Audit and Assurance Final

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Controls related to Step 5. Cash Disbursements

(1) review of transactions, by which someone reviews the expenditures and compares them to other key data (e.g., production, budgets, other measures of volume) and (2) review of vendor disputes by someone outside the process.

British Petroleum (BP) Loss Contingency

(BP) released its second quarter 2010 earnings report. - discussed the risks associated with the ongoing events and cleanup effort in the Gulf of Mexico due to the oil spill associated with BP - included an income statement with a $32 billion pretax charge and a notation that "second quarter and first half 2010 include a charge of $32,192 million in production and manufacturing expenses, and a credit of $10,003 million in taxation in relation to the Gulf of Mexico oil spill." - BP's auditors would have obtained assurance that the client accurately reported and disclosed the contingency in connection with the oil spill. Deepwater Horizon documents the failures in oversight and internal controls, and poor decision making that led to the disaster

the auditor usually reaches a conclusion about accounting estimates b

(a) testing the client's methodology for reaching the estimate (when the auditor believes the client's process is strong and incorporates all relevant variables), or (b) developing the auditor's own model to come up with the estimate and then comparing that estimate to the amount recorded by the client

requisition

(formal request) for goods and services - An approved requisition will result in a purchase

examples of Type I subsequent events:

- A major customer files for bankruptcy during the subsequent period because of a deteriorating financial condition, which the client and auditor were unaware of until learning about the bankruptcy filing - The client settles a lawsuit for a different amount than was accrued. - The client should disclose a stock dividend or split that takes place during the subsequent period. - A sale of inventory below carrying value provides evidence that the net realizable value was less than cost at year-end. - Information becomes available that provides evidence about the valuation of an estimate or reserve that had been accrued at year-end.

Known misstatements are those that the auditor has specifically identified and about which there is no doubt; they are also known as factual misstatements.

Management can provide disclosures on the face of the financial statements, or in the notes to the financial statements.

OAO Gazprom is a natural gas producer in Russia; top management used their power to siphon profits out of Gazprom and into their own pockets. In its filings, the company did not disclose many specific details about its related party transactions.

Objective criteria for evaluating the quality of the client's accounting policies is not available; assessing the quality, not just the acceptability of the significant accounting policies is a matter or professional judgment.

Review analytics should corroborate conclusions formed during the audit, thereby enabling the auditor to draw conclusions upon which to base the audit opinion.

The audit of inventory can be complex because inventory is easily transportable, exists at multiple locations, may become obsolete, and may be difficult to value.

The auditor should provide the audit opinion in a written report.

The auditor's expectations when performing review analytical review can be less precise than those for substantive analytics.

The following are possible manipulations that may occur when employees perpetrate fraud during the purchase of inventory: under-recording purchases, recording purchases in a later period, and not recording purchases.

The going-concern evaluation is based on information obtained from typical audit procedures performed to test management's assertions; no separate procedures are required, unless the auditor believes that there is substantial doubt about the client's ability to continue as a going concern.

The management letter is not required, but auditors use it to make significant operational or control recommendations to the client.

The most common concerns for inventory are that purchases are understated or ending inventory is overstated, both of which will result in lower cost of goods sold and higher net income.

The primary reason for issuing an adverse audit opinion is that the client's financial statements contain a pervasive and material unjustified departure from GAAP.

The terms engagement quality review and concurring partner review are synonymous.

Two important complexities in auditing inventory arise because inventory accounts experience a high volume of activity and are valued according to various inventory valuation methods.

Type I subsequent events provide evidence about conditions that existed at the balance sheet date, while Type II subsequent events provide evidence about conditions that did not exist at the balance sheet date, but that may require disclosure.

Under guidance issued by the PCAOB in 2017, the audit report should include a statement indicating how long the audit firm has served as the company's auditor.

When conducting the audit of acquisition and payment cycle accounts, the auditor will likely conduct less substantive tests for companies with effective internal controls than for companies with ineffective internal controls.

When considering the appropriate mix of evidence, the sufficiency and appropriateness of selected procedures vary across inventory assertions to achieve the desired level of assurance for each relevant assertion.

Inventories

items of tangible property that are: (1) held for sale in the ordinary course of business (2) in the process of production for such sale, or (3) to be used in the production of goods or services to be available for sale.

Supply chain management

management and control of materials in the logistics process from the acquisition of raw materials to the delivery of finished products to the end user (customer)

An engagement quality review is required for publicly traded companies, and is optional for privately held company audits.

Qualified Opinion: Departure from GAAP

(1) inadequate disclosure (including the omission of a statement of cash flows, or inadequate disclosure about the client's ability to continue as a going concern for a reasonable period of time); (2) departures from GAAP involving risks or uncertainties (including inadequate disclosure, inappropriate accounting principles, and unreasonable accounting estimates); and (3) departures from GAAP related to changes in accounting principle. In deciding whether the effects of the departure require a qualified or an adverse opinion, one factor the auditor will consider is the dollar magnitude of such effects and 1. significance of an item to a particular entity (e.g., inventories to a manufacturing company) 2. pervasiveness of the misstatement 3. effect of the misstatement on the financial statements taken as a whole

When auditors detect an intentional misstatement

(1) reconsider the level of audit risk for the client, (2) consider revising the nature, timing, and extent of audit procedures, and (3) evaluate whether to resign from the audit engagement

examples of Type II subsequent events

- An uninsured casualty loss that occurred after the balance sheet date causes a customer's bankruptcy during the subsequent period. Because the inability of the customer to pay did not exist as of the balance sheet date, the allowance for doubtful accounts should not be adjusted, but the information should be disclosed. - A customer initiates a significant lawsuit relating to an incident that occurred after the balance sheet date. - Because of a natural disaster such as fire, earthquake, or flood, a company loses a major facility after the balance sheet date. - The client makes a major decision during the subsequent period, such as to merge, discontinue a line of business, or issue new securities. - A material change occurs in the value of investment securities.

AICPA basic principles related to audit reporting

- The purpose of an audit is to enhance the degree of confidence that users can place in the financial statement. This purpose is achieved when an auditor expresses an opinion on the financial statements. - The auditor expresses an opinion as to whether the financial statements are free of material misstatement or states that an opinion cannot be expressed. The principles, guidance, and objectives of AICPA, PCAOB, and IAASB vary somewhat in terminology, but all support this objective

procedures related to subsequent events include:

- cutoff tests - review of subsequent collections of receivables - search for unrecorded liabilities. - Read the minutes of the meetings of the board of directors, stockholders, and other authoritative groups - Read interim financial statements and compare them to the audited financial statements, noting and investigating significant changes. - Inquire of management

When assessing the adequacy of disclosures, the auditor should have reasonable assurance that:

1. Disclosed events and transactions have occurred and pertain to the organization. 2. All disclosures that should have been included are included. 3. The disclosures are understandable to users. 4. The information is accurately disclosed and at appropriate amounts.

procedures engagement quality reviewer should perform

1. Discussing with the audit team any significant matters related to the financial statements and internal controls, including the audit team's identification of material weaknesses and audit procedures to address significant risks 2. Evaluating judgments about materiality and the disposition of corrected and uncorrected identified misstatements 3. Reviewing the engagement team's evaluation of the firm's independence in relation to the engagement 4. Reviewing the related audit documentation to determine its sufficiency 5. Reading the financial statements, management's report on internal control, and auditor's report 6. Confirming with the lead audit partner that there are no significant unresolved matters 7. Determining if appropriate consultations have taken place on difficult or contentious matters 8. Evaluating whether the auditor documentation supports the conclusions reached by the engagement team with respect to the matters reviewed 9. Assessing whether appropriate matters have been communicated to audit committee members, management, and other appropriate parties 10. Evaluating whether appropriate levels of supervision and reviews of individual audit tasks were completed adequately during the audit

Situations Requiring a Modification to the Audit Report on Internal Control Financial Reporting

1. If there are restrictions placed on the scope of the engagement, the auditor will either withdraw from the engagement or disclaim an opinion (thereby stating that the auditor does not express an opinion on ICFR effectiveness). 2. If the auditor determines that management's report on ICFR is incomplete or not properly presented, the auditor's report will include an explanatory paragraph that describes the reasons for this determination. 3. If management chooses to provide information in its report on ICFR in addition to the information required to be provided, the auditor will disclaim an opinion on that additional information.

Indicators of Potential Going-Concern Problems

1. Negative trends, such as recurring losses, working-capital deficiencies, negative cash flows from operating activities, and adverse key financial ratios 2. Internal matters, such as loss of key personnel, employee strikes, outdated facilities and products, and uneconomic long-term commitments 3. External matters, such as new legislation, pending litigation, loss of a key franchise or patent, loss of a principal customer or supplier, and uninsured or underinsured casualty loss 4. Other miscellaneous matters, such as default on a loan, inability to pay dividends, restructuring of debt, violation of laws and regulations, and inability to buy from suppliers on credit 5. Significant changes in the competitive market and the competitiveness of the client's products

Report Sections:

1. Opinion on the Financial Statements 2. Basis for Opinion 3. Critical Audit Matters (CAMs) (delayed effective date) 4. Other Information: Signature of Firm and Audit Partner, Tenure, Location, Date

To review and assess the adequacy of disclosures, the auditor will

1. Read the client's disclosures for each financial statement line item and associated discussion in the footnotes 2. Obtain evidence to determine whether the disclosures are adequate in light of required GAAP - e.g., by completing a disclosure checklist 3. Consider alternative or enhanced disclosures that may be helpful to users

Performing Substantive Fraud-Related Procedures for Accounts Payable and Related Expenses

1. Send blank confirmations or electronic confirmations via confirmation.com to vendors that ask them to furnish information about all outstanding invoices, payment terms, payment histories, and so forth. 2. Scan journals for unusual or large year-end transactions and adjustments, 3. Review client's vendor files for unusual items. Unusual items might include nonstandard forms, different delivery addresses, or vendors that have multiple addresses. 4. Obtain and examine documentation for payments of invoices that are for amounts just under the limit that typically requires some level of approval.

Unqualified Audit Reports: U.S. Public Companies: new reporting standards

1. Specific mention of comprehensive income and the notes to the financial statements 2. An affirmative statement the audit firm is registered with the PCAOB 3. An affirmative statement regarding the requirement for the auditor to be independent with respect to the company 4. Amended language that adds the phrase whether due to error or fraud when describing the auditor's responsibility to plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatements 5. A new disclosure, which includes the year in which the auditor began serving consecutively as the company's auditor

Documenting Substantive Procedures

1. Substantive analytical procedures conducted, conclusions reached, and related actions that were taken 2. Evidence about physical inventory observations for all material amounts: 3. Evidence about product costing 4. Evidence pertaining to net realizable valuable calculations 5. Evidence from inventory specialists 6. Summaries of evidence obtained and conclusions reached about material amounts of inventory on consignment 7. Evidence from evaluating subsequent disbursements for accounts payable 8. Vendor statements 9. Confirmations with vendors regarding accounts payable 10. Evidence regarding conducting a review of unusual entries

Situations when the auditor would issue an unqualified/unmodified audit opinion with report modifications:

1. The auditor chooses to emphasize some matter in the financial statements 2. The auditor opts to include information about audit participants in the audit report (applicable only for PCAOB audits) 3. The auditor decides to refer to other auditors as the basis, in part, for the auditor's own report 4. There is a lack of consistency in the financial statements 5. There is a justified departure from GAAP 6. Substantial doubt about the client being a going concern exists 7. The client had a material misstatement in previously issued financial statements that it has corrected

Scenarios resulting in Unqualified Audit Opinion with Explanatory Paragraph

1. The auditor wants to emphasize a matter, e.g., an uncertainty relating to important litigation, potential regulation, a major catastrophe, significant related party transactions, and/or unusually important subsequent events, among others (at the auditor's discretion, and likely after discussing the matter(s) with the audit committee and management). 2. The auditor wants to disclose the name of the audit partner and/or other auditing firms that participated in the audit in some way (explanation should indicate the division of responsibility and the relative proportion of work performed by each party). 3. There is an inconsistent application of GAAP (e.g., change in accounting methods), but it is NOT PERVASIVE, i.e., does not render the ENTIRE financial statements materially misstated. 4. · There is a justified departure from GAAP, i.e., for some unusual reasons following GAAP would result in misleading financial statements. 5. · The client corrects a material misstatement in previously issued financial statements. 6. · There is substantial doubt about the client being a going concern. DISCLAIMER OF OPINION: - Alternatively for going concern problems, the auditor can decide to pull away from the client and refuse to issue any opinion, which is called a 'disclaimer' of opinion. - self-fulfilling prophecy relating to going concern audit reports: The client blames the auditor for the company going bankrupt because, e.g., suppliers have refused to accept credit from the client, thereby causing the business to fail.

When will the auditor issue an unqualified/unmodified audit opinion?

1. There are no material violations of GAAP and 2. disclosures are adequate and 3. the auditor was able to perform all of the necessary procedures ... and 4. there was no change in accounting principles that had a material effect on the financial statements ... and 5. the auditor does not have significant doubt about the client remaining a going concern and 6. the auditor is independent.

Scenarios resulting in Qualified Audit Opinion

1. There is a non-justified departure from GAAP, the effect of which is material but it is NOT PERVASIVE, i.e., does not render the ENTIRE financial statements materially misstated. 2. There is a scope limitation, such that the auditor is unable to gather sufficient, appropriate audit evidence for some reason. DISCLAIMER OF OPINION: - Alternatively for scope limitations, the auditor can decide to pull away from the client and refuse to issue any opinion, which is called a 'disclaimer' of opinion.

