AUD Exam Chapter 4

Does the auditor or client count the client's inventory?

"Inventory observation" does not mean the auditor counts the client's inventory. The client counts the inventory and the auditor simply observes. The observation of beginning and ending physical inventory counts is a required generally accepted auditing procedure.

Financing Cycle Includes an entity's debt and equity. An entity's internal control over debt should include the following:

-Adequate documentation of all financing arrangements -Authorization of new debt by BOD or management (evidenced in minutes of board meetings) -Adequate controls over interest and principal payments and recording of bond premium and discount authorization amounts

Discovery of Material Misstatements in Opening Balances

-Auditor should determine the effect on the current period financials -Determine if predecessor auditor financial statements require revision -If auditor is not satisfied with resolution - should consider impact on current audit and whether to resign from the engagement

Management Representation Letter Requirements

-Final piece of evidential matter (obtained at end of auditor fieldwork) -Letter is *mandatory* (management refusal to furnish the letter will generally result in disclaimer of opinion or withdrawal) -Dated same date as auditor's report -Signed by CEO and CFO -Addressed to auditor

Contents of Management Representation Letter

-Management is responsible for the fair presentation of the f/s and the design, implementation and maintenance of internal control -Fraud; management has disclosed its knowledge of fraud -Management believes that the effects of uncorrected misstatements are immaterial -All known litigations and claims are disclosed -Management believes that significant estimates used are reasonable -Related parties are identified and properly accounted for -Subsequent events have been adjusted or disclosed -Additional representations (ex. restrictions on cash)

When evaluating audit findings, the auditor should consider any potential bias in management's judgements about the amounts and disclosures in the financial statements. Examples of management bias include:

-Selective correction of misstatements brought to management's attention during the audit -Identification by management of additional adjusting entries that offset misstatements accumulated by the auditor -Bias in the selection and application of accounting principles -Bias in accounting estimates If the auditor identifies bias in management's judgements, the auditor should evaluate whether this bias, together with the effect of uncorrected misstatements, results in material misstatement in the f/s

Functions of Audit Committee

-Selects and appoints the independent auditor and sets the audit fee -Reviews the quality of the auditor's work -Reviews the scope of the audit -Main line of communication between auditor and BOD

To whom may a CPA disclose confidential client information without consent of the client?

-Supoena or summons -Quality review -Ethics division or trial board of the AICPA

Investment Cycle Internal control over investments requires strong segregation of the following duties:

1. Authorization of Purchase or Sale of Investments - The BOD should authorize the purchase or sale of investments. 2. Custody of Investments - An independent, third party custodian is recommended, but at minimum, custody should take the form of joint control by *two company officials with the investments kept in a safe deposit box* (May also mention signatures of two officials) 3. Record Keeping - A separate party from those mentioned above must keep detailed records of the investments.

Auditing Accounts Receivable Negative confirmations should be used when:

1. Combined assessed level of inherent and control risk is low (RMM low) 2. A large number of small account balances are being confirmed 3. There is no reason to expect the recipients of the requests will ignore them Less effective than positive confirms

Going Concern Documentation Requirements

1. Conditions or events that gave rise to the substantial doubt 2. Any mitigating factors that the auditor considers significant 3. Audit work performed 4. The auditor's conclusion about whether substantial doubt remains or is alleviated 5. The effect of the auditor's conclusion on the f/s and the resulting auditor's report

When control deficiencies are noted, the auditor should....

1. Consider compensating controls 2. Decide whether there is a significant deficiency or material weakness 3. Determine potential misstatements that could occur 4. Design substantive tests related to the deficiency to provide evidence that the f/s are free from MM

Other Going Concern Considerations

1. IF in the auditor's judgement, the entity's going concern disclosures are inadequate, it may result in a qualified or adverse opinion (GAAP issue) 2. IF management is unwilling to perform or extend its evaluation to meet the period of time required when requested by the auditor, the auditor should issue a qualified or adverse opinion (GAAS issue) 3. IF financial statements have been prepared using the going concern basis of accounting, but the use by management was inappropriate - adverse opinion (GAAP issue) 4. IF the auditor's doubts about the entity's ability to continue as a going concern are removed in a subsequent period, emphasis of matter paragraph of the prior period need not be repeated

Ordinarily, the disclosure of noncompliance to parties other than management and those charged with governance is not the auditor's responsibility because of the duty of confidentiality. However, a duty to disclose may exist.....

1. In response to inquiries of the predecessor auditor 2. In response to a court order 3. Entities that receive federal funding from a government agency

Deficiencies are considered (3 types)

1. Material Weakness 2. Significant Deficiency 3. Control Deficiency

Sales Under strong internal control, segregation of the following functions in a sales transaction should exist...

