Test 3

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10-8: Among the departments of J-R Company are a purchasing department, receiving department, accounting department, and finance department. If you were preparing a flowchart of a voucher system to be installed by the company, in which department would you show 1. The assembling of the purchase order, receiving report, and vendor's invoice to determine that these documents are in agreement? 2. The preparation of a check? 3. The signing of a check? 4. The mailing of a check to the payee? 5. The cancellation of the voucher and supporting documents?

1. Accounting 2. Accounting 3. Finance 4. Finance 5. Finance

Requirements for Changing Principle

1. Generally accepted 2. Change method meets GAAP 3. Adequate disclosures 4. New principle preferable If even one not met, then cannot issue unmodified

Simulation Johnson & Barkley, CPAs, audited the consolidated financial statements of Jordan Company (a public company) for the year ended December 31, 20X7. Johnson & Barkley previously have audited and issued standard unqualified audit reports on Jordan Company's financial statements for the preceding 7 years (beginning in 20X0). The 20X7 consolidated financial statements are being presented on a comparative basis (two years for the balance sheet, three years for the other statements) and an unqualified opinion is being expressed. Smith, the engagement supervisor, instructed Abler, an assistant on the engagement, to draft the auditors' report. In drafting the report below, Abler considered the following: Jordan changed its method of accounting for inventory from LIFO to FIFO in 20X7. Jordan is a defendant in a lawsuit alleging patent infringement. This is adequately disclosed in the notes to Jordan's financial statements, but no provision for liability has been recorded because the ultimate outcome of the litigation cannot presently be determined. Abler drafted the following audit report: Report of Independent Registered Public Accounting Firm (Point 1) To Jordan Company and its shareholders (Point 2) Opinion on the Financial Statements We have audited the accompanying balance sheets of Jordan Company (the "Company") as of December 31, 20X7 and 20X6, the related statements of income, comprehensive income, stockholders' equity, and cash flows, for each of the three years in the period ended December 31, 20X7, and the related notes [and schedules] (collectively referred to as the "financial statements"). In our opinion, the financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 20X7 and 20X6, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 20X7, in conformity with accounting principles generally accepted in the United States of America. As indicated in the next paragraph, the Company has a change in Accounting Principles in 20X7. (Point 3) Change in Accounting Principles As discussed in Note 2 to the consolidated financial statements, the Company adopted the first-in-first-out method of inventory valuation in 20X7. Our opinion is not modified with respect to this matter. (Point 4) Basis for Opinion (Point 5) Our responsibility is to express an opinion on the Company's financial statements based on our audits. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. We conducted our audits in accordance with the standards of the PCAOB. (Point 6) Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion. Critical Audit Matters (Point 7) The critical audit matters communicated below are matters arising from the current period audit of the financial statements that were communicated or required to be communicated to management (Point 8) and that (1) relate to accounts or disclosures that are material to the financial statements and (2) involved our especially challenging, subjective, or complex judgments. The communication of critical audit matters does not alter in any way our opinion on the financial statements, taken as a whole, and we are not, by communicating the critical audit matters below, providing separate opinions on the critical audit matters or on the accounts or disclosures to which they relate. [Assume critical audit matters properly described] Johnson & Barkley, CPAs We have served as the Company's auditor since 20X0. (Point 9) Los Angeles, California December 31, 20X8 (Point 10) Required: Page 747 Smith reviewed Abler's draft and stated in the Supervisor's Review Notes below that there were deficiencies in Abler's draft. Items 1 through 10 represent the deficiencies noted by Smith. For each deficiency, indicate whether Smith is correct or incorrect in the criticism of Abler's draft. The report's title is incorrect as it should not include the word "independent." The report also must be addressed to the board of directors. The change in accounting principles should not be referred to in the opinion paragraph—delete that sentence. The Change in Accounting Principles paragraph should include the dollar effect of the change. The Basis for Opinion section should begin with a statement that the financial statements are the responsibility of management. The sentence should state generally accepted auditing standards of the PCAOB. When critical matters exist, the two related paragraphs (this and the following paragraph) should immediately follow the opinion paragraph. The point should say communicated to the audit committee. This disclosure also must include the name of the engagement partner. The report should be dated as of February 12, the date on which sufficient appropriate audit evidence was obtained.

1. Incorrect 2. Correct 2. C 4. I 5. C 6. I 7. I 8. C 9. I 10. C

A control deficiency, or a combination of control deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the company's annual or interim financial statements will not be prevented or detected on a timely basis A weakness in the design or operation of a control that does not allow management or employees, in the normal course of performing their functions, to prevent or detect misstatements on a timely basis An account for which there is a reasonable possibility that it could contain misstatements that individually, or when aggregated with others, could have a material effect on the financial statements The primary section of the Sarbanes-Oxley Act dealing with management and auditor reporting on internal control over financial reporting Those transaction flows that have a meaningful bearing on the totals accumulated in the company's significant accounts and, therefore, have a meaningful bearing on relevant assertions Tracing a transaction from origination through the company's information systems until it is reflected in the company's financial reports

1. Material weakness 2. Control deficiency 3. Significant account 4. Section 404 5. Major classes of transactions 6. Walk-through

For each of the following brief scenarios, assume that you are reporting on a client's financial statements. Reply as to the type(s) of opinion (per below) possible for the scenario. In addition: Unless stated otherwise, assume the matter involved is material. If the problem doesn't tell you whether a misstatement pervasively misstates the financial statements or doesn't list a characteristic that indicates pervasiveness, two reports may be possible (i.e., replies 6 to 9). Do not read more into the circumstances than what is presented. Do not consider an auditor discretionary circumstance for modification of the audit report unless the situation explicitly suggests that the auditor wishes to emphasize a particular matter. Types of Opinion Unmodified—standard. Unmodified with an emphasis-of-matter paragraph. Qualified. Adverse. Disclaimer. Unmodified with an emphasis-of-matter paragraph or disclaimer. Qualified or adverse. Qualified or disclaimer. Adverse or disclaimer. Other. Situation Report A company has not followed generally accepted accounting principles in the recording of its leases. A company has not followed generally accepted accounting principles in the recording of its leases. The amounts involved are immaterial. A company valued its inventory at current replacement cost. Although the auditor believes that the inventory costs do approximate replacement costs, these costs do not approximate any GAAP inventory valuation method. A client changed its depreciation method for production equipment from the straight-line method to the units-of-production method based on hours of utilization. The auditor concurs with the change. A client changed its depreciation method for production equipment from the straight-line to a units-of-production method based on hours of utilization. The auditor does not concur with the change. A client changed the depreciable life of certain assets from 10 years to 12 years. The auditor concurs with the change.Page 745 A client changed the depreciable life of certain assets from 10 years to 12 years. The auditor does not concur with the change. Confined to fixed assets and accumulated depreciation, the misstatements involved are not considered pervasive. A client changed the method it uses to calculate postemployment benefits from one acceptable method to another. The effect of the change is immaterial this year but is expected to be material in the future. A client changed the salvage value of certain assets from 5 percent to 10 percent of original cost. The auditor concurs with the change. A client uses the specific identification method of accounting for valuable items in inventory, and LIFO for less valuable items. The auditor concurs that this is a reasonable practice. Due to recurring operating losses and working capital deficiencies, an auditor has substantial doubt about an entity's ability to continue as a going concern for a reasonable period of time. The notes to the financial statements adequately disclose the situation. The auditor has decided not to issue a disclaimer of opinion. Due to recurring operating losses and working capital deficiencies, an auditor has substantial doubt about an entity's ability to continue as a going concern for a reasonable period of time. The notes to the financial statements do not adequately disclose the substantial doubt situation, and the auditor believes the omission fundamentally affects the users' understanding of the financial statements. An auditor reporting on group financial statements decides to take responsibility for the work of a component auditor who audited a 70 percent owned subsidiary and issued an unmodified opinion. The total assets and revenues of the subsidiary are 5 percent and 8 percent, respectively, of the total assets and revenues of the entity being audited. An auditor reporting on group financial statements decides not to take responsibility for the work of a component auditor who audited a 70 percent owned subsidiary and issued an unqualified opinion. The total assets and revenues of the subsidiary are 5 percent and 8 percent, respectively, of the total assets and revenues of the entity being audited. An auditor was hired after year-end and was unable to observe the counting of the year-end inventory. She is unable to apply other procedures to determine whether ending inventory and related information are properly stated. An auditor was hired after year-end and was unable to observe the counting of the year-end inventory. However, she was able to apply other procedures and determined that ending inventory and related information are properly stated. An auditor discovered that a client made illegal political payoffs to a candidate for president of the United States. The auditor was unable to determine the amounts associated with the payoffs because of the client's inadequate record-retention policies. The client has added a note to the financial statements to describe the illegal payments and has stated that the amounts of the payments are not determinable. An auditor discovered that a client made illegal political payoffs to a candidate for president of the United States. The auditor was unable to determine the amounts associated with the payoffs because of the client's inadequate record-retention policies. Although there is no likelihood that the financial statements are pervasively misstated, they may be materially misstated. The client refuses to disclose the payoffs in a note to the financial statements. In auditing the long-term investments account of a new client, an auditor finds that a large contingent liability exists that is material to the consolidated company. It is probable that this contingent liability will be resolved with a material loss in the future, but the amount is not estimable. Although no adjusting entry has been made, the client has provided a note to the financial statements that describes the matter in detail. In auditing the long-term investments account of a new client, an auditor finds that a large contingent liability exists that is material to the consolidated company. It is probable that this contingent liability will be resolved with a material loss in the future, and this amount is reasonably estimable as $2,000,000. Although no adjusting entry has been made, the client has provided a note to the financial statements that describes the matter in detail and includes the $2,000,000 estimate in that note. A client is issuing two years of comparative financial statements. The first year was audited by another auditor who is not being asked to reissue her audit report. (Reply as to the successor auditors' report.) A client is issuing two years of comparative financial statements. The first year was audited by another auditor who is being asked to reissue her audit report. (Reply as to the successor auditors' report.) A client's financial statements follow GAAP, but the auditor wishes to emphasize in his audit report a significant related party transaction that is adequately described in the notes to the financial statements. A client's financial statements follow GAAP except that they do not include a note on a significant related party transaction.