Scenarios resulting in Adverse Audit Opinion

1. There is an inconsistent application of GAAP, that IS PERVASIVE, i.e., renders the ENTIRE financial statements materially misstated (e.g., dollar magnitude or qualitatively important). 2. There is a material departure from GAAP, the effect of which is material and IS PERVASIVE, i.e., renders the ENTIRE financial statements materially misstated (e.g., dollar magnitude or qualitatively important). DISCLAIMER OF OPINION: - a situation in which the auditor is not independent, e.g., through owning the client's stock or preparing their financial statements.

Issues for auditors to consider when evaluating the quality of a client's accounting policies.

1. What is the consistency of the organization's accounting principles and their application? 2. What is the clarity of the financial statements and related disclosures? 3. What is the completeness of the financial statements and related disclosures? 4. Are there any items that have a significant impact on the representational faithfulness, verifiability, and neutrality of the accounting information included in the financial statements? - Selection of new accounting policies or changes to current ones - Estimates, judgments, and uncertainties - Unusual transactions

An auditor will issue an unqualified/unmodified report when all of the following conditions are present:

1. there are no material violations of GAAP 2. disclosures are adequate the auditor was able to perform all of the necessary procedures 3. there was no change in accounting principles that had a material effect on the financial statements 4. the auditor does not have significant doubt about the client remaining a going concern 5. the auditor is independent When these conditions are not present, the auditor will modify the unqualified report in one of the following ways: 1. Issue an unqualified opinion, with report modifications 2. Qualify the audit opinion 3. Issue an adverse opinion 4. Issue a disclaimer of opinion

Inconsistent Application of GAAP

A change in accounting principle that has a material effect on the financial statements should be recognized in the audit report - change in accounting principles includes a change from one GAAP to another, such as from FIFO to LIFO - A change from non-GAAP to GAAP—such as from the cash basis to the accrual basis—is accounted for as a correction of an error, but is treated by the auditor as a change in accounting principle requiring an additional paragraph. Both changes requires the auditor to add a paragraph to the audit report If the client has changed an accounting principle, has reasonable justification for the change, and has followed GAAP in accounting for and disclosing this change, the explanatory paragraph serves as a flag directing the user's attention to the relevant footnote disclosure If the change in accounting principle is not justified or accounted for correctly, or there is inadequate disclosure, the auditor is dealing with a departure from GAAP - leads either to a qualified or adverse opinon

Purchase Order

A legally binding document between a supplier and a buyer. - details the items the buyer agrees to purchase at a certain price point. - outlines the delivery date and terms of payment for the buyer. - typically created using electronic purchasing systems, which enable businesses to track purchase orders and submit them electronically. - Prenumbered purchase orders are used to establish the uniqueness of each order and the completeness of the purchase order population

iron curtain method

A method of misstatement correction that focuses on assuring that the year-end balance sheet is correct; this method does not consider the impact of prior-year uncorrected misstatements reversing in later years

rollover method

A method of misstatement correction that focuses on the materiality of the current-year misstatements and the reversing effect of prior year misstatements - may allow misstatements to accumulate on the balance sheet

SEC's Staff Accounting Bulletin (SAB) 108

Addresses the approach auditors should use in assessing both current-year and prior-year misstatements The dual approach requires the simultaneous application of both the rollover method and the iron curtain method. - If a misstatement is material under either method, the client must correct the misstatement in the current period Rollover Method -

Omitted Audit Procedures

After the audit report has been issued, the auditor may discover an omitted procedure - an important audit procedure that was not performed - ex. auditor failed to follow up on a material accounts receivable confirmation response indicating a difference between the client's recorded balance and the customer's recorded balance. When an omitted procedure is discovered, the auditor should decide whether the previously issued audit report can still be supported. - review of the working papers - discussion of the circumstances with engagement personnel and others - reevaluation of the overall scope of audit The auditor may conclude that results of other procedures that were performed may compensate for the omitted procedure or make its omission less important. Proper audit documentation can aid auditors in mitigating the risk of accidentally omitting audit procedures

Qualified or Disclaimer This is actually difficult to answer, because the auditor may not have enough information to render an opinion. If the auditor is satisfied that the loans need to be written down by the $7.5 million, the qualified, except for opinion is appropriate. If the auditor suspects fraud, then additional audit work needs to be performed. Finally, if sufficient appropriate evidence cannot be gathered a disclaimer of opinion must be issued.

An audit client has a significant amount of loans receivable outstanding (40% of assets), but has an inadequate internal control system over the loans. The auditor cannot obtain sufficient appropriate evidence to prepare an aging of the loans or to identify the collateral for about 75% of the loans, even though the client states that all loans are collateralized. The auditor sent confirmations to verify the existence of the receivables, but only 10 of the 50 sent were returned. The auditor attempted to verify the other loans by looking at subsequent receipts, but only eight had remitted payments during the month of January, and the auditor wants to wrap up the audit by February 15. The auditor estimates that if only 10 of the 50 loans were correctly recorded, loans would need to be written down by $7.5 million.

Adverse Opinions

An auditor issues an adverse opinion when, in the auditor's judgment, the financial statements taken as a whole are not presented fairly in conformity with GAAP - appropriate when the auditor concludes that misstatements, individually or in the aggregate, are both material and pervasive to the financial statements. When expressing an adverse opinion, the auditor should disclose in a separate paragraph(s): (1) all the substantive reasons for the adverse opinion, and (2) the principal effects of the subject matter of the adverse opinion on financial position, results of operations, and cash flows, if practicable.

Disclaimer: Auditor Lacking Independence

An auditor may lack independence, yet be required by law or regulation to report on the financial statements. - auditor should issue a disclaimer of opinion. - disclaimer should specifically state that the auditor is not independent - auditor may choose to provide the reasons for the lack of independence, but is not required to do so

Engagement Quality Review

As part of a quality audit for public companies, the audit firm has policies and procedures for conducting an engagement quality review of each audit before issuing the audit opinion. ●Auditors of privately held companies generally perform these reviews, even though they are not explicitly required. ●An experienced reviewer who was not a part of the audit team, but who has appropriate competence, independence, integrity, and objectivity, should perform this independent review, referred to as an engagement quality review or concurring partner review. The purpose of these reviews is to provide reasonable assurance that the audit and audit documentation are complete and support the audit opinion on the financial statements and, for integrated audits, on the client's internal controls. -The engagement quality review is a risk-based review, where the reviewer evaluates the significant judgments and conclusions made by the engagement team.

Critical Audit Matters (CAMs)

Auditing standards differ in their requirements related to reporting important audit matters - referred to as a a critical audit matter by the PCAOB. the auditor's report must disclose whether any CAM arose during the current period audit, or state that there was none. A CAM is: 1. Any matter that was communicated or required to be communicated to the audit committee, and 2. Relates to accounts or disclosure material in regard to financial statements, and 3. Involves especially challenging, subjective, or complex auditor judgment. To determine whether a matter involved especially challenging, subjective, or complex auditor judgment, the auditor takes into account: 1. The auditor's assessment of the risks of material misstatement, including significant risks; 2. The nature and timing of significant unusual transactions and the extent of audit effort and judgment related to requisite transactions; and, 3. The degree of auditor subjectivity in applying audit procedures to address the matter or in evaluating the results of those procedures. Matters that are material to the financial statements, but that do not relate to accounts or disclosures are not critical audit matters

Key Audit Matters (KAMs)

Auditing standards differ in their requirements related to reporting important audit matters - referred to as a key audit matter by the IAASB and the ASB of the AICPA, requires that key audit matters be included in the audit report - matters that the auditor considers to be the most significant in the current audit. KAM topics: 1. revenue 2. IT applications and controls 3. management override of controls 4. taxation 5. recoverability of loans and receivables 6. goodwill and intangibles. Lengthy lists of key audit matters may be contrary to the notion of such matters being those of most significant in the audit. - Therefore, an important challenge to the auditor lies in determining whether a matter rises to the level of a KAM - require that the auditor will report KAMs in the audit report. - The order of presentation of individual KAM is a matter of professional judgment

Dating the Auditor's Report: Guidance from the Standards

Auditing standards of the AICPA, PCAOB, and IAASB provide similar guidance on the date of the auditor's report. - should be dated no earlier than the date on which the auditor has obtained sufficient appropriate audit evidence on which to base the auditor's opinion on the financial statements.

Client Correction of a Material Misstatement in Previously Issued Financial Statements

Auditor's report must recognize a correction of a material misstatement in previously issued financial statements through an additional paragraph including: (1) a statement that the previously issued financial statements have been restated for the correction of a misstatement in the respective period and (2) a reference to the note disclosure describing the correction of the misstatement.

Noncompliance with Laws and Regulations

Auditors are responsible for obtaining reasonable assurance that the financial statements are free from material misstatements, including material misstatements relating to a client's compliance with laws and regulations. ●Auditing standards recognize that there are inherent limitations in an auditor's ability to detect material misstatements relating to the client's compliance with laws and regulations. These limitations include: - Laws and regulations often relate to operational issues within the client that do not necessarily relate to the financial statements. - Management may act to conceal noncompliance, or may override controls, or may intentionally misrepresent facts to the auditor. - The legal implications of noncompliance are ultimately a matter for legal authorities to resolve, and are not a matter the auditor can resolve.

Unmodified Audit Reports: Non-U.S. Companies

Auditors following the ISAs would refer to ISA 700 for relevant guidance on audit reports. - format of an ISA audit report is similar to the PCAOB's report format under the reporting standard, AS 3101, adopted in 2017 1. One difference between the ISA and AS guidance involves terminology. - ISA 700 allows for the description in the audit report to indicate that the financial statements present fairly, in all material respects or give a true and fair view of. - U.S. auditing standards do not include any references to true and fair view 2. Another difference is that the engagement partner's name must be included in the ISA audit report, while for U.S. public company audits, it is optional to include that information in the audit report 3. A third difference is that the ISA report does not include information on audit firm tenure with the client. 4. A major current difference in audit reports between non-U.S. companies and U.S. companies is the inclusion of important audit matters in the audit report. - ISA 701, Communicating Key Audit Matters in the Independent Auditor's Report, requires that such matters be included in the audit report. - July 2017, the ASB voted to consider aligning it guidance with ISA 701, and require auditors to include in the auditor's report key audit matters.

Emphasis-of-Matter

Auditors have the option of including a paragraph with an unqualified opinion to emphasize a matter regarding the financial statements. - The choice to emphasize a matter (other than those required to be emphasized) is strictly one of auditor judgment - Including an emphasis-of-matter paragraph does not affect the auditor's opinion Auditor may choose to include an emphasis-of-matter paragraph when: 1. An uncertainty relating to the future outcome of unusually important litigation or regulatory action 2. A major catastrophe that has had, or continues to have, a significant effect on the entity's financial position 3. Significant transactions with related parties 4. Unusually important subsequent events "We draw attention to Note X of the financial statements, which describes the effects of hurricane-related damage in the Company's production facilities and headquarters offices"

The Going-Concern Assumption

Auditors issue an opinion based on a going-concern assumption. ●As part of this assumption, auditors are required to evaluate the likelihood of each client continuing as a going concern for a reasonable period of time. ●The auditor's assessment of the going-concern assumption is based on information obtained from typical audit procedures performed to test management assertions. If there is substantial doubt about the ability of the client to remain a going concern, the auditor identifies and assesses management's plans to overcome the problems. Two possible outcomes: 1. If, after reviewing management's plans, the auditor concludes that substantial doubt about the entity's ability to continue as a going concern has been alleviated, the auditor considers the disclosure of the conditions or events that initially caused the auditor to believe there was substantial doubt. 2. Alternatively, if the auditor concludes that substantial doubt about the entity's ability to continue as a going concern for a reasonable period of time remains, the auditor should modify the audit report to include an emphasis-of-matter paragraph that reflects that conclusion.

Qualified Opinions

Auditors will issue a qualified report when: 1. The auditor believes that the financial statements contain a departure from GAAP, the effect of which is material but not pervasive, and the auditor has concluded not to express an adverse opinion 2. There is a lack of sufficient appropriate evidential matter or there are restrictions on the scope of the audit that have led the auditor to conclude that he or she cannot express an unqualified opinion and concluded not to disclaim an opinion auditor should disclose all of the substantive reasons for the qualified opinion in one or more separate paragraph(s) - should include the word 'except' or 'exception' in a phrase such as 'except for' or with the 'exception of' Departure from GAAP - When financial statements contain a material departure from GAAP the auditor should express a qualified or an adverse opinion

Accounts Payable and Related Expense Accounts: Substantive Test of Details for Presentation and Disclosure

Companies disclose very little about accounts payable and related expense accounts. These accounts and related amounts typically only appear on the face of the financial statements.

Inventory and Cost of Goods Sold: Substantive Tests of Details for Completeness

Cutoff test of receipts and shipments of inventory at year-end to determine whether all items are recorded in the correct period - provide evidence related to both the existence and completeness assertions. Allowance for Returns - client should establish an allowance for returns, in effect reversing the recorded gross profit on the original sale - The auditor should consider the allowance account for any organization experiencing a large volume of returns. - auditor needs to understand management's process for determining the estimate and then test the reasonable of that process.

Obtain Remaining Audit Evidence

Detected misstatements ●The auditor summarizes the misstatements detected during the audit to determine: - Whether they are material - Whether the client needs to record and correct them ●Misstatements fall into three categories: 1. Known misstatements - client recorded revenue in error 2. Projected misstatements - auditor calculates misstatement based on statistical sampling procedures - e.g., during inventory count, auditor discovers errors and projects them to the population 3. Judgmental misstatements - client and auditor disagree about valuation of accounts receivable ●Summary of Unadjusted Audit Differences (SUAD)

corruption perception index

Developed in 1995 by Transparency International -a ranking of countries according to the extent to which people believe corruption exists. - Transparency International ranks about 200 countries on a scale from 0 (highly corrupt) to 100 (very clean).

Unqualified, with no report modifications The auditor has a well-developed sampling plan and has sufficient justification to utilize the work of the internal auditors to corroborate the audit approach. No exceptions were noted, and the extent of work appears to be sufficient to justify the audit opinion.