1. Preparation of the Sales Order - Receipt of a customer sales order by the sales department. If that order can be filled, a *serially numbered* sales order is prepared and sent to the credit department for approval. 2. Credit Approval - Credit department determines whether or not the customer may receive goods on credit. If approved, a copy of the *approved* sales order is sent to the shipping department, billing department and accounting department. 3. Shipment - In the shipping department, a *serially numbered* bill of lading is prepared and a copy is sent to the customer. The goods are shipped and an invoice is created based on invoice shipping terms. 4. Billing - The billing department prepares a *serially numbered* sales invoice. The shipping documents, sales orders and invoices are matched. Invoice is sent to the customer and the A/R department. 5. (Usually combined with Billing) Accounting - Sales is entered into the sales journal, and a receivable is recorded.

Purchases The following three functions in a purchase transaction should be segregated:

1. Purchase Requisition - The purchase requisition begins the purchasing cycle. The department in need of the assets send a *properly approved, serially numbered* requisition to the purchasing department. The requisitioning department should not have the authority to actually place the purchase order. This would indicate a weakness in internal control. (Whatever department wants to buy something should issue a requisition) 2. Purchase Orders - Once properly approved, the purchasing department should create the purchase order, which indicates the quantity, etc. of the goods being requested. Prenumbered purchase orders should be used. There should be multiple copies sent to *(1) the requisitioning department (2) the vendor (3) the receiving department and (4) the accounting department.* If a purchase order is cancelled, all copies should be recalled and filed. 3. Receipt of Goods - The copy of the purchase order sent to the receiving department serves as an authorization to accept the goods when they arrive. It is *preferable that the copy not indicate the quantity ordered (blind copy)* to the receiving department is forced to count the goods upon arrival. A receiving report is prepared by the receiving department and forwarded to the accounting department. The goods are forwarded to the requisitioning department.

Inventory Proper internal control includes safeguarding of inventory and proper segregation of duties:

1. Purchasing - Serially numbered, properly approved purchase orders should be prepared and issued to the accounting and receiving departments. 2. Receiving - The receiving department is solely responsible for the receipt of goods. The receiving department should receive a copy of the purchase order that does not indicate the quantity ordered (blind copy) so the receiving department is forced to count the goods upon arrival. 3. Warehouse - The warehouse department acts as custodian for the verified quantity of goods received. 4. Shipping - The shipping department is responsible for the shipment of goods after authorization (in the form of an approved sales order from the credit department)

Accounts Payable Once the accounting department receives the receiving report, it will record the payable, approve the invoice for payment, and record the payment after it is paid by the treasurer.

1. Recording the Payable - The receiving report sent to the accounting department is compared with the copy of the purchase order that was sent to the accounting department and the vendor's invoice. Match the receiving report, purchase order and vendor invoice. The accounting department records the goods as received in inventory and records a payable. 2. Approving Invoice for Payment and Recording Payment - When the invoice arrives, the accounting department approves it by matching the vendor invoice, purchase order, receiving report (and sometimes the requisition). When payment is made, the payable is reversed.

Transaction Cycles (6 most common)

1. Revenue 2. Expenses 3. Cash 4. Inventory 5. Investments 6. Other (PPE, Payroll, Financing)

Accounts Receivable Under a strong internal control, segregation of the functions in an A/R transaction should exist as follows...

1. Sales - A receivable is recorded in the A/R account in the general ledger and in the A/R subsidiary ledger. Periodically, an independent person should reconcile these two records. 2. Collection of Cash Receipts - Receivable eliminated when payment received from customer. 3. Uncollectible Receivables - Aging schedule prepared. At some point uncollectibles should be written off. Controls for writing off receivables include proper authorization (by the treasurer) and record keeping. Without proper control, amounts collected could be misappropriated by employees. 4. Sales Returns - A *serially numbered* receiving report may be used as a sales return slip. Once return is approved, sales return is recorded and outstanding receivable is eliminated. Credit memos should *not* be prepared by individuals who collect or receive cash payments on A/R; to do so would be inadequate segregation of duties.

Auditing Accounts Receivable Positive confirmations should be used when:

1. There are large individual accounts 2. There are expected errors or items in dispute 3. Internal control is weak Blank confirmations may also be sent where recipient fills in the balance. They provide greater assurance, but also have lower response rates because more effort is required by the recipient. Provide evidence of existence and rights & obligations, but not reliable for valuation or completeness.

The three main purposes for obtaining Management Representation Letter are:

1. To confirm representations explicitly or implicitly given to the auditor 2. To indicate and document the continuing appropriateness of such representations 3. To reduce the possibility of misunderstanding concerning matters that are the subject of the representations

Audit Committee

A committee of the board of directors, generally made up of three to five members of the board who are neither employees nor part of management and who do not have a material financial interest in the company

Significant Deficiency

A control deficiency, or a combination of control deficiencies, that is less severe than a material weakness, but important enough to merit attention by those charged with governance (potential misstatement is less than materiality but more than inconsequential)

Material Weakness

A deficiency, or combination of deficiencies, in internal control, such that there is a reasonable possibility that a material misstatement of the entity's financial statements will not be prevented, or detected and corrected, on a timely basis. (Potential misstatement is equal to or greater than materiality) The existence of a material weakness does not necessarily mean the f/s are misstated

An auditor suspects that certain client employees are ordering merchandise for themselves over the Internet without recording the purchase or receipt of the merchandise. When vendors' invoices arrive, one of the employees approves the invoices for payment. After the invoices are paid, the employee destroys the invoices and the related vouchers. In gathering evidence regarding the fraud, the auditor most likely would select items for testing from the file of all: A) Cash disbursements. B) Approved vouchers. C) Receiving reports. D) Vendors' invoices.