1. Qualified or Adverse 2. Unmodified 3. Qualified or Adverse 4. Unmodified - Emphasis of Matter 5. Qualified or Adverse 6. Unmodified 7. Qualified 8. Unmodified 9. Unmodified 10. Unmodified 11. Unmodified - Emphasis of Matter 12. Adverse 13. Unmodified 14. Other - Additional wording 15. Disclaimer or Qualified 16. Unmodified 17. Qualified or Disclaimer (Withdraw) 18. Qualified (Withdraw) 19. Unmodified - Emphasis of Matter 20. Qualified or Adverse 21. Other - Add paragraph 22. Unmodified 23. Unmodified - Emphasis of Matter 24. Qualified or Adverse

Group/Component Auditors 1. Make No reference 2. Make reference 3. Qualify opinion

1. Sue only me 2. Shared opinion 3. Want no responsibility Still clean opinion with modified wording

Which of the following ordinarily involves the addition of an emphasis-of-matter paragraph to an audit report of a nonpublic company?

A consistency modification.

Which of the following is least likely to result in inclusion of an additional paragraph being added to an audit report?

A decision not to confirm accounts receivable.

Simulation You are working on your firm's fifth audit of SSC. The previous audits have all resulted in standard unqualified audit reports. Read the following write-up from your audit files concerning SSC and its industry, and then reply to the questions that follow. Company Information In 20X1, Gary Sherwood founded Sherwood Stone Company (SSC). In the middle of its second year of existence, the company completed development of a large extraction pit area and constructed an aggregate processing plant that is equipped to crush, screen, and wash aggregate products. By 20X4, the sand and gravel operation was profitable and growing market conditions justified modifications and expansion. Currently, SSC produces a wide range of sand and stone products from its pit near Bisbee, Arizona. The materials it develops are composed of sand and stone materials for commercial construction and highway projects. SSC sells to a wide variety of commercial and governmental customers, with only one of its numerous customers—Wingo Corporation—accounting for more than 5 percent of total sales. In total, Wingo has represented approximately 30 percent of sales (and receivables) for the past few years. Wingo Corporation is by far Arizona's largest street and road contractor and seems solid financially. Virtually all of SSC's sales are on credit, although all but the smallest contracts require "progress" billings that result in payment being received by SSC on a pro rata basis with delivery of materials to the customer. Payments from customers are made directly to the company's lockbox system with SSC's local bank. All transactions occur in U.S. dollars, and SSC maintains both a general checking account and a payroll account. SSC has worked closely with Wingo Corporation in developing a superior road paving product ("QuietRide"). Not only is the car ride relatively quiet on QuietRide roads, but it is also relatively cool (thus lengthening the life of automobile tires) and less likely to lead to cars sliding in rainy conditions. Although Wingo Corporation holds the overall patent, SSC has patented a critical component that is used in the product (the component is "QSand"). The product now accounts for approximately 25 percent of the company's sales (all to Wingo Corporation) and 33 percent of its profits. The success of QSand has led SSC to start developing another product, QDeck. QDeck will be a final finishing coat over the pool deck—the concrete walking and lounging area that surrounds a swimming pool. QDeck is intended to address two problems: (1) individuals slipping and falling on pool decks while walking with wet feet and (2) individuals burning their feet on the deck on particularly hot days. Gary indicates that the current compound seems to allow good traction and decks remain much cooler than with products of other companies. The problem being addressed at this point is that the current compound seems to crack easily and has a relatively short useful life. Indeed, in one test of the product on the deck at Gary's home, Gary's wife Madonna cut her foot on one of the cracks and required several stitches to close the wound. Gary laughed and said that at least she didn't slip or burn her feet on that hot day when it happened. More seriously, he suggested that this deficiency is currently being worked on and must be solved before the product goes to market. The product is being independently developed and is intended for both residential and commercial markets. In 20X8, the company experienced a level of profitability just slightly above that of 20X7—but this was well below the net incomes of the preceding few years. Gary suggested to you that, surprisingly, intense price competition from several smaller competitors in the Bisbee area caused the somewhat low level of profitability. But, he added, he didn't expect the problem to last for long because he doubted that those companies could continue to operate selling at those lower prices. Gary had hoped for a more profitable year in 20X8, as a significant amount of the company's long-term debt is payable in 20X9. SSC is currently involved in discussions with the bank on refinancing. Page 442 SSC added significant additional crushing and washing plant and equipment during 20X8 to increase production in the future by more than 100 percent while expanding capabilities to produce custom specification materials. No dividends have been paid during the past two years, although previously most of the earnings were distributed through dividends to SSC's five shareholders—CEO and Chair of the Board of Directors Gary Sherwood, his wife Madonna Sherwood, CFO Jane Zhan, and two college friends of Gary's who invested in the company, Cindy Stone and Kelly Higgins. These five individuals make up the company's board of directors. The Bank of Arizona is the financial institution with which SSC maintains its two cash accounts (general and payroll cash accounts) and from which it obtains a significant portion of its financing; the inventories are pledged on the Bank of Arizona loan. This year, in reaction to pressure from the bank, SSC established an audit committee composed of Madonna Sherwood, Cindy Stone, and Kelly Higgins. Industry Information The industry activities consist of the extraction and preparation of sand and rock products. These activities include the cleaning, separating, and sorting of quarried sand and the process of crushing rocks. The products are in the form of sand used in making concrete; sand used in laying bricks (which contains little soil); sand used for fill (which contains a large amount of soil); and quartz sand. It excludes the products of gravel quarrying (sandstone, gravel stone, and iron sand). While sales within the industry are relatively unaffected by changes in technology or obsolescence, industry sales rely heavily upon both the residential and commercial construction markets as well as government spending. During the past five years, construction has performed well and that trend is expected to continue for at least the next several years. Sand and gravel production has increased at approximately 4 percent per year during this time period, as has construction within the central Arizona area. Which of the following correctly identifies a risk facing SSC that might adversely affect sales during the coming years?

A general slowdown in the economy.

A material weakness is a control deficiency (or combination of control deficiencies) that results in a reasonable possibility that a misstatement of at least what amount will not be prevented or detected?

A material amount

To test the existence assertion for recorded receivables, the auditors would select a sample from the:

Accounts receivable subsidiary ledger.

Standard Confirmation Form

Addresses only client's deposit and loan balances

Related Party Transactions

All must be disclosed!

Electronic Data Interchange (EDI)

Allows funds to be transferred between businesses

Board Meeting Minutes

Always read, Pay most attention to special minutes

11-28: In their work on accounts receivable and elsewhere in an audit, the independent auditors often make use of confirmation requests. What is an audit confirmation request? What characteristics should an audit confirmation response possess if a CPA firm is to consider it to be valid evidence? Distinguish between a positive confirmation request and a negative confirmation request in the auditors' examination of accounts receivable. In confirming a client's accounts receivable, what characteristics should be present in the accounts if the CPA firm is to use negative confirmations?

Always want to hear back either way

The auditors who wish to draw reader attention to a financial statement note disclosure on significant transactions with related parties should disclose this fact in:

An emphasis-of-matter paragraph to the auditors' report.

Assume that the opinion paragraph of an auditors' report begins as follows: "With the explanation given in Note 6, . . . the financial statements referred to above present fairly . . ." This is:

An improper type of reporting.

A possible loss, stemming from past events that will be resolved as to existence and amounts, is referred to as a(n):

Analytical process.

The auditors should confirm accounts receivable unless the auditors' assessment of the risk of material misstatement is low:

And accounts receivable are immaterial, or the use of confirmations would be ineffective.

An audit of internal control over financial reporting ordinarily assesses internal control:

As of the last day of the fiscal period.

10-31: In the audit of a client with a fiscal year ending December 31, the CPAs obtain a January 10 bank statement directly from the bank. Explain how this cutoff bank statement will be used In the review of the December 31 bank reconciliation. To obtain other audit information.

Ask for bank cutoff statement (Extra 10 days after)

Which of the following would provide the most assurance concerning the valuation of accounts receivable?

Assess the allowance for uncollectible accounts for reasonableness.

Projected Misstatements

Audit sampling used to draw conclusion about general population

Report Release Date

Auditors grant client permission to use audit report

The auditors' report should be dated as of the date the:

Auditors have accumulated sufficient appropriate evidence.

S-1 Review

Auditors return after effective date of registration for new securities issued

Voucher

Authorization sheet providing space for initials of employees for various functions

Substantive Procedures in Internal Control Audit

Can be lessened if have good internal controls

Unmodified Opinion

Can have going concern or change in principles applied either in emphasis of matter or explanatory (public) paragraph

Control Deficiency

Cannot prevent or detect misstatements on a timely basis

When auditing the statement of cash flows, which of the following would an auditor not expect to be a source of receipts and payments?

Capitalization.

Presentation of Cash

Cash Equivalent or Not?; Available for Use?

Window Dressing

Cash at end of year not deposited is an example Okay if not misleading

10-40: Items a through l represent possible errors and fraud that you suspect may be present at Rex Company. The accompanying List of Auditing Procedures represents procedures that the auditor would consider performing to gather evidence concerning possible errors and fraud. For each item, select one or two procedures, as indicated, that the auditor most likely would perform to gather evidence in support of that item. The procedures on the list may be selected once, more than once, or not at all. The entity's cash receipts of the first few days of the subsequent year were properly deposited in its general operating account after the year-end. However, the auditor suspects that the entity recorded the cash receipts in its books during the last week of the year under audit.

Compare the details of the cash receipts journal entries with the details of the corresponding daily deposit slips.

10-40: Items a through l represent possible errors and fraud that you suspect may be present at Rex Company. The accompanying List of Auditing Procedures represents procedures that the auditor would consider performing to gather evidence concerning possible errors and fraud. For each item, select one or two procedures, as indicated, that the auditor most likely would perform to gather evidence in support of that item. The procedures on the list may be selected once, more than once, or not at all. The auditor suspects that a lapping scheme exists because an accounting department employee who has access to cash receipts also maintains the accounts receivable ledger and refuses to take any vacation or sick days.

Compare the details of the cash receipts journal entries with the details of the corresponding daily deposit slips. Send requests to confirm the entity's accounts receivable on a surprise basis at an interim date.

