ratio is much higher than the prior year (8%). HOWEVER, if eight percent is the more appropriate ratio, the allowance (and bad debt expense) may be overstated by $42,000 (7% x $600,000). Expense accruals might have been omitted in the amount of $18,000, which would bring the accrued expenses up to the prior year amount ($50,000). Depreciation expense appears to have been calculated on the basis of the planned capital addition of $1,700,000 instead of the actual recorded amount of $1,500,000. ($1,500,000 for 25 years, 1/2 year, no salvage is $30,000 in addition to the prior year $300,000.) The bank loan interest accrual for the 4th quarter ($35,000 = $1,750,000 x .08 x 1/4 year) appears to have been overlooked. Interest expense for the six months should be $70,000 ($1,750,000 x .08 x 1/2 year) plus the $40,000 on the long term debt, for a total of $110,000 instead of $75,000. The income-reducing potential errors have a tax effect (40%) of $53,200. Since ALPHA.COM, INC. apparently paid the taxes based on the unaudited income, a tax refund receivable will arise with the final tax return.

2.

3.

4. 5.

6.

7.

Although the problem information is not explicit, ALPHA.COM, INC. apparently paid dividends of $120,000 (same as prior year). If this is not the case, a $120,000 unexplained debit is buried in the retained earnings account. If it is not a dividend, it might be a misclassified loss or a prior period adjustment.

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4.49

Analytical Procedures Ratio Relationships a. The current ratio was made larger than it should have been. The current asset numerator was made larger (fictitious accounts receivable larger than the inventory removed) while the current liability denominator did not change. (However, if the income tax effect of the error is included, the current liabilities change by a greater proportion that the current assets change, and it turns out that the current ratio was made smaller !) In this case the relative rate of change is important, because both the numerator and denominator of the current ratio are changed by the same amount. 1. Current ratio (before) was greater than 1:1--the incorrect accounting makes the ratio larger than it should be. Example: 2. Before $100,000 / $20,000 = 5.0:1 After $ 90,000 / $10,000 = 9.0:1

b.

Current ratio (before) was equal to 1:1--the incorrect accounting does not change the ratio. Example: Before $100,000 / $100,000 = 1:1 After $ 90,000 / $ 90,000 = 1:1

3.

Current ratio (before) was less than 1:1--the incorrect accounting makes the ratio smaller than it should be. Example: Before $ 20,000 / $100,000 = 0.2:1 After $ 10,000 / $ 90,000 = 0.11:1

c.

Effect of unrecorded purchase counted in physical inventory, assuming the accounts are adjusted to include the inventory on hand. Inventory is not misstated. Cost of goods sold is understated. Gross profit is overstated. Net income is overstated. The effect on the ratios compared to what they would have been without the error: Current ratio: Greater than 1:1 before. Equal to 1:1 before. Less than 1:1 before. Gross margin ratio: The error of recording the inventory and not the current payable makes the ratio larger. The error makes the ratio larger. The error makes the ratio larger.

The error makes it larger. The error makes it smaller. The error does not affect either the sales numerator or the receivables denominator, so the ratio is not affected.

Cost of goods sold ratio: Receivables turnover:

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Analytical Procedures Ratio Relationships (Continued) d. In this case the net receivables amount is correct. The proper adjustment should be to reduce gross receivables and the allowance for doubtful accounts by an equal amount. Current ratio: Day's sales in receivables: Doubtful account ratio: Not affected because the current asset and current liability totals are not affected. Not affected when the net receivables is used to calculate the ratio. The improper accounting causes the ratio to be larger than it should be. (Proper accounting would cause the allowance numerator to be reduced to a greater extent, by a faster rate, than the receivables denominator.) Not affected when the net receivables is used to calculate the ratio. Not affected because the income is measured properly with adequate allowance for doubtful accounts. Not affected because both terms are measured properly.

Receivables turnover: Return on beginning equity: Working capital/Total assets: e.

The effect on the Altman (1968) discriminate Z score is a larger score because of the directional effect of all the changes mentioned: Working capital/Total assets: Retained earnings/Total assets: Earnings BIT/Total assets: Market equity/ Total debt: Net sales/Total assets: The ratio is larger because WC is greater and TA is smaller. The ratio is larger because retained earnings remained the same while TA is smaller. The ratio is larger, because EBIT is about the same as last year, and TA is smaller. The ratio is larger because market equity is the same, while total debt is lower. The ratio is larger because net sales have decreased less (5%) than the total assets have decreased (10%).