During the audit of a large manufacturing company, the auditor did not observe all locations of physical inventory. The auditor chose a random number of sites to visit, and the company's internal auditors visited the other sites. The auditor has confidence in the competence and objectivity of the internal auditors. The auditor personally observed only about 20% of the total inventory, but neither the auditor nor the internal auditors noted any exceptions in the inventory process

Qualified The auditor has substantial doubt about the ability of the company to remain a going concern. Although management has confidence that an alternative source may be found, the doubt still exists. Management's problems and plans are not adequately described in a note to the statements. This is a GAAP violation, and a qualified opinion should be rendered that makes it clear the auditor has substantial doubt about the client being a going concern and that the required disclosures are missing. In addition, if the client does not reclassify the loan as a current liability, that would also be a GAAP violation that should be disclosed in the auditor's report.

During the course of the audit of Sail-Away Company, the auditor noted that the current ratio had dropped to 1.75. The company's loan covenant requires the maintenance of a current ratio of 2.0, or the company's debt is immediately due. The auditor and the company have contacted the bank, which is not willing to waive the loan covenant because the company has been experiencing operating losses for the past few years and has an inadequate capital structure. The auditor has substantial doubt that the company can find adequate financing elsewhere and may encounter difficulties staying in operation. Management, however, is confident that it can overcome the problem. The company does not deem it necessary to include any additional disclosure because management members are confident that they will find an alternative source of funds by pledging their personal assets

Unqualified, with no report modifications The research related to the development of a specific product is adequately described in the notes to the financial statements. It appears that the capitalized costs are appropriate.

During the past year, Network Computer, Inc. devoted its entire research and development efforts to develop and market an enhanced version of its state-of-the-art telecommunications system. The costs, which were significant, were capitalized as research and development costs. The company plans to amortize these capitalized costs over the life of the new product. The auditor has concluded that the research to date will likely result in a marketable product. A full description of the research and development, and the costs, is included in a note. The note also describes that basic research costs are expensed as incurred, and the auditor has verified the accuracy of the statement

Unqualified Audit Reports: U.S. Public Companies

Effective December 15, 2017 auditors following PCAOB standards will issue audit reports that include 1. Title "Report of Independent Registered Public Accounting Firm," and the addressee(s) 2. Opinion on the Financial Statements 3. Basis for Opinion section that follows the Opinion 4. Signature, Tenure, Location, and Date - The audit firm is also required to report the name of the engagement partner and information about the involvement of other accounting firms participating in the audit

Typical controls for Step 1: Requisition (Request) for Goods and Services

Embedded in the requisition process are controls to provide assurance that appropriate employees have properly approved all purchases - Typically, a department supervisor prepares a requisition request and obtains approval for the request. - A requisition request is an internal document requesting the purchase of goods or services. - An employee in the accounting area often serves as the approver.

disclosure checklist

Engagement teams use audit firm disclosure checklists to help ensure a quality audit so that auditors do not forget important disclosures. - serves as a cue to guiding audit planning around management's assertions in various disclosures - often industry-specific, e.g., disclosures for a bank are very different from those of a retailer - convenient documentation format for evidence that the auditor adequately evaluated management's assertions about the adequacy of its disclosures The auditor should not blindly follow a checklist, but use good audit judgment when there are unusual circumstances of which the users should be aware.

Identifying Fraud Risks

Examples of fraud in the acquisition and payment cycle include: - Theft of inventory by the employee - Inventory shrinkage: a reduction in inventory presumed to be due to physical loss or theft - Employee schemes involving vendor fraud - Employees recording fictitious inventory or inappropriately recording higher values for existing inventory by creating false records for items that do not exist (e.g., inflated inventory count sheets and bogus receiving reports or purchase orders) - Large manual adjustments to inventory accounts - Schemes to classify expenses as assets: (e.g., inappropriately capitalizing items that are truly current-period expenses) - Executives misusing travel and entertainment accounts and charging them as company expenses

All audit reports issued under the guidance of ISA 701, Communicating Key Audit Matters in the Independent Auditor's Report, will include one or more KAMs.

An example of a Type I subsequent event would be when a significant lawsuit is initiated relating to an incident that occurred after the balance sheet date.

Auditors should not issue a going-concern audit opinion if it would be a self-fulfilling prophecy that the company will, indeed, go bankrupt

Because a purchase order is an external document, its level of reliability is higher than that of a requisition, which is an internal document.

If after the audit report was issued, the auditor discovers that an important audit procedure was not performed, SOX requires that the auditor file a Form 8-K with the SEC.

If an auditor conducts an audit in accordance with multiple auditing standards in their entirety, the auditor can only mention one set of standards in the audit report.

If the auditor is conducting an integrated audit, the auditor must provide both opinions in the same report.

An example of a situation in which the auditor discovers omitted procedures after the audit report was issued would be one in which the auditor failed to confirm receivables, and this fact comes to light as part of an internal review program.

One of the common ways that managers have committed fraud in the acquisition and payment cycle involves inappropriately classifying assets (e.g., inventory) as expenses.

One of the issues that the auditor is required to communicate to the audit committee is the competence, training, and industry specialization of each of the highest ranking members of the engagement team (the partner, manager, and audit senior).

The auditor is responsible for designing and maintaining policies and procedures to identify, evaluate, and account for loss contingencies; management is responsible for determining that the auditor has properly identified, accounted for, and disclosed material loss contingencies.

The auditor should provide an audit report on the financial statements only if the audit opinion indicates that the financial statements are fairly stated in all material respects.

The legal implications of a client's noncompliance with laws and regulations are ultimately a matter for the auditor to resolve before the auditor can issue the audit opinion.

The management letter confirms management responses obtained by the auditor earlier in the audit and the continuing appropriateness of those responses.

When conducting the audit of the acquisition and payment cycle for a client with a high risk of material misstatement in its inventory accounts, the following mix of evidence would be appropriate: significant tests of internal control, significant reliance on substantive analytical procedures, and limited tests of details.

F 50% test of details, 30% analytics, 20% test of controls)

International auditing standards generally permit the auditor to refer to other auditors in the auditor's report, while the U.S. auditing standards allow this reference only if required by law or regulation.

F (US permits reference, IFRS only if required by law)

A substantive procedure appropriate for testing the existence of inventory would be to perform year-end cutoff tests by noting the last shipping and receiving document numbers used before the physical inventory count is taken.

F (completeness)

One important primary source of evidence concerning loss contingencies is the client's management; a primary source of corroborative evidence concerning contingencies is the client's legal counsel, which provides the management representation letter.

F (legal council, letter of audit inquiry)

When the auditor issues a disclaimer because of a lack of independence, the audit report must state the lack of independence, and must describe the reasons for the lack of independence.

F (may choose to provide reasons for lack of independence)

The auditor issues an adverse opinion on ICFR if the client has one or more significant deficiencies in ICFR.

F (one or more material weaknesses)

ISA 701, Communicating Key Audit Matters in the Independent Auditor's Report, mandates the order of presentation of KAMs.

F (order subject to judgement)

If an auditor decides to include additional language in the audit report because of concerns about the client's ability to remain a going concern, the additional language should include the terms material doubt and going concern.

F (substantial doubt and going concern)

Auditing standards recognize that there are inherent limitations in an auditor's ability to detect material misstatements relating to an organization's compliance with laws and regulations.

Information about Certain Audit Participants

For U.S. public companies, the auditor may include in the auditor's report information regarding the engagement partner and/or other accounting firms participating in the audit If the auditor decides to provide this information in the audit report, the auditor must disclose: 1. Engagement partner and/or 2. Other accounting firms participating in the audit

Reference to Other Auditors

For some clients, part of the audit will be performed by other independent auditors, or by another legal entity within the firm's network - ex. an auditor may involve another auditor to observe the inventory count or inspect long-term assets at a remote location - When the principal auditor decides to make reference to the audit of the other auditor, the audit report should clearly indicate the division of responsibility between that portion of the financial statements covered by the principal auditor and that covered by the other auditor - disclose the magnitude of the portion of the financial statements audited by the other auditor

Reporting Requirements

Goal is to clarify the auditor's role and responsibilities, provide information about the auditor, and make the auditor's report easier to read. •Audit firm tenure must be disclosed in terms of the year that the audit firm began serving consecutively as the company's auditor. •The mandate for auditor independence must be affirmatively stated. •The report will be addressed to (at a minimum) the shareholders and board of directors or equivalents (additional addressees are permitted). •The report will include the phrase "whether due to error or fraud," when describing the auditor's responsibility to obtain reasonable assurance about whether the financial statements are free of material misstatements. •The opinion will appear in the first paragraph, and the report will include section titles to guide the reader.

KAMs or CAMs?

IAASB - Jurisdiction: Outside the U.S. listed entities, for which ISAs are applicable - Key Audit Matter (KAM) Auditing Standards Board (ASB) - Jurisdiction: U.S. private entities for which AU-C are applicable - July 2017, the ASB voted to consider aligning its guidance with ISA 701, and requiring auditors to include a discussion of KAMs in the audit report. PCAOB - Jurisdiction: U.S. public entities for which AS are applicable - CAM

effect of illegal acts by the client on the audits report for companies, both in the U.S. and internationally.

If the auditor concludes that an illegal act has a material effect on the financial statements, and the act has not been properly accounted for or disclosed, the auditor should express a qualified opinion or an adverse opinion on the financial statements taken as a whole, depending on the materiality of the effect on the financial statements. - If the client refuses to accept the auditor's report for the above modifications, the auditor should withdraw from the engagement and indicate the reasons for withdrawal in writing to the audit committee or board of directors - all auditor changes for publicly traded organizations in the U.S. must be disclosed within four days to the SEC via a Form 8-K to alert users to these material, unplanned events - if management does not want the disagreement to be made public, they will need to concede to the auditor's demands with respect to the quality of financial reporting, which will then enable the auditor to avoid having to issue a qualified, adverse, or disclaimer opinion, or having to withdraw from the audit altogether.

Mitigating Factors

If the auditor concludes that the going-concern assumption may not be valid for a client, the auditor should assess management's plans to overcome this problem. ●Identify those factors that are most likely to resolve the problem. ●Gather independent evidence to determine the likely success of such plans. ●Evaluate the reasonableness of other assumptions made by management, including management's assumption about: - Increasing prices or market share - Cost savings related to a reduction in workforce - Selling off assets After considering these factors, the auditor will assess whether management can mitigate the going-concern problem, and audit reporting decisions will follow based upon that assessment and possible disclosures that may be necessary.

Justified Departure from GAAP

If the statements or data contain such a departure and the member can demonstrate that due to unusual circumstances the financial statements or data would otherwise have been misleading, the member can comply with the rule by describing the departure, its approximate effects, if practicable, and the reasons why compliance with the principle would result in a misleading statement.

Substantial Doubt about the Client Being a Going Concern

If, after considering identified conditions and events and management's plans, the auditor concludes that substantial doubt about the entity's ability to continue as a going concern for a reasonable period of time remains, the audit report should include an additional paragraph, including an appropriate title to reflect that conclusion. - should be expressed through the use of the phrase "substantial doubt about its (the entity's) ability to continue as a going concern" The additional paragraph should not include conditional language ex: - If the Company continues to suffer recurring losses from operations and continues to have a net capital deficiency, there may be substantial doubt about its ability to continue as a going concern.

Standard For Accruing and Disclosing Loss Contingencies

In Accounting Standards Codification (ASC) 450, the FASB provides the standard for accruing and disclosing loss contingencies that can be reasonably estimated. ●The categories of contingencies are organized around probability of outcomes that reflect the contingent nature of the loss. - Probable - Reasonably possible - Remote ●ASC 450 requires the following: - The accrual and disclosure of contingent losses that are reasonably estimated and probable. - The client disclose a contingent loss if there is at least a reasonable possibility that a loss may occur and either an accrual has not been made or an exposure exists that is greater than the amount accrued.

Audit Reports on Internal Control Over Financial Reporting for U.S. Public Companies

In determining the appropriate opinion on internal control over financial reporting (ICFR), the auditor evaluates identified control deficiencies individually, and in the aggregate, to assess whether there is a material weakness in ICFR. - issue an unqualified opinion on ICFR when the auditor determines that there are no material weaknesses in ICFR - issue an adverse opinion when there are one or more material weaknesses in ICFR - may issue a separate report on internal control over financial reporting

Disclaimer: Substantial Doubt about the Client Being a Going Concern

In some reporting situations, doubt about the client continuing as a going concern is such that the auditor does not believe that an additional paragraph to an unqualified opinion is appropriate. In such cases, the auditor may issue a disclaimer of opinion.

Identifying Inherent Risks for Accounts Payable and related expense accounts

In terms of accounts payable and related expense accounts, the auditor should consider the inherent risk that management is more likely to: ●(1) understate, rather than overstate, expenses and payables, and ●(2) classify expense items as assets.

Audit Committee Communications

It is important that the auditor have a constructive and detailed dialogue with the audit committee. ●This communication is important because the audit committee serves as an independent subcommittee of the board of directors. ●The audit committee can also assist the auditor should a disagreement occur between the auditor and management. ●The audit committee must be assured that the auditor is free of any restrictions and has not been inappropriately influenced by management during the course of the audit.

SEC Reporting Deadlines for Form 10-K (Annual Report)

Large accelerated filer—Market capitalization greater than $700 million - 60 days after year end Accelerated filer—Market capitalization greater than $75 million, but less than $700 million - 75 days after year end Nonaccelerated filer—Market capitalization less than $75 million - 90 days after year end

Common Controls in the Requisition and Purchasing Processes: Inventory Purchases: Manufacturing Organization

Manufacturing Organization 1. Written requisitions are made for specific products by the production manager or stockroom manager. 2. Computer-generated requisitions are generated based on current inventory levels and production plans.