Statement of Cash Flows

Compare to findings on other statements

Proof of Cash

Comparing month to month with withdrawals and deposits Reconciles cash transactions occurring during a specified period

Simulation You are working on your firm's fifth audit of SSC. The previous audits have all resulted in standard unqualified audit reports. Read the following write-up from your audit files concerning SSC and its industry, and then reply to the questions that follow. Company Information In 20X1, Gary Sherwood founded Sherwood Stone Company (SSC). In the middle of its second year of existence, the company completed development of a large extraction pit area and constructed an aggregate processing plant that is equipped to crush, screen, and wash aggregate products. By 20X4, the sand and gravel operation was profitable and growing market conditions justified modifications and expansion. Currently, SSC produces a wide range of sand and stone products from its pit near Bisbee, Arizona. The materials it develops are composed of sand and stone materials for commercial construction and highway projects. SSC sells to a wide variety of commercial and governmental customers, with only one of its numerous customers—Wingo Corporation—accounting for more than 5 percent of total sales. In total, Wingo has represented approximately 30 percent of sales (and receivables) for the past few years. Wingo Corporation is by far Arizona's largest street and road contractor and seems solid financially. Virtually all of SSC's sales are on credit, although all but the smallest contracts require "progress" billings that result in payment being received by SSC on a pro rata basis with delivery of materials to the customer. Payments from customers are made directly to the company's lockbox system with SSC's local bank. All transactions occur in U.S. dollars, and SSC maintains both a general checking account and a payroll account. SSC has worked closely with Wingo Corporation in developing a superior road paving product ("QuietRide"). Not only is the car ride relatively quiet on QuietRide roads, but it is also relatively cool (thus lengthening the life of automobile tires) and less likely to lead to cars sliding in rainy conditions. Although Wingo Corporation holds the overall patent, SSC has patented a critical component that is used in the product (the component is "QSand"). The product now accounts for approximately 25 percent of the company's sales (all to Wingo Corporation) and 33 percent of its profits. The success of QSand has led SSC to start developing another product, QDeck. QDeck will be a final finishing coat over the pool deck—the concrete walking and lounging area that surrounds a swimming pool. QDeck is intended to address two problems: (1) individuals slipping and falling on pool decks while walking with wet feet and (2) individuals burning their feet on the deck on particularly hot days. Gary indicates that the current compound seems to allow good traction and decks remain much cooler than with products of other companies. The problem being addressed at this point is that the current compound seems to crack easily and has a relatively short useful life. Indeed, in one test of the product on the deck at Gary's home, Gary's wife Madonna cut her foot on one of the cracks and required several stitches to close the wound. Gary laughed and said that at least she didn't slip or burn her feet on that hot day when it happened. More seriously, he suggested that this deficiency is currently being worked on and must be solved before the product goes to market. The product is being independently developed and is intended for both residential and commercial markets. In 20X8, the company experienced a level of profitability just slightly above that of 20X7—but this was well below the net incomes of the preceding few years. Gary suggested to you that, surprisingly, intense price competition from several smaller competitors in the Bisbee area caused the somewhat low level of profitability. But, he added, he didn't expect the problem to last for long because he doubted that those companies could continue to operate selling at those lower prices. Gary had hoped for a more profitable year in 20X8, as a significant amount of the company's long-term debt is payable in 20X9. SSC is currently involved in discussions with the bank on refinancing. Page 442 SSC added significant additional crushing and washing plant and equipment during 20X8 to increase production in the future by more than 100 percent while expanding capabilities to produce custom specification materials. No dividends have been paid during the past two years, although previously most of the earnings were distributed through dividends to SSC's five shareholders—CEO and Chair of the Board of Directors Gary Sherwood, his wife Madonna Sherwood, CFO Jane Zhan, and two college friends of Gary's who invested in the company, Cindy Stone and Kelly Higgins. These five individuals make up the company's board of directors. The Bank of Arizona is the financial institution with which SSC maintains its two cash accounts (general and payroll cash accounts) and from which it obtains a significant portion of its financing; the inventories are pledged on the Bank of Arizona loan. This year, in reaction to pressure from the bank, SSC established an audit committee composed of Madonna Sherwood, Cindy Stone, and Kelly Higgins. Industry Information The industry activities consist of the extraction and preparation of sand and rock products. These activities include the cleaning, separating, and sorting of quarried sand and the process of crushing rocks. The products are in the form of sand used in making concrete; sand used in laying bricks (which contains little soil); sand used for fill (which contains a large amount of soil); and quartz sand. It excludes the products of gravel quarrying (sandstone, gravel stone, and iron sand). While sales within the industry are relatively unaffected by changes in technology or obsolescence, industry sales rely heavily upon both the residential and commercial construction markets as well as government spending. During the past five years, construction has performed well and that trend is expected to continue for at least the next several years. Sand and gravel production has increased at approximately 4 percent per year during this time period, as has construction within the central Arizona area. Which of the following correctly identifies a risk facing SSC that might affect its ability to continue as a going concern over the long run?

Competition from several competitors.

Which assertion relating to sales is most directly addressed when the auditors compare a sample of shipping documents to related sales invoices?

Completeness.

10-40: Items a through l represent possible errors and fraud that you suspect may be present at Rex Company. The accompanying List of Auditing Procedures represents procedures that the auditor would consider performing to gather evidence concerning possible errors and fraud. For each item, select one or two procedures, as indicated, that the auditor most likely would perform to gather evidence in support of that item. The procedures on the list may be selected once, more than once, or not at all. The entity borrowed funds from a financial institution. Although the transaction was properly recorded, the auditor suspects that the loan created a lien on the entity's real estate that is not disclosed in its financial statements.

Confirm the terms of borrowing arrangements with the lender.

As a result of analytical procedures, the independent auditors determine that the gross profit percentage has declined from 30 percent in the preceding year to 20 percent in the current year. The auditors should:

Consider the possibility of a misstatement in the financial statements.

Management's documentation of internal control ordinarily should include information on:

Controls designed to prevent fraud

Existence of Cash

Count; Do they care enough

Valuation of Cash

Counting

Which of the following is most likely to be considered a Type 1 subsequent event?

Customer checks deposited prior to year-end but determined to be uncollectible after year-end.

The search for unrecorded liabilities for a public company includes procedures usually performed through the:

Date of the auditors' report.

Under SEC rules, which of the following is not among the criteria that ordinarily exist for revenue to be recognized?

Delivery has occurred or is scheduled to occur in the near future.

Simulation You are working on your firm's fifth audit of SSC. The previous audits have all resulted in standard unqualified audit reports. Read the following write-up from your audit files concerning SSC and its industry, and then reply to the questions that follow. Company Information In 20X1, Gary Sherwood founded Sherwood Stone Company (SSC). In the middle of its second year of existence, the company completed development of a large extraction pit area and constructed an aggregate processing plant that is equipped to crush, screen, and wash aggregate products. By 20X4, the sand and gravel operation was profitable and growing market conditions justified modifications and expansion. Currently, SSC produces a wide range of sand and stone products from its pit near Bisbee, Arizona. The materials it develops are composed of sand and stone materials for commercial construction and highway projects. SSC sells to a wide variety of commercial and governmental customers, with only one of its numerous customers—Wingo Corporation—accounting for more than 5 percent of total sales. In total, Wingo has represented approximately 30 percent of sales (and receivables) for the past few years. Wingo Corporation is by far Arizona's largest street and road contractor and seems solid financially. Virtually all of SSC's sales are on credit, although all but the smallest contracts require "progress" billings that result in payment being received by SSC on a pro rata basis with delivery of materials to the customer. Payments from customers are made directly to the company's lockbox system with SSC's local bank. All transactions occur in U.S. dollars, and SSC maintains both a general checking account and a payroll account. SSC has worked closely with Wingo Corporation in developing a superior road paving product ("QuietRide"). Not only is the car ride relatively quiet on QuietRide roads, but it is also relatively cool (thus lengthening the life of automobile tires) and less likely to lead to cars sliding in rainy conditions. Although Wingo Corporation holds the overall patent, SSC has patented a critical component that is used in the product (the component is "QSand"). The product now accounts for approximately 25 percent of the company's sales (all to Wingo Corporation) and 33 percent of its profits. The success of QSand has led SSC to start developing another product, QDeck. QDeck will be a final finishing coat over the pool deck—the concrete walking and lounging area that surrounds a swimming pool. QDeck is intended to address two problems: (1) individuals slipping and falling on pool decks while walking with wet feet and (2) individuals burning their feet on the deck on particularly hot days. Gary indicates that the current compound seems to allow good traction and decks remain much cooler than with products of other companies. The problem being addressed at this point is that the current compound seems to crack easily and has a relatively short useful life. Indeed, in one test of the product on the deck at Gary's home, Gary's wife Madonna cut her foot on one of the cracks and required several stitches to close the wound. Gary laughed and said that at least she didn't slip or burn her feet on that hot day when it happened. More seriously, he suggested that this deficiency is currently being worked on and must be solved before the product goes to market. The product is being independently developed and is intended for both residential and commercial markets. In 20X8, the company experienced a level of profitability just slightly above that of 20X7—but this was well below the net incomes of the preceding few years. Gary suggested to you that, surprisingly, intense price competition from several smaller competitors in the Bisbee area caused the somewhat low level of profitability. But, he added, he didn't expect the problem to last for long because he doubted that those companies could continue to operate selling at those lower prices. Gary had hoped for a more profitable year in 20X8, as a significant amount of the company's long-term debt is payable in 20X9. SSC is currently involved in discussions with the bank on refinancing. Page 442 SSC added significant additional crushing and washing plant and equipment during 20X8 to increase production in the future by more than 100 percent while expanding capabilities to produce custom specification materials. No dividends have been paid during the past two years, although previously most of the earnings were distributed through dividends to SSC's five shareholders—CEO and Chair of the Board of Directors Gary Sherwood, his wife Madonna Sherwood, CFO Jane Zhan, and two college friends of Gary's who invested in the company, Cindy Stone and Kelly Higgins. These five individuals make up the company's board of directors. The Bank of Arizona is the financial institution with which SSC maintains its two cash accounts (general and payroll cash accounts) and from which it obtains a significant portion of its financing; the inventories are pledged on the Bank of Arizona loan. This year, in reaction to pressure from the bank, SSC established an audit committee composed of Madonna Sherwood, Cindy Stone, and Kelly Higgins. Industry Information The industry activities consist of the extraction and preparation of sand and rock products. These activities include the cleaning, separating, and sorting of quarried sand and the process of crushing rocks. The products are in the form of sand used in making concrete; sand used in laying bricks (which contains little soil); sand used for fill (which contains a large amount of soil); and quartz sand. It excludes the products of gravel quarrying (sandstone, gravel stone, and iron sand). While sales within the industry are relatively unaffected by changes in technology or obsolescence, industry sales rely heavily upon both the residential and commercial construction markets as well as government spending. During the past five years, construction has performed well and that trend is expected to continue for at least the next several years. Sand and gravel production has increased at approximately 4 percent per year during this time period, as has construction within the central Arizona area. Which of the following represents a correct statement concerning the risk of misappropriation of cash for SSC?