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4.50

Audit Documentation a. 1. 2. b. The functions of audit documentation are to aid the CPA in the conduct of his work and to provide support for his opinion and his compliance with auditing standards. Audit documentation is the CPA's record of the procedures performed, and conclusions reached in the audit.

The factors that affect the CPA's judgment of the type and content of the audit documentation for a particular engagement include: 1. 2. 3. 4. 5. The nature of the auditor's report. The nature of the client's business. The nature of the financial statements, schedules or other information upon which the CPA is reporting and the materiality of the items included therein. The nature and condition of the client's records and internal controls. The needs for supervision and review of work performed by assistants.

c.

Evidence which should be included in audit documentation to support a CPA's compliance with generally accepted auditing standards includes: 1. 2. 3. 4. 5. Evidence that the financial statements or other information upon which the auditor is reporting were in agreement or reconciled with the client's records. Evidence that the client's system of internal control was reviewed and evaluated to determine the nature, timing, and extent of audit procedures. Evidence of the audit procedures performed in obtaining audit evidence for evaluation. Evidence of how exceptions and unusual matters disclosed by audit procedures were resolved or treated. Evidence of the auditor's conclusions on significant aspects of the engagement with appropriate commentaries.

d.

The CPA should perform an adequate examination at minimum cost and effort and the preceding year's programs will aid in doing this. The preceding year's audit programs ordinarily contain information useful in the current examination (such as descriptions of the unique features of a client's operations or records, a formalized sequence of audit steps in logical order, and approximate time requirements to perform various phases of the work.) The auditor should decide whether to use the old program or prepare a new one.

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4.51

Analytical Procedures and Interest Expense a. The audit estimate of interest expense for these notes is about $ 24,400. COGBURN COMPANY Notes Payable Balances Auditor's Interest Calculation 1 2 1 1 1 1 1 1 1 1 1 12 Interest $1,250 $3,334 $1,875 $2,375 $3,125 $2,969 $3,404 $2,296 $1,663 $1,362 $752 $24,405 $24,432

Date Balance Rate Time Jan 1 $150,000 10.0% 1 month Feb 1 $200,000 10.0% 2 months Apr 1 $225,000 10.0% 1 month May 1 $285,000 10.0% 1 month Jun 1 $375,000 10.0% 1 month Jul 1 $375,000 9.5% 1 month Aug 1 $430,000 9.5% 1 month Sep 1 $290,000 9.5% 1 month Oct 1 $210,000 9.5% 1 month Nov 1 $172,000 9.5% 1 month Dec 1 $95,000 9.5% 1 month Weighted Average Balance $250,583 Rate 9.75% 12 months Calculated on Average Balance and Average Rate b.

The type of analytical procedure is "study of the relationships of current-year account balances with relevant nonfinancial information." While the interest rate may not seen to be an item of "nonfinancial information," it is not a direct entry or element in the client's financial statements. Anyway, three of the other four types of analytical procedures do not describe the estimate (because it does not compare to prior periods, compare to budget, or compare to industry information). However, a case might be made that the estimate is an "evaluation of a relationship of current-year account balances (notes payable) to other current-year balances (related interest expense) for conformity with a predictable pattern (interest rate relation) based on the company's experience. The recorded interest expense appears to be too small. The company may have forgotten or miscalculated the year-end interest expense accrual. (In fact this amount was specified because the missing amount is approximately the $750 of the accrual for the December interest.) The recorded interest expense is about right. Some differences in timing and calculation might explain the small difference, but it is not material enough to warrant further work. The recorded interest expense appears to be too large. Maybe the company has other debt on which interest is being paid, but the debt is not recorded in the accounts. (In fact this amount was specified in terms of an extra $100,000 being borrowed in July at 9.5% interest, not recorded, but paid back by August 1 before the next recorded borrowing. This would account for about $800 additional interest: $100,000 x 9.5% x 1/12 = $792.) Could be that Weyman found he could borrow the company's cash for himself, earn interest, and then pay back the principal!) Actually, this kind of maneuver could have been carried out in any month and not noticed by auditors who saw only the first-of-the-month balances.

c.

d. e.