An unqualified opinion, because the GAAP violation is not material to the consolidated statements. No report modifications are needed.

One of your client's subsidiaries was audited by another audit firm, whose opinion was qualified because of a GAAP violation. You do not believe that the GAAP violation is material to the consolidated financial statements on which you are expressing an opinion.

Qualified Opinion: Scope Limitations

Restrictions on the scope of the audit, whether imposed by the client or by circumstances beyond the auditor's or client's control, may require the auditor to qualify an opinion. - depends on the importance of the omitted procedure(s) to auditor's ability to form an opinion on the financial statements Circumstances that may limit the audit scope 1. timing of the fieldwork, such as being engaged to do the audit after year-end 2. the inability to gather sufficient appropriate evidence, 3. or an inadequacy in the accounting records When a qualified opinion results from a scope limitation or an insufficiency of evidence, the auditor's report should describe the basis for departure from an unqualified opinion in a separate paragraph - It is not appropriate for the auditor to explain the scope of the audit in a note to the financial statements, since the description of the audit scope is the responsibility of the auditor and not that of the client

A substantive procedure appropriate for testing rights and obligations associated with inventory would be to review vendor invoices when testing disbursements to determine that proper title is conveyed.

Even if immaterial, an intentional misstatement may cause serious difficulties in the audit, and for the client.

Documentation of an Engagement Quality Review

Should contain sufficient information to enable an experienced auditor, having no previous connection with the engagement, to understand the procedures performed by the engagement quality reviewer, and others who assisted the reviewer, to comply with the provisions of this standard 1. The engagement quality reviewer, and others who assisted the reviewer, 2. The documents reviewed by the engagement quality reviewer, and others who assisted the reviewer, 3. The date the engagement quality reviewer provided concurring approval of issuance or, if no concurring approval of issuance was provided, the reasons for not providing the approval. Documentation of an engagement quality review should be included in the engagement documentation.

Auditing standards differ in their guidance on referring to other auditors in the audit report.

Similar to the PCAOB standards, AU-C 600 allows the auditor's report to include a reference to another auditor. - In contrast, ISA 600 does not permit the auditor's report to make reference to another auditor, unless required by law or regulation. - If the group engagement partner decides to assume responsibility for work of a component auditor , no reference should be made to the component auditor in the auditor's report on the group financial statements .

Qualified The financial statements contain a material departure from GAAP, but the departure is limited to a single asset account. Its effects can easily be identified and described. Some students can argue that an adverse audit opinion could be given because of the materiality. Most auditors, however, would likely give the qualified opinion because the departure is not pervasive and overall material.

The Wear-Ever Wholesale Company has been very profitable. It recently received notice of a 10% price increase for a significant portion of its inventory. The company believes it is important to manage its products wisely and has a policy of writing all inventory up to current replacement cost. This assures that profits will be recognized on sales sufficient to replace the assets and realize a normal profit. This operating philosophy has been very successful, and all salespeople reference current cost, not historical cost, in making sales. Only inventory has been written up to replacement cost, but inventory is material because the company carries a wide range of products. The company's policy of writing up the inventory and its dollar effects is adequately described in a footnote to the financial statements. For the current year, the net effect of the inventory write-up increased reported income by only 3% and assets by 15% above historical cost.

Unqualified, with no report modifications The key is that the manager was confident that the audit was eventually completed in accordance with professional auditing standards and that the statements did not contain any material errors.

The audit of NewCo was staffed primarily by three new hires and a relatively inexperienced audit senior. The manager found numerous errors during the conduct of the audit and developed very long to-do lists for all members of the audit to complete before the audit was concluded. Although the manager originally doubted the staff's understanding of the audit procedures, by the time the audit was finished, he concluded that the new auditors did understand the company and the audit process and that no material errors existed in the financial statements.

Letter of Audit Inquiry

The auditor should ask the client to send a letter of audit inquiry to its legal counsel asking counsel to confirm information about asserted claims and those claims that are probable of assertion - primary source of corroborative evidence concerning litigation, claims, and assessments is the client's legal counsel Letter Should include: - Identification of the company, its subsidiaries, and the date of the audit - Management's list that describes and evaluates the contingencies to which the lawyer has devoted substantial attention - A request that the lawyer furnish the auditor with: 1. A comment on the completeness of management's list and evaluations 2. For each contingency: a. A description of the nature of the matter, the progress to date, and the action the company intends to take b. An evaluation of the likelihood of an unfavorable outcome and an estimate of the potential loss or range of loss 3. Any limitations on the lawyer's response, such as not devoting substantial attention to the item or that the amounts are not material The client should instruct legal counsel to respond directly to the auditors

Accounts Payable and Related Expense Accounts: Substantive Test of Details for Rights and Obligations

The auditor should examine contracts to purchase inventory to determine penalties associated with default, and the auditor should gain sufficient knowledge to assess the client's estimate of the probability of contract default or losses.

Sources of Audit Evidence concerning loss contingencies

The auditor should obtain the following from management: - A description and evaluation of contingencies that existed at the balance sheet date or that arose prior to the end of the fieldwork and for which matters were referred to legal counsel, including correspondence and invoices from lawyers - Assurance that the accounting and disclosure requirements concerning contingent liabilities have been met - Information about major contracts in which contingencies may be present, such as the sale of receivables - Documentation of communication with internal and external legal counsel of the client - Documentation of contingent liabilities contained in corporate minutes, correspondence from governmental agencies, and bank confirmations

An unqualified opinion, with no modifications to the audit report, because the auditor obtained sufficient appropriate evidence.

The auditor was unable to obtain confirmations from two of the client's major customers that were included in the sample. These customers wrote on the confirmation letters that they were unable to confirm the balances because of their accounting systems. The auditor was able to achieve satisfaction through other audit procedures.

i. An unqualified opinion, with a modification to report to include an additional paragraph to alert the readers to this change. ii. A qualified opinion, because this is a GAAP violation. The audit report should contain an additional paragraph.

The client changed from FIFO to LIFO this year. The effect is material. Address the following two situations: i. The client properly accounted for, justified, and disclosed the change. ii. The client properly accounted for and disclosed the change, but did not properly justify the change.

An unqualified opinion; the auditor may choose to emphasize this by adding an additional paragraph to the audit report.

The client is engaged in a product liability lawsuit that is properly accounted for and adequately described in the footnotes. The lawsuit does not threaten the going-concern assumption, but an adverse decision by the court could create a material obligation for the client.

A disclaimer of opinion, because of this significant scope limitation imposed by the client. The audit report should contain an additional paragraph.

The client restricted the auditor from observing the physical inventory. Inventory is a material item and has pervasive effects on the financial statements.

A qualified or possibly adverse opinion, because of a material GAAP violation. The choice depends on how material and pervasive are the effects. The audit report should contain an additional paragraph.

The client treated a lease as an operating lease, but the auditor believes the client should have accounted for it as a capital lease. The effects are material.

A qualified opinion, with an additional paragraph in the audit report—because a company needs to disclose a change in accounting principles when the effect on future financial statements is likely to be material.

The client, with reasonable justification, has changed its method of accounting for depreciation for all factory and office equipment. The effect of this change is not material to the current-year financial statements, but is likely to have a material effect in future years. The client's management will not disclose this change because of its immaterial effect on the current-year statements. You have been unable to persuade management to make the disclosure.

Unmodified Audit Reports: U.S. Nonpublic Companies

The components of the audit report for U.S. nonpublic companies include: 1. Title and Addressee 2. What was audited (introductory paragraph) 3. Responsibilities of client management 4. Responsibilities of the auditor and the nature of the audit process 5. The auditor's opinion on the fairness of the financial statements 6. Signature of the auditor 7. Auditor's Address 8. Date of the Auditor's Report

Qualified Opinions, Adverse Opinions, and Disclaimers of Opinion

The issuance of other than an unqualified opinion is unusual. - In the U.S. the SEC, with limited exceptions, will not accept financial statements where the audit opinion is other than unqualified - the auditor has significant advantage to encourage the client to make corrections that would allow for an unqualified audit opinion - When the auditor is not able to give an unqualified opinion, the auditor will provide a qualified opinion, an adverse opinion, or a disclaimer of opinion.

Compliance with the Foreign Corrupt Practices Act (FCPA) of 1977

The main provisions of the FCPA include: 1. No U.S. person or company that has securities listed on U.S. markets may make a payment to a foreign official for the purpose of obtaining or retaining business. ( anti-bribery provision) 2. Companies that have securities listed on U.S. markets must make and keep financial records that accurately and fairly reflect the transactions of the company and must design and maintain an adequate system of internal accounting controls. 3. Certain payments to foreign officials are acceptable. These include grease payments, which are payments made to an official to expedite the performance of the duties that the official would already be bound to perform.

Review Analytical Procedures

The objective of review analytical procedures is to help the auditor form an overall conclusion about whether the financial statements are consistent with the auditor's understanding of the entity. - indicate whether certain relationships make sense in light of the knowledge obtained during the audit. - Ratio analysis, common-size analysis, and analysis of the dollar and percentage changes in each income statement item over the previous year

PCAOB basic principles related to audit reporting

The objective of the ordinary audit of financial statements by the independent auditor is the expression of an opinion on the fairness with which they present, in all material respects, financial position, results of operations, and its cash flows in conformity with generally accepted accounting principles. The auditor's report is the medium through which he expresses his opinion or, if circumstances require, disclaims an opinion.

unqualified opinion

The opinion expressed by the auditor when the auditor concludes that the financial statements are presented fairly, in all material respects, in accordance with the applicable financial reporting framework - also referred to as an unmodified opinion - the expectation of both the auditor and the client is usually that the report includes an unqualified opinion

An unqualified opinion, with an additional paragraph in the audit report. Alternatively, the auditor could issue a disclaimer of opinion, and include an additional paragraph to the report.

The status of the client as a going concern is extremely doubtful. The problems are properly described in the footnotes

The three primary types of payroll fraud include:

Timesheet fraud - paying employees incorrectly for the hours they work. - Employees accomplish this by falsifying their timesheets, having another employee clock in for them when they are not actually at work, or having a payroll clerk increase the rate of pay. Ghost employee fraud - a ghost employee is a fake employee who has never worked for the organization, or a former employee who was never terminated from the payroll system and is still receiving paychecks. Worker misclassification fraud - the organization fraudulently classifies employees as independent contractors when these employees are actually full-time employees to avoid having to pay payroll taxes, healthcare premiums, and pension benefits.

Review of Subsequent Events (Period A)

Type I Subsequent Events ●Type I subsequent events provide evidence about conditions that existed at the balance sheet date, e.g., information that helps the auditor assess the valuation of A/R ●The financial statement numbers should be adjusted to reflect these events. Type II Subsequent Events ●Type II subsequent events indicate conditions that did not exist at the balance sheet date, but that may require disclosure, e.g., a natural disaster occurs that destroys an important client factory after the balance sheet date. ●The events that the auditor should consider for disclosure are financial in nature and material.

Bankruptcy Prediction Models

Used in analyzing whether the going-concern assumption is valid for a particular client Certain combinations of ratios can indicate the likelihood of bankruptcy. Two Altman Z-scores are available for auditor use 1. Z-scores falling below 1.81 in the five-ratio model or below 1.1 in the four-ratio model indicate high potential for bankruptcy 2. Scores above 2.99 in the five-ratio model or above 2.6 in the four-ratio model indicate very little potential for bankruptcy

summary of unadjusted audit differences (SUAD)

Used to accumulate the known and projected misstatements and the carryover effects of prior-year uncorrected misstatements. - management and the auditor discuss which misstatements the client will correct in the financial statements, and which the client will waive (leave uncorrected) - client can only waive immaterial misstatements.

Disclaimer: Scope Limitation

When a scope limitation exists, the auditor may decide that a qualified audit opinion is not appropriate, and may choose to disclaim an opinion - auditor should state in a separate paragraph or paragraphs, all of the substantive reasons for the disclaimer - state that the scope of the audit was not sufficient to warrant the expression of an opinion - also disclose any other reservations auditor has regarding fair presentation in conformity with GAAP

Dual Dating (Period B)

When the auditor becomes aware of an event that occurs after the audit report date, but before the report release date and the event is disclosed in the footnotes, the auditor has two options for dating the audit report: 1. Use the date of this event as the date of the audit report. 2. Dual-date the report, using the dates of the original audit report and the date of the event, to disclose the work done only on that event after the original audit report date. The auditor assumes less responsibility by dual-dating the report

Accounts Payable and Related Expense Accounts: Substantive Test of Details for Existence

While the existence assertion is not typically a very relevant assertion for accounts payable - send confirmations to vendors and suppliers to confirm transactions the client has recorded - auditors may vouch recorded payables balances to suppliers' statements

support letter

Written evidence from management to the auditor providing assurance that the entity has received a commitment of necessary financial support to ensure that the entity remains a going concern

An adverse opinion, because of the potential impact on the only product the company makes—with an additional paragraph in the audit report. This is a very material illegal act. Practically speaking, the client will likely refuse to accept the auditor's adverse opinion and the auditor should then withdraw from the engagement.

You are convinced that your client is violating another company's patent in the process of manufacturing its only product. The client will not disclose this because it does not want to wave a red flag and bring this violation to the other company's attention. A preliminary estimate is that the royalty payments required would be material to the financial statements.

Disclosure Committee

a sub-committee of the Board of Directors, and is charged with ensuring that the organization's MD&A and footnotes to the financial statements comply with financial accounting standards.