A) Cash disbursements. B - Approved vouchers. (Destroyed), C - Receiving reports (Not Recording), D - Vendors' invoices. (Destroyed)

In performing a search for unrecorded retirements of fixed assets, an auditor must: A) Inspect the property ledger and the insurance and tax records, and then tour the client's facilities B) Tour the client's facilities, and then inspect the property ledger and the insurance and tax records. C) Analyze the repair and maintenance account, and then tour the client's facilities D) Tour the client's facilities, and then analyze the repair and maintenance account

A) Inspect the property ledger and the insurance and tax records, and then tour the client's facilities

On receiving a client's bank cutoff statement, an auditor most likely would trace: A) Prior year checks listed in the cutoff statement to the year-end outstanding checklist. B) Deposits in transit listed in the cutoff statement to the year-end bank reconciliation. C) Checks dated after year-end listed in the cutoff statement to the year-end outstanding checklist. D) Deposits recorded in the cash receipts journal after year-end to the cutoff statement.

A) Prior year checks listed in the cutoff statement to the year-end outstanding checklist.

Property, Plant and Equipment Cycle The internal control for property, plant and equipment includes the controls in both the revenue and expenditure cycles as well as the following:

Acquisition: A *special requisition* form is generated. Should be approved by top management. Acquisitions are tied to the capital budget, which BOD usually approves. Subsidiary Ledgers: Detailed information about each asset should be kept in the ledger. Physical Security: Fixed assets should have identification plates with a serial number. Comparison of the serial number on the plate to that listed in the control account should be made. The auditor should also determine whether there are appropriate controls in place to safeguard fixed assets and prevent theft and destruction. Written Policies: Specific capitalization policies are necessary to prevent misstatements of revenues and expenses. Disposition: Retirements of assets should be documented on a *sequentially numbered work order* containing evidence of proper authorization and reason for retirement. There should be a proper segregation of duties between those who authorize a disposal and those who actually dispose of the asset.

If control risk is assessed as low, less substantive testing is necessary. In such instances, substantive testing would normally be limited to...?

Analytical procedures and recalculating year end accruals

An auditor most likely would perform substantive tests of details on payroll transactions and balances when...?

Analytical procedures indicate fluctuations and recurring payroll entries

Auditing Accounts Payable Perform a search for unrecorded liabilities

Audit procedures that aid the auditor in identifying obligations that should have been recorded at the balance sheet date, but were not. An auditor would most likely examine cash disbursements recorded after the B/S date (Jan, Feb, etc) to determine whether the payables related to the prior period have been recorded in the A/P trial balance Should compare cash payments made after the B/S date to the related receiving reports and vendor invoices; any payments made on transactions dated before year-end reflect a liability that should've been recorded

Misstatements Documentation Requirements

Auditor should document: -Amount below which misstatements are clearly trivial (aka very low; not material whether taken alone or in aggregate) -All misstatements accumulated during the audit and whether they have been corrected -Auditor's conclusion about whether misstatements are material individually or in the aggregate -Aggregate affect on the f/s

An Entity's Ability to Continue as a Going Concern - Audit Procedures (ADMITS)

Auditor should obtain evidence to determine if there is information contrary to the basic principle of going concern. A - *Analytical Procedures* D - *Debt Compliance* - Review terms of debt and loan agreements (covenants) M - *Minutes* - Review I - *Inquiry* - Of client's legal counsel T - *Third Parties* - Ability and intent of third parties to provide necessary financial support S - *Subsequent Events* - Review

Auditing Property, Plant and Equipment Transactions Completeness

Auditor should review the related repair and maintenance expense accounts to test for completeness of asset additions. The auditor is looking for items recorded as repairs that should have been capitalized.

Payroll and Personnel Cycle Even when a service organization (ex. ADP) is used, there should be proper segregation of duties, as follows:

Authorization to Employ and Pay: Function of the human resource department to hire new employees and maintain personnel records. Supervision: All pay base data should be approved by an employee's immediate supervisor Timekeeping and Cost Accounting: Data on which pay is based, such as hours worked or jobs completed, should be accumulated independent of any other function. When employees are paid by hour, they should use time clocks. Payroll Check Preparation: If a service organization is not used, this department is responsible for issuing the *unsigned* payroll checks that are later signed by treasurer or CFO. Check Distribution: If paychecks are manually distributed, then the payroll checks should be distributed by a person who has no other payroll function. Sometimes called paymaster.