Deposit of cash into a lockbox system decreases the risk of misappropriation.

Compensating Balance

Designated minimum

Subsequent to the issuance of the auditor's report, the auditor became aware of facts existing at the report date that would have affected the report had the auditor then been aware of such facts. After determining that the information is reliable, the auditor should next:

Determine whether there are persons relying or likely to rely on the financial statements who would attach importance to the information.

Judgmental Misstatement

Differences between estimates of auditors and management

Other-Matter Paragraph

Disclaiming

10-26: Fluid Controls, Inc., a manufacturing company, has retained you to perform an audit for the year ended December 31. Prior to the year-end, you begin to obtain an understanding of the new client's controls over business processes related to the cash account. You find that nearly all the company's cash receipts are in the form of checks received through the mail, but there is no prelisting of cash receipts before they are recorded in the accounts. Also, the incoming mail is opened either by the cashier or by the employee maintaining the accounts receivable subsidiary ledger, depending on which employee has time available. The controller stresses the necessity of flexibility in assignment of duties to the 20 employees comprising the office staff, in order to keep all employees busy and achieve maximum economy of operation. Required: Explain how prelisting of cash receipts strengthens internal control. List specific duties that should not be performed by an employee assigned to prelist the cash receipts in order to avoid any opportunity for that employee to conceal embezzlement of cash receipts.

Don't want cash or checks coming directly into office.

Simulation You are working on your firm's fifth audit of SSC. The previous audits have all resulted in standard unqualified audit reports. Read the following write-up from your audit files concerning SSC and its industry, and then reply to the questions that follow. Company Information In 20X1, Gary Sherwood founded Sherwood Stone Company (SSC). In the middle of its second year of existence, the company completed development of a large extraction pit area and constructed an aggregate processing plant that is equipped to crush, screen, and wash aggregate products. By 20X4, the sand and gravel operation was profitable and growing market conditions justified modifications and expansion. Currently, SSC produces a wide range of sand and stone products from its pit near Bisbee, Arizona. The materials it develops are composed of sand and stone materials for commercial construction and highway projects. SSC sells to a wide variety of commercial and governmental customers, with only one of its numerous customers—Wingo Corporation—accounting for more than 5 percent of total sales. In total, Wingo has represented approximately 30 percent of sales (and receivables) for the past few years. Wingo Corporation is by far Arizona's largest street and road contractor and seems solid financially. Virtually all of SSC's sales are on credit, although all but the smallest contracts require "progress" billings that result in payment being received by SSC on a pro rata basis with delivery of materials to the customer. Payments from customers are made directly to the company's lockbox system with SSC's local bank. All transactions occur in U.S. dollars, and SSC maintains both a general checking account and a payroll account. SSC has worked closely with Wingo Corporation in developing a superior road paving product ("QuietRide"). Not only is the car ride relatively quiet on QuietRide roads, but it is also relatively cool (thus lengthening the life of automobile tires) and less likely to lead to cars sliding in rainy conditions. Although Wingo Corporation holds the overall patent, SSC has patented a critical component that is used in the product (the component is "QSand"). The product now accounts for approximately 25 percent of the company's sales (all to Wingo Corporation) and 33 percent of its profits. The success of QSand has led SSC to start developing another product, QDeck. QDeck will be a final finishing coat over the pool deck—the concrete walking and lounging area that surrounds a swimming pool. QDeck is intended to address two problems: (1) individuals slipping and falling on pool decks while walking with wet feet and (2) individuals burning their feet on the deck on particularly hot days. Gary indicates that the current compound seems to allow good traction and decks remain much cooler than with products of other companies. The problem being addressed at this point is that the current compound seems to crack easily and has a relatively short useful life. Indeed, in one test of the product on the deck at Gary's home, Gary's wife Madonna cut her foot on one of the cracks and required several stitches to close the wound. Gary laughed and said that at least she didn't slip or burn her feet on that hot day when it happened. More seriously, he suggested that this deficiency is currently being worked on and must be solved before the product goes to market. The product is being independently developed and is intended for both residential and commercial markets. In 20X8, the company experienced a level of profitability just slightly above that of 20X7—but this was well below the net incomes of the preceding few years. Gary suggested to you that, surprisingly, intense price competition from several smaller competitors in the Bisbee area caused the somewhat low level of profitability. But, he added, he didn't expect the problem to last for long because he doubted that those companies could continue to operate selling at those lower prices. Gary had hoped for a more profitable year in 20X8, as a significant amount of the company's long-term debt is payable in 20X9. SSC is currently involved in discussions with the bank on refinancing. Page 442 SSC added significant additional crushing and washing plant and equipment during 20X8 to increase production in the future by more than 100 percent while expanding capabilities to produce custom specification materials. No dividends have been paid during the past two years, although previously most of the earnings were distributed through dividends to SSC's five shareholders—CEO and Chair of the Board of Directors Gary Sherwood, his wife Madonna Sherwood, CFO Jane Zhan, and two college friends of Gary's who invested in the company, Cindy Stone and Kelly Higgins. These five individuals make up the company's board of directors. The Bank of Arizona is the financial institution with which SSC maintains its two cash accounts (general and payroll cash accounts) and from which it obtains a significant portion of its financing; the inventories are pledged on the Bank of Arizona loan. This year, in reaction to pressure from the bank, SSC established an audit committee composed of Madonna Sherwood, Cindy Stone, and Kelly Higgins. Industry Information The industry activities consist of the extraction and preparation of sand and rock products. These activities include the cleaning, separating, and sorting of quarried sand and the process of crushing rocks. The products are in the form of sand used in making concrete; sand used in laying bricks (which contains little soil); sand used for fill (which contains a large amount of soil); and quartz sand. It excludes the products of gravel quarrying (sandstone, gravel stone, and iron sand). While sales within the industry are relatively unaffected by changes in technology or obsolescence, industry sales rely heavily upon both the residential and commercial construction markets as well as government spending. During the past five years, construction has performed well and that trend is expected to continue for at least the next several years. Sand and gravel production has increased at approximately 4 percent per year during this time period, as has construction within the central Arizona area. In addition to the risk factor identified in the preceding question, another risk factor relating to misstatements arising from fraudulent financial reporting is:

Earnings this year are lower than management had hoped.

For each of the following brief scenarios, assume that you are reporting on a client's financial statements. Reply as to the type(s) of opinion possible for the scenario. In addition: Unless stated otherwise, assume the matter involved is material. If the problem does not state that a misstatement (or possible misstatement) is pervasive, assume that it may or may not be pervasive (thus, the appropriate reply may include two possible reports). Do not read more into the circumstance than what is presented. Page 742 Do not consider an auditor discretionary circumstance for modification of the audit report unless the situation explicitly suggests that the auditors wish to emphasize a particular matter. Report Types may be used once, more than once, or not at all. Slade Company has material investments in stocks of subsidiary companies. Stocks of the subsidiary companies are actively traded in the market. Management insists that all investments be carried at original costs, and the CPA firm is satisfied that the original costs are accurate. The CPA firm believes that the client will never ultimately realize a substantial portion of the investments because the market value is much lower than the cost; the client has fully disclosed the facts in notes to the financial statements.

Either qualified or adverse

For each of the following brief scenarios, assume that you are reporting on a client's financial statements. Reply as to the type(s) of opinion possible for the scenario. In addition: Unless stated otherwise, assume the matter involved is material. If the problem does not state that a misstatement (or possible misstatement) is pervasive, assume that it may or may not be pervasive (thus, the appropriate reply may include two possible reports). Do not read more into the circumstance than what is presented. Page 742 Do not consider an auditor discretionary circumstance for modification of the audit report unless the situation explicitly suggests that the auditors wish to emphasize a particular matter. Report Types may be used once, more than once, or not at all. Draves Company owns substantial properties that have appreciated significantly in value since the date of purchase. The properties were appraised and are reported in the balance sheet at the appraised values (which materially exceed costs) with related disclosures. The CPAs believe that the appraised values reported in the balance sheet reasonably estimate the assets' current values.

Either qualified or adverse (didn't follow GAAP)

For each of the following brief scenarios, assume that you are reporting on a client's financial statements. Reply as to the type(s) of opinion possible for the scenario. In addition: Unless stated otherwise, assume the matter involved is material. If the problem does not state that a misstatement (or possible misstatement) is pervasive, assume that it may or may not be pervasive (thus, the appropriate reply may include two possible reports). Do not read more into the circumstance than what is presented. Page 742 Do not consider an auditor discretionary circumstance for modification of the audit report unless the situation explicitly suggests that the auditors wish to emphasize a particular matter. Report Types may be used once, more than once, or not at all. During the audit of Eagle Company, the CPA firm has encountered a significant scope limitation relating to inventory record availability and is unable to obtain sufficient appropriate audit evidence in that area.

Either qulified or disclaimer

Channel Stuffing

Encouraging customers to buy more inventory than they could resell

10-40: Items a through l represent possible errors and fraud that you suspect may be present at Rex Company. The accompanying List of Auditing Procedures represents procedures that the auditor would consider performing to gather evidence concerning possible errors and fraud. For each item, select one or two procedures, as indicated, that the auditor most likely would perform to gather evidence in support of that item. The procedures on the list may be selected once, more than once, or not at all. The auditor suspects that vouchers were prepared and processed by an accounting department employee for merchandise that was neither ordered nor received by the entity.

Examine the supporting purchase orders and receiving reports for selected paid vouchers.

Management Assertions for Cash and Receivables

Existence vs Completeness

The aggregated misstatement in the financial statements is made up of:

Factual, Projected, and Judgmental

An auditor accepted an engagement to audit the 20X8 financial statements of EFG Corporation and began the fieldwork on September 30, 20X8. EFG gave the auditor the 20X8 financial statements on January 17, 20X9. The auditor completed the audit on February 10, 20X9, and delivered the report on February 16, 20X9. The client's representation letter normally would be dated:

February 10, 20X9. Same as date of audit report

The CPA firm of Carson & Boggs LLP is performing an internal control audit in accordance with PCAOB AS 2201. The partner in charge of the engagement has asked you to explain the process of determining which controls to test. Describe the process, presenting each of the links in this process and a short summary of how the auditors approach each of them.