In obtaining evidence about loss contingencies, which of the following are sources of evidence that the auditor should obtain from management?

a. A description and evaluation of contingencies that existed at the balance sheet date. b. Assurance that the accounting and disclosure requirements concerning contingent liabilities have been met. c. Documentation of communication with internal and external legal counsel of the client. d. All of the above d

In completing the audit, the auditor obtains a letter of audit inquiry. Which of the following is an accurate description of a letter of audit inquiry?

a. A letter that is the primary source of corroborative evidence concerning litigation, claims, and assessments, which is received from the client's legal counsel. b. A letter that is the primary source of corroborative evidence concerning cash valuation, which is received from the client's bank. c. A letter that is the primary source of corroborative evidence concerning accounts receivable valuation, which is received from the client's customer. d. A letter that is the primary source of corroborative evidence concerning inventory valuation, which is received from the client's supplier. a

Which of the following statements is true when an omitted audit procedures is discovered after the audit report was issued?

a. After the audit report has been issued, the auditor may discover that an important audit procedure was not performed. b. Such an omission may be discovered when audit documentation is reviewed as part of an external or internal review program. c. The auditor should decide whether the previously issued audit report can still be supported in light of the omitted procedures. d. All of the above. d

In evaluating whether the client is a going concern, which of the following questions should the auditor ask?

a. Are there indicators of going-concern problems? b. Is it likely that management can mitigate any identified going-concern problems? c. Are disclosures about the going-concern problems adequate? d. All of the above. d

Which of the following statements is false regarding audit reporting?

a. Auditing standards require auditors to provide positive assurance—that is, an explicit statement as to whether the financial statements are presented fairly. b. The auditor should provide an opinion in accordance with the auditor's findings or state that an opinion cannot be expressed. c. The auditor's opinion should state whether the financial statements are presented fairly, in all material respects, in accordance with the applicable financial reporting framework. d. None of the above statements are false. d

Which of the following is an important provision of the Foreign Corrupt Practices Act?

a. Auditors of clients operating in foreign countries must hire a joint auditor in the foreign country to provide assurance that laws and regulations have been followed by the client. b. Auditors of clients operating in foreign countries must provide reasonable assurance that any inventory observations that occur in the foreign country are observed by at least some audit personnel from the U.S.; this requirement is in place because fraud often occurs in inventory accounts. c. Companies that have securities listed on U.S. markets must make and keep financial records that accurately and fairly reflect the transactions of the company and must design and maintain an adequate system of internal accounting controls. d. Companies that have securities listed on U.S. markets must adhere to the internal control requirements of both the U.S. and the applicable foreign country. c

Which of the following statements is true regarding the auditor's responsibilities related to reporting?

a. Auditors should obtain sufficient appropriate evidence to provide a reasonable basis for the opinion regarding the financial statements under audit. b. The audit opinion relates only to the client's financial statements, and does not relate to the required footnote disclosures. c. If the auditor has reservations about the fairness of presentation of the financial statements, the auditor does not need to provide the reason for this reservation, but needs to only state that the financial statements are not fairly presented. d. All of the above statements are true. a

After the report release date, the auditor may become aware of facts that may have affected the financial statements and auditor's report, had the auditor known the facts at the time of issuance. With regard to this situation, which of the following statements is true?

a. Because such facts become known after the report release date, the auditor cannot reasonably be held accountable for these issues; no action is required on the part of the auditor. b. If the auditor decides that steps should be taken to prevent further reliance on the financial statements and audit report, the client is advised to make appropriate and timely disclosure of these new facts. c. If such facts would have been investigated had they been known at the report date, the auditor should determine whether engagement personnel are competent and qualified to perform audits; action is required on the part of the auditor to assess whether engagement personnel should be retained to work on the engagement in the subsequent year. d. If the auditor decides that steps should be taken to prevent further reliance on the financial statements and audit report, the auditor should notify the audit committee immediately; no action beyond this is required on the part of the auditor because of confidentiality concerns. b

Which of the following audit procedures would an auditor use to test the valuation or allocation assertion for inventory?

a. Inquire of production and warehouse personnel about the existence of obsolete inventory. b. Test inventory cost by taking a sample of recorded inventory, and trace to source documents indicating cost of inventory. c. Review trade journals for changes in product technology. d. Inquire of the client about sales adjustments (markdowns) that have been offered to sell any products. e. All of the above. e

The analytical procedures of the financial statements of Koss Corporation that are depicted in Exhibit 14.3 reveal which of the following indicators of the fraud?

a. Cash balances had declined to their lowest level since FYE 2004. b. Cost of goods sold as a percentage of sales had risen sharply over the period, with a particularly significant increase from FYE 2008 to 2009. c. Net income as a percentage of sales had decreased sharply over the period, with a particularly significant decrease from FYE 2008 to 2009. d. All of the above. d

Which of the following statements is false?

a. Disclosure checklists are a convenient documentation format for evidence that the auditor adequately evaluated management's assertions about the adequacy of its disclosures. b. The auditor's report, and assurance therein, covers mandatory disclosures in the basic financial statements and the related notes, along with voluntary disclosures in the MD&A. c. When assessing the adequacy of disclosures, the auditor should have reasonable assurance that the disclosures are understandable to users. d. Disclosure checklists tend to be industry-specific. All of the above are false. b

Which of the following is not a typical communication between the auditor and the audit committee at the end of an audit engagement?

a. Discussion of the auditor's responsibility. b. Discussion of the client continuance decision. c. Discussion about auditor independence. d. Discussion about management judgments and accounting estimates. b

Which of the following is not a procedure that an engagement quality reviewer would perform?

a. Evaluating whether or not to continue providing audit services to the client in the subsequent year, based on information gained during the current-period audit. b. Discussing significant matters related to the financial statements and internal controls. c. Evaluating judgments about materiality and the disposition of corrected and uncorrected identified misstatements. d. Reviewing the engagement team's evaluation of the firm's independence in relation to the engagement. a

Which of the following items would not be included in a PCAOB audit report that includes CAMs?

a. Identification of the CAM. b. Description of the principal considerations that led the auditor to determine that the matter is a CAM. c. Indication as to whether management agreed that the matter was a CAM. d. Description of how the CAM was addressed in the audit. e. Reference to the relevant financial statement accounts or disclosures. c

The auditor discovers various errors in the client's financial statements during the audit. At the end of the audit, the auditor analyzes these misstatements to determine if the client needs to correct them. In which of the following situations could management and the auditor decide not to correct the misstatement?

a. If, by correcting the misstatements, net income would increase rather than decrease. b. If, by correcting the misstatements, net income would decrease rather than increase. c. If the misstatements, in the aggregate, are material. d. If the misstatements, in the aggregate, are immaterial. d

Tech Company has an uncertainty because of pending litigation. The auditor decided to issue a qualified opinion rather than an unqualified opinion. Which of the following factors most likely influenced this decision?

a. Inconsistent application of GAAP. b. Inability to estimate the amount of loss. c. The client's lack of experience with such litigation. d. Adequacy of the disclosures. d

The auditor has responsibility regarding a client's noncompliance with laws and regulations. Management may try to hide acts involving noncompliance, which limits the auditor's ability to detect such acts. Which of the following are inherent limitations that affect the auditor's ability to detect acts involving noncompliance?

a. Laws and regulations often relate to operational issues within the entity that do not necessarily relate to the financial statements, so the information systems relating to financial reporting may not capture noncompliance. b. Management may act to conceal noncompliance, or override controls, or intentionally misrepresent facts to the auditor. c. The legal implications of noncompliance are ultimately a matter for legal authorities to resolve and are not a matter about which the auditor can resolve. d. All of the above. d

Which of the following statements is false?

a. Management's incentives may bias their willingness to book, or correct, detected misstatements. b. Known misstatements are those that arise from differences in judgments of management concerning accounting estimates that the auditor considers unreasonable, or the selection or application of accounting policies that the auditor considers inappropriate. c. Section 10A(b) of the Exchange Act requires auditors to take action upon discovery of an illegal act even if it does not have a material effect on the financial statements, including alerting management and the audit committee. d. The auditor evaluates the misstatements that have been posted to the summary of unadjusted audit differences (SUAD) to determine whether uncorrected misstatements are material—either individually or in combination with other misstatements. b

Which of the following audit procedures would an auditor use to test the existence assertion for inventory?

a. Perform year-end cutoff tests by noting the last shipping and receiving document numbers used before the client takes physical inventory. b. Make inquiries of the client regarding the segregation of duties between the purchasing department and the receiving department. c. Review the client's proposed physical inventory procedures to determine whether they are likely to result in a complete and correct physical inventory. d. Make inquiries of the client regarding allowances made for expected returns. c

Which of the following statements concerning review analytical procedures is false?

a. Review analytical procedures help auditors assess the overall presentation of the financial statements. b. The auditor's expectations in review analytical procedures should be more precise than those for substantive analytics. c. Auditing standards require the use of review analytical procedures to assist in identifying ending account relationships that are unusual. d. Ratio analysis, common-size analysis, and analysis of the dollar and percentage changes in each income statement item over the previous year are useful for performing review analytical procedures. b

With regard to discussing significant audit adjustments with the audit committee, which of the following statements is false?

a. Significant audit adjustments reflect a lack of independence between the auditor and client management. b. Significant audit adjustments may reflect on the stewardship and accountability of management. c. The audit committee should be made aware of significant audit adjustments, even if management readily agrees to make them. d. Significant adjustments, by definition, suggest that there have been internal control failures that must be communicated to the audit committee. e. Two of the above (a-d). a

Refer to the Why It Matters feature "Situations Requiring a Modification to the Audit Report on ICFR." In which of the following situations would the auditor modify the audit report on ICFR?

a. The auditor identifies multiple unrelated significant deficiencies in ICFR. b. The auditor concludes that management's report on ICFR is not complete or is improperly presented. c. The unaudited financial statements did not contain any misstatements. d. The auditor would modify the audit report on ICFR in all of the above situations. b

The auditor of a large U.S. public company is conducting an integrated audit and has determined that a material weakness exists in the client's ICFR. Which of the following statements is true?

a. The auditor is required to issue an adverse opinion on the financial statements. b. The auditor should express an adverse opinion on internal controls only if a material misstatement was found in the financial statements. c. The auditor should express an adverse opinion on ICFR, even if no material misstatements were found in the financial statements. d. The auditor is not required to express an opinion on internal controls. c

If it is discovered after the audit report is issued that the auditor failed to confirm receivables, which of the following statements is true?

a. The auditor should try to examine subsequent collections of accounts receivable to help determine whether the accounts receivables existed and whether they were properly valued at the balance sheet date. b. The auditor must resign immediately. c. The auditor must notify the SEC immediately. d. The auditor must notify users of the financial statements immediately. a

Noncompliance

involves "acts of omission or commission by the entity, either intentional or unintentional, which are contrary to the prevailing laws or regulations" (AU-C 250).

In which of the following situations would an auditor ordinarily issue an unqualified audit opinion without any report modifications?

a. The auditor wishes to emphasize that the client had significant related party transactions. b. The auditor complies with only one set of auditing standards. c. The client issues financial statements that present financial position and results of operations, but omits the statement of cash flows. d. The auditor has substantial doubt about the client's ability to continue as a going concern, and the circumstances are fully disclosed in the financial statements. b

As part of identifying CAMs, which of the following factors would an auditor consider when determining whether a matter involved especially challenging, subjective, or complex auditor judgment?

a. The auditor's assessment of the risks of material misstatement, including significant risks. b. The nature and timing of significant unusual transactions and the extent of audit effort and judgment related to requisite transactions. c. The degree of auditor subjectivity in applying audit procedures to address the matter or in evaluating the results of those procedures. d. The auditor would consider all of the above factors. d

In Exhibit 14-8 "An Example Management Letter to a College Foundation," which of the following items is not present in the management letter?

a. The auditor's observations and recommendations to management. b. Management's response. c. The issue of whether or how management responded to the management letter related to the prior year's audit. d. What actions the auditor will take in the subsequent-year audit to help management address the identified weaknesses. d

In which of the following situations would an auditor typically issue an unqualified opinion, but modify the audit report to include additional language?

a. The client has changed an accounting principle, has reasonable justification for the change, and has followed GAAP in accounting for and disclosing the change. b. The auditor has substantial doubt about the client being a going concern. c. The client has had significant transactions with related parties that the auditor wants to emphasize. d. An auditor would typically issue an unqualified opinion, but include additional language, in all of the above situations. d

Which of the following would require other than an unqualified opinion?

a. The client has prepared its financial statements using IFRS as the financial reporting framework. b. The auditor has complied with the auditing standards of both the AICPA and the IAASB. c. The auditor is not independent. d. The auditor believes that the client will remain a going concern for a reasonable period of time. c

Which of the following is an example of a Type II subsequent event?

a. The client settles a lawsuit for a different amount than was accrued at the balance sheet date. b. A sale of inventory below carrying value provides evidence that the net realizable value was less than cost at year-end. c. Information becomes available that provides evidence about the valuation of an estimate or reserve that had been accrued at year-end. d. None of the above. d

In completing the audit, the auditor should review the adequacy of the disclosures in the financial statements. When assessing the disclosures, the auditor should have reasonable assurance about which of the following?

a. The disclosed events and transactions have occurred and pertain to the entity. b. All the disclosures that should have been included are included. c. The disclosures are understandable to users. d. All of the above. d

In completing the audit, the auditor communicates with management via the management letter. Which of the following statements is false about management letters?

a. The management letter is used to make significant operational or control recommendations to management. b. Many audit firms consider management's inattention to addressing comments in the letter to be an important risk factor in subsequent-year audits. c. The management letter is required for publicly traded companies in the United States, but not privately held companies. d. All of the above are false. c

Which of the following statements is false concerning engagement quality reviews?

a. The purpose of the engagement quality review is to provide reasonable assurance that the audit and audit documentation are complete and that they support the audit opinion on the financial statements. b. The engagement quality review must be documented, and the documentation should include who performed the review, which documents were reviewed, and the date the engagement quality reviewer provided approval of the issuance of the audit opinion. c. Engagement quality reviews are required for both publicly traded companies and private companies in the United States d. One of the procedures that would be performed during the engagement quality review is to determine if appropriate consultations have taken place on difficult or contentious matters. c

IAASB basic principles related to audit reporting

a. To form an opinion on the financial statements based on an evaluation of the conclusions drawn from the audit evidence obtained; and b. To express clearly that opinion through a written report.