Which of the following circumstances most likely would cause an auditor to suspect that material misstatements exist in a client's financial statements? A) The assumptions used in developing the prior year's accounting estimates have changed B) Differences between reconciliations of control accounts and subsidiary records are not investigated C) Negative confirmation requests yield fewer responses than in the prior year's audit D) Management consults with another CPA firm about complex accounting matters

B) Differences between reconciliations of control accounts and subsidiary records are not investigated

An auditor vouched data for a sample of employees in a payroll register to approved clock card data to provide assurance that: A) Payments to employees are computed at authorized rates B) Employees work the number of hours for which they are paid C) Segregation of duties exists between the preparation and distribution of the payroll D) Internal controls related to unclaimed payroll checks are operating effectively

B) Employees work the number of hours for which they are paid

To satisfy the valuation assertion when auditing an investment accounted for by the equity method, an auditor most likely would: A) Inspect the stock certificates evidencing the investment B) Examine the audited financial statements of the investee company C) Obtain market quotations from financial newspapers or periodicals D) Review the broker's advice or canceled checks for the investment's acquisition

B) Examine the audited financial statements of the investee company If the financial statements are not audited, the auditor should request the investee to have them audited

Which of the following statements is correct about an auditor's required communication with those charged with governance? Assume those charged with governance are not involved in managing the entity. A) Any matters communicated to those charged with governance also are required to be communicated to the entity's management. B) The auditor is required to inform those charged with governance about significant errors discovered by the auditor and subsequently corrected by management C) Disagreements with management about the application of accounting principles are not required to be communicated to those charged with governance if they have been appropriately resolved D)Significant deficiencies in internal control previously reported to those charged with governance that have not been corrected need not to be communicated again

B) The auditor is required to inform those charged with governance about significant errors discovered by the auditor and subsequently corrected by management C is incorrect because the auditor should communicate disagreements with management whether resolved or not D is incorrect because they should be communicated again

Which of the following would an auditor *least* likely consider with respect to fair values? A) Segregation of duties between those committing the entity to certain transactions and those responsible for undertaking the valuations related to those transactions. B) The effect of fair value measurement and disclosures of information available subsequent to the audit C) The role of information technology in determining fair value measurements and disclosures. D) Whether the valuation methods used are appropriate in relation to the industry in which the entity operates.

B) The effect of fair value measurement and disclosures of information available subsequent to the audit

Which of the following matters would an auditor most likely include in a management representation letter? A) Communications with those charged with governance concerning weaknesses in internal control B) The reasonableness of significant assumptions used in making accounting estimates C) Plans to acquire or merge with other entities in the subsequent year D) Management's acknowledgement of its responsibility for the detection of employee fraud

B) The reasonableness of significant assumptions used in making accounting estimates Note: A is the auditor's responsibility

In auditing long term bonds payable, an auditor most likely would: A) Perform analytical procedures on the bond premium and discount accounts B) Examine documentation of assets purchased with bond proceeds for liens C) Compare interest expense with the bond payable amount for reasonableness D) Confirm the existence of individual bondholders at year end

C) Compare interest expense with the bond payable amount for reasonableness

During the audit of a new client, the auditor determined that management had given illegal bribes to municipal officials during the year under audit and for several prior years. The auditor notified the client's board of this act of noncompliance, but the board decided to take no action because the amounts involved were immaterial to the financial statements. Under these circumstances, the auditor should: A) Add an explanatory paragraph emphasizing that certain matters, while not affected the unmodified opinion, require disclosure B) Report the illegal bribes to the municipal official at least one level above those persons who received the bribes C) Consider withdrawing from the audit engagement and disassociating from future relationships with the client D) Issue an "except for" qualified opinion or an adverse opinion with a separate paragraph that explains the circumstances.

C) Consider withdrawing from the audit engagement and disassociating from future relationships with the client

Which of the following is an audit procedure that an auditor would most likely perform concerning litigation, claims and assessments? A) Request the client's lawyer to evaluate whether the client's pending litigation, claims and assessments indicate a going concern problem. B) Examine the legal documents in the client's lawyer's possession concerning litigation, claims and assessments to which the lawyer has devoted substantial attention. C) Discuss with management the controls adopted for evaluating and accounting for litigation, claims and assessments D) Confirm directly with the client's lawyer that all litigation, claims, and assessments have been recorded or disclosed in the financial statements.

C) Discuss with management the controls adopted for evaluating and accounting for litigation, claims and assessments

An auditor concludes that there is substantial doubt about an entity's ability to continue as a going concern for a reasonable period of time. If the entity's financial statements adequately disclose its financial difficulties, the auditor's report is required to include an explanatory/emphasis-of-matter paragraph that specifically uses the phrase(s): "Reasonable period of time not to exceed one year" and "Going Concern" A) Yes, Yes B) Yes, No C) No, Yes D) No, No

C) No, Yes

To gain assurance that all inventory items in an entity's inventory listing schedule are valid, an auditor most likely would trace: A. Inventory tags noted during the auditor's observation to items listed in the inventory listing schedule. B. Inventory tags noted during the auditor's observation to items listed in receiving reports and vendors' invoices. C. Items listed in the inventory listing schedule to inventory tags and the auditor's recorded count sheets. D. Items listed in receiving reports and vendors' invoices to the inventory listing schedule.