Financial Statements Accounts Transactions

Probable or Likely Contingencies

Financial Statements if can estimate amount Notes if don't know amount Only book deductible if have insurance and disclose additional information in notes

Top-down Approach

Financial statement, then accounts, then transactions

Internal Control of Financial Investments

Formal investment policies, Investment committee, Separation of duties, Provisions and terms, Registration, Physical inspection, Complex financial insturments

Lapping

Found often when comparing details of sample of cash receipts listings to cash receipts journal, accounts receivable postings, and authenticated deposit slips Should not allow employee to both collect and post on accounts

An audit report for a public client indicates that the financial statements were prepared in conformity with:

Generally accepted accounting principles (United States).

10-5: Explain how a lockbox system contributes to internal control over cash receipts.

Gets to the bank faster. Not through employees. Need two people to access.

16-44: Your client is a company that owns a shopping center with 30 store tenants. All leases with the store tenants provide for a fixed rent plus a percentage of sales, net of sales taxes, in excess of a fixed dollar amount computed on an annual basis. Each lease also provides that the lessor may engage CPAs to audit all records of the tenant for assurance that sales are being properly reported to the lessor. You have been requested by your client to audit the records of Traders Restaurant to determine that the sales totaling $390,000 for the year ended December 31, 20X2, have been properly reported to the lessor. The restaurant and the shopping center entered into a five-year lease on January 1, 20X1. Traders Restaurant offers only table service; no liquor is served. During mealtimes, there are four or five waiters and waitresses in attendance who prepare handwritten prenumbered restaurant checks for the customers. Payment is made at a cash register, operated by the proprietor, as the customer leaves. All sales are for cash. The proprietor also is the accountant. Complete files are kept of restaurant checks and cash register tapes. A daily sales journal and general ledger are also maintained. List the auditing procedures that you would employ to verify the total annual sales of Traders Restaurant.

Good internal control to have proprietor run cash register, but can lie to owner of shopping center. Prenumbered checks allow evaluation of completeness. Ash only is risky because may be trying to avoid taxes. Compare all other records to each other. Can compare inventory to sales.

FASB Revenue Recognition Standard

Identify contract, Identify performance obligation, Determine transaction price, Allocate transaction price to performance obligations, Recognize revenue when performance obligations are satisfied

Material Weakness

If known, cannot give clean opinion Reasonable possibility material misstatement will not be prevented or detected on timely basis

16-27: In your audit of the financial statements of Wolfe Company for the year ended April 30, you find that a material account receivable is due from a company in reorganization under Chapter 11 of the Bankruptcy Act. You also learn that on May 28 several former members of the bankrupt company's management formed a new company and that the new company had issued a note to Wolfe Company that would pay off the bankrupt customer's account receivable over a four-year period. What presentation, if any, should be made of this situation in the financial statements of Wolfe Company for the year ended April 30? Explain.

If numbers aren't real, then adjust. If will affect future business, then footnote. If not going to influence or readily available, then ignore. They are now receiving a long-term receivable in place of a short-term current asset. Is it collectible?

Petty Cash Funds

Immaterial often so auditors care more about process than end amount

Which of the following is most likely to be considered a material weakness in internal control?

Ineffective oversight of financial reporting by the audit committee.

Which of the following would most likely be detected by an auditor's review of the client's sales cutoff?

Inflated sales for the year.

Auditors' Objectives for Cash

Inherent Risks, Internal Control, Assess Risk and Design FAP (Existence and Occurrence, Accuracy, Completeness, Cutoff, Rights, Presentation and Disclosure)

Supplementary Information Steps

Inquire, Compare, Obtain Written Representation

Fidelity Bonds

Insurance on actions of trusted employees

Integrated Audit Reporting

Internal Control audit should be dated last day of fiscal year (as of date) Internal control of financial statements is for period

Format of AICPA Current

Introduction, Auditors' Responsibilities, Management's Responsibilities

Adverse Opinion

Know something is wrong (big elephant), so must say wrong Materially misstated, do not present fairly, failure to follow GAAP

In an integrated audit, which of the following must the auditors communicate to the audit committee?

Known Material Weaknesses and Known Significant Deficiencies

In an integrated audit, which of the following must be communicated by management to the audit committee?

Known material weaknesses and known significant deficiencies

In an integrated audit, which of the following lead(s) to an adverse opinion on internal control?

Known material weaknesses only

Boilerplate Language

Lacks transparency. Don't understand and not enough information.

Unasserted Claims

List of potential litigation that have not yet been acted upon Counsel does not have to tell auditor but should tell client to tell auditor and consider resigning if will not

Which of the following is the best way for the auditors to determine that every name on a company's payroll is that of a bona fide employee presently on the job?

Make a surprise observation of the company's regular distribution of paychecks on a test basis Not real-life procedure

10-40: Items a through l represent possible errors and fraud that you suspect may be present at Rex Company. The accompanying List of Auditing Procedures represents procedures that the auditor would consider performing to gather evidence concerning possible errors and fraud. For each item, select one or two procedures, as indicated, that the auditor most likely would perform to gather evidence in support of that item. The procedures on the list may be selected once, more than once, or not at all. The auditor suspects that selected employees of the entity received unauthorized raises from the entity's payroll supervisor, who has access to payroll records.

Make inquiries of the entity's attorney concerning the details of real estate transactions.

Which of the following need not be included in management's report on internal control under Section 404(a) of the Sarbanes-Oxley Act of 2002?

Management's acknowledgment of its responsibility to establish and maintain internal control that detects all significant deficiencies.

Which of the following is defined as a weakness in internal control that allows a reasonable possibility of a misstatement that is material?

Material weakness.

Major Classes of Transactions

Materially affect significant financial statement accounts

Possible Contingencies

Most likely scenario because lawyers don't want it to look like the company is giving up Carefully worded in the notes

Critical Audit Matters

Must be communicated to audit committee Needs to relate to material account Key Audit Matters are the international version

Significant Deficiencies

Must be communicated to audit committee at a minimum Less severe yet merits attention

Unmodified Opinions

Must include going concern and principle used changes Optional to include related parties, contingencies, subsequent events

Title of Auditors' Report

Must include the word "independent"

10-28: During the first few months of the year, John Smith, the cashier in a small company, was engaged in lapping operations. However, he was able to restore the amount of cash "borrowed" by March 31, and he refrained from any fraudulent acts after that date. Will the year-end audit probably lead to the discovery of his lapping activities? Explain.

Need more bodies, vacations. Probably not going to find as auditors.

Section 404

Need to know by number a. Regular report of public company b. Report integrated if over 75 million

Factual Misstatement

No doubt

11-30: Lakeside Company has retained you to conduct an audit so that it will be able to support its application for a bank loan with audited financial statements. The president of Lakeside states that you will have unlimited access to all records of the company and may carry out any audit procedures you consider necessary, except that you are not to communicate with customers. The president feels that contacts with customers might lead them to believe that Lakeside is in financial difficulty. Under these circumstances, will it be possible for you to issue the auditors' standard unqualified audit report? Explain.

No, we cannot give a clean opinion if we cannot do all procedures Confirmation #5: #5 - verify internal control to see where checks are being deposited (lapping, error) #22 - what is the procedure for cancelled orders; shipping and receiving document (going concern) #47 - Client and company should be able to view balance; second request #51 - nothing #62 - how to find out clients' addresses #68 - what is the process of receiving checks and depositing them #72 - #77 - what about the other $8,000 #79 -

For each of the following brief scenarios, assume that you are reporting on a client's financial statements. Reply as to the type(s) of opinion possible for the scenario. In addition: Unless stated otherwise, assume the matter involved is material. If the problem does not state that a misstatement (or possible misstatement) is pervasive, assume that it may or may not be pervasive (thus, the appropriate reply may include two possible reports). Do not read more into the circumstance than what is presented. Page 742 Do not consider an auditor discretionary circumstance for modification of the audit report unless the situation explicitly suggests that the auditors wish to emphasize a particular matter. Report Types may be used once, more than once, or not at all. London Company has material investments in stocks of subsidiary companies. Stocks of the subsidiary companies are not actively traded in the market, and the CPA firm's engagement does not extend to any subsidiary company. The CPA firm is able to determine that all investments are carried at original cost but has no real idea of market value. Although the difference between cost and market could be material, it could not have a pervasive effect on the overall financial statements.

Not publicly traded - carried at cost Qualify because with closely-related party

What type or types of audit opinion are appropriate when financial statements are materially and pervasively misstated?

Not qualified, but yes adverse

When the matter is properly disclosed in the financial statements of a nonpublic company, the likely result of substantial doubt about the ability of the client to continue as a going concern is the issuance of which of the following audit opinions?

Not qualified, yes adverse

In an audit report on combined financial statements, reference to the fact that a portion of the audit was performed by a component auditor is:

Not to be construed as a qualification, but rather as a division of responsibility between the two CPA firms.

10-40: Items a through l represent possible errors and fraud that you suspect may be present at Rex Company. The accompanying List of Auditing Procedures represents procedures that the auditor would consider performing to gather evidence concerning possible errors and fraud. For each item, select one or two procedures, as indicated, that the auditor most likely would perform to gather evidence in support of that item. The procedures on the list may be selected once, more than once, or not at all. The auditor suspects that fictitious employees have been placed on the payroll by the entity's payroll supervisor, who has access to payroll records and to the paychecks.

Observe payroll check distribution on a surprise basis.

10-40: Items a through l represent possible errors and fraud that you suspect may be present at Rex Company. The accompanying List of Auditing Procedures represents procedures that the auditor would consider performing to gather evidence concerning possible errors and fraud. For each item, select one or two procedures, as indicated, that the auditor most likely would perform to gather evidence in support of that item. The procedures on the list may be selected once, more than once, or not at all. An auditor suspects that the controller wrote several checks and recorded the cash disbursements just before year-end but did not mail the checks until after the first week of the subsequent year.

Obtain the cutoff bank statement and compare the cleared checks to the year-end bank reconciliation.

Subsequent Event

Occurring after date of balance sheet but prior to date of auditors' report If no note disclosure, then can dual-date. Following audit but before release.

Rollover Approach

Only consider current year misstatements

Format of PCAOB Current

Opinion, Basis, Critical Audit Matters (varies) Must tell how long have been auditing

AICPA New

Opinion, Basis, Going Concern, Emphasis of Matter, Critical Audit Matters, Management's Responsibilities, Auditors' Responsibilities

Emphasis-of-Matter

Optional paragraph referring to subsequent event in auditors' report

Which of the following is least likely to be considered an inherent risk relating to receivables and revenues?

Over-recorded sales due to a lack of control over the sales entry function.

Unmodified

PCAOB's version of unqualified

Imprest Account

Payroll to look for ghost employees; should zero out

Which of the following procedures is most likely to be included near completion of an audit?