Which of the following planning analytical relationships is most typically suggestive of a heightened risk of fraud in the acquisition and payment cycle?

a. Unexpected increases in gross margin. b. Unexpected decreases in gross margin. c. Inventory that is growing at a rate slower than sales. d. Expense accounts that have significant debit entries. a

Eagle Company's financial statements contain a departure from GAAP because, due to unusual circumstances, the statements would otherwise be misleading. Which of the following is descriptive of the type of audit report the auditor should provide?

a. Unqualified opinion, with no mention of the departure in the auditor's report. b. Unqualified opinion, with a description of the departure in the audit report. c. Either a or b d. Neither a nor b b

Which of the following phrases should an auditor not use when qualifying the audit opinion?

a. With the exception of b. Except for c. Subject to d. Any of the above phrases would be appropriate. c

The Altman Z-Score is a model used to help assess the likelihood that a company will go bankrupt. Which of the following ratios is included in the model?

a. Working capital to total assets. b. Working capital to total sales. c. Sales to total debt. d. Sales to total accounts receivable. a

Positive Assurance

an explicit statement as to whether the financial statements are presented fairly and, for larger U.S. public companies, whether internal control over financial reporting is effective.

Judgmental misstatements

are those that arise from material differences in judgments of the auditor and client management concerning accounting estimates or the application of account principles - auditor needs to recognize that misstatements from prior periods may have been uncorrected because they were judged immaterial in the prior period - However, those misstatements may materially affect the current period's financial results

Emphasis-of-Matter vs Other-Matter

emphasis-of-matter paragraph - "included in the auditor's report that is required by auditing standards, or is included at the auditor's discretion, and that refers to a matter appropriately presented or disclosed in the financial statements that, in the auditor's professional judgment, is of such importance that it is fundamental to users' understanding of the financial statements." Other-matter paragraph - included in the auditor's report that is required by the auditing standards, or is included at the auditor's discretion, and that refers to a matter other than those presented or disclosed in the financial statements that, in the auditor's professional judgment, is relevant to users' understanding of the audit, the auditor's responsibilities, or the auditor's report - ex. auditor may consider it necessary to include an other-matter paragraph in the auditor's report to explain why it is not possible for the auditor to withdraw from the engagement

Subsequent events

events occurring between the date of the financial statements and the date of the auditor's report - A subsequent events review is the auditor's review of events occurring in the period between the balance sheet date and the audit report date to determine their possible effect on the financial statements.

materiality of a misstatement

includes consideration of the quantitative amount of the misstatement, and any qualitative features that could make it material

Subsequently Discovered Facts That Become Known to the Auditor after the Report Release Date (Period C)

may come to the auditor's attention through reading news reports, performing another service for the client or other business contacts, or performing a subsequent audit. If the auditor had known such facts at the report date, and therefore would have investigated those facts during the audit, the auditor should determine: 1. The reliability of the new information 2. Whether the development or event had occurred by the report date, as issuance of revised financial statements and an audit report is not required when the development or event occurs after the report date 3. Whether users are likely to still be relying on the financial statements 4. Whether the audit report would have been affected had the facts been known to the auditor at the report date

Accounts Payable and Related Expense Accounts: Substantive Test of Details for Valuation

simply verifying the mathematical accuracy of the accounts and agreeing them to general ledger and supporting documentation.

Disclaimers of Opinion

states that the auditor does not express an opinion on the financial statements - should not be expressed because the auditor believes, on the basis of the audit, that there are material departures from GAAP. - auditor should disclaim an opinion when the auditor is unable to obtain sufficient appropriate audit evidence on which to base the opinion, and the auditor concludes that the possible effects on the financial statements of undetected misstatements, if any, could be both material and pervasive A disclaimer of opinion is appropriate when: 1. A scope limitation exists, and a qualified opinion is not appropriate 2. Substantial doubt exists about the client being a going concern, and an unqualified opinion with an additional paragraph is not appropriate 3. The auditor lacks independence

Using Technology and Data Analytics When Auditing Inventory

technology and data analytics have begun to change the audit process. - In the near future, the auditing profession may undergo a transformation by exploiting the use of drone technology. One audit area where this disruption has begun is in auditing inventory.

Projected misstatements

the auditor's best estimate of the total misstatements in a given population - based on the misstatements detected in an audit sample of that population

Known misstatements

those that the auditor has specifically identified and about which there is no doubt - also referred to as factual misstatements

Thor Industries, Inc. and Mark Schwartzhoff: Fraudulent Reductions in Cost of Goods Sold Through Manipulation of Inventory

using inventory and cost of sales to fraudulently overstate net income Schwartzhoff (VP of finance) engaged in a fraudulent accounting scheme to understate Thor's cost of goods sold in order to avoid recognizing rising inventory costs during the period.

CAM

•Any matter that was communicated or required to be communicated to the audit committee •Relates to accounts or disclosure material in regard to financial statements, and •Involves especially challenging, subjective, or complex auditor judgment Matters that are material to the financial statements, but that do not relate to accounts or disclosures are not CAMs. Example: •The auditor communicated a potential loss contingency to the audit committee, and •The auditor determined that the likelihood of a contingency coming to fruition was remote, and •Management did not record a relevant item in the financial statement accounts or disclose it under the applicable financial reporting framework.

Accounting for Inventories

●Accounting for inventories is a major consideration for many organizations because of its significance to both the balance sheet and the income statement. ●A major component of accounts payable relates to inventory purchases. ●When shipments of raw materials and finished goods are received and placed in inventory, this results in an account payable until payment is made. ●Accounts payable is also comprised of amounts owed to other suppliers (such as suppliers of electricity or other goods and services not used in production or resale).

Typical Communications Between the Auditor and the Audit Committee

●Auditor's responsibilities ●Overview and planned scope of the audit ●Independence ●Significant accounting policies ●Management judgments and accounting estimates ●Significant audit adjustments ●Judgments about the quality of the company's accounting principles ●Other information in annual reports ●Disagreements with management ●Major issues discussed with management before retention ●Internal control over financial reporting

Subsequent Events

●Auditors have responsibility for some events occurring after the client's balance sheet date. ●Every audit includes procedures to review for subsequent events and transactions that occur in the period between the balance sheet date and the audit report date (Period A). ●The auditor has no responsibilities to continue obtaining audit evidence after the audit report date: Period B and Period C. - However, the auditor may become aware of relevant information during Period B and Period C and will have to assess appropriate actions to take.

Management Representation Letter

●Auditors should obtain a management representation letter at the end of each audit. ●The letter is not a substitute for audit procedures performed during the audit. ●Rather, the purposes of the letter include: - Reminding management of its responsibility for the financial statements. - Confirming oral responses obtained by the auditor earlier in the audit and the continuing appropriateness of those responses. - Reducing the possibility of misunderstanding concerning the matters that are the subject of the representations. ●Management's refusal to sign the management representation letter is a scope limitation sufficient to preclude the auditor from issuing an unqualified opinion.

Responsibilities Related to Loss Contingencies

●Management is responsible for designing and maintaining policies and procedures to identify, evaluate, and account for loss contingencies. ●Auditors are responsible for determining that the client has properly identified, accounted for, and disclosed material loss contingencies.

Adequacy of Disclosures

●The auditor's report covers the basic financial statements, which include the balance sheet, income statement, statement of cash flows, a statement of changes in stockholders' equity or retained earnings, and the related notes. ●If the auditor determines that disclosures are not reasonably adequate, the auditor must identify that fact in the auditor's report. ●Disclosures can be made on the face of the financial statements (in the form of classifications or parenthetical notations), or they can be made in the notes to the statements.

Examples of Loss Contingencies

●Threat of expropriation of assets in a foreign country ●Litigation, claims, and assessments ●Guarantees of debts of others ●Obligations of banks under standby letters of credit ●Agreements to repurchase receivables that have been sold ●Purchase and sale commitments - Watch video of Deepwater sinking.

Management Letter

●Throughout an audit, auditors often notice opportunities for recommendations to management. ●The auditor generally reports these observations in a management letter. ●Such a letter is different from a management representation letter. - The management letter is not required; the auditor uses it to make significant operational or control recommendations to the client. - The letter helps to provide management comfort that the auditor has done a quality job and that the auditor knows and understands the client's business. - Many audit firms consider management's inattention to addressing comments in the letter to be an important risk factor in subsequent-year audits.

relationships that might suggest a heightened risk of misstatement:

1. Unexpected increases in gross margin 2. Inventory that is growing at a rate greater than sales 3. Expenses that are either significantly above or below industry norms 4. Unexpected increases in the number of suppliers 5. Capital assets that seem to be growing faster than the business and for which there are no strategic plans 6. Expense accounts that have significant credit entries 7. Travel and entertainment expense accounts, but no documentation or approval of expenditures 8. Inadequate follow-up to the auditor's recommendations on needed controls

Perpetual inventory system

A system of inventory recordkeeping where book inventory is continuously in agreement with inventory on hand within specified time periods. - In some systems, book inventory and inventory on hand may be reconciled with each transaction; in other systems, these two numbers may be reconciled less often. - This process is useful in keeping track of availability of goods and determining the correct time to reorder from suppliers. Cycle counts are part of a perpetual inventory system. - involve periodic testing of the accuracy of the perpetual inventory record by counting all inventories on a cyclical, or periodic, basis.

Overview of Internal Controls in the Acquisition and Payment Cycle

A well-conceived inventory control system should provide reasonable assurance that: ●All purchases are authorized. ●There exists a timely, accurate, and complete recording of inventory transactions. ●Receipt of inventory is properly accounted for and independently tested to verify quality in adherence to company standards. ●The cost accounting system is up-to-date; costs are properly identified and assigned to products; and variances are analyzed, investigated, and properly allocated to inventory and cost of goods sold.

Identifying Inherent Risks for Inventory

Inventory is usually material, complex, and subject to manipulation, because of the following factors: ●A great variety (diversity) of items exists in inventory. ●Inventory accounts typically experience a high volume of activity. ●Inventory accounts may be valued according to various alternative accounting valuation methods. ●Identifying obsolete inventory and applying the lower of cost or market principle to determine valuation are difficult tasks. ●Inventory is easily transportable. ●Inventory often exists at multiple locations, with some locations being remote from the company's headquarters.

Financial reporting vs Asset Misappropriation Frauds in Purchasing cycle

Financial reporting frauds - often involve overstatement of inventory or assets and understatement of expenses. Asset misappropriation frauds - often involve fictitious purchases or kickbacks to suppliers.

Performing Substantive Fraud-Related Procedures for Inventory and Cost of Goods Sold

1. Observe all inventory locations simultaneously 2. Confirm inventories at locations that are outside the entity 3. Compare carrying inventory amounts to recent sales amounts 4. Examine consignment agreements and determine that consignments are properly accounted for 5. Send confirmations to vendors confirming invoices and unusual terms 6. Determine if there are bulk sales at steep discounts, as these sales could indicate decreasing values for the company's products

Common Controls in the Requisition and Purchasing Processes: Inventory Purchases: Retail Organization

1. Overall authorization to purchase product lines is delegated to individual buyers by the marketing manager. The authorization is built into the computer as a control. The limits for individual goods can be exceeded only on specific approval by the marketing manager. 2. Store managers may be granted authority to purchase a limited number of goods. The store manager's ability to issue a purchase order may be subject to overall corporate limits, usually specified in dollars. 3. The supplier may have access to the retailer's inventory database and, by contract, ship replacement merchandise based on sales activity and reorder points.

Controls to Prevent and Detect Vendor Fraud

1. Perform appropriate due diligence when selecting new vendors. 2. Ensure segregation of duties. 3. Use data analytics to your advantage. 4. Provide training to all employees with respect to vendor fraud, and the organization's commitment to prevent and detect it; this serves as a warning to potential fraudsters. 5. Establish a fraud hotline. Doing so enables employees to report suspicious activity, and enables vendors who are being coerced by purchasing agents to report their situation to the organization.

Controls in Traditional Receiving

1. Purchase orders are prepared and sent to vendors. 2. Purchase orders are based on projected sales or production, or current inventory levels. 3. Price is either negotiated or competitively bid among a number of vendors. 4. Independent receiving function exists. 5. Independent, sequentially numbered receiving documents are prepared to provide evidence that the goods are received. 6. Accounts payable department matches purchase order, receiving document, and invoice and accrues accounts payable. 7. Payments are made via check or by electronic transfer once or twice a month. 8. Differences between goods received and goods ordered are identified before payments are made.

Common Controls in the Requisition and Purchasing Processes: Supplies Purchases

1. Requisitions are issued by individual departments and sent to the appropriate department manager for approval. 2. Each department may be given a budget for supplies and may have the ability to issue purchase orders directly for the needed items or may be able to purchase a limited number of items without a purchase order.

Accounts Payable and Related Expense Accounts: Substantive Test of Details for Completeness

1. Testing Subsequent Disbursements - The auditor examines a sample of cash disbursements the client made after year-end (subsequent disbursements) to determine whether the disbursements are for goods and services applicable to the previous year—and, if so, whether the client recorded the liability in the previous year 2. Reconciling Vendor Statements or Confirmations with Recorded Payables - The auditor may request vendors' monthly statements or send confirmations to major vendors requesting a statement of open account items - The auditor reconciles the vendor's statement or confirmation with the client's accounts payable trial balance - reliable but costly 3. Related Expense Accounts -p legal expense, travel and entertainment expense, repairs and maintenance expense, and income tax expense To perform substantive tests of details for expenses is to either: - have the client create a schedule of all larger items making up the expense account (usually done for smaller clients), or - use data analytical tools to examine randomly selected items from the expense account using sampling and to generate a list of all credits to the expense items for further review.

auditor can use data analytics tools to obtain the following types of evidence related to inventory accounts:

1. The mathematical accuracy of inventory records 2. Reports of recent shipments to be used for cutoff testing 3. Items to be counted during the physical inventory observation 4. Evaluations of gross margin amounts by product line

It is acceptable to have the client take the physical inventory before year-end provided that:

Many organizations that take an annual physical inventory find that year-end is not a convenient time to do it 1. Internal control is effective. 2. There are no red flags indicating both opportunity and motivation to misstate inventory. 3. The auditor can effectively test the year-end balance through a combination of analytical procedures and selective testing of transactions between the physical count and year-end. 4. The auditor reviews transactions in the roll-forward period for evidence of any manipulation or unusual activity.