C. Items listed in the inventory listing schedule to inventory tags and the auditor's recorded count sheets.

CASH CYCLE

CASH CYCLE

Auditing the Inventory Cycle -What does the CPA Test Counts to Company Prenumbered Inventory Tags measure? -What does the Company Prenumbered Inventory Tags to CPA Test Counts measure?

CPA Test Counts ----> Company Prenumbered Inventory Tags measures? *Accuracy* Company Prenumbered Inventory Tags ---> CPA Test Counts measures? *Accuracy*

Auditing the Inventory Cycle -What does the CPA Test Counts to Company Inventory Report (Listing) measure? -What does the Company Inventory Report (Listing) to the CPA Test Counts measure?

CPA Test Counts ---> Company Inventory Report (Listing) measures? *Completeness* Company Inventory Report (Listing) ---> CPA Test Counts measures? *Existence*

Communication of Deficiencies in Internal Control (Financial Statement Audit Only for Nonissuer)

Communicate the deficiency to *management only* either orally or in writing: Control Deficiency Communicate the deficiency *to management* in writing: Significant Deficiency and Material Weakness Communicate the deficiency to *those charged with governance* in writing: Significant Deficiency and Material Weakness Communication should be made within *60 days of the report release date*: Control Deficiency, Significant Deficiency and Material Weakness

Auditing the Inventory Cycle (p. A4-22) -What assertion does the Company Inventory Report (Listing) to the Company Prenumbered Inventory Tags measure? -What assertion does the Company Prenumbered Inventory Tags to Company Inventory Report (Listing) measure?

Company Inventory Report (Listing) ---> the Company Prenumbered Inventory Tags measures? *Existence* Company Prenumbered Inventory Tags ---> Company Inventory Report (Listing) measures? *Completeness*

Performing cutoff procedures for shipping and receiving provides assurance about....? (name assertion)

Completeness

Which assertions are most relevant to accounts payable?

Completeness and valuation/accuracy are generally more relevant than the existence and rights & obligations assertions for accounts payable, because there is more of a risk of understatement than overstatement.

Auditing the Equity Balance -Completeness -Existence

Completeness: If the client uses a stock transfer agent, third-party confirmations should be used to provide evidence of completeness of the shares authorized, issued and outstanding. If the client does not use a stock transfer agent, evidence of completeness is the stock certificate book. Existence: Vouch transactions recorded during the current period to board minutes.

Auditing the Payroll Accrual When internal control over payroll is effective, the auditor generally focuses substantive procedures on analytical procedures and the recalculation of payroll accruals. Tests related to assertions are generally performed when internal control is ineffective.

Completeness: Test the completeness of the payroll accrual when performing the search for unrecorded liabilities. Valuation: Recalculate any year end payroll accrual Existence: Vouch from payroll accrual to supporting documents

Auditing Investment Transactions Completeness Existence Understandability and Classification

Completeness: The auditor should perform analytical procedures testing the reasonableness of dividend and interest income to determine that all investment income has been recorded Existence: The analytical procedures performed to test the reasonableness of dividend and interest income provide evidence of the existence of investment income. Understandability and Classification: Available for Sale --> OCI Trading ---> Earnings

Auditing Payroll Transactions Completeness Existence

Completeness: Trace a sample of time cards to the payroll register Existence: Vouch time on payroll summaries by selecting a sample of payroll register entries and comparing with time cards and approved time reports. From a sample of payroll transactions, the auditor should find the related employee to verify existence and current employment status.

Auditing the Debt Balance -Completeness -Valuation

Completeness: Trace all new debt agreements and bank confirmations to the financial statements Valuation: Recompute any interest payable and recompute the amortization of premiums or discounts

Auditing Property, Plant and Equipment Balance Completeness Existence

Completeness: Trace the actual asset to the fixed asset subsidiary ledger Existence: Vouch additions by examining internal documents, external evidence and the actual asset. The auditor should also select older fixed assets from the subsidiary ledgers and then locate those assets, as a means of testing for unrecorded liabilities.

What are the 2 documents most likely to be generated by the revenue cycle application?

Credit memos and sales invoices (maybe remittance advices)

An auditor's letter issued on significant deficiencies relating to a nonissuer's internal control observed during a financial statement audit should: A) Include a brief description of the tests of controls performed in searching for significant deficiencies and material weaknesses. B) Indicate that the significant deficiencies should be disclosed in the annual report to the entity's shareholders. C) Include a paragraph describing management's assertion concerning the effectiveness of internal control. D) Indicate that the audit's purpose was to report on the financial statements and not to provide assurance on internal control.

D) Indicate that the audit's purpose was to report on the financial statements and not to provide assurance on internal control.