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4.52

Appropriateness of Evidence and Related Parties a. Do you perceive any problems with related party involvement in the evidence used by M. Johnson? Explain. Yes, there are problems. Verbal assurance of collectibility from Bumpus, the S&L officer with an investment in the Smith Street property, is the weakest type of information. Bumpus is a related party and information from him ought to be regarded as biased. Another problem lies in the appraisal company. With the name of Guaranteed Appraisal Partners, Inc., the appraisers may be related, even owned by, the client--Guaranteed Savings & Loan Company. An auditor's general knowledge of financial institution difficulties in real estate lending and the widespread problems with appraisers should alert Johnson to the possible relation of the appraisers to the client. Further investigation should be carried out to identify the appraisers. b. Do you perceive any problems with M. Johnson's reasoning or the appropriateness of evidence used in that reasoning? Yes, there are problems. In addition to the dubious related party sources of information just mentioned, Johnson's "assumption" about the collectibility of the Baker Street loan is unwarranted. Auditors are not entitled to "assume" collectibility on any grounds with supporting evidence. The facts that a loan is new or construction is still in progress is no reason to "assume" collectibility.

4.53

Communications between Predecessor and Successor Auditors The procedures Anderson should follow prior to accepting the engagement include the following: 1. 2. Anderson should explain to Apollo the need to inquire of Smith & Smith and should request permission to make such inquiries. Anderson should ask Apollo to authorize Smith & Smith to respond fully to all inquiries since Smith & Smith would be prohibited from disclosing confidential information without former client permission. Anderson should advise Smith & Smith of Apollo's decision to change auditors. Advising Smith & Smith would be a good business judgment as well as an act of professional courtesy. Anderson should make reasonable inquiries of Smith & Smith regarding matters that will aid in deciding whether to accept the engagement. (Anderson's inquiries should ask about facts that might bear on the integrity of management, disagreements with management about accounting and auditing matters, and Smith & Smith' understanding of the reason(s) for the change of auditors.) If Smith & Smith does not respond fully to Anderson's questions, Anderson should consider the implications of the limited response in deciding whether to accept the engagement. After weighing all information received from Smith & Smith, Anderson should inform Apollo that a first-time audit is more time-consuming than a recurring audit because the new auditor is generally unfamiliar with the client's operations and does not have the benefit of past knowledge of company affairs to use as a guide. A discussion with Apollo of the estimated required audit time and fee arrangement should be coordinated with a clear explanation of the purpose and scope of the audit. Any work that can be done by client personnel should also be discussed so that excess audit time might be eliminated and proposed report deadlines can be reasonably met.

3. 4.

5. 6.

7.

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Communications between Predecessor and Successor Auditors (Continued) 8. To satisfy Anderson's quality control objective, Anderson should use procedures such as reviewing the financial statements of Apollo; inquiring of third parties such as Apollo's banks, legal counsel, investment bankers, and others in the business community as to Apollo's reputation; and evaluating his ability to serve Apollo properly with reference to industry expertise, size of engagement, and available staff. If Anderson has no reservations, after all significant factors have been considered, discussed, and agreed to, Anderson should accept the engagement and confirm the understandings in an engagement letter.

9.

4.54

Predecessor and Predecessor and Successor Auditors Wells & Ratley need to initiate communications with both predecessor auditors. The situation is unusual, but W&R need to obtain complete information from all the predecessors involved since the last audit (2000 financial statements). Both Canby & Co. and Albrecht & Hubbard are predecessors. (If Canby & Co. had completed the 2001 audit, and W&R had been hired to perform the 2002 audit, then Canby & Co. would be the only predecessor. A&H would be history.) Inquiry of only one of the predecessors would not result in complete information because the circumstances surrounding each auditor change may be different. The two predecessors, having served at different times and for different lengths of time, may have different knowledge about Allpurpose Loan Company and its president. If the company is public and subject to SEC reporting requirements, forms 8-K for both changes should have been filed.