Performing analytical procedures.

Auditors' Role in Internal Control Audit

Plan the Engagement Use a Top-Down Approach to Identify Controls to Test Test and Evaluate Design Effectiveness Test and Evaluate Operating Effectiveness Form an Opinion on Effectiveness

Lockbox

Post office box controlled by financial institution

10-40: Items a through l represent possible errors and fraud that you suspect may be present at Rex Company. The accompanying List of Auditing Procedures represents procedures that the auditor would consider performing to gather evidence concerning possible errors and fraud. For each item, select one or two procedures, as indicated, that the auditor most likely would perform to gather evidence in support of that item. The procedures on the list may be selected once, more than once, or not at all. The auditor suspects that a kiting scheme exists because an accounting department employee who can issue and record checks seems to be leading an unusually luxurious lifestyle.

Prepare a bank transfer schedule.

10-40: Items a through l represent possible errors and fraud that you suspect may be present at Rex Company. The accompanying List of Auditing Procedures represents procedures that the auditor would consider performing to gather evidence concerning possible errors and fraud. For each item, select one or two procedures, as indicated, that the auditor most likely would perform to gather evidence in support of that item. The procedures on the list may be selected once, more than once, or not at all. The auditor suspects that the entity is inappropriately increasing the cash reported on its balance sheet by drawing a check on one account and not recording it as an outstanding check on that account and simultaneously recording it as a deposit in a second account.

Prepare a bank transfer schedule.

Letter of Inquiry

Prepared by management and sent by auditors to legal counsel to verify and expand on management's perception of litigation

Compensating Control

Prevent or detect misstatement with alternative

Significant Account

Reasonable possibility any potential misstatement could have material effect on financial statements

Which of the following is most likely to be an example of fraudulent financial reporting relating to sales?

Recording sales when the customer is likely to return the goods.

Positive Confirmations

Reply whether total receivable amount is correct and provide correct amount

Negative Confirmations

Respond only if incorrect Typically must be supported by other substantive procedures

Bill-and-Hold Transactions

Sales are received but goods are not shipped which may not meet revenue recognition

Simulation You are working on your firm's fifth audit of SSC. The previous audits have all resulted in standard unqualified audit reports. Read the following write-up from your audit files concerning SSC and its industry, and then reply to the questions that follow. Company Information In 20X1, Gary Sherwood founded Sherwood Stone Company (SSC). In the middle of its second year of existence, the company completed development of a large extraction pit area and constructed an aggregate processing plant that is equipped to crush, screen, and wash aggregate products. By 20X4, the sand and gravel operation was profitable and growing market conditions justified modifications and expansion. Currently, SSC produces a wide range of sand and stone products from its pit near Bisbee, Arizona. The materials it develops are composed of sand and stone materials for commercial construction and highway projects. SSC sells to a wide variety of commercial and governmental customers, with only one of its numerous customers—Wingo Corporation—accounting for more than 5 percent of total sales. In total, Wingo has represented approximately 30 percent of sales (and receivables) for the past few years. Wingo Corporation is by far Arizona's largest street and road contractor and seems solid financially. Virtually all of SSC's sales are on credit, although all but the smallest contracts require "progress" billings that result in payment being received by SSC on a pro rata basis with delivery of materials to the customer. Payments from customers are made directly to the company's lockbox system with SSC's local bank. All transactions occur in U.S. dollars, and SSC maintains both a general checking account and a payroll account. SSC has worked closely with Wingo Corporation in developing a superior road paving product ("QuietRide"). Not only is the car ride relatively quiet on QuietRide roads, but it is also relatively cool (thus lengthening the life of automobile tires) and less likely to lead to cars sliding in rainy conditions. Although Wingo Corporation holds the overall patent, SSC has patented a critical component that is used in the product (the component is "QSand"). The product now accounts for approximately 25 percent of the company's sales (all to Wingo Corporation) and 33 percent of its profits. The success of QSand has led SSC to start developing another product, QDeck. QDeck will be a final finishing coat over the pool deck—the concrete walking and lounging area that surrounds a swimming pool. QDeck is intended to address two problems: (1) individuals slipping and falling on pool decks while walking with wet feet and (2) individuals burning their feet on the deck on particularly hot days. Gary indicates that the current compound seems to allow good traction and decks remain much cooler than with products of other companies. The problem being addressed at this point is that the current compound seems to crack easily and has a relatively short useful life. Indeed, in one test of the product on the deck at Gary's home, Gary's wife Madonna cut her foot on one of the cracks and required several stitches to close the wound. Gary laughed and said that at least she didn't slip or burn her feet on that hot day when it happened. More seriously, he suggested that this deficiency is currently being worked on and must be solved before the product goes to market. The product is being independently developed and is intended for both residential and commercial markets. In 20X8, the company experienced a level of profitability just slightly above that of 20X7—but this was well below the net incomes of the preceding few years. Gary suggested to you that, surprisingly, intense price competition from several smaller competitors in the Bisbee area caused the somewhat low level of profitability. But, he added, he didn't expect the problem to last for long because he doubted that those companies could continue to operate selling at those lower prices. Gary had hoped for a more profitable year in 20X8, as a significant amount of the company's long-term debt is payable in 20X9. SSC is currently involved in discussions with the bank on refinancing. Page 442 SSC added significant additional crushing and washing plant and equipment during 20X8 to increase production in the future by more than 100 percent while expanding capabilities to produce custom specification materials. No dividends have been paid during the past two years, although previously most of the earnings were distributed through dividends to SSC's five shareholders—CEO and Chair of the Board of Directors Gary Sherwood, his wife Madonna Sherwood, CFO Jane Zhan, and two college friends of Gary's who invested in the company, Cindy Stone and Kelly Higgins. These five individuals make up the company's board of directors. The Bank of Arizona is the financial institution with which SSC maintains its two cash accounts (general and payroll cash accounts) and from which it obtains a significant portion of its financing; the inventories are pledged on the Bank of Arizona loan. This year, in reaction to pressure from the bank, SSC established an audit committee composed of Madonna Sherwood, Cindy Stone, and Kelly Higgins. Industry Information The industry activities consist of the extraction and preparation of sand and rock products. These activities include the cleaning, separating, and sorting of quarried sand and the process of crushing rocks. The products are in the form of sand used in making concrete; sand used in laying bricks (which contains little soil); sand used for fill (which contains a large amount of soil); and quartz sand. It excludes the products of gravel quarrying (sandstone, gravel stone, and iron sand). While sales within the industry are relatively unaffected by changes in technology or obsolescence, industry sales rely heavily upon both the residential and commercial construction markets as well as government spending. During the past five years, construction has performed well and that trend is expected to continue for at least the next several years. Sand and gravel production has increased at approximately 4 percent per year during this time period, as has construction within the central Arizona area. Which of the following correctly identifies a risk facing SSC that might adversely affect cash receipts during the coming years?

Sales to Wingo.

Remote Contingencies

Same for copycat lawsuits Ignore

10-40: Items a through l represent possible errors and fraud that you suspect may be present at Rex Company. The accompanying List of Auditing Procedures represents procedures that the auditor would consider performing to gather evidence concerning possible errors and fraud. For each item, select one or two procedures, as indicated, that the auditor most likely would perform to gather evidence in support of that item. The procedures on the list may be selected once, more than once, or not at all. The details of invoices for equipment repairs were not clearly identified or explained to the accounting department employees. The auditor suspects that the bookkeeper incorrectly recorded the repairs as fixed assets.

Scan the debits to the fixed asset accounts and vouch selected amounts to vendors' invoices and management's authorization.

Qualified/Modified Opinions

Scope Limitations or GAAP AICPA - Basis for Qualified precedes opinion PCAOB - Separate paragraph following opinion paragraph

Things to Do at End of Audit

Search for Unrecorded Liabilities Review Minutes of Meetings Perform Final Analytical Procedures Perform Procedures to Identify Loss Contingencies Perform Review for Subsequent Events Obtain Representation Letter Communicate Misstatements to Management Evaluate Audit Findings Review Engagement

10-40: Items a through l represent possible errors and fraud that you suspect may be present at Rex Company. The accompanying List of Auditing Procedures represents procedures that the auditor would consider performing to gather evidence concerning possible errors and fraud. For each item, select one or two procedures, as indicated, that the auditor most likely would perform to gather evidence in support of that item. The procedures on the list may be selected once, more than once, or not at all. The auditor discovered an unusually large receivable from one of the entity's new customers. The auditor suspects that the receivable may be fictitious because the auditor has never heard of the customer and because the auditor's initial attempt to confirm the receivable has been ignored by the customer.

Send a second request for confirmation of the receivable to the customer and make inquiries of a reputable credit agency concerning the customer's creditworthiness. Examine the entity's shipping documents to verify that the merchandise that produced the receivable was actually sent to the customer.

16-29: During an audit engagement, Robert Wong, CPA, has satisfactorily completed an examination of accounts payable and other liabilities and now plans to determine whether there are any loss contingencies arising from litigation, claims, or assessments. What are the audit procedures Wong should follow with respect to the existence of loss contingencies arising from litigation, claims, or assessments? Do not discuss reporting requirements.

Send inquiry letter to company's attorney. Ask employees in company (CFO, Production Managers). Research online. Ask to see correspondence file. Owner or board minutes should show discussion.

Cooper, CPA, is auditing the financial statements of a small rural municipality. The receivable balances represent residents' delinquent real estate taxes. Internal control at the municipality is weak. To determine the existence of the accounts receivable balances at the balance sheet date, Cooper would most likely:

Send positive confirmation requests.

10-40: Items a through l represent possible errors and fraud that you suspect may be present at Rex Company. The accompanying List of Auditing Procedures represents procedures that the auditor would consider performing to gather evidence concerning possible errors and fraud. For each item, select one or two procedures, as indicated, that the auditor most likely would perform to gather evidence in support of that item. The procedures on the list may be selected once, more than once, or not at all. The auditor suspects that the entity's controller has overstated sales and accounts receivable by recording fictitious sales to regular customers in the entity's books.

Send requests to confirm the entity's accounts receivable on a surprise basis at an interim date. Examine the entity's shipping documents to verify that the merchandise that produced the receivable was actually sent to the customer.

Management's Assessment of Internal Control

Separate from auditors

Which of the following events occurring on January 5, 20X2, is most likely to result in an adjusting entry to the 20X1 financial statements?

Settlement of litigation.

