Review Questions Chapter 7

explain the importance of analytical procedures as evidence in determining the fair presentation of the financial statements

Analytical procedures are useful for indicating account balances that may be distorted by unusual or significant transactions and that should be intensively investigated. They are also useful in reviewing accounts or transactions for reasonableness to corroborate tentative conclusions reached on the basis of other evidence.

Explain the purposes and benefits of audit documentation software

The auditor can more efficiently prepare a trial balance, lead schedules, supporting audit documentation, financial statements, and ratio analysis using the computer rather than by hand. The effects of adjusting journal entries are automatically carried through to the trial balance and financial statements, making last-minute adjustments easier to make. Tick marks and review notes can be entered directly into computerized files, and the audit progress can be easily monitored. Data can be imported and exported to other applications. For example, a client's general ledger can be downloaded and tax information can be downloaded into a commercial tax preparation package after the audit is completed.

Identify the two factors that determine the persuasiveness of evidence. How are these two factors related to audit procedures, sample size, items to select, and timing?

The two determinants of the persuasiveness of evidence are appropriateness and sufficiency. Appropriateness refers to the relevance and reliability of evidence, or the degree to which evidence can be considered believable or worthy of trust. Appropriateness relates to the audit procedures selected, including the timing of when those procedures are performed. Sufficiency refers to the quantity of evidence and it is related to sample size and items to select.

why is it essential that the auditor not leave questions or exceptions in the audit documentation without an adequate explanation?

Unanswered questions and exceptions may indicate the potential for significant errors or fraud in the financial statements. These should be investigated and resolved to make sure that financial statements are fairly presented. The audit files can also be subpoenaed by courts as legal evidence. Unanswered questions and exceptions may indicate lack of due care by the auditor.

How does the auditor read and evaluate infomation that is available only in machine-readable form?

When evidence can be examined only in machine-readable form, auditors use computers to read and examine evidence. There are commercial audit software programs designed specifically for use by auditors, such as ACL Software and Interactive Data Extraction and Analysis (IDEA). Spreadsheet software packages can also be used by auditors to perform audit tests on data that is available only in machine-readable form.

Identify the six characteristics that determine the reliability of evidence.

7-7 Following are six characteristics that determine reliability of evidence and an example of each. Independence of provider- conformation of bank balance effectiveness of client's internal controls- use of duplicate sales invoices for a large well-run company Auditor's direct knowledge- physical examination of inventory by the auditor Qualifications of provider- letter from an attorney dealing with the client's affairs Degree of Objectivity- Count of cash on hand by auditor Timeliness- Observe inventory on the last day of the fiscal year

describe what is meant by an audit procedure. Why is it important for audit procedures to be carefully worded?

An audit procedure is the detailed instruction for the collection of a type of audit evidence that is to be obtained. Because audit procedures are the instructions to be followed in accumulating evidence, they must be worded carefully to make sure the instructions are clear.

Describe what is meant by an audit program for accounts receivable. What four things should be included in an audit program?

An audit program for accounts receivable is a list of audit procedures that will be used to audit accounts receivable for a given client. The audit procedures, sample size, items to select, and timing should be included in the audit program.

Distinguish between attention-directing analytical procedures and those intended to eliminate or reduce detailed substantive procedures.

Attention-directing analytical procedures occur when significant, unexpected differences are found between current year's unaudited financial data and other data used in comparisons. If an unusual difference is large, the auditor must determine the reason for it, and satisfy himself or herself that the cause is a valid economic event and not an error or misstatement due to fraud. When an analytical procedure reveals no unusual unexpected fluctuations, the implication is minimized. In that case, the analytical procedure constitutes substantive evidence in support of the fair statement of the related account balances, and it is possible to perform fewer detailed substantive tests in connection with those accounts. Frequently, the same analytical procedures can be used for attention directing and for reducing substantive tests, depending on the outcome of the tests. Simple procedures, such as comparing the current year account balance to the prior year account balance, are more attention-directing (and provide less assurance) than more complex analytical procedures (e.g., those which rely on regression analysis or comparison to nonfinancial data). More sophisticated analytical procedures help the auditor examine relationships between several information variables simultaneously. The nature of these tests may provide greater assurance than simple procedures.

Who owns the audit files? Under what circumstances can they be used by other people?