4.55

Client Acceptance Case a. b. c. The sources of information and inquiries are listed in the solution to Review Checkpoint 4.1. Yes. AICPA Quality Control Standards require firms to investigate prospective audit clients. Students can decide this acceptance question either way, although the brief facts prejudice the conclusion toward nonacceptance. The CPA's own firm decided to resign only 10 years ago, presumably over matters of owner-manager integrity. Yet, Mr. Shine appears to be a respected member of his new community. Maybe his "fast and loose" accounting past is behind him. Maybe not.

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4.56

Using the Work of Internal Auditors (AICPA adapted solution) a. Control Risk Assessment: Tyler's work [internal auditing] may be relevant to North [external auditor] in obtaining a sufficient understanding of the design of General's internal control policies and procedures, in determining whether they have been placed in operation, and in assessing risk. Since an objective of most internal audit functions is to review, assess, and monitor internal control policies and procedures, the procedures performed by Tyler in this area may provide useful information to North. Substantive Auditing: Tyler's work may also provide direct evidence about material misstatements in assertions about specific account balances or classes of transactions. Therefore, Tyler's work may be relevant to North in planning substantive procedures. Consequently, North may be able to change the nature, timing, or extent of certain procedures. North may request direct assistance from Tyler. This direct assistance relates to work North specifically requests Tyler to perform to complete some aspect of North's work. b. Efficiency: If North concludes that Tyler's work is relevant to North's audit of General's financial statements, North should consider whether it would be efficient to consider how Tyler's work might affect the nature, timing, and extent of North's audit procedures. If so, North should assess Tyler's competence and objectivity in light of the intended effect of Tyler's work on North's audit. Competence and Objectivity: North ordinarily should inquire about Tyler's organizational status within General and about Tyler's application of the professional internal auditing standards developed by the Institute of Internal Auditors. North also should ask about Tyler's internal audit plan, including the nature, timing, and extent of the audit work performed. Additionally, North should inquire about Tyler's access to General's records and whether there are any limitations on the scope of Tyler's activities.

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4.57

Discovering Intentional Financial Misstatements in Transactions and Account Balances--Using the Computer 1. Inventory write-downs for obsolete and damaged goods were deferred. Scanning. Scan inventory records on the date of issue field and select old last-issue dates for further investigation regarding need to write down or write off. The sales entry system was kept open after the quarterly and annual cutoff dates, recording sales of goods shipped after the cutoff dates. Analytical Procedures. Summarize and resequence sales data by shipment date or shipping document number to detect next-period shipments recorded in the accounting period under audit, then, Confirmation. Select and print these customers for accounts receivable confirmation at the cutoff date. 3. Transactions coded as leases of office equipment were recorded as sales. Scanning. Scan the sales file on the transaction code field to detect the leased equipment recorded as sales (then examine the underlying source documentation). Shipments to branch offices were recorded as sales. Scanning. Scan the customer name or code field for comparison to known names or codes used for branch offices (select matches for further document examination). Analytical Procedures. To accomplish the same purpose, compare data on separate files--branch name and code file-- to sales customer name and code fields. Vendors' invoices for parts and services were not recorded until later, but the actual invoice date was faithfully entered according to accounting policy. Document Examination (limited). Enter balances from period-end vendor statements and compare to the company's accounts payable records. Analytical Procedures. Summarize the subsequent-period accounts payable entries on the invoice date field to find the total of invoices recorded late. 5. 2.

4.

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4.58

Horizontal and Vertical Analysis TO: FROM: DATE: SUBJECT: Current Audit Documentation File Auditor Retail Company audit--preliminary analytical review