Disclaimer of Opinion

Severe Scope Limitation Do not have opinion

To determine that all sales have been recorded, the auditors would select a sample of transactions from the:

Shipping documents file.

Rowe Manufacturing Company has about 50 production employees and uses the following payroll procedures. The factory supervisor interviews applicants and on the basis of the interview either hires or rejects the applicants. After being employed, the applicant prepares a W-4 form (Employee's Withholding Exemption Certificate) and gives it to the supervisor. The supervisor writes the hourly rate of pay for the new employee in the corner of the W-4 form and then gives the form to a payroll clerk as notice that the applicant has been employed. The supervisor verbally advises the payroll department of pay-rate adjustments. A supply of blank time cards is kept in a box near the entrance to the factory. Each employee takes a time card on Monday morning, signs it, and notes in pencil on the time card the daily arrival and departure times. At the end of the week, the employees drop the time cards in a box near the door to the factory. The completed time cards are taken from the box on Monday morning by a payroll clerk. Two payroll clerks divide the cards alphabetically between them, one taking the A-L section of the payroll and the other taking the M-Z section. Each clerk is fully responsible for one section of the payroll. The payroll clerks compute the gross pay, deductions, and net pay; post the details to the employees' earnings records; and prepare and number the payroll checks. Employees are automatically removed from the payroll when they fail to turn in time cards. The payroll checks are manually signed by the chief accountant and given to the supervisor, who distributes the checks to the employees in the factory and arranges for the delivery of the checks to the employees who are absent. The payroll bank account is reconciled by the chief accountant, who also prepares the various quarterly and annual payroll tax reports. List your suggestions for improving Rowe Manufacturing Company's internal control over factory hiring practices and payroll.

Shoud be hired by someone in HR or supervisor could manipulate who is hired. HR should also collect W-4 and check pay rate. Pay rate adjustments should follow policy. Time cards should be written in pen. Electronic scanning would be more reliable. Payroll duties should be separated. Audit trail should exist for employee termination. Deposits to bank accounts would be better than checks. Absent employee checks could be taken by supervisor. Chief accountant should not both create checks and prepare reports.

Counting Cash on Hand

Should be a surprise and should be accompanied by cash custodian

Voided Checks

Should be defaced to eliminate use and kept in prenumbered sequence

Restatements or Updating

Show failed, even if just changing methods (reason why have to change method)

An audit report for a public client indicates that the audit was performed in accordance with:

Standards of the Public Company Accounting Oversight Board (United States).

Going Concern

Substantial Doubt Reasonable Period of Time (about 1 year) If management's plan will fix then do not need to identify title of emphasis of matter paragraph as being for going concern. If client does not disclose adequately in financial statements, then qualified or adverse opinion. Client needs to use liquidation basis.

Which of the following is least likely to be considered a substantive procedure relating to payroll?

Test whether employee time reports are approved by supervisors. Not including monetary calculation.

Simulation You are working on your firm's fifth audit of SSC. The previous audits have all resulted in standard unqualified audit reports. Read the following write-up from your audit files concerning SSC and its industry, and then reply to the questions that follow. Company Information In 20X1, Gary Sherwood founded Sherwood Stone Company (SSC). In the middle of its second year of existence, the company completed development of a large extraction pit area and constructed an aggregate processing plant that is equipped to crush, screen, and wash aggregate products. By 20X4, the sand and gravel operation was profitable and growing market conditions justified modifications and expansion. Currently, SSC produces a wide range of sand and stone products from its pit near Bisbee, Arizona. The materials it develops are composed of sand and stone materials for commercial construction and highway projects. SSC sells to a wide variety of commercial and governmental customers, with only one of its numerous customers—Wingo Corporation—accounting for more than 5 percent of total sales. In total, Wingo has represented approximately 30 percent of sales (and receivables) for the past few years. Wingo Corporation is by far Arizona's largest street and road contractor and seems solid financially. Virtually all of SSC's sales are on credit, although all but the smallest contracts require "progress" billings that result in payment being received by SSC on a pro rata basis with delivery of materials to the customer. Payments from customers are made directly to the company's lockbox system with SSC's local bank. All transactions occur in U.S. dollars, and SSC maintains both a general checking account and a payroll account. SSC has worked closely with Wingo Corporation in developing a superior road paving product ("QuietRide"). Not only is the car ride relatively quiet on QuietRide roads, but it is also relatively cool (thus lengthening the life of automobile tires) and less likely to lead to cars sliding in rainy conditions. Although Wingo Corporation holds the overall patent, SSC has patented a critical component that is used in the product (the component is "QSand"). The product now accounts for approximately 25 percent of the company's sales (all to Wingo Corporation) and 33 percent of its profits. The success of QSand has led SSC to start developing another product, QDeck. QDeck will be a final finishing coat over the pool deck—the concrete walking and lounging area that surrounds a swimming pool. QDeck is intended to address two problems: (1) individuals slipping and falling on pool decks while walking with wet feet and (2) individuals burning their feet on the deck on particularly hot days. Gary indicates that the current compound seems to allow good traction and decks remain much cooler than with products of other companies. The problem being addressed at this point is that the current compound seems to crack easily and has a relatively short useful life. Indeed, in one test of the product on the deck at Gary's home, Gary's wife Madonna cut her foot on one of the cracks and required several stitches to close the wound. Gary laughed and said that at least she didn't slip or burn her feet on that hot day when it happened. More seriously, he suggested that this deficiency is currently being worked on and must be solved before the product goes to market. The product is being independently developed and is intended for both residential and commercial markets. In 20X8, the company experienced a level of profitability just slightly above that of 20X7—but this was well below the net incomes of the preceding few years. Gary suggested to you that, surprisingly, intense price competition from several smaller competitors in the Bisbee area caused the somewhat low level of profitability. But, he added, he didn't expect the problem to last for long because he doubted that those companies could continue to operate selling at those lower prices. Gary had hoped for a more profitable year in 20X8, as a significant amount of the company's long-term debt is payable in 20X9. SSC is currently involved in discussions with the bank on refinancing. Page 442 SSC added significant additional crushing and washing plant and equipment during 20X8 to increase production in the future by more than 100 percent while expanding capabilities to produce custom specification materials. No dividends have been paid during the past two years, although previously most of the earnings were distributed through dividends to SSC's five shareholders—CEO and Chair of the Board of Directors Gary Sherwood, his wife Madonna Sherwood, CFO Jane Zhan, and two college friends of Gary's who invested in the company, Cindy Stone and Kelly Higgins. These five individuals make up the company's board of directors. The Bank of Arizona is the financial institution with which SSC maintains its two cash accounts (general and payroll cash accounts) and from which it obtains a significant portion of its financing; the inventories are pledged on the Bank of Arizona loan. This year, in reaction to pressure from the bank, SSC established an audit committee composed of Madonna Sherwood, Cindy Stone, and Kelly Higgins. Industry Information The industry activities consist of the extraction and preparation of sand and rock products. These activities include the cleaning, separating, and sorting of quarried sand and the process of crushing rocks. The products are in the form of sand used in making concrete; sand used in laying bricks (which contains little soil); sand used for fill (which contains a large amount of soil); and quartz sand. It excludes the products of gravel quarrying (sandstone, gravel stone, and iron sand). While sales within the industry are relatively unaffected by changes in technology or obsolescence, industry sales rely heavily upon both the residential and commercial construction markets as well as government spending. During the past five years, construction has performed well and that trend is expected to continue for at least the next several years. Sand and gravel production has increased at approximately 4 percent per year during this time period, as has construction within the central Arizona area. Of the following, the most significant risk factor relating to the risk of misstatement arising from fraudulent financial reporting for SSC is that:

The company must refinance a significant portion of its debt.

Which of the following is an example of misappropriation of assets relating to sales?

Theft of cash register sales.

Iron Curtain Approach

Total balance sheet amount that needs to be corrected

Kiting

Transfer amount included in both banks Found by analyzing bank transfers for last week of audit year and first week of following year

17-26: For each of the following brief scenarios, assume that you are reporting on a client's financial statements. Reply as to the type(s) of opinion possible for the scenario. In addition: Unless stated otherwise, assume the matter involved is material. If the problem does not state that a misstatement (or possible misstatement) is pervasive, assume that it may or may not be pervasive (thus, the appropriate reply may include two possible reports). Do not read more into the circumstance than what is presented. Do not consider an auditor discretionary circumstance for modification of the audit report unless the situation explicitly suggests that the auditors wish to emphasize a particular matter. Report Types may be used once, more than once, or not at all. Bowles Company is engaged in a hazardous trade and has obtained insurance coverage related to the hazard. Although the likelihood is remote, a material portion of the company's assets could be destroyed by a serious accident.

Unmodified - Standard

The auditors identified a material weakness in internal control in August. The client was informed and the client corrected the material weakness prior to year-end (December 31); the auditors concluded that management eliminated the material weakness prior to year-end. The appropriate audit report on internal control is:

Unqualified.

Check Clearing for the 21st Century Act

Using electronic form of check to process

Rights of Cash

Verify ownership

Payroll

Verify tax and withholdings Verify hours recorded accurately Check for ghost employees 3-part Identification: Something you have (card), are (fingerprint), or know (password). Need two of three!

A procedure that involves tracing a transaction from origination through the company's information systems until it is reflected in the company's financial report is referred to as a(n):

Walk-through

Which of the following is not a typical question asked during a walk-through?

What is the largest fraudulent transaction you ever processed?

Auditors' Report Date

When have sufficient, appropriate evidence Same date as representation letter

A material departure from generally accepted accounting principles will result in auditor consideration of:

Whether to issue an adverse opinion rather than a qualified opinion

Identify the control that is most likely to prevent the concealment of a cash shortage resulting from the improper write-off of a trade account receivable:

Write-offs must be approved by a responsible official after review of credit department recommendations and supporting evidence.

A nonpublic company's change in accounting principles that the auditors believe is not justified is likely to result in which of the following types of audit opinions?