Control Examples and Tests

Objective: Recorded Inventory Exists - Control Example: Near year-end, the client takes a complete physical count of inventory. - Tested: The auditor attends the inventory count and observes whether the client follows the appropriate procedures. Objective: All completed purchases are recorded. - Control: The client employs prenumbered receiving reports to provide evidence that the goods are received. - Tested: For a sample of purchases, the auditor will review receiving reports and trace them through the system to the recording of the purchase. Objective: Accounts payable are only recorded for approved purchases and goods or services received. - Control: The accounts payable department matches the purchase order, receiving document, and invoice to record accounts payable. - Tested: For a sample of recorded accounts payable, the auditor will obtain and review supporting documentation, including the purchase order, receiving document, and invoice. Objective: Inventory disclosures provided in the financial statements comply with the relevant accounting literature. - Control: A disclosure committee reviews the client's financial statements and footnotes; - Tested: The auditor can review documentation of the disclosure committee's review.

automated matching approach for approval of payment

Purchase orders are entered into a purchase order database that is accessed by the receiving department to determine whether an incoming shipment of goods should be accepted The lack of human intervention is compensated for by control procedures and authorization concepts built into the automated system such as: - Authorized vendors - Restricted access - Automatic processes - Reconciliations inherent in the process - Automation of error-prone activities - Restricted access to transferring funds - Monitoring

innovative partnerships with suppliers and customers

more agreements will take place where a supplier's goods will be at a retailer such as Wal-Mart, but title will not change until the retailer makes sale to the customer. - auditor needs to determine that the client has an effective process for determining the amount of inventory that is physically stored at a trading partner's location If such controls do not exist, the auditor will need to consider complementary testing methodologies, which might include: (a) confirming inventory amounts with the trading partner (b) examining subsequent payments from the trading partner, or (c) visiting selected trading partners to inspect inventory.

Accounts Payable; Presentation and disclosure

Substantive Audit Procedures 1. Review management's financial statement disclosure of: - Accounts payable - Expense accounts such as travel and entertainment

Management Assertions and Substantive Procedures for Inventory and Cost of Goods Sold: Rights and Obligations

Substantive Audit Procedures 1. Review vendor invoices when testing disbursements to determine that proper title is conveyed. 2. Review purchase contracts to assess rights to return merchandise.

Accounts Payable: Valuation

Substantive Audit Procedures 1. Use data analytics tools to verify mathematical accuracy of accounts payable, and agree to general ledger

Management Assertions and Substantive Procedures for Inventory and Cost of Goods Sold: Existence

Substantive Audit Procedures: 1. Review the client's proposed physical inventory procedures to determine whether they are likely to result in a complete and correct physical inventory. 2. Observe the client's count of the annual physical inventory. Randomly select items from the client's perpetual inventory record and observe (count) the items on hand. Sample should emphasize high-dollar-value items.

Periodic Inventory Sysytem

System of inventory recordkeeping in which management does not keep a continuous record of changes in inventory (receipts, uses, sales of inventory items). - At the end of an accounting period, management determines the ending inventory by a physical count of every item, and computes its value using a suitable method.

A planning analytical procedure in the acquisition and payment cycle that might indicate fraud is that inventory is growing at a rate greater than sales.

A well-conceived inventory control system should provide reasonable assurance that all purchases are authorized and that inventory transactions are recorded accurately, completely, and in a timely manner.

When selecting controls to test and performing tests of controls in the acquisition and payment cycle, the auditor might reasonably take a sample of receiving reports and trace them through the system to test controls related to the completeness assertion for inventory and accounts payable.

Using Data Analytics to Identify Employees' Fraudulent Travel and Expense Reimbursement Claims

T&E fraud often happens when employees use their organizations' purchasing cards (p-cards) to pay for personal expenditures; there exists a heightened threat when employees realize that their purchases are not subject to review and approval. The following are data analytics that an organization or the auditor can employ to test for fraudulent T&E reimbursement claims: 1. Analyze complete populations of data to identify various types of anomalies 2. Compare T&E records with human resources records to see if there exist instances whereby an employee uses their p-card while on vacation. 3. Compare employee descriptions of expenses with data from credit card companies in terms of merchant codes and categories of expenses.

Inventory and Cost of Goods Sold: Substantive Tests of Details for Rights and Obligations

Test of the initial recording of purchases. - review long-term contracts to determine obligations to take delivery of merchandise, customer rights to return merchandise, or buy-back obligations. - gain an understanding of any inventory held on consignment.

Identifying Control Risks

The auditor needs to understand the controls that the client has designed and implemented to address the inherent and fraud risks of material misstatement in the acquisition and payment cycle. The auditor typically obtains this understanding by ● A walkthrough of the process ● Inquiry ● Observation ● Review of the client's documentation The auditor considers both entity-wide controls and transaction controls at the account and assertion levels.

Inventory and Cost of Goods Sold: Substantive Tests of Details for Presentation and Disclosure

The auditor reviews the client's proposed disclosure for compliance with the relevant accounting literature. - auditor will review the client's inventory footnote for completeness and accuracy A number of financial disclosures are required for inventory: 1. Inventory valuation method used (FIFO, LIFO, moving average) and the percentage of inventory valued under each method 2. Changes made in the method of valuing inventory FIFO or current cost if the inventory is valued using LIFO 3. Composition of inventory as to raw materials, work-in-process, and finished goods 4. Purchase commitments that could have an adverse effect on future financial results

Selecting Controls to Test and Performing Tests of Controls

The auditor selects both entity wide and transaction controls for testing. The auditor tests internal controls that are designed to provide reasonable assurance that: ●(1) all purchases are authorized, ●(2) all payments are for goods received, ●(3) payments are made at the appropriate amount and in the correct period, and ●(4) payments are paid only once to the authorized vendor. Typical tests of controls include: ●Inquiry of relevant personnel ●Observation of the control being performed ●Examination of documentation corroborating that the control has been performed ●Reperformance of the control by the auditor testing the control

Financial Reporting Fraud in the Acquisition and Payment Cycle at WorldCom and Phar-Mor

WorldCom management recorded billions of line rental expenses as fixed assets. In other words, managers inappropriately debited fixed assets rather than debiting expenses, thereby bolstering current-period income. Phar-Mor was dominated by an officer who viewed the company as his own and diverted more than $10 million to support a now failed minor league basketball team. To cover up this misuse of company money, the officers directed the managers of each store to inflate their inventory costs

automated purchasing system

a networked software system linking to vendors whose offerings and prices supply chain management personnel have preapproved - enables purchasers to negotiate favorable prices with vendors while streamlining the purchasing process - Best practice for an automated system consolidates the acquisition and payment activities, assuring timely and accurate orders. Automated purchasing system will perform the following tasks: - Apply preloaded specifications and materials lists to the system to start the process - Automatically flag invoices that do not reconcile with purchase orders - Create change orders and analyze variances from purchase orders

Which mix of evidence would be most appropriate for the following scenario? Assume a client where the auditor has assessed the risk of material misstatement related to the existence of inventory as high. This client has incentives to overstate income to achieve profit targets that affect management bonuses. Oversight of the vice president of finance is relatively weak because of a lack of supervision by top management. Other controls are effectively designed.

a. 100% tests of details. b. 50% tests of details, 30% analytics, 20% tests of controls. c. 30% tests of details, 40% analytics, 30% tests of controls. d. 20% tests of details, 40% analytics, 40% tests of controls. b

Which mix of evidence would be most appropriate for the following scenario? Assume a client where the auditor has assessed the risk of material misstatement related to the existence of inventory as low. Top management appears to have a high level of integrity. Management has spent the resources necessary to ensure effective design, implementation, and operation of controls.

a. 100% tests of details. b. 70% tests of details, 10% substantive analytics, 20% tests of controls. c. 50% tests of details, 10% substantive analytics, 40% tests of controls. d. 20% tests of details, 40% substantive analytics, 40% tests of controls. d

Which of the following tasks will an automated purchasing system perform?

a. Apply preloaded specifications and materials lists to the system to start the process. b. Automatically flag invoices that do not reconcile with purchase orders. c. Create change orders and analyze variances from purchase orders. d. All of the above. d

Which of the following expected relationships is reasonable in terms of performing planning analytical procedures in the acquisition and payment cycle?

a. Assume that the company's production and pricing strategies have remained the same during the past year. Gross margin is expected to improve because of the stability. b. Assume that the company has introduced a new product with a low price point and significant customer demand. Inventory turnover is expected to increase and days' sales in inventory is expected to decrease. c. Assume that the company has invested in a new manufacturing process resulting in significantly less waste and overall increases in efficiency during the production process. Cost of goods sold is expected to increase, and gross margin is expected to decrease. d. All of the above are reasonable expected relationships. b

Which of the following controls is related to the payment of inventory purchases?

a. Cycle counts. b. A disclosure committee. c. A three-way match. d. Both a. and c. c

Which of the following statements is false regarding obtaining evidence about internal control operating effectiveness in the acquisition and payment cycle?

a. For integrated audits, the auditor will test the operating effectiveness of important controls as of the client's year-end. b. The auditor will select controls to test that are important to the auditor's conclusion about whether the client's controls adequately address the assessed risk of material misstatement in the acquisition and payment cycle. c. Evidence of proper payment is not necessary for each purchase and payment, but is only necessary for those that are material. d. The auditor will take a sample of receiving reports and review whether independent counts were made of the goods received. c

Which of the following is a common inherent risk relating to accounts payable and related expenses?

a. Management would generally prefer to record assets as expenses. b. Because of debt covenants requiring that the client maintain a certain level of the current ratio, management may prefer to understate accounts payable. c. Ending inventory balances may be valued according to various accounting valuation methods. d. Because of the lower of cost or market requirements, it may be difficult to value accounts payable. b

Refer to Exhibit 11.2 to identify the possible inventory or cost of goods sold manipulation that might occur when inventory is sold.

a. Overstate returns. b. Overcount inventory. c. Not record cost of goods sold nor reduce inventory. d. Under-record purchases c

Which of the following activities is not an activity associated with the acquisition and payment cycle?

a. Receive a customer purchase order. b. Purchase of goods and services. c. Receipt of goods and services. d. Approval of items for payment. a

Which of the following is not an inherent risk relating to inventory?

a. Sales contracts may contain unusual terms, and revenue recognition is often complex. b. Inventory accounts typically experience a high volume of activity. c. Inventory accounts may be valued according to various accounting valuation methods. d. Identifying obsolete inventory and applying the lower of cost or market principle to determine valuation are difficult. a

Refer to the Why It Matters "Inventory Controls at Flow International Corporation." feature Which of the following represents an implication of weaknesses in the company's controls over inventory?

a. The company could not adequately process and account for the valuation of inventory. b. The board of directors fired the CEO because of the internal control deficiencies. c. The company developed a plan to remediate its material weaknesses related to inventory. d. Both a. and c. e. Both a. and b. d

Refer to Exhibit 11.3 to identify which of the following is a typical control associated with the requisition process for inventory purchases in a just-in-time manufacturing process.

a. The store manager's ability to issue a purchase order may be subject to overall corporate limits, usually specified in dollars. b. An agreement is signed with the supplier whereby the supplier agrees to ship merchandise according to the production schedule set by the manufacturer. c. Overall authorization to purchase product lines is delegated to individual buyers by the marketing manager. d. The limits for individual goods can be exceeded only on specific approval by the marketing manager. b

Which of the following is an example of fraud in the acquisition and payment cycle?

a. Theft of inventory by an employee. b. Employee schemes involving fictitious vendors as means to transfer payments to themselves. c. Executives recording fictitious inventory or inappropriately recording higher values for existing inventory. d. All of the above. d

vendor fraud

include schemes involving improper payments to real or fictitious vendors; - can occur through an internal employee or employees (i.e., collusion), - through an outside vendor, or - through collusion between an outside vendor and an internal employee(s)

Purchasing Cards as an Alternative to the Traditional Purchasing Process

some organizations use a purchasing card (P-card) that allows employees to make purchases without using the traditional purchasing process. - If a client has significant purchasing activities with P-Cards, auditors should understand the client's risks and controls related to P-Cards - Organizations issue P-cards to employees so that the employees can easily purchase low-dollar goods and services, thereby eliminating the need for various activities in the traditional purchasing process, including purchase requisitions, purchase orders, and vendor invoices.

Other Controls in the Acquisition and Payment Cycle

●Assigned employees systematically review all products for obsolescence, and follow up with appropriate accounting action. ●Management periodically reviews inventory, takes action on excessive inventory, and manages inventory to minimize losses caused by technological obsolescence. ●Market studies and quality-control tests are performed before new products are introduced. ●Assigned employees closely monitor long-term contracts and excess purchase requirements, and follow up with appropriate accounting action (e.g., recognize potential losses).

An Overview of the Audit Opinion Formulation Process in the Revenue Cycle

●In auditing the acquisition and payment cycle, the auditor will perform risk assessment procedures, tests of controls, and substantive procedures—Phases II, III, and IV of the audit opinion formulation process. ●As part of performing risk assessment procedures, the auditor obtains information to assess the risk of material misstatement. ●Once the risks of material misstatement have been identified, the auditor then determines how best to respond to them.