Revenue and Current Ratio Sales decreased 10%, and the company may be tempted to misstate accounts in order to avoid reporting an income decrease. The requirement to maintain a 2:1 current ratio presents temptation to overstate current asset accounts and understate current liability accounts. Sales, Sales Returns, and Accounts Receivable Both sales and accounts receivable are down. The days' sales in receivables and receivables turnover ratios confirm the relative decrease. The allowance for doubtful accounts ratio is approximately in line with last year. Even though the sales decline might tempt people to record invalid sales, there is not much room to hide them in accounts receivable. If the allowance for doubtful accounts should be 8%, as last year, the allowance should be $32,000, indicating a $2,000 understatement in the allowance and $2,000 overstatement of net realizable value of accounts receivable. Inventory and Cost of Goods Sold Cost of goods sold as a percent of sales is down from 70 percent to about 65 percent. If 70 percent is more accurate, cost of goods sold might be understated by $405,000, or almost 76 percent of the $530,000 operating income (before taxes, interest expense, and other revenue and expense). The related inventory accounts may therefore be overstated, perhaps as much as $405,000. The trial balance shows inventory increased $440,000 (29 percent). The days' sales in inventory and inventory turnover ratios confirm the relative increase of inventory dollars. We should audit the physical inventory and inventory pricing carefully. Accruals and Expenses The depreciation expense is the same as last year, but $1,000,000 new assets are in the Equipment account. We need to recalculate depreciation expense. Either the company forgot to record depreciation on new assets, the assets are fictitious and have not been put on the depreciation schedule, or the assets were acquired so late in the year that fractional depreciation is immaterial. Interest expense on the new bank loan appears not to have been paid or accrued. The interest expense in the trial balance seems to be interest on the long term debt at 10 percent. According to the problem information, interest since July 1 at 11% on $750,000 (expense = $41,250) should have been recorded. Other accruals are smaller than last year, and general expenses are only slightly lower. Maybe some accrued expenses did not get recorded. We need to be sure to conduct the search for unrecorded liabilities and expenses. If the ratio of accruals to expense for last year (0.03) is relevant for this year, the accruals should be about $60,000 instead of $10,000. Liabilities It looks like there was an error in the prior year audited financial statements. $100,000 of the long-term debt should have been classified as "current portion of long-term debt." None is classified as a current liability in the current year unaudited financial statements. Retained Earnings We were told that no dividends have been declared or paid, but the ending retained earnings is not equal to the beginning retained earnings plus net income. There is a $100,000 discrepancy that could be dividends, a prior period adjustment, or a loss improperly debited to retained earnings. Maybe the books just do not balance! McGraw-Hill/Irwin Auditing and Assurance Services, Louwers et al., 2/e The McGraw-Hill Companies, Inc., 2007 4-23

4.58

Horizontal and Vertical Analysis (Continued) A constructed cash flow statement (attached) shows an unexplained $100,000 cash "shortage." Maybe a loss or expense was debited directly to retained earnings. Going Concern Consideration The company appears to have used operating cash flow and new bank loans ($750,000) to finance asset purchases ($1,000,000) and long term debt repayment ($100,000). Current liabilities increased much more than current assets (inventory increase), and the current ratio declined from 4.57 to 2.00. Likewise the total debt to equity ratio increased from .35 to .56 Overstatement of the inventory, omission of accrued expenses, and misclassification of the current portion of long term debt would cause the current ratio to be 2:1, exactly as required by the loan agreement, instead of less than 2:1. The existence of the loan agreement requirement make the risk of misstatement higher under these conditions. While the company does not seem to be in dire financial straits, we ought to review the cash flow budget for next year. Retail Company Cash Flow Statement Operations: Net income Depreciation Decrease net accounts receivable Increase inventory Increase accounts payable Decrease accruals Cash Flow from Operations Investing Activities: Additions to fixed assets Financing Activities: New loan acquisition Debt repayment Financing Cash Flow Net Cash Increase Beginning Cash Balance Ending Cash Balance Reported Cash Balance Unexplained Cash Difference $ 750,000 ( 100,000) 650,000 $ ( 16,000) 600,000 $ 584,000 484,000 $ 100,000 $ 294,000 300,000 90,000 (440,000) 150,000 ( 60,000) $ 334,000 ( 1,000,000)

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Horizontal and Vertical Analysis (Continued) Retail Company Summary of Potential Problems Reported (unaudited) Added bad debt allowance Overstated inventory Interest accrual Expense accrual Depreciation expense Unidentified RE debit Reclassify long term debt Income tax reduction* Adjusted Income $ 294,000 ( 2,000) ( 405,000) ( 41,250) ( 50,000) (100,000) (100,000) 279,300 $(124,950) Current Assets $ 2,794,000 ( 2,000) ( 405,000) Current Liabilities $ 1,400,000 41,250 50,000 100,000 _________ $1,591,250

279,300 $ 2,666,300 1.68:1

Adjusted current ratio *Refund of taxes paid plus refund from tax loss carryback.