Yes qualified, not unmodified with emphasis of matter

In connection with her audit of the financial statements of Flowmeter, Inc., for the year ended December 31, 20X3, Joan Hirsch, CPA, is aware that certain events and transactions that have taken place after December 31, 20X3, but before she has issued her report dated February 28, 20X4, may affect the company's financial statements. The following material events or transactions have come to her attention: On January 3, 20X4, Flowmeter, Inc., received a shipment of raw materials from Canada. The materials had been ordered in October 20X3 and shipped FOB shipping point in December 20X3. On January 15, 20X4, the company settled and paid a personal injury claim of a former employee as the result of an accident that had occurred in March 20X3. The company had not previously recorded a liability for the claim. On January 25, 20X4, the company agreed to purchase for cash the outstanding stock of Porter Electrical Co. The business combination is likely to double the sales volume of Flowmeter, Inc. On February 1, 20X4, a plant owned by Flowmeter, Inc., was damaged by a flood, resulting in an uninsured loss of inventory. On February 5, 20X4, Flowmeter, Inc., issued to an underwriting syndicate $2 million in convertible bonds. For each of the subsequent events, indicate whether they should result in: Adjustment—an adjusting entry as of 20X3. Possible Disclosure—Consider note disclosure as of 20X3.

a. Adjust because should have been included b. Adjust because probable contingent liability Footnote because affects future of business but not last year's numbers d. Footnote e. Footnote

n connection with your audit of the financial statements of Hollis Mfg. Corporation for the year ended December 31, 20X3, your review of subsequent events disclosed the following items: January 7, 20X4: The mineral content of a shipment of ore en route to Hollis Mfg. Corporation on December 31, 20X3, was determined to be 72 percent. The shipment was recorded at year-end at an estimated content of 50 percent by a debit to Raw Materials Inventory and a credit to Accounts Payable in the amount of $82,400. The final liability to the vendor is based on the actual mineral content of the shipment. January 15, 20X4: Following a series of personal disagreements between Ray Hollis, the president, and his brother-in-law, the treasurer, the latter resigned, effective immediately, under an agreement whereby the corporation would purchase his 10 percent stock ownership at book value as of December 31, 20X3. Payment is to be made in two equal amounts in cash on April 1 and October 1, 20X4. In December, the treasurer had obtained a divorce from his wife, who is Ray Hollis's sister. January 16, 20X4: As a result of reduced sales, production was curtailed in mid-January and some workers were laid off. On January 18, 20X4, a major customer filed for bankruptcy. The customer's financial condition had been degenerating over recent years.Page 704 On January 28, 20X4, a famous analyst who followed the industry provided a negative report on his expectations concerning the short and intermediate term for the industry. For each of the subsequent events, indicate whether they should result in: Adjustment—an adjusting entry as of 20X3. Consider Disclosure—consideration of note disclosure as of 20X3. Depending upon the details of the circumstances involved, some of the events may result in neither adjustment nor note disclosure. Select the two events least likely to be reflected (resulting in adjustment or disclosure) in the financial statements.

a. Adjust books because significant amount known. b. Footnote because need to pay but don't change because end of year was correct c. Normal business cycle, so ignore (in news) d. Adjust books - write-off (Only footnote if sudden event caused loss) e. Don't act on predictions (in news)

Use the following to provide the type of audit report the auditors generally should issue in the situations presented below: Unmodified—standard. Unmodified—with an emphasis-of-matter paragraph. Qualified. Adverse. Disclaimer Situation: Client-imposed restrictions significantly limit the scope of the auditors' procedures, and they are unable to obtain sufficient appropriate audit evidence. The possible effects on the financial statements of undetected misstatements, if any, could be both material and pervasive. The auditors decide not to make reference to the report of a component auditor that audited a portion of group financial statements. The auditors believe that the financial statements have been presented in conformity with generally accepted accounting principles in all respects, except that a loss contingency that should be disclosed through a note to the financial statements is not included. While they consider this a material omission, they do not believe that it pervasively affects the financial statements. The client has changed from LIFO to FIFO for inventory valuation purposes; the auditors concur with this change. The effect is considered material to the financial statements, although inventory is not a large part of total assets. The client has changed from LIFO to FIFO for inventory valuation purposes; the auditors do not concur with this change. The effect is considered material and pervasive.

a. Disclaimer b. Unmodified c. Qualified d. Unmodified - Emphasis of Matter e. Adverse (consistency implied)

17-22: Rowe & Myers audits the financial statements of Dunbar Electronics. During the audit, Rowe & Myers engaged Jones & Abbot, a Canadian public accounting firm, as a component auditor to audit Dunbar's wholly owned Canadian subsidiary. Should Rowe & Myers make reference to the component auditor in its audit report? Explain. Assume that Jones & Abbott issued a qualified report on the Canadian subsidiary. Should Rowe & Myers include the same qualification in its report on Dunbar Electronics?

a. How much responsibility do you want? International means more risk. b. If not material to overall company, then can ignore

17-24: While performing your audit of Williams Paper Company, you discover evidence that indicates that Williams may not have the ability to continue as a going concern. Discuss types of information that may indicate substantial doubt about a client's ability to remain a going concern. Explain the auditors' obligation in such situations.

a. Management has to disclose in footnotes. Can't pay debts, No operating cash inflow, Selling fixed assets, Ratios may be concerning, Inventory counts, Dividends have stopped, Working capital low b. Talk to management, then audit committee, Disclose in audit report but does not change opinion

17-23: Lando Corporation is a domestic company with two wholly owned domestic subsidiaries. Michaels, CPA, has been engaged to audit the financial statements of the parent company and one of the subsidiaries and to act as the group auditors. Thomas, CPA, has audited financial statements of the other subsidiary. Michaels has not yet decided whether to make reference to the audit of Thomas. What audit procedures should Michaels perform with respect to the component auditor, regardless of whether Michaels decides to make reference to Thomas in the report? What modifications are made to the audit report if Michaels decides to make reference to the audit of Thomas?

a. Need to research other auditor - Change in auditors for subsidiary, Google search (court filings), State CPA societies, Check independence, Capacity and expertise of auditor b. Say other auditor but do not name and identify work done

11-39: An auditor's working papers include the following narrative description of the cash receipts and billing portions of Southwest Medical Center's internal control. Evaluate each condition following the narrative as being either (1) a strength, (2) a deficiency, or (3) not a strength or a deficiency. Southwest is a health care provider that is owned by a partnership of five physicians. It employs 11 physicians, including the five owners; 20 nurses; five laboratory and X-ray technicians; and four clerical workers. The clerical workers perform such tasks as reception, correspondence, cash receipts, billing, accounts receivable, bank deposits, and appointment scheduling. These clerical workers are referred to as office manager, clerk #1, clerk #2, and clerk #3. Assume that the narrative is a complete description of the system. About two-thirds of Southwest's patients receive medical services only after insurance coverage is verified by the office manager and communicated to the clerks. Most of the other patients pay for services by cash or check when services are rendered, although the office manager extends credit on a case-by-case basis to about 5 percent of the patients. When services are rendered, the attending physician prepares a prenumbered service slip for each patient and gives the slip to clerk #1 for pricing. Clerk #1 completes the slip and gives the completed slip to clerk #2 and a copy to the patient. Using the information on the completed slip, clerk #2 performs one of the following three procedures for each patient: Clerk #2 files an insurance claim and records a receivable from the insurance company if the office manager has verified the patient's coverage, or Clerk #2 posts a receivable from the patient on clerk #2's PC if the office manager has approved the patient's credit, or Clerk #2 receives cash or a check from the patient as the patient leaves the medical center, and clerk #2 records the cash receipt. At the end of each day, clerk #2 prepares a revenue summary. Clerk #1 performs correspondence functions and opens the incoming mail. Clerk #1 gives checks from insurance companies and patients to clerk #2 for deposit. Clerk #2 posts the receipt of patients' checks on clerk #2's PC patient receivable records and insurance companies' checks to the receivables from the applicable insurance companies. Clerk #1 gives mail requiring correspondence to clerk #3. Clerk #2 stamps all checks "for deposit only" and each day prepares a list of checks and cash to be deposited in the bank. (This list also includes the cash and checks personally given to clerk #2 by patients.) Clerk #2 keeps a copy of the deposit list and gives the original to clerk #3. Clerk #3 personally makes the daily bank deposit and maintains a file of the daily bank deposits. Clerk #3 also performs appointment scheduling for all of the doctors and various Page 500correspondence functions. Clerk #3 also maintains a list of patients whose insurance coverage the office manager has verified. When insurance claims or patient receivables are not settled within 60 days, clerk #2 notifies the office manager. The office manager personally inspects the details of each instance of nonpayment. The office manager converts insurance claims that have been rejected by insurance companies into patient receivables. Clerk #2 records these patient receivables on clerk #2's PC and deletes these receivables from the applicable insurance companies. Clerk #2 deletes the patient receivables that appear to be uncollectible from clerk #2's PC when authorized by the office manager. Clerk #2 prepares a list of patients with uncollectible balances and gives a copy of the list to clerk #3, who will not allow these patients to make appointments for future services. Once a month, an outside accountant posts clerk #2's daily revenue summaries to the general ledger, prepares a monthly trial balance and monthly financial statements, accounts for prenumbered service slips, files payroll forms and tax returns, and reconciles the monthly bank statements to the general ledger. This accountant reports directly to the physician who is the managing partner. All four clerical employees perform their tasks on PCs that are connected through a local area network. Each PC is accessible with a password that is known only to the individual employee and the managing partner. Southwest uses a standard software package that was acquired from a software company and that cannot be modified by Southwest's employees. None of the clerical employees are able to write checks on the company's account. For each of the following conditions, indicate whether they represent an internal control "strength" or "deficiency." If the condition is not an internal strength or deficiency, respond that the condition is "neither." Conditions Southwest is involved only in medical services and has not diversified its operations. Insurance coverage for patients is verified and communicated to the clerks by the office manager before medical services are rendered. The physician who renders the medical services documents the services on a prenumbered slip that is used for recording revenue and as a receipt for the patient. Cash collection is centralized in that clerk #2 receives the cash (checks) from patients and records the cash receipt. Southwest extends credit rather than requiring cash or insurance in all cases. The office manager extends credit on a case-by-case basis rather than using a formal credit search and established credit limits. The office manager approves the extension of credit to patients and also approves the write-offs of uncollectible patient receivables. Clerk #2 receives cash and checks and prepares the daily bank deposit. Clerk #2 maintains the accounts receivable records and can add or delete information on the PC. Prenumbered service slips are accounted for on a monthly basis by the outside accountant, who is independent of the revenue-generating and revenue-recording functions. The bank reconciliation is prepared monthly by the outside accountant, who is independent of the revenue-generating and revenue-recording functions. Computer passwords are only known to the individual employees and the managing partner, who has no duties in the revenue-recording functions. Computer software cannot be modified by Southwest's employees. None of the employees who perform duties in the revenue-generating and revenue-recording functions are able to write checks.

a. Neither b. Strength c. S d. Deficiency e. N f. D g. D h. D i. D j. S k. S l. S m. S n. S


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