Performing Planning Analytical Procedures

●Step 1: Identify Suitable Analytical Procedures ●Step 2: Evaluate Reliability of Data Used to Develop Expectations ●Step 3: Develop Expectations ●Step 4 and Step 5: Define and Identify Significant Unexpected Differences ●Step 6 and Step 7: Investigate Significant Unexpected Differences and Ensure Proper Documentation

Processing Transactions in the Acquisition and Payment Cycle

●The acquisition and payment cycle consists of five distinct activities. 1. Requisition (request) for goods or services 2. Purchase of goods and services 3. Receipt of goods and services 4. Approval of items for payment 5. Cash disbursements

Examples of Fraud in Inventory

- Empty boxes or hollow squares in stacked goods - Mislabeled boxes containing scrap, obsolete items, or lower-value materials - Consigned inventory, inventory that is rented, or traded-in items for which credits have not been issued - Inventory diluted so it is less valuable (e.g., adding water to liquid substances) - Altering the inventory counts for those items the auditor did not test count

Common Controls in the Requisition and Purchasing Processes: Inventory Purchases: Just-in-Time Manufacturing Process

1. An agreement is signed with the supplier whereby the supplier agrees to ship merchandise (just in time) according to the production schedule set by the manufacturer. A long-term supply contract is negotiated specifying price, quality of products, estimated quantities, penalties for product shortages or quality problems, and so forth. Specific purchase orders are not issued; rather, the production plan is communicated to the supplier with the specified delivery dates. The production plan serves as the requisition.

trends indicative of fraud relating to the overstatement of inventory

1. Ending inventory increasing faster than sales trends 2. Unexplained reductions in inventory turnover (cost of goods sold ÷ ending inventory) 3. Shipping expenses that are decreasing as a percentage of inventory. 4. Inventory levels rising faster than increases in total assets. 5. Cost of goods sold for financial reporting purposes not agreeing with cost of goods sold for income tax purposes.

Assertions Relevant to Accounts Payable

1. Existence/occurrence - Accounts payable balances exist at the balance sheet date. 2. Completeness - Accounts payable balances include all accounts payable transactions that have taken place during the period. 3. Rights and obligations - The organization actually owes a liability for the accounts payable as of the balance sheet date. 4. Valuation or allocation - The recorded balances reflect the true underlying economic value of those liabilities. 5. Presentation and disclosure - Accounts payable is properly classified on the balance sheet and disclosed in the notes to the financial statements. Completeness is usually the most relevant assertion for accounts payable - primary concern is that the account is understated - managers may not record accounts payable transactions because they do not want to record the associated liability and expense.

Assertions Relevant to Inventory

1. Existence/occurrence - Inventory balances exist at the balance sheet date. 2. Completeness - Inventory balances include all inventory transactions that have taken place during the period. 3. Rights and obligations - The organization has title to the inventory as of the balance sheet date. 4. Valuation or allocation - The recorded balances reflect the true underlying economic value of those assets. 5. Presentation and disclosure - Inventory is properly classified on the balance sheet and disclosed in the notes to the financial statements. The existence and valuation assertions are usually the most relevant for inventory - Existence is a concern because managers can manipulate the inventory account to manipulate cost of goods sold and net income - Valuation of inventory is a concern because inventory may fluctuate in value, and there may be complexities in assessing an accurate value - Rights and obligations can also be a concern; even though a company possesses inventory, that does not necessarily imply the company owns it.

Controls in Automated Integrated Receiving System

1. Long-term contract is signed with vendor specifying: - Quality - Shipping and delivery requirements - Payment terms - Penalties for performance failures - Reconciliations between trading partners for goods shipped/received 2. Quantities are based on production plans or sales programs. Quantities and delivery times are updated monthly or more frequently depending on scheduling and shipping constraints. 3. Price is locked in with a preferred vendor. 4. Goods are delivered to production line. 5. Disruptions of production provide evidence that goods were not delivered. 6. Accruals are set up based on contract (production, sales of goods, etc.). 7. Payments are electronically transferred to vendor based on contractual terms. 8. Processes are described in the contract to resolve difference between goods received and goods that were shipped by vendor.

Procedures for Observing a Physical Inventory Count

1. Meet with client personnel to discuss the procedures, timing, location, and personnel involved in taking the annual physical inventory. 2. Review plans for counting and tagging inventory items. 3. Review the inventory-taking procedures with all audit firm personnel. Familiarize them with the nature of the client's inventory, potential problems with the inventory, and any other information that will ensure that both the client and audit personnel will properly recognize inventory items, high-dollar-value items, and obsolete items, and understand potential problems that might occur in counting the inventory. 4. Determine whether specialists are needed to test or assist in correctly identifying inventory items. 5. Upon arriving at each site: - Meet with client personnel, obtain a map of the area, and obtain a schedule of inventory counts to be made for each area. - Obtain a list of sequential tag numbers to be used in each area. - Observe the procedures that client supervisory personnel have implemented to shut down movement of goods. - Observe that the client has shut down production. - Obtain document numbers for the last shipment and receipt of goods before the physical inventory is taken. Use the information to perform cutoff tests. 6. Observe the counting of inventory and note the following on inventory count working papers: - The first and last tag number used in the section. - All tag numbers and the disposition of all tag numbers in the sequence. - The product identification, product description, units of measure, and number of items on a count sheet. - Items that appear to be obsolete or of questionable value. - All high-dollar-value items included in inventory. 7. Document conclusion as to the quality of the client's inventory-taking process, noting any problems that could be of audit significance. Determine whether a sufficient inventory count has been taken to properly reflect the goods on hand at year-end.

Controls related to Step 4. Approval of Items for Payment

Approval for payment typically involves a three-way match among the vendor invoice, the purchase order, and the receiving report to determine whether the vendor's invoice is correct and should be paid - can be automated or manual - If all items on the three documents properly match, the vendor's invoice is set up as an account payable with a scheduled payment date - The purchasing agent reviews all discrepancies. - The supporting documentation and authorization are then presented to the accounts payable department for payment. Internal controls should assure that all items are recorded in a timely manner, that the authorization process includes a review of documents, and that supporting documentation is cancelled on payment to avoid duplicate payments.

Cost of Goods Sold

Beginning inventory + purchases - ending inventory = Cost of Goods Sold We do not separately discuss assertions for cost of goods sold - The most common concerns for inventory are that purchases are understated or ending inventory is overstated, which will result in both lower cost of goods sold and higher net income

internal control questionnaire for the acquisition and payment cycle

Each negative (no) answer in the questionnaire represents a potential internal control deficiency 1. Are purchases of inventory approved at the proper level? 2. Is there adequate documentation of approvals? 3. Are purchase orders prenumbered and accounted for? 4. Are purchases of inventory made from an approved vendor list? Are changes to the approved vendor list approved at the proper level? 6. Does the company have a formal policy and appropriate oversight about the nature of appropriate vendor relationships and gifts? 7. Are controls over the process of handling returned goods adequate? 8. Is the recording of purchases made in a timely manner? 9. Is the recording of returns made in a timely manner?

In terms of planning analytical procedures, assume that the client has introduced a new product with a low price point and significant customer demand. The auditor would expect inventory turnover to increase and days' sales in inventory to also increase.

The existence and presentation/disclosure assertions are usually the most relevant for inventory.

F (existence and valuation)

Controls related to Step 3. Receipt of Goods and Services

Receiving departments should make sure that: (1) the department accepts only authorized goods, (2) the goods meet order specifications, (3) an accurate count of the goods received is taken, and (4) accountability is established to assure that all receipts are recorded. Methods of recording the receipt of goods include: 1. The receiving department prepares prenumbered receiving documents to record all receipts. 2. The receiving department electronically scans bar codes on the goods received to record quantity and vendor and then visually inspects the goods for quality. The information system prepares a sequentially numbered receiving record for goods scanned in. 3. w may receive goods directly, such as office supplies, and must approve payment for the merchandise. 4. Goods are received directly into the production process.

Typical Controls for Step 2. Purchase of Goods and Services

Requisitions and purchase orders are important controls in the acquisition and payment cycle. - An efficient approach is an electronic system that integrates easily with other financial systems. A significant risk is that purchasing agents may enter into kickback arrangements with vendors. - Controls to mitigate this risk include requiring competitive bids for large purchases and rotating purchasing agents across product lines. - Perhaps the most important control is an authorized vendor database. Company employees cannot purchase from vendors other than those in the database, thereby making it difficult to set up fictitious vendors. Other important purchasing controls include: - approval supplier contracts, - restricted access to the relevant computer programs, - a bidding process for large purchases - monitoring of inventory and purchase levels by management.

Year-End Physical Inventory

Standard procedure for some organizations is to shut down operations at year-end or near year-end to take a complete physical count of inventory - Organizations that use these procedures are typically small organizations using a periodic inventory system, where the perpetual records are not sufficiently reliable, or where fraud risk indicators exist. If the client performs a year-end physical inventory count, the auditor should: 1. Review the client's procedures for the count 2. Observe the client personnel taking inventory to determine if the personnel are following the procedures 3. Make selected test counts for subsequent tracing into the client's inventory compilation 4. Test the client's inventory compilation by tracing test counts to the compilation and independently test the client's computation of extended cost 5. Look for evidence of slow-moving, obsolete, or damaged inventory that the client may need to write down to lower of cost or market 6. Walk through the inventory areas, documenting the first and last tag numbers used as well as the tag numbers not used 7. Observe the handling of scrap and other material 8. Observe whether any physical movement of goods occurs during the counting of inventory 9. Record all high-dollar-value items for subsequent tracing into the accounting records.

Management Assertions and Substantive Procedures for Inventory and Cost of Goods Sold: Valuation

Substantive Audit Procedures 1. Determine whether the valuation method is appropriate for the client. 2. Inquire of production and warehouse personnel about the existence of obsolete inventory. 3. Note potentially obsolete inventory while observing the physical inventory counts. Trace the potentially obsolete items to the client's inventory compilation and determine whether they are properly labeled as obsolete items. 4. Test inventory cost by taking a sample of recorded inventory and trace to source documents, 5. Test for the possibility of obsolete inventory that should be written down to market value:

Accounts Payable: Existence

Substantive Audit Procedures 1. Perform a cutoff test of purchases and cash disbursements

Management Assertions and Substantive Procedures for Inventory and Cost of Goods Sold: Completenesss

Substantive Audit Procedures 1. Perform year-end cutoff tests by noting the last shipping and receiving document numbers used before physical inventory is taken 2. Make inquiries of the client regarding the potential existence of goods on consignment or located in outside warehouses 3. Make inquiries of the client regarding allowances made for expected returns

Accounts Payable: Completeness

Substantive Audit Procedures 1. Request vendors' monthly statements or send confirmations to major vendors requesting a statement of open account items 2. Agree monthly statements and confirmations from major vendors with accounts payable list 3. Examine a sample of cash disbursements made after the end of the year to determine whether the disbursements are for goods and services applicable to the previous year 4. Perform analytical review of related expense accounts, such as travel and entertainment or legal expenses

Management Assertions and Substantive Procedures for Inventory and Cost of Goods Sold: Presentation nd Disclosure

Substantive Audit Procedures 1. Review client's financial statement disclosure of: - Inventory valuation methods used FIFO cost figures and LIFO liquidation effects if LIFO is used - The percentage of inventory valued by each different valuation method - The classification of inventory as raw material, work in process, and finished goods - The existence of contingent losses associated with long-term contracts or purchase commitments - Inventory policy regarding returns and allowances, if expected to be material, for merchandise expected to be returned

Accounts Payable: Rights and obligations

Substantive Audit Procedures 1. Review long-term purchase commitments and determine whether a loss needs to be accrued

Inventory and Cost of Goods Sold: Substantive Tests of Details for Valuation

The auditor will likely use a combination of tests of details and substantive analytical procedures to determine inventory valuation. 1. Direct Tests of Product Costs - auditor should examine underlying supporting documentation (ex. invoices) to determine that the client has recorded the cost correctly. 2. Testing for Obsolete Inventory (Net Realizable Value Tests) - Determining the amount of inventory that the client should write off because of obsolescence - auditor should understand management's process for determining the value of its inventory and gather evidence on potential inventory obsolescence from a number of corroborating sources 3. Testing a Standard Costing System - auditor will inquiry of client management about: - The method for developing standard costs - How recently the standards have been updated - The method for identifying components of overhead and of allocating overhead to products - The methods for identifying variances, following up on their causes, and allocating them to inventory and cost of goods sold - The procedures for assigning raw material costs to products or cost centers 4. Testing a Perpetual Inventory System - auditor will typically test perpetual inventory records to determine that: (1) authorized receipts and sales of inventory are recorded accurately and promptly, and (2) only authorized receipts and sales of inventory have been recorded. 5. Using the Work of a Specialist or Expert When Auditing Inventory

Inventory Controls at Flow International Corporation

The effectiveness of a client's internal controls can significantly influence the audit of the accounts and assertions affected by those controls: material weakness in the control environment within Brazilian operations, and in related monitoring of these operations, that resulted in design and operating control deficiencies, including those related to the physical quantities and valuation of inventory and the preparation and review of income taxes for our subsidiary in Brazil.

Audit Program for Standard Cost System

The program outlines the steps the auditor should use to determine the accuracy and reliability of the standard cost system as a basis for valuing a client's year-end inventory - assumes a standard cost system, but the concepts implicit in the program could be modified for other systems, such as a job cost system - program requires the auditor to understand the client's business process as well as its standard cost system - program requires analyses of both variances and individual cost assignments.

three-way match

This control may be manual or automated. Manual three-way match control - the auditor may test whether the control was operating effectively by taking a sample of payments and tracing them to the documentation corroborating that the control was performed

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