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4.59

Analysis and Judgment (See also form B of problem 4.59 following) This problem is one of Robert Ashton's cases on judgment and decision making (Accounting Review, January, 1984, pp. 78-97.) Ashton gives credit to Joyce and Biddle, "Anchoring and Adjustment in Probabilistic Inference in Auditing." Journal of Accounting Research, Spring 1981. The case is set up to illustrate a person's tendency to anchor an estimate on some known information and adjust from that point in the course of performing analysis. This particular case set-up is intended to illustrate conjunctive and disjunctive events. Ashton's "answer key" explains in this manner: Ashton's Answer Key (abridged) This exercise focuses on probability estimates for two types of complex events called "conjunctive" and "disjunctive." The occurrence of a conjunctive event depends on the joint occurrence of all of a number of sub-events, each with a given probability of occurrence. An example is getting three 3's in a row when rolling a die. This is a conjunctive event with probability of 1/6 raised to the third power (1/6 x 1/6 x 1/6), or about 0.005. An example of a disjunctive event is getting at least one of a number of sub-events, such as one 3 in three rolls of the die. The probability of this disjunctive event is about 0.42. If you are asked to estimate the probabilities of the conjunctive and disjunctive events of rolling the die, a natural starting place (anchor) would be to know that the probability of getting one three in one roll is 1/6, or 0.167. Then to estimate the harder conjunctive event (three 3's in a row), a downward adjustment would be required. Conversely, for the disjunctive event (one 3 in three rolls), an upward adjustment would be needed. However, since adjustments from an anchor are usually insufficient, the estimated probability of the conjunctive event will likely be too large, and that of the disjunctive event too small. Form A of the problem (the one in the textbook chapter) is a conjunctive statement of the problem, and it asks for an estimate of the probability of successful product introduction. With the five sub-events considered independent of each other, the best answer is 0.554 (.80 x .90 x .95 x .90 x .90). Students may anchor on the probabilities of the elementary sub-events and fail to adjust sufficiently downward, and their probability estimates will be higher than 0.554. Form B of the problem (reproduced on the next page, not in the textbook) is a disjunctive statement of the same problem, and the best answer is still 0.554. Form B, however, is stated in terms of failure in the chain of events. (Student responses must be subtracted from 1.000 to make them comparable to Form A.) If students anchor on the probabilities of the elementary disjunctive sub-events in Form B, their probability estimates (subtracted from 1.000) will probably be too low. NOTE TO INSTRUCTORS: You may want to reproduce Form B and give both the textbook problem (conjunctive) and the Form B alternative (disjunctive) to different groups of students to illustrate the anchoring and adjustment behavioral phenomenon. You may also want to give students a response scale to make your classroom discussion easier. Ask them to circle one: .00 .10 .20 .30 .40 .50 .60 .70 .80 .90 1.00

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FORM B Analysis and Judgment As part of your regular year-end audit of a publicly-held client, you must make an estimate of the probability of success of its proposed new product line. The client has experienced financial difficulty during the last few years and--in your judgment--a successful introduction of the new product line is necessary for the client to remain a going concern. Any one of the following occurrences will prevent successful introduction of the new product line: (1) unsuccessful labor negotiations between the construction firms contracted to build the necessary addition to the present plant and the building trades unions; (2) unsuccessful defense of patent rights; (3) failure to obtain product approval by the FDA; (4) failure to successfully negotiate a long-term raw materials contract with a foreign supplier; and (5) failure to successfully conclude distribution contract talks with a large national retail distributor. In view of the circumstances, you contact experts who have provided your audit firm with reliable estimates in the past. The labor relations expert estimates that there is a 20 percent chance that labor negotiations will not be successfully resolved before the strike deadline. Legal counsel advises that there is a 10 percent chance that the patent rights defense will not be successful. The expert on FDA product approvals estimates the probability of failing to obtain approval at five percent. The experts in the two remaining areas estimate the probabilities of failing to resolve (a) the raw materials contract and (b) the distribution contract talks to be 10 percent in each case. Assume these estimates are reliable. Required: What is your assessment of the probability that the product introduction will fail? (Hint: You can assume the five steps are independent of each other.)

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4.60

Kaplan CPA Exam Simulation: The Effect of Computers on the Audit Two correct responses appear below: Traditional paper transactions are replaced by electronic transactions, thereby obscuring audit trails. The above excerpt is from Electronic Commerce. OR Source documents may exist only for a short time and in electronic form only. The above excerpt is from Methods of Processing and Data Files.

4.61

Kaplan CPA Exam Simulation: Audit Documentation Note to Instructor: In superseding SAS No. 41, SAS No. 96 changed the terminology working paper to audit documentation. AS 3 uses both terms synonymously. In this solution, we use the term audit documentation to include the working papers prepared by the auditor. Audit Documentation (SAS No. 96; AS 3) The auditor should prepare and maintain audit documentation, the form and content of which should be designed to meet the circumstances of a particular engagement. The information contained in audit documentation constitutes the principal record of the work that the auditor has done and the conclusions that he has reached concerning significant matters. Content of Audit Documentation The quantity, type, and content of audit documentation vary with the circumstances, but they should be sufficient to show that the accounting records agree or reconcile with the financial statements or other information reported on and that the applicable standards of field work have been observed. Audit documentation should show that: The work has been adequately planned and supervised, indicating observance of the first standard of field work. The internal control has been considered to the degree necessary to determine whether, and to what extent, other auditing procedures are to be restricted, indicating observance of the second standard of field work. The audit evidence obtained, the auditing procedures applied, and the testing performed have provided sufficient competent evidential matter to afford a reasonable basis for an opinion, indicating observance of the third standard of field work.

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4.62

Kaplan CPA Exam Simulation: Engagement Letters Possible Engagement Letter Statements We will perform our audit in accordance with U.S. generally accepted auditing standards Include? (X) Explanation The auditors responsibility to conduct the audit in accordance with the generally accepted auditing standards is usually included in an engagement letter. Additional services to be provided such as income tax preparation are typically included in the engagement letter. Auditors do not discuss the details of procedures necessary to perform the audit with management. Management is not required to provide its auditors with a preliminary assessment of risk of material misstatement due to fraud. Managements responsibility for the financial statements is usually explicitly stated in the engagement letter. The determination of materiality for the audit is not mentioned in the engagement letter. Information on fees and billing are typically included in the engagement letter. Managements responsibility to provide a representation letter is generally included in the engagement letter. Management responsibility for making all financial records available is normally included in the engagement letter. Management is not required to recognize responsibility for illegal actions committed by its employees. Engagement letters do include the limitations of the auditor, such as the risk of not detecting material errors and fraud.

As part of our engagement, we will prepare the federal, state and local income tax returns for Woodson Flavors International After performing our assessment of control risk we will discuss with you the other procedures we consider necessary to complete the engagement Management is responsible for providing us with a preliminary assessment of risk of material misstatement due to fraud. The financial statements are the responsibility of management

(X)

( )

( )

(X)

Materiality for the audit will be determined by using the annualized interim financial statements. Fees will be billed as work progresses and are based on our daily rates at various levels of responsibility. Invoices are payable upon receipt. Management is responsible for providing us a representation letter at the conclusion of our audit fieldwork. Management is responsible for making all financial records available to us.

( )

(X)

(X)

(X)

Management recognizes responsibility for illegal actions committed by its employees Our engagement is subject to the risk that material misstatements or fraud, if they exist, will not be detected.

( )

(X)

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Kaplan CPA Exam Simulation: Analytic Procedures 1 Analytical procedures are useful in planning the audit, in substantive testing and in overall review. Two of these three are required, and one of them is only recommended. When analytical procedures are used in planning an audit, generally the auditor uses data at a very detailed level to assist in planning the nature, timing and extent of other auditing procedures. While analytical procedures usually include the calculation of financial ratios, they may also include reading the financial statements to assess the adequacy of evidence gathered for unexpected balances. One of the major reasons for the usefulness of analytical procedures is that they assist the auditor in setting expectations of what account balances should be. The auditor should ask the client about reasons for unexpected fluctuations before doing independent research of the clients industry. If bad debt expense is not significantly different in dollar amount vs. last year, the auditor gains assurance that BDE is not understated this year. If the clients ratios have improved this year, it is not necessary to compare the clients data to industry data or other external data. True. Analytical procedures are required in the planning phase of the audit and in the overall review at the conclusion of the audit.

False. The opposite is true. The auditor generally uses data at a very high level for this purpose.