Audit files are owned by the auditor. They can be used by the client if the auditor wants to release them after a careful consideration of whether there might be confidential information in them. The audit files can be subpoenaed by a court and thereby become the property of the court. They can be released to another CPA firm without the client's permission if they are being reviewed as a part of a voluntary peer review program under AICPA, state CPA society, or state Board of Accountancy authorization. The audit files can be sold or released to other users if the auditor obtains permission from the client.

Explain why it is important for audit documentation to include each of the following: identification of the name of the client, period covered, description of the contents, initials of the preparer and the reviewer, dates of the preparation and review, and an index code.

Audit schedules should include the following: Name of the client Enables the auditor to identify the appropriate file to include the audit schedule in if it is removed from the files. Period covered Enables the auditor to identify the appropriate year to which an audit schedule for a client belongs if it is removed from the files. Description of the contents A list of the contents enables the reviewer to determine whether all important parts of the audit schedule have been included. The contents description is also used as a means of identifying audit files in the same manner that a table of contents is used. Initials of the preparer Indicates who prepared the audit schedule in case there are questions by the reviewer or someone who wants information from the files at a later date. It also clearly identifies who is responsible for preparing the audit documentation if the audit must be defended. Date of preparation Helps the reviewer to determine the sequence of the preparation of the audit schedules. It is also useful for the subsequent year in planning the sequence of preparing audit schedules. Indexing Helps in organizing and filing audit schedules. Indexing also facilitates in searching between related portions of the audit documentation

Discuss the similarities and differences between evidence in a legal case and evidence in an audit of financial statements

In both a legal case and in an audit of financial statements, evidence is used by an unbiased person to draw conclusions. In addition, the consequences of an incorrect decision in both situations can be equally undesirable. For example, if a guilty person is set free, society may be in danger if the person repeats his or her illegal act. Similarly, if investors rely on materially misstated financial statements, they could lose significant amounts of money. Finally, the guilt of a defendant in a legal case must be proven beyond a reasonable doubt. This is similar to the concept of sufficient appropriate evidence in an audit situation. As with a judge or jury, an auditor cannot be completely convinced that his or her opinion is correct, but rather must obtain a high level of assurance. The nature of evidence in a legal case and in an audit of financial statements differs because a legal case relies heavily on testimony by witnesses and other parties involved. While inquiry is a form of evidence used by auditors, other more reliable types of evidence such as confirmation with third parties, physical examination, and inspection are also used extensively. A legal case also differs from an audit because of the nature of the conclusions made. In a legal case, a judge or jury decides the guilt or innocence of the defendant. In an audit, the auditor issues one of several audit opinions after evaluating the evidence.

Distinguish between internal documentation and external as audit evidence and give three examples of each.

Internal documentation is prepared and used within the client's organization without ever going to an outside party, such as a customer or vendor. Examples: check request form receiving report payroll time record adjusting journal entry External documentation either originated with an outside party or was an internal document that went to an outside party and is now either in the hands of the client or is readily accessible. Examples: vendor's invoice cancelled check cancelled note validated deposit slip

List the eight types of audit evidence included in this chapter and give two examples of each

Physical examination - count petty cash on hand, examine fixed assets additions Confirmation- Confirm accounts receivable balances of a sample of client customers, confirm client's cash balance with bank Inspection- Examine copies of monthly bank statements, examine vendor's invoices supporting a sample of cash disbursement transactions throughout the year Analytical procedures- Evaluate reasonableness of receivable by calculating and comparing ratios, Compare expenses as a percentage of net sales with prior year's percentages Inquiries of the client - Inquire of management whether there is obsolete inventory, inquire of management regarding the collectibility of large accounts receivable balances Recalculation- Recompute invoice total by multiplying item price times quantity sold, food the sales journal for a one-month period and compare all totals to the general ledger Reperformance- Agree sales invoice price to approved price list, match quantity on purchase invoice to receiving report Observation- Observe client employees in the process of counting inventory, observe whether employees are restricted from access to the check signing machine

For how long does the Sarbanes-Oxley Act require auditors of public companies to retain audit documentation?

The Sarbanes-Oxley Act of 2002 requires auditors of public companies to prepare and maintain audit schedules and other information related to any audit report in sufficient detail to support the auditor's conclusions, for a period of not less than 7 years.

what are the characteristics of a confirmation? Distinguish between a confirmation and external documentation.