According to PCAOB standards, which one of the following statements does not reflect a qualitative standard that should be considered when evaluating the materiality of an uncorrected misstatement? A) The effects of misclassifications, for example, between operating and nonoperating. B) The significance of the misstatement relative to the needs of users C) The cost of correction D) The dollar amount of the error

D) The dollar amount of the error

An auditor is confirming accounts receivable using confirmations. The auditor decides to leave the accounts receivable amount blank rather than stating the amount owed. The auditor should be aware that the blank form may be less efficient because: A. Subsequent cash receipts need to be verified B. Statistical sampling may not be used C. A higher assessed level of detection risk is required D. More nonresponses are likely to occur

D. More nonresponses are likely to occur

Adjusting entry made if sales made on account are overstated

DR: Sales CR: Accounts Receivable

Internal Control Deficiencies -Deficiencies in the design of controls -Failure in effectively designed controls

Deficiencies in the design of controls: -Inadequate design of IT controls -Lack of appropriate qualifications or training of client personnel Failure in effectively designed controls: -Management override of controls -Undue bias or lack of objectivity -Failure of control over a significant process

EXPENDITURE CYCLE (mirror of revenue cycle)

EXPENDITURE CYCLE (mirror of revenue cycle)

What type of paragraph should the auditor include in their report when there is a going concern uncertainty?

Emphasis of matter (explanatory) paragraph should be added when there is going concern uncertainty The wording must include the terms "substantial doubt" and "going concern" Do not indicate for "one year" Note: In addition to issuing an unqualified opinion w an explanatory paragraph, the auditor may also issue a disclaimer of opinion

Auditing the Investment Balance Existence Valuation

Existence: (2 primary tests) Confirmations of securities held by third parties and examination of securities on hand Valuation: Agree the totals to the general ledger, review the schedule of investment activity for additions or subtractions, determine whether there has been any permanent impairment

Based on the procedures performed, the auditor identifies conditions and events that may be indicative of substantial doubt (FINE)....

F - *Financial Difficulties* - Loan defaults, dividend, arrearages, denial of usual trade credit, debt restructuring I - *Internal Matters* - Work stoppages, labor difficulties, significant revision of operations N - *Negative Trends* - Recurrent losses, working capital deficiencies, negative cash flows, adverse financial ratios E - *External Matters* - Legal proceedings, new legislation, loss of franchise/license/patent, loss of principal supplier, natural disasters

FINANCING CYCLE (mirror image of investing cycle)

FINANCING CYCLE (mirror image of investing cycle)

1. Factual Misstatement 2. Projected Misstatement 3. Judgmental Misstatement

Factual Misstatement - No doubt about, clear evidence Projected Misstatement - Based on the results of sampling projected to the population Judgmental Misstatement - Judgement call (Ex. estimated litigation)

Why are confirmations for accounts payable amounts rarely used?

For accounts payable, you are concerned about the risk of understatement. This means you want to look at smaller amounts. But, it doesn't make sense to ask for confirmations of small amounts.

INVENTORY CYCLE

INVENTORY CYCLE

INVESTMENT CYCLE

INVESTMENT CYCLE

Cash Disbursements Cash receipts is not part of the revenue cycle

Ideally invoices should be paid by check. For effective internal control, approving the payment and signing the checks should be segregated. The matched vendor invoice, purchase order, receiving report and requisition (called the voucher packet) prepared by the accounts payable accounting department are received by the treasurer, who prepares, signs and mails the checks. And cancels all supporting documents after payment.

Auditing the Investment Balance Completeness

If the entity has a high volume of material investment transactions, the auditor should search for unrecorded purchases of securities by examining transactions a few days after year end. Derivates may involve only a commitment and no exchange of tangible consideration so the auditor should not focus on cash receipts or cash disbursements for completeness assertion.

Matters That Require Special Consideration Opening Balances - Audit Procedures

In order to obtain sufficient appropriate evidence regarding opening balances, the auditor should: 1. Read the most recent financial statements and the predecessor auditor's report 2. Request that management authorize the predecessor auditor to allow review of the predecessor auditors documentation 3. Perform audit procedures on current period transactions that provide evidence about opening balances Auditor remains solely responsible for the audit work performed and conclusions reached even if they consider work from predecessor auditor. Don't make reference to predecessor auditor in report

Cash Receipts Cash disbursements is not part of the revenue cycle

Incoming mail must be opened by a person who does not have access to the accounts receivable ledger. The receipts should be listed in detail and 3 copies distributed to the following personnel. 1. *Cashier*: Receives actual receipts and prepares bank deposit. 2. *Accounts Receivable Personnel*: Enters receipts into the A/R subsidiary records. 3. *Accounting Department*: Enters receipts into the A/R general ledger account. Cash collections should be endorsed upon receipt and deposited daily. Devices such as cash registers, or lockboxes should be used a safeguards.

Employees in the payroll department compute salaries, create the payroll register and prepare unsigned checks. They should never have the authority to ....?

Initiate changes in hours or rates, nor the ability to sign checks

Testing the entity's computation of standard overhead rates generally provides assurance about a client's....? (name assertion)

Inventory Valuation

In testing long term investments, the auditor should use procedures to ascertain the reasonableness of completeness of....?

Investment income

Measuring Fair Value Level 1 Level 2 Level 3

Level 1 - Observable quoted prices in active markets for identical assets or liabilities Level 2 - Observable inputs other than quoted market prices for identical assets or liabilities Level 3 - Unobservable inputs using estimates and valuation methods, such as discounted cash flow, determined based on management's judgement

The auditor should consider both the ______ and _____ of potential misstatements.