True. A review of the financials at the end of the audit may show unidentified balances or relationships and help assess the adequacy of evidence for unexpected balances.

False. Auditor expectations are based on prior year data, industry trends, client budgets/plans, and nonfinancial data. Analytical procedures compare client data to expected data. False. The auditor should do his or her own independent research of the clients industry prior to making inquiries of the client. False. Even though Bad Debt Expense may not have changed in absolute amount, the auditor still needs to consider its relationship to Sales and Accounts Receivable. False. It is always necessary to compare the clients ratios to external data. The clients ratios may have improved slightly, but industry data may show that other companies improved significantly.

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Kaplan CPA Exam Simulation: Interpreting Ratios The current ratio, which is a measure of the companys liquidity, shows a positive working capital balance, and may assist in the planning of procedures for long-term debt. True The Current Ratio (current assets divided current liabilities) shows a positive working capital balance for Woodson (see ratios on Situations tab). This is a measure of the liquidity in that it shows the dollars of current assets available to pay current liabilities. It is one of the ratios used in the planning of procedures for debt in that it helps to assess the clients ability to repay debt and pay interest. (Other ratios used for this purpose may be Cash Ratio or Quick Ratio.) The Accounts Receivable Turnover is not a measure of profitability, but a measure of liquidity. It measures how fast the companys receivables are collected in cash. It is useful in planning procedures related to revenue. The Debt-to-Equity ratio is a measure of how much debt is used to finance the business. A high ratio could mean the company has utilized most of its borrowing capacity, and may have difficulty in borrowing in the future. A ratio that is unusually low may mean that the company is not taking advantage of available leverage. Gross Profit Margin is a measure of profitability (gross profit divided by sales). Woodsons margin this year increased. This could happen if sales were overstated, not understated. If sales were overstated, gross margin (sales minus cost of goods sold) would be overstated, so the numerator and denominator of the fraction would be overstated by the same amount. Since the fraction itself is less than one, overstating both components by the same amount would cause the fraction to increase.

Accounts receivable turnover is one measure of the companys profitability, and may assist in the planning of procedures for revenues. The debt-to-equity ratio is a measure of the companys longterm solvency, and may be used to assess the companys use of leverage. Gross Profit Margin is a measure of the companys profitability. The change reflected by this years Gross Profit Margin may indicate an understatement of sales.

False

True

False

McGraw-Hill/Irwin Auditing and Assurance Services, Louwers et al., 2/e

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Kaplan CPA Exam Simulation: Audit Planning Evaluate the reasonableness of the companys accounting estimates. The evaluation of the reasonableness of the companys accounting estimates will occur subsequent to the planning stage (AU 342). Gain an understanding of the flavoring manufacturing industry. The auditor is required to gain an understanding of a new clients business and industry. Inquire of the clients future plans for an IPO. Inquiries of the client regarding current business developments are considered appropriate during the planning phase. Test the internal control design to identify types of potential misstatements. The testing of the internal control design is performed subsequent to planning the audit. The auditor must only gain an understanding of the internal controls during the planning stage. Review unaudited interim financial statements. Any available current year interim financial statements will be read during the planning stage. The interim financial statements may be annualized to determine materiality to properly design the audit procedures. The auditor may use the interim financial statements because many materiality measures relate to an annual number (such as sales or net income). Inquire of the clients attorney as to whether any unrecorded claims are probable of assertion. The auditor does not inquire of the clients attorney during the initial planning stage. Legal inquiries are generally performed subsequent to the planning stage during the fieldwork when the focus is on gathering evidential matter. Do not include in planning audit Include in planning audit Include in planning audit Do not include in planning audit Include in planning audit Include in planning audit Do not include in planning audit

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Kaplan CPA Exam Simulation: Predecessor-Successor Auditor Communications The Robert & Samuel partner failed to communicate with the predecessor auditor, Stein & Smith, prior to accepting the new engagement. SAS No. 84 states the following: Communications Before Successor Accepts Engagement Inquiry of the predecessor auditor is a necessary procedure because the predecessor may be able to provide the successor with information that will assist him in determining whether to accept the engagement. The successor should bear in mind that, among other things, the predecessor and the client may have disagreed about accounting principles, auditing procedures, or similarly significant matters.

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The McGraw-Hill Companies, Inc., 2007 Solutions Manual