The characteristics of a confirmation are: 1. Receipt directly by auditor 2. Written or electronic response 3. From independent third party 4. Requested by the auditor A confirmation is prepared specifically for the auditor and comes from an external source.

your client, Harper Company, has a contractual commitment as a part of a bond indenture to maintain a current ratio of 2.0. If the ratio falls below that level on the balance sheet date, the entire bond becomes payable immediately. In the current year, the client's financial statments show the ratio has dropped from 2.6 to 2.05 over the past year. how should this situation affect the audit plan?

The decrease of the current ratio indicates a liquidity problem for Harper Company since the ratio has dropped to a level close to the requirements of the bond indenture. Special care should be exercised by the auditor to determine that the 2.05 ratio is proper since management would be motivated to hide any lower ratio. The auditor should expand procedures to test all current assets for proper cutoff and possible overstatement and to test all current liabilities for proper cutoff and possible understatement.

list four major evidence decisions that must be made on every audit

The four major audit evidence decisions that must be made on every audit are: 1. Which audit procedures to use. 2. What sample size to select for a given procedure. 3. Which items to select from the population. 4. When to perform the procedure.

identify the most important reasons for performing analytical procedures

The most important reasons for performing analytical procedures are the following: 1. Understanding the client's business and industry 2. Assessment of the entity's ability to continue as a going concern 3. Indication of the presence of possible misstatements in the financial statements 4. Reduction of detailed audit tests

Define what is meant by a permanent file, and list several types of information typically included. Why does the auditor not include the contents of the permanent file with the current year's audit file?

The permanent file contains data of an historical and continuing nature pertinent to the current audit. Examples of items included in the file are: 1. Articles of incorporation 2. Bylaws, bond indentures, and contracts 3. Analysis of accounts that have continuing importance to the auditor 4. Information related to the understanding of internal control: a. flowcharts b. internal control questionnaires 5. Results of previous years' analytical procedures, such as various ratios and percentages compiled by the auditors By separating this information from the current year's audit files, it becomes easily accessible for the following year's auditors to obtain permanent file data.

Distinguish between the following types of current period supporting schedules and state the purpose of each: analysis, trial balance, and tests of reasonableness.

The purpose of an analysis is to show the activity in a general ledger account during the entire period under audit, tying together the beginning and ending balances. The trial balance includes the detailed makeup of an ending balance. It differs from an analysis in that it includes only those items comprising the end of the period balance. A test of reasonableness schedule contains information that enables the auditor to evaluate whether a certain account balance appears to be misstated. One example of a test of reasonableness schedule is a schedule that compares current year expenses to prior years' amounts. This type of schedule is intended to show which accounts need investigation due to significant variances.

list the purposes of audit documentation and explain why each purpose is important.

The purposes of audit documentation are as follows: 1. To provide a basis for planning the audit. The auditor may use reference information from the previous year in order to plan this year's audit, such as the evaluation of internal control, the time budget, etc. 2. To provide a record of the evidence accumulated and the results of the tests. This is the primary means of documenting that an adequate audit was performed. 3. To provide data for deciding the proper type of audit report. Data are used in determining the scope of the audit and the fairness with which the financial statements are stated. 4. To provide a basis for review by supervisors and partners. These individuals use the audit documentation to evaluate whether sufficient appropriate evidence was accumulated to justify the audit report. Audit documentation is used for several purposes, both during the audit and after the audit is completed. One of the uses is the review by more experienced personnel. A second is for planning the subsequent year audit. A third is to demonstrate that the auditor has accumulated sufficient appropriate evidence if there is a need to defend the audit at a later date. For these uses, it is important that the audit documentation provide sufficient information so that the person reviewing an audit schedule knows the name of the client, contents of the audit schedule, period covered, who prepared the audit schedule, when it was prepared, and how it ties into the rest of the audit files with an index code.

Explain why the auditor can be persuaded only with a reasonable level of assurance, rather than convinced, that the financial statements are correct.

There are two primary reasons why the auditor can only be persuaded with a reasonable level of assurance, rather than be convinced that the financial statements are correct: 1. The cost of accumulating evidence. It would be extremely costly for the auditor to gather enough evidence to be completely convinced. 2. Evidence is normally not sufficiently reliable to enable the auditor to be completely convinced. For example, confirmations from customers may come back with erroneous information, which is the fault of the customer rather than the client.

Define what is meant by a tick mark. What is its purpose?

Tick marks are symbols adjacent to information in audit schedules for the purpose of indicating the work performed by the auditor. An explanation of the tick mark must be included at the bottom of the audit schedule to indicate what was done and by whom.