Likelihood - Whether it is *reasonably possible* that the entity's controls will fail to prevent, or detect and correct, a misstatement of an account balance or disclosure. Magnitude - Consider both the dollar amount and volume of activity in accounts exposed to the deficiency

If those charged with governance are not involved in managing the entity, then the auditor should tell them about: (MARS)

M - Material, corrected misstatements A - Accountants that management consulted with R - Representations of management requested by the auditor S - Significant issues or findings arising from the audit that was discussed with management

Accounting Estimates Including Fair Value Estimates Management's vs. Auditor's Responsibility

Management Responsibility: It is the responsibility of management to make reasonable estimates and include them in the f/s Auditor's Responsibility: -Determine if the estimate is reasonable and focus on assumptions significant to the estimate, sensitive to the variations, deviations from historical patterns or subjective and susceptible to misstatement or management bias.

Matters That Require Special Consideration Accounting Estimates Including Fair Value Estimates - Audit Procedures

Obtain an understanding of how management developed its estimate: 1. Review and test the procedures used by management to develop the estimate 2. Develop an independent estimate of the item and compare 3. Review subsequent events that corroborate the value of the estimate

Confirmation Exceptions

Occur when there is a disparity between the amount of the receivable on client's records and the amount confirmed by the customer. Could be due to: 1. Timing Differences - Not a misstatement 2. Misstatement (ex. fictitious sale, goods or invoice sent to the wrong customer, incorrect price charged to customer)

Kiting

Occurs when a check drawn on one bank is deposited in another bank and no record is made of the disbursement in the balance of the first bank until after year-end. Cash recorded in two different banks at once To detect kiting effectively, a bank transfer schedule should be prepared.

Lapping

Occurs when an employee withholds funds received by a customer for personal use and fails to apply these receipts of cash or checks to the customer's receivable account. Today's cash receipts cover yesterday's theft One of the best methods to guard against lapping is the use of a "lock box" system. In this system, customer's send their payments directly to the bank.

An Entity's Ability to Continue as a Going Concern

On every audit, the auditor is responsible for evaluating audit evidence to determine whether there is substantial doubt about the entity's ability to continue as a going concern for a reasonable period of time. Reasonable period of time: FASB: Date f/s are issued + 1 year GASB: F/s date + 1 year + if the government knows information that may raise substantial doubt shortly thereafter, such information should also be considered Not FASB or GASB: Date f/s issued + 1 year

Concluding Procedures Litigation, Claims, and Assessments

Once the auditor has reviewed audit evidence regarding potential claims and assessments and has received the letter of inquiry from the client's attorney, the information should be analyzed to determine if management has adequately accounted for and recorded any amounts that are considered probable and are reasonably estimable. Amounts that are probably but not reasonably estimable, or are reasonably possible, should be disclosed in the footnotes.

An auditor most likely would extend substantive test of payroll when...?

Overpayments are discovered in performing tests of details

MUST be communicated with those charged with governance: (SPAM *PODIUM*)

P - Planned scope and timing O - Other issues judged significant by the auditor D - Difficulties encountered in performing the audit (delays, unreasonable timetables) I - Impairment to independence U - Uncorrected, nontrivial misstatements, and their possible effects on the audit opinion M - Management (disagreements with)

PAYROLL AND PERSONNEL CYCLE

PAYROLL AND PERSONNEL CYCLE

PROPERTY PLANT AND EQUIPMENT CYCLE

PROPERTY PLANT AND EQUIPMENT CYCLE

Matters That Require Special Consideration Litigation, Claims, and Assessments - Audit Procedures

Potential litigation, claims and assessments can be discovered by conducting the following audit procedures: -Inquiring of management about unrecorded contingencies related to litigation -Reviewing IRS reports -Reviewing minutes of board and stockholder meetings -Obtaining a letter from the client's attorney Note: It is management's responsibility to identify and account for litigations, claims and assessments

Confirmation of inventory pledged under loan arrangements provides assurance about....? (name assertion)

Presentation and disclosure Classification and understandability

Auditing the Cash Balance -Bank Confirmation -Bank Reconciliation

Primary audit procedures to test the completeness, valuation/allocation and existence of the ending cash balance. Bank Confirmation: Should be sent to all banks which the client has done business with during the year. In addition to verifying year-end balances, it also provides evidence about *actual loans, contingent liabilities, discounted notes, pledged collateral and guarantee or security agreements.* Bank Reconciliation: 1. Foot the bank reconciliation and the list of outstanding checks 2. Agree the balance per the books on the year bank reconciliation to the general ledger. 3. Agree the balance per the bank on the year end bank reconciliation to the balance per the bank confirmation. 4. Agree deposits in transit and outstanding checks to the cutoff bank statement.

Probable and Can Estimate Probably and Cannot Estimate Reasonably Probably and Can Estimate Reasonably Probable and Cannot Estimate Remote

Probable and Can Estimate: Accrue and Disclose Probably and Cannot Estimate: Disclose Reasonably Probably and Can Estimate: Disclose Reasonably Probable and Cannot Estimate: Disclose Remote: Generally ignore

Segregation of Duties Control procedures and tests of controls related to cash receipts and cash disbursements were covered previously in the discussions of the revenue cycle and the expenditure cycle. Segregation of duties is a key control over cash.

Proper segregation of duties demands that close consideration be given to check-writing authority. *Separation of cash-handling, record keeping and reconciliation of banks statements should exist.* Good internal control for cash would also include the use of a voucher system for cash disbursements.

REVENUE CYCLE

REVENUE CYCLE

Which two functions should someone not have?

Recordkeeping responsibilities and custody of assets

MUST be communicated with those charged with governance: (*SPAM* PODIUM)

S - Selection of, changes in, and appropriateness of significant accounting policies P - Processes used by management in formulating significant accounting estimates A - Adequacy of financial statement disclosures M - Management judgements that are significant

SEE APPENDIX CONTROL PROCEDURES AND TESTS OF CONTROLS p. A4-89

SEE APPENDIX CONTROL PROCEDURES AND TESTS OF CONTROLS p. A4-89

When audit procedures indicate that there are actual or potential litigation, claims or assessments, the auditor should.....

Seek direct communication with the entity's external legal counsel through a letter of inquiry. The letter is prepared my managements and sent by the auditors to the attorneys. Note: Management is the primary source of information regarding contingencies, including litigation, claims and assessments. The letter sent to the client's attorney is simply a means of corroborating information provided by management

Although the purpose of an audit of a nonissuer is to express an opinion on the financial statements and not to express an opinion on the effectiveness of internal control, certain deficiencies related to internal control may be noticed by the auditor during the audit. Such deficiencies create a reporting responsibility for the auditor. What standards is this situation governed by?

Statements on Auditing Standards (SAS) Note: For issuers, they are required to have an audit of internal control - this is governed by PCAOB auditing standards

What to do if the auditor determines that the estimate is unreasonable or was not determined in conformity with the applicable financial reporting framework?

The auditor should treat as a misstatement the difference between the recorded estimate and the best estimate supported by the audit evidence. If the auditor determines a range of reasonable estimates, then the auditor should treat as a misstatement the difference between the recorded estimate and the closest reasonable estimate supported by audit evidence. If there is a difference between the reported estimate and the best estimate supported by audit evidence the auditor should evaluate whether there is possible *management bias*

What are the most significant payroll and personnel cycle risks?

The creation of fictitious employees and the falsification of hours worked

Who should mail each check?

The person who signs it

Revenue Cycle Fraud Risk

There should be a presumption in every audit that there is a risk of material misstatement due to revenue recognition fraud.

(True or False) All material weaknesses are significant deficiencies, but not all significant deficiencies are material weaknesses.

True

(True or False) Significant deficiencies and material weaknesses may exist even though the auditor has not identified misstatements during the audit.

True

Mitigating Factors

When an auditor believes there is substantial doubt about going concern, the auditor is required to consider MANAGEMENTS PLAN FOR DEALING WITH the conditions or events that led to the auditors belief: -Plan to borrow money or restructure debt -Plan to sell assets -Plan to delay or reduce expenditures -Plan to increase ownership equity Must have BOTH intent and ability Note: NOT repurchasing stocks because that is cash outflow

Control Defiency

When the design or operation of a control does not allow management or employees to prevent, detect or correct misstatements on a timely basis and is not considered a significant deficiency or material weakness (potential misstatement is inconsequential)

An auditor finds several errors in the financial statements that the client prefers not to correct. The auditor determines that the errors are not material in the aggregate. Which of the following actions by the auditor is most appropriate? a. Document the errors in the summary of uncorrected errors, and document the conclusion that the errors do not cause the financial statements to be misstated. b. Document the conclusion that the errors do not cause the financial statements to be misstated , but do not summarize uncorrected errors in the working papers. c. Summarize the uncorrected errors in the working papers, but do not document whether the errors cause the financial statements to be misstated. d. Do not summarize the uncorrected errors in the working papers, and do not document a conclusion about whether the uncorrected errors cause the financial statements to be misstated.

a. Document the errors in the summary of uncorrected errors, and document the conclusion that the errors do not cause the financial statements to be misstated .

Based on the result of substantive audit procedures, the auditor will propose _______ journal entries to the client. The client ______ book these proposed entries. Management is responsible for the financial statements and has the final decision on whether or not to book the recorded entries. If management does not make the recommended entries and the auditor determines that the uncorrected misstatements are ________ in the aggregate, the auditor should document the errors in the summary of uncorrected errors and document the conclusion that the errors do not cause the f/s to be misstated.

adjusting may or may not not material

Generally, the auditor may discuss matters with ___________ prior to communicating those matters with ______________ . Certain matters communicated to those charged with governance, such as those related to the __________ and _______ of management, might not be appropriate for discussion with management.

management those charged with governance competence